Where does Bonus Depreciation tax benefit fit into deal valuation?

Question

I'm reading through "Real Estate by the Numbers" -- awesome book! As I'm modeling out my second STR, I look forward to taking advantage of 80% Bonus Depreciation for tax year 2023, and claim that against W2 income.

So let say I use 20% of the value of the home purchase price + improvements as a rule of thumb for the depreciation "loss" that i'll get back against my W2 in April 2024.

My question is: Where do I realize the value of that incremental federal refund check I will get in the mail in April 2024 for my 2023 purchase? Do I put it into an IRR calculation in April 2024? And do I have to account for the impact of the bonus depreciation on my cap gains when I sell the place, say in year 10 of the model?

I'm guessing there's a spreadsheet or blog or something out there that would help... I was kind of hoping it would be in the book. TIA!

(my first post, and just want to add that the biggerpockets community is amazing. 5 stars all around).

J Scott · Answer

First, while I always like to know what the tax benefits are of my properties, I rarely factor the financial benefit into my return calculations when trying to determine if I will do the deal. The main reason for this is that most tax benefits will be recaptured at the end of the deal, so the benefit is not quite as good as it may seem.

To be more specific, consider the situation where you get a lump sum of $5,000 back at the end of the year (or avoid paying $5,000) thanks to depreciation.  Given that you will likely have to pay that $5,000 at some point in the future, the benefit is the arbitrage you get from time value of money. Basically, how much can you earn from that $5,000 between the time you save it and have to pay it back.

Factoring this into your returns is probably more difficult than it's worth. At least for single family and smaller properties. Now, if you are doing larger properties where the tax savings are in the six or seven figures, and you have the ability to push that savings out over decades instead of years, then or may be worth the time to factor that into your returns.

There's a simple way to do this and a more complex way.  The simple way is that you take the year one or annual savings and you factor that into your cash on cash return for that year.  If it's bonus depreciation, it will give you a nice COC bump for a single year, so don't be confused into thinking that's going to be every year.

The more complex, but more accurate way to do this is exactly what I said above. Do a time value of money calculation (PV calculation) on the money you'd save between tax benefit and recapture and add that to the equity that the property would generate for you.

Personally, I treat tax benefits similar to natural appreciation.  I don't assume I'm going to get any or that it will be valuable to me, but I know that anything I do get is a bonus and will make my numbers better than what my analysis has indicated.

I just rolled out of bed, so if that's not coherent, let me know and I'm happy to explain further. 🙂

Jack Martin · Answer

@Ken Press As @J Scott mentioned above, be careful not to allow the "tax tail" to wag the dog. When you find a deal that makes sense without the tax benefits, that's a deal worth pursuing. Let the tax benefits be a bonus and allow the fundamentals of the real estate as an investment to drive your decision.

All the best,

Jack

Greg Scott · Answer

Unless you are a real estate professional or below the income threshold, Bonus Depreciation is probably not going to take much off your W2 income tax bill.  Talk to a CPA.

That aside, I wouldn't intertwine personal taxes in the IRR of the deal.  Once you had a portfolio of properties, any action on one would then affect the return of all your properties, which makes no sense.

John Teachout · Answer

I think a lot of people are looking at bonus/accelerated depreciation and are not fully considering that eventually the IRS will want their share. Recapture can be a big bill upon sale. Sure there's 1031 options but even that is just kicking the can down the road. Depreciation is a tax deferment, not a deduction.

Ken Press · Answer

Thanks @j Scott! Really appreciate the deep response, and the effort to correct typos.

One more arbitrage question. In addition to the TVM of getting money now (or next April 15) w the bonus depreciation tax write off in year 1… Would I also be gaining the difference between bonus depreciation money now offsetting ordinary income at a 37% tax rate vs the future sale recapture at capital gains rate of 25% (assuming I don’t 1031 into the next property)?

Example: On a $100,000 depreciation that would mean paying $25,000 in taxes at the future sale date vs $37,000 tax offset today. So an additional net $12,000 in todays dollars

Do I have that right?

J Scott · Answer

Though keep in mind that it's quite possible that depreciation benefits could completely offset all income.  And if you had paid estimated taxes throughout the year, you would be getting a refund for some or all of it.  Even if you didn't pay estimated taxes, you could reduce your tax burden to $0.

I typically have seven figures in depreciation each year, which means I can make a lot of income before I have to start paying taxes. And every dollar I don't give to the IRS this year, I can reinvest and leverage until the day I need to recapture.

Julio Gonzalez · Answer

@Ken Press Great questions. I think a common misconception with cost segregation studies is that you will receive a refund check as a result of the study. Cost segregations allow you to accelerate depreciation which is a tax deduction and therefore reduces your taxable income. So rather than getting a bigger refund check, you are simply writing a smaller check to the IRS.

J Scott · Answer

Sorry for all the typos (I use voice to text).  I just edited and corrected the mistakes...  :)

Where does Bonus Depreciation tax benefit fit into deal valuation?

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