Really Trying to understand Depreciation and Recapture upon sale

[Chris Armstrong]

Hey BP 

I have been thinking a lot about the issue of depreciation on rental properties and what happens when you sell one after a long time without use of a 1031. 

I guess I have been thinking about a property that is owned outright and has no mortgage on it. Lets say you bought with cash ($100K) and held for a long time (28 yrs). Would you actually lose some of the original money used to buy the property  if the market didn't experience and significant appreciation over the 27.5 (life of depreciation) years and sold for $100K? I know you can 1031 exchange and avoid it all. It just makes me think there is an optimal amount of time to hold a property for and sometimes that might not be forever. 

I have not really read many posts about depreciation recapture and what that looks like on the selling end of the investment. So, any words of wisdom or good references for this type of thing would be appreciated. Also if you have experience in doing this, it would be beneficial to hear how it played out for you. 

Conversely, How would this look different if the property appreciated from $100K up to $200K over the lifetime of the investment? I assume cap gains would be another chunk taken from you at the end alongside the depreciation recap.  

Thanks 

[Barry Ruby]

Hey Chris,

Depreciation may not be "in the news" on Bigger Pockets or otherwise, but I am learning it can have dramatic positive effects on any income producing real estate property.

I spent the first 40 years of my life developing a wide range of real estate projects. During that time, I built many pro forma spreadsheets and the only line item in them that dealt with taxation was "property taxes". The last 10 years of my life have been devoted to developing utility scale solar projects which deal heavily in taxation issues such as investment tax credits, bonus and MACRS depreciation schedules. 

I recently renewed my activities in real estate which is mostly focused on acquiring and developing multifamily projects. This has has caused me to take a serious look at introducing depreciation into the financial models I build to analyze various projects. 

It is puzzling that little or no attention appears to be paid to depreciation in Realtor's Offering memorandums or Sponsor's projections for projects that are being packaged and sold as LLC shares. Depreciation is a FACT that will have to be dealt with whether it is taken or not for any real estate property and a 25% recapture tax along with capital gains taxes will be due and payable upon the sale of any property held and disposed of after a holding period of 1 year or longer. Failing to take depreciation is foolish in that it provides benefits that enhance project performance. Even if you elect not to take depreciation, you will still have to pay a 25% tax on the depreciation applicable to the property whether it was taken or not.

I began including 27.5 year depreciation to my pro forma models because it is a reality which had a positive effect on raising cash on cash and IRR returns as well as equity multiples. These increases are especially noticeable in the early years of the property's holding period.

I recently began doing a deep dive into the cause and effect of applying cost segregation as a refined method of determining depreciation amounts and its timing. This method significantly affects both the dollar values and their timing which in turn produces significant benefits over and above using a 27.5 year straight-line deprecation schedule.

Cost Segregation involves identifying certain real property assets that can be primarily depreciated in 5, 7 and 15 years. The types of property that fall into these categories are defined by the IRS and can be applied to a property. The best and safest way to know that these factors are being defined and applied correctly is to engage an entity that specializes in conducting what amounts to a forensic engineering study of the property in question. As is the case with any professional service, the quality of their work is directly tied to their experience and integrity, so selecting a qualified engineer plays a big part in the validity of the findings presented and used in the report they produce.

Many Cost Segregation companies offer a "benchmark" study free of charge which will provide a conservative estimate of how much accelerated depreciation will come from segregating depreciable assets. These benchmark reports generally will reflect numbers that will increase if a formal study is conducted. Both the benchmark and formal reports will provide an estimate of the tax savings that can be realized from segregation.

What appears to be missing from most if not all of the Segregation specialist's studies and reports is an analysis that shows the effects the tax savings has on a project's financial performance as measured in industry standard metrics. 

By applying the amounts and timing of the segregated depreciation to the project's cashflows I have found that IRR, cash on cash and equity multiples are improved for both "to be built" and existing properties. One of the principal reasons for these significant boosts to performance has to do with a recent change in the tax codes which allows for 100% bonus depreciation. Specifically, what this provision allows is the ability to take any and all assets that can be depreciated in 20 years or less and write off the entire sum of those assets in YEAR 1 of the project.

By applying the above program, return rates increase by 100's of basis points over not using depreciation at all and or using a 27.5 year schedule. For example, I am working on an apartment project that has a $5,200,000 total cost and a $4,300,000 depreciable cost basis (total cost - land and other non allowable costs). Using a 100% bonus depreciation schedule produces a $1,300,000 depreciation amount in Year 1. In turn, this would result in a tax savings of $450,000 in year 1.

The fact that this savings occurs in Year 1 has a very positive effect on the project's financial performance that cannot be overstated. This injection of cashflow occurs at the time when most real estate projects are showing their lowest income and therefore produces a hit of cash at a time when any project could and can use it the most.

I am in the process of refining pro forma models and vetting these factors and concepts with a CPA that I've used for 10 years for my renewable energy projects to make sure things are as they appear to be. I am also investigating methods of monetizing the tax benefits which could provide a vehicle to introduce equity capital to cover all or a significant portion of the equity required to fund a project.

I would be happy to share my research and analysis to date with anyone interested in learning more about how cost segregation might benefit a project they are working on or just want to learn more about this important set of tools that appear to be widely ignored by the real estate development and investment sectors.