All Forum Posts by: Melanie Baldridge

Imagine making millions of dollars over the course of your career and then having to pay 30-50% every year to uncle sam instead of compounding that cash over time.

This is exactly what real estate professionals have learned to mitigate.

To reduce their taxable income, they just buy a building every year, do a cost seg, and use depreciation to reduce their tax liability dramatically.

Their personal wealth snowball grows much larger and much faster than their W2 counterparts who give most of their money back to the government each year.

Following this strategy as a real estate professional is one of best ways to end up with a much larger net worth at the end of your career.

To qualify as an RE Pro you must:

1. Spend more than half of your total working hours in an RE business in which you materially participate.

2. You must work at least 750 hours per year in a qualified RE business.

So most people who have high-earning W-2 jobs outside of real estate won't qualify.

But the unique thing about RE pro status is that even if you don’t qualify but your spouse does, you can both file jointly and claim the losses from your RE investments to offset your other active income together.

It's an incredibly powerful benefit if you do meet the criteria.

Newton's law of tax: What goes down must come up.

Everyone enjoys the sweet benefits of bonus depreciation, but what happens when you sell?

A post on recapture.

People are concerned about recapture when they cost segregate their improvements and for good reason.

Recapture is real, and those deferred taxes will need to be paid.

But fear not! If you think ahead, you can minimize recapture with the right tax planning.

So what is recapture?

Basically, there's no free lunch when it comes to taxes.

Depreciating property lowers your tax basis. When you go to sell, you're subject to tax on the amount of profit between your adjusted basis and sale price, not your purchase vs sale price.

Recapture is not repaying the depreciation. It's a tax on the gain.

How is this calculated?

To set the scene: A cost seg study breaks your property into two important categories:

1250 "real" property aka the building, foundation and other long life assets.

1245 property aka anything that can be accelerated such as 5, 7, or 15 year property like carpets, cabinets, or other site improvements. This is most of the depreciation you are taking year one.

You can calculate your depreciation recapture by taking the sale price of the asset and subtracting the adjusted cost basis.

The adjusted cost basis is what you paid for the asset plus any improvements you made along the way minus the depreciation you took along the way.

The profit above this original cost is taxed as a capital gain, but the part linked to depreciation is taxed at a maximum rate of 25% under the unrecaptured gains of section 1250.

To recap the tax rates are:

- Sec. 1250 real property: 25%

- Sec. 1245 property and 15 year 1250 property: Ordinary Tax Rates

There are ways to minimize depreciation recapture especially if you know how to work smart with your CPA.

1) Asset Valuation at Time of Sale - Sellers can minimize recapture by reallocating the price of the assets on sale. Your old carpet did not become more valuable over the seven years you owned the property, even if you are selling for a gain. Work with your CPA to allocate more value to land and structure. For larger properties, some of our clients run another cost segregation study at the time of sale.

2) Partial Dispositions - Taxpayers can carve out and dispose of components removed or demolished from a building. By making partial dispositions, you can also avoid subsequent recapture on these items when you go to sell. Note this election MUST be made in the year of the dispositions.

2) 1031 - There's usually no tax on gains or losses when swapping property for similar property. However, even in an equal exchange, recapture tax might apply. But, if a cost-seg study is done on the old property, you can manage Sec. 1245 recapture tax by doing a study on the new property to confirm it has as much or more Sec. 1245 property.

You cannot swap a fully depreciated gas station for a raw piece of land and avoid recapture - you must replace all the 1245 and 1250 property.

3) OZ - Sure you can defer your capital gains for a few years into an OZ fund, but the magic of OZ investments is the ability to achieve tax-exempt growth after a 10-year holding period. Cost seg depreciation is not subject to recapture here! The compliance on these can be tricky, tread carefully or work with experienced funds.

4) Death - Nothing is certain but death and taxes. For RE owners, death allows you to pass assets to your heirs and step up in basis, effectively eliminating recapture. We generally advise our clients to go ahead and pay the recapture rates if death is the alternative.

The good news about recapture - the deductions are a deferred tax liability to you, and an interest free loan from the government. You will never pay more tax in recapture than what you originally deferred, assuming your personal tax rate stays the same. Borrow the money interest free and compound on.

In US tax law, the depreciable lifespan of an asset is defined by its MACRS classification which stands for “Modified Accelerated Cost Recovery System.”

Under MACRS, depreciable assets are assigned to different classes, with each class having a specific recovery period.

When it comes to real estate, here's a general list of eligible assets and their depreciable lifespans that you should know:

Residential Rental Property = 27.5 years

This includes any building or structure where 80% or more of its gross rental income is from residential units.

That means:

- Apartment buildings

- Single-family rental homes

- Duplexes, triplexes, and quadplexes

- Mobile homes (used for residential rental)

- Any kind of residential lodging facility where the primary purpose is long-term rental

Commercial Property = 39 years

This includes non-residential properties like:

-Office buildings

-Retail stores and shopping centers

-Warehouses

-Industrial complexes

-Hotels and motels that do not qualify as residential rental property

Land Improvements = 15 years

These include sidewalks, roads, fencing, some landscaping, and parking lots that are separate from the building.

Personal Property = 5 or 7 years

Personal property used in a rental activity usually has a 5 or 7-year life.

This includes most furniture, appliances, carpeting and various machinery.

Qualified Improvement Property (QIP) = 15 years

Generally, this includes any improvements made to the interior of a non-residential building after the building was placed in service, excluding elevators, enlargements, and the internal structural framework.

Computers and Related Peripheral Equipment = 5 years

Vehicles = 5 years

Note that the land itself is not depreciable.

The tax advantages of buying/holding gas stations are pretty great.

Many of the components of gas stations including pumps, tanks, external parking areas, and other equipment are classified as either 5 or 15 year property so you can bonus depreciate a lot of it (minus the land value) and get significant deductions in year 1.

With the 2025 bonus depreciation rate at 40%, a $1 million gas station acquisition could still lead to $100K+ in year 1 deductions depending on the specifics of your deal.

There are several different types of income in the US tax code.

Two main types are “active income” and “passive income".

Active income is money you earn from working, such as wages from a W-2 job or income from running a business.

Passive income is money you earn from investments like real estate, stocks, or rental income from your RE portfolio where you earn $ without actively working.

Normally, you can't use passive losses (like losses from real estate investments) to offset active income like your salary from a W-2 job.

That is unless you are an RE Pro.

The reality is, that Real Estate Pro status is just a filing status similar to filing married or jointly.

And if you are a real estate professional you CAN use passive real estate losses to offset active income from other sources.

To qualify as an RE Pro you must:

1. Spend more than half of your total working hours in an RE business in which you materially participate.

2. You must work at least 750 hours per year in a qualified RE business.

So most people who have high-earning W-2 jobs outside of real estate wouldn't qualify.

But the unique thing about RE pro status is that even if you don’t qualify but your spouse does, you can both file jointly and claim the losses from your RE investments to offset your other active income together.

It's an incredibly powerful hack if you do meet the criteria.

In other words, marry a real estate agent who's an RE Pro!

We’re being funny because there's still a bit of nuance here.

There are strict guidelines and it's sometimes a blurry line between being an RE pro vs not.

Always talk to your CPA to see if you qualify.

That said, the benefits are definitely worth it if you do.

Bonus depreciation is just a special part of the US tax code.

It allows you to take accelerated depreciation on portions of your property depending on when an asset is put into service.

At the time of this writing, you can write off a huge portion (60% in 2024) of many qualified components that have a useful lifespan of 15 years or less.

That means a certain percentage of things like landscaping, sidewalks, latches, appliances, fences, certain flooring, etc is depreciable in year 1.

The bonus depreciation rate percentage changes yearly depending on the administration and the tax code.

For years 2015 through 2017 first-year depreciation for all the items on a 15-year schedule or less was set to 50%.

It was scheduled to go down to 40% in 2018 and 30% in 2019 and then 0% in 2020.

But then Trump got elected, and he enacted the Tax Cuts and Jobs Act.

That moved the bonus depreciation percentage to 100% from 2017 to 2022.

In 2023 it went down to 80% and it’s currently at 60%.

Depending on who gets elected again, 100% may be back on the table.

Only time will tell.

We know that the US government wants to incentivize more development and ownership of RE.

They want Americans to continue to build and maintain our physical world.

That’s why real estate is one of the most tax-advantaged assets in the US.

Depreciation and bonus depreciation for RE are very positive and will likely continue in the years ahead.

The tax benefits of bonus depreciation can lead to massive savings but losses won’t help one bit if you can’t use them.

Before you buy a cost seg, you need to know the rules:

Tax all starts with the types of income.

1. Active = Income earned from Material Participation.

Whether that's SMB, W-2, contract income, or prof real estate.

This is income where ordinary tax is paid and losses offset other income.

Other sources have certain loss limitations.

2. Portfolio = Income derived from financial instruments like dividends (including REITs), interest, royalties, and capital gains.

Mostly income w/out loss potential, and favorable tax rates.

Cap losses may offset cap gains w up to $3,000 loss. Investment interest can be deductible.

3. Passive income which sec 469 defines as:

1. Income from a trade or business where a taxpayer doesn’t materially participate.

2. Rental activity.

Passive losses may only offset passive income, not active or portfolio.

This is a problem for wage-earning real estate investors.

So HOW DO I GET THOSE DEDUCTIONS?

Become a Material Participant.

We are given a clear framework for determining Material Participation (not passive) in Pub 925.

There are 7 scenarios that will get you there.

Material participation scenarios (Pub 925):

1. 500 hours.

2. Substantially all participation.

3. More than 100 hours and 1/2 of your time.

4. Significant participation.

5. You materially participated in the activity for any 5 of the last 10 tax years.

6. Personal service activity w participation in last 3 years.

7. Continuous participation.

This is great if you are talking about an SMB with effectively connected Real Estate.

Note rental activity is considered passive unless you meet the RE Pro threshold of 750 hours and more than 1/2 your time.

This is the conundrum for passive real estate investors.

If you have a full-time job or a large, time-consuming business it can be difficult or impossible to qualify.

A huge loss from depreciation if you have one LP investment isn’t going to do anything for you.

You won’t be able to deduct it.

So what to do?

A few ideas:

1. Acquire enough RE that it takes you or your spouse more than 750 hours a year and 1/2 of your time to manage.

When you are a material participating RE pro all of your and your spouses’ RE activity becomes active, allowing you to offset RE losses against other active income.

One pitfall of a RE Pro spouse if you are full-time W-2.

Mind Excess Business Loss Rules.

You can only offset W-2 income with $610K in 2024.

For single filers, the limit is $305K.

2. Run an Opco/Propco model.

If your business utilizes real estate as part of ongoing operations you can get all the tax benefits of active RE by having the building purchase and hold the RE.

3. Build an SMB on top of your real estate (the reverse of #2)

Short-term rentals and high owner-participation real estate businesses can have great returns.

Obviously not for you if you just want passive RE.

We are in the deep end here, where each case should be judged on its own facts and merits by your CPA.

You should hire a professional to review your particular situation before you make an investment. It is worth it to know where you stand.

Why I like investing in real estate more than 401(k)s.

Both offer tax deferrals, but here's the difference:

If you're making pre-tax contributions to your 401(k), then withdrawals = ordinary income tax.

With real estate gains, you're paying capital gains tax (which is typically lower).

Plus, RE investors get:

1. Cash flow from their properties

2. The ability to do cost segregation and bonus depreciation

3. The ability to use leverage to acquire more attractive assets and amplify their potential gains

4. A physical property that has real-world use and value vs. holding stocks and bonds

5. The ability for 1031 exchanges

6. Access to Opportunity Zones

7. Step up in basis to reduce your heirs' taxes and more

Too many entrepreneurs make good money each year but pay Uncle Sam 35-50% of it.

It takes a long time to build a massive wealth snowball when 1/3 to 1/2 of your snow gets chopped off each year.

Real estate can help with this.

The best model I've seen is:

1. Earn cashflow from entrepreneurship.

2. Buy real estate as a "real estate professional."

3. Book losses through bonus depreciation.

4. End up with all cash and little to no tax.

Your wealth snowball ends up a lot larger 10 years down the road when you make and keep your money in a more tax efficient way.