All Forum Posts by: Melanie Baldridge

Understanding the IRS Section 179 Election to Expense Depreciable Assets is crucial to making the most of your tax strategy.

This provision allows taxpayers to expense certain qualifying assets upfront instead of depreciating them over a period of years.

However, there are several factors to consider when using this tax tool.

Let’s break down how it works:

What Is Section 179?

Section 179 of the Internal Revenue Code allows businesses to deduct the full purchase price of qualifying equipment and software up to an annual limit.

In 2024, for example, taxpayers can expense up to $1,220,000 of qualified assets.

This election can apply to many types of tangible personal property, such as machinery, equipment, and off-the-shelf software, which are used predominantly in your business.

Limits on Section 179 Expensing

As attractive as Section 179 may seem, there are limits.

For tax year 2024, the maximum investment limit is set at $3,050,000.

If your business places more than this amount in service, the amount you can expense is reduced dollar-for-dollar over this threshold.

In addition to the dollar and investment limits, the amount of your Section 179 deduction cannot exceed your taxable business income for the year.

This means that even if your business invests heavily in qualified property, the deduction could be limited by the business’s profitability.

Also, not all property qualifies for Section 179.

Real property, like buildings and structural components, generally does not qualify unless it is "qualified improvement property."

Examples of qualified improvement property include improvements made to the interior of nonresidential real property, such as HVAC systems or alarm and security systems.

We refrain from making direct recommendations on Section 179 because we believe this decision is best made by the CPA, who completely understands the client’s overall tax situation.

The decision to elect Section 179 is deeply tied to broader tax implications, including other deductions, income limitations, and future business planning.

Your CPA has a holistic view of your finances and can help you make the right choice.

TLDR:

* Section 179 is a powerful tool for business owners and real estate investors, allowing immediate expensing of qualifying assets in the year they are placed in service.

* Annual limits apply to how much can be expensed, with the 2024 cap set at $1,220,000, and investment limits that start to phase out when more than $3,050,000 of property is placed in service.

* Not all property qualifies for Section 179. Typically, tangible personal property qualifies, but real property does not unless it meets the definition of qualified improvement property.

* The importance of consulting a CPA—The Section 179 election can be a valuable tax strategy, but it’s also complex and should be made in the context of your entire tax picture. Your CPA is the best resource for guiding you through this decision.

Real estate is one of the most tax-advantaged investment strategies out there.

Real estate pros buy property using leverage and bonus depreciate to perpetually defer taxes.

Making millions a year and often paying $0 in taxes.

Short Term Rentals supercharge this:

RE pros use cost segregation and bonus depreciation combined with leverage to create massive losses with minimal cash.

Combined with 1031s and snowballing, you create a business that never pays tax.

Problem is only "RE pros" get to do it.

There are 3 income classifications in the US - Active, Portfolio, and Passive

Active income is income derived from your job, or normal trade or business.

Portfolio income is derived from bank instruments - stocks, bonds, etc.

Passive income is income earned from investments.

Active losses can wipe out both passive and portfolio income, but it doesn't work the other way around.

Portfolio (capital) losses are limited to $3,000 annually.

Passive losses can only be offset by passive gains.

Real estate rental income by its nature is deemed passive per IRC Sec 469

One way to get around it is to become a pro - spend more than 750 hours or 1/2 your time in real estate.

But most folks aren't real estate pros. Or they have jobs that won't allow them to commit the time.

Therefore, partners who write checks into real estate deals cannot use the wonderful passive losses created to offset their ordinary income from their job or business.

But what if I told you there might be a way to use leverage and depreciation even if you aren't a pro?

Enter the STR:

Short term rentals are defined by the IRS as properties with an average stay is less than 7 days.

They buck the passive rules for 469, and are considered active.

BUT - As with any other business, to deduct the losses the owner must materially participate.

Material participation is achieved by:

1. Spending more than 500 hours in the business

or

2. Spending more than 100 hours and more than anyone else, or substantially all the time in the business.

So if you own an STR and meet the test, you can set up a tax deduction machine.

Some issues -

- You have to count your time, and the time other people work in the biz (cleaning, maintenance, etc..)

- If use the property more than 15 days or 10% of the time it becomes a residence

I suspect this is part of why the STR trend has picked up so greatly amongst professionals working in tech.

The ability to use leverage and reduce taxes in your highest earning years without having to put money into qualified retirement accounts is a great way to build wealth.

So - If you own an STR:

1. Keep good accounting of your money and your time spent on the business.

2. Do not stay in the property for more than 15 days.

3. Complete a cost seg study - combined with leverage it is feasible to deduct your entire equity contribution in year 1.

Also follow me for more insights around cost segregation and real estate taxes!

There is a unique tax deduction in the US called a “conservation easement.”

It was designed by the IRS to encourage real estate owners to make pristine land, that could be enjoyed by the public, a conservation ground, and thus un-developable.

In return, the landowner could treat the act of granting a “conservation easement” as tax-deductible.

It would be similar to a charitable gift.

In a conservation easement, a real estate investor “donates” development rights on a piece of property to a qualified charity, public agency, or land conservatory.

In return for the donation, they get a tax deduction as if they gave cash to a charity.

Let's dive into the basics.

Let's say you buy a 20-acre piece of real estate that includes a 5-acre self-storage facility.

The rest of the land isn’t really easy to build on so It is virtually worthless to you.

Let's say you paid $5MM for the facility based on NOI and the land came with it, virtually free.

So you decide to get the property appraised for development value and donate it to a land conservatory.

The appraiser runs some comps on other land recently purchased to get you a value.

They come back and tell you the current development value of that land is $50,000 an acre.

$50,000 times 15 acres equals $750,000.

You give that $750k development right to an agency, and It is treated as if you gave $750k to the Red Cross.

It's a huge deduction.

Depending on your tax bracket, that tax deduction could be worth several hundred thousand dollars to you.

It's a pretty big deal.

Imagine you bought a property for $2M.

The land (excluding any structures) is valued at $400K.

Since land is not depreciable in the eyes of the IRS, we subtract the land value from your purchase price to get your depreciable basis.

Your depreciable basis is simply where a cost seg engineer starts from when allocating your eligible assets into either 5, 7, or 15 year property.

In the scenario above, your starting basis would be $1.6M since your basis = your purchase price - the land value.

Having an accurate land value is essential to getting your depreciation/bonus depreciation calculations right.

This is the starting point for any cost seg study that you do.

Here’s the answer:

To qualify as a Real Estate Professional (RE Pro) in 2024, you need to meet certain criteria set forth by the IRS.

Here are some of the key requirements:

1. Material Participation in a Real Estate Trade or Business.

This is pretty straightforward but you must materially participate in a real property trade or business, such as development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.

2. Time Requirement.

You must spend more than 750 hours in real estate activities during the tax year.

And you must spend more than half of your personal service hours in real estate activities.

3. Joint Filing Considerations.

If you are married and file a joint tax return, either spouse can qualify as a real estate professional. However, hours cannot be combined between spouses to meet the 750-hour requirement.

4. Aggregation Election.

You can elect to aggregate all of your real estate activities into a single activity for purposes of meeting the material participation requirements. This election must be filed with your tax return.

5. Proof of Services.

Be prepared to provide proof of the services performed and hours worked, especially if the IRS requests this information during an audit.

6. Exclusions.

Certain work, such as time spent as an investor reviewing financial statements or participating in management decisions without active involvement, may not count towards the 750-hour requirement.

As always, talk to your CPA to make sure that you meet the criteria above.

If you do, there are many helpful benefits to you.

Here’s how in 6 easy steps:

1. Check local regulations.

First, verify that your local zoning laws, HOA rules, or condo bylaws permit renting your property.

2. Update your insurance.

If they do, inform your insurance company about the change in your property's use. You will have to switch from a homeowner’s insurance policy to a landlord insurance policy which covers rental specific risks.

3. Let your lender know.

Notify your mortgage lender about the change if required by your loan agreement.

4. Get a cost seg study done.

Once you convert your primary residence into a rental, you can get a new cost seg study done and take bonus depreciation to offset the new rental income.

5. Market your property and get tenants.

This could be through flyers, direct mail, rental marketplaces, newspaper ads, or on social media etc.

6. Hire a property manager.

If you choose to self-manage, be prepared to handle tenant comms, maintenance requests, and rent collection.

Otherwise you can hire a property manager to do all of that for you. Reminder to always keep a record of all rental income and expenses for tax purposes.

And that’s pretty much it.

If you think about your career and your journey to build wealth over a long time horizon, this is still the strategy that I like most:

1. Start a business that produces cashflow.

2. Use your personal cashflow to buy or invest in real estate that produces more cashflow and has other great tax benefits.

3. Reinvest whatever money you save on taxes via depreciation back into more real estate or property improvements to continue increasing the size and quality of your portfolio.

4. Occasionally sell and 1031 into more attractive assets.

5. WAIT as long as you can and don't die.

This is easier said than done but it's a proven model to create wealth in your life that has worked for many people over time.

Here is a framework to think about how buying properties creates the most tax efficiency for you.

The 6 levers of depreciation:

Lever 1 - % of Land

One of the components of a property is land.

Land is NOT DEDUCTIBLE, so low value land properties mean more tax deduction.

A value of your overall purchase will be assigned to the land or lot.

You receive no near-term tax benefits for buying land.

For example - If you buy a $2 MM industrial building outside a rural town on 5 acres, the land value could be $5k an acre. The land represents ~1% of the purchase

On the contrary - if you purchase a $2 MM shack in manhattan on a postage stamp lot, the land could represent 99%

Lever 2 - % of the property with a shorter useful life.

Not all parts of a piece of real estate are depreciated at the same speed.

Certain personal property assets have SHORTER lifespans in the eyes of the IRS vs the standard 27.5/39 year lives

Properties with tons of this often have:

- Over-developed land sites (hardscaping, pools, retaining walls)
- Fancy Fixtures
- Fancy Furniture (STRs!)
- Lots of Equipment (R&D Facilities, Car Washes)
- Gas Stations (100% 15 year properties)
- Movable walls (self storage)

You can find anywhere from 15-35% of the purchase price of a typical apartment complex is this type of property.

More of it means less tax for you from higher depreciation amounts!

Lever 3 - % of Leverage

This is a big one! The more leverage (debt) that is applied to a property or deal, the more cost savings you will get up front relative to the equity you put in.

Let's say you buy a $10 MM dollar deal that has $3 MM of year one depreciation.

If you used $7m of bank debt and only $3m of equity, your year 1 deduction will equal the amount of money you put into the deal!

If you had used cash for the full $10 m, you would get a deduction worth 30% of your investment.

(remember, more debt = more risk)

Lever 4 - % Tax Rate

Another HUGE consideration.

Depreciation is a deduction that you are allowed to take at your Marginal Tax Rate. Similar to a 401k, part of the strategy is a tax arbitrage.

It is a much better outcome to take the deduction at 37% rather than 24%.

Lever 5 - % Bonus Allowed

In 2023 Bonus depreciation has been limited to 80%, and will continue to ramp down 20%/yr until it hits zero in 2027.

Bonus depreciation has come and gone in the past, but the more you get, that first year payback is higher and higher.

Lever 6 - % Payback Ratio

Ultimately how much you save vs. how much you pay matters.

Caveat - Talk to your CPA before you purchase a cost seg study.

You need to have a way to monetize your losses through

1. Being a Real Estate Pro
2. Having Passive income you can offset
3. Using the STR (or carwash, etc..) Loophole

Don't cost seg if you can't use the losses!

You’re going to pay this entity more money than anyone else in your life.

If you're successful, that could mean that you will pay them millions over the course of your business career.

So who is “this entity?”

That's right. Good old Uncle Sam.

For most folks in the US, taxes are anywhere from 30-50% of their gross income every year.

To protect yourself, you should do 2 key things.

1. Study and learn how the tax code works and where you might be able to optimize and save.

2. Hire the very best people you can to advise you based on your exact situation and circumstances and then let them help you implement a solid tax strategy that makes sense for you.

Regardless of your position and role, this is without a doubt one of the highest leverage activities that you can do.

Remember, it's not just about what you make, it's about what you keep in the end that matters most.

Quote from @Marc Lock:

How is material participation defined?

Once a taxpayer meets the REP status, do they need to materially participate in each property?

No. You don’t have to materially participate in each property.

If you own multiple properties, you can elect to group them together as a single activity for tax purposes, known as a "grouping election.”

This allows you to meet the material participation requirements based on your combined activities across all the grouped properties.

But yes, RE Pros still have to spend over 750 hours in real estate activities during the year (and more time doing this than anything else) to be considered material.