Strategy at End of 27.5 Year Depreciation

[Ben Sears]

I was having a conversation with a partner on some of his SFR properties in regard to depreciation strategy. He owns three SFR with a monthly cash flow of ~$2600. Two of the properties are paid off and one has a mortgage. All are nearing the end of the 27.5 year depreciation cycle. So BP, I ask the experts what are your strategies with regard to taxes and depreciation? Does he sell the properties and 1031 into something with more cash flow and depreciation deduction or keep the properties and maintain his cash flow? What are the pros and cons to both?

[Dave Foster]

@Anthony Clayton, unfortunately you do not get a new depreciation clock simply by doing a 1031 exchange.  As @Christopher Smith said, in a 1031 your basis is carried forward into the new property.  So if you only buy as much as you sell you will not get any more depreciation to claim.  But you will defer all of the depreciation recapture along with the tax on gain.

If you want to get access to more depreciation then one of the answers for @Ben Sears friend would be to purchase more than you sell.  The additional amount becomes additional depreciable basis.  So if you have a property that you depreciated down to 0 and sell it for $100K  using a 1031 exchange to purchase a $200K property you're in essence getting a fresh $100K ish of depreciation to claim.  But you don't get to re-depreciate the original $100K.

Ben,  Most investors will follow one of the following paths.  @Steven Ko is spot on - It just depends on where the investor is in their life cycle and what the numbers look like.

1. If the properties are providing a good roi and investor has energy or good management in place then keeping them is certainly an option.  No debt and no depreciation available makes it much like an annuity.  So price and compare the return accordingly.

2. If growth is desired, the investor has energy, doesn't mind debt and needs tax breaks then a 1031 into larger properties allows for geometric growth and new depreciable basis.  The debt service is also an expense paid for by the tenants.

3. If investor is tired and done with active management or can't find good passive management or doesn't like the emotional stress then once again a 1031 in in order to defer all depreciation and tax on gain. But the 1031 would be into a passive vehicle designed to be out of sight out of mind and simply produce cash flow. Like a NNN commercial or if those numbers are too large then a fractional DST or TIC. Fully 1031 compliant but also passive. So just like scenario 1 they act like an annuity.

In all three cases the key is that you avoid the significant tax on depreciation recapture and gain and get to continue using that deferred money to generate returns for you personally until death when it does reset for your heirs and they get the property tax free.