Depreciation benefits - cashout refi?

Question

Hey all, I'm a noob to all this but had a question and looking for some guidance.

I have two out of state properties, both mulifamily. I owner occupied one and bought the other as an investment. The investment property is being remodeled and is almost ready to hit the market. I have no desire to be an out of state landlord or dealing with property mgt companies for both properties.

The other property is a duplex, both sides are being rented. It's worth about 350k, I owe 150k.

My question is how does depreciation work with the property value? Would it make more sense to sell the property outright (I've owned for over 2 years and will make less than 150k so gains aren't an issue) or do a cashout refi to roll into another property and get depreciation benefits from the higher value? I'm not too clear on how that whole thing works or how much the depreciation would actually make a difference. Any guidance is much appreciated.

J Scott Hamilton · Answer

To amplify what @Wayne Brooks said, you have a choice of swapping out of your target out of state property by either selling it or like kind exchanging it via Section 1031. We're assuming here that you dispose of an out of state property and acquire another property closer to you to manage. Whether you cash out refinance or sell the old property and buy the new one, your new property's depreciation would be based on how much you paid for it, not based on how you paid for it.

If you do not have a lot of capital gains nor a lot of accumulated depreciation in the property being sold, then it probably would not be worth it do a 1031 exchange. The trade off with 1031 is you defer taxes on the gain, but you consequently have less basis (cost) in the new property available for depreciation. (I'm mentioning this more for people reading this thread other than the original poster.)

Since depreciation on real estate is more of a "benefit now but pay it back later" proposition, you want to treat its value as means of sheltering current income at the expense of paying a bigger tax bill when you finally sell the property.

J Scott Hamilton · Answer

Depreciation only applies to the buildings you do not use as a personal residence, aka the income properties.  It only applies to the building, not the land.  Usually you can figure the land/building value split by looking at the county tax assessment and using the assessment value to determine the ratio.

You don't have a choice about taking depreciation on business property. If you "don't take it", you'll still be hit with taxes at the time of sale as if you did take it. Keep in mind that depreciation is sort of bogus on real estate, because it assumes the building turns to rubble in about 28 years. We all know that buildings usually sell for as much or more than what we paid for it. So depreciation usually gets recaptured on sale, and makes the tax bill higher.  This is offset by the tax deduction you got from depreciation while you were carrying the property.

If you want to roll over the gains and depreciation recapture in a property you held long term the vehicle for that is a 1031 exchange (like kind exchange). You will need to buy up, and your future property will have less depreciation benefit. 1031 exchanges are tricky, and if you make any mistakes with them then part or all of the exchange will be taxable.  Consult a professional with 1031 experience if you want to take that path.

Scott

Marc Andrew · Answer

@Dave Foster Also something to look into! I like the no tax game... Anything I can do to defer I will!

Dave Foster · Answer

@Marc Andrew,  If the gains justify, it is very easy to structure your sale so that 50% of the gain comes to you tax free under sec 121 exemption and the remaining 50% of the sale goes into a 1031 exchange to defer the remainder of the tax.

Marc Andrew · Answer

@Albert Bui I didnt think of the possibility that 50% could apply to to the rule since the other half would technically be an investment. Something to factor in and get advice from a tax expert.

Albert Bui · Answer

@Marc Andrew well then you best figure out if you want to sell you only have 2-3 years left of IRC 121 to use the exemption since its "lived in the property for 2 of the last 5 years."

Since half of the property is investment and half is primary I am sure the exemption will only apply to 50% of your profit while the other 50% would potentially be taxable at regular long term rates, I would advise to check with a tax professional.

Marc Andrew · Answer

@Wayne Brooks @J Scott Hamilton@Upen Patel Thanks for the depreciation clarifications. Makes more sense now. I'm not sure a 1031 would be in my benefit because I can clear the gains tax free.

@Albert Bui to clarify, I owner occupied the duplex for 2 years, then purchased and moved to the other property down the street after the two years. I have since relocated for my day job and am now across the country. I was referring to the IRC 121 for capital gains for owner occupied residence.

Albert Bui · Answer

@Marc Andrew

You mentioned two out of state properties and you occupy one as primary? How can it be "out of state," and primary? Wouldnt it be "in- state."

What did you meant you live in the property for 2 years and your gain is less than 150k so you'll be okay? Are you referring to section IRC 121 for home owner exemption of capital gains?

Upen Patel · Answer

@Marc Andrew Depreciation is based on the purchase price (structure only not land) and any improvements you make (structure and/or yard). So doing a refi will not increase your depreciation.

Just because you sell you don't have to pay taxes. You can do a 1031 exchange. @Dave Foster is a 1031 expert would be able to guide you better.

Upen Patel, Mortgage Banker

Federal NMLS# 1374243

Wayne Brooks · Answer

To clarify, doing a refi, or an increase in value, has no affect on your depreciation.  Depreciation is based on your actual cost.  Sounds like you don't want to keep the property, so simply paying the cap gain and recapture taxes lets you do whatever you want with the cash.

Depreciation benefits - cashout refi?

Most Popular Reply