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The IRS’ Gifts to the Real Estate Owner

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Tax season 2016 is gaining steam, marking an ideal time to hunt for tax policy that affords compelling after-tax returns for most real estate investments. Fortunately, Congress has over the years carved out a number of tax code benefits for the real estate industry, a few of which are worth mentioning for anyone looking to seize new opportunities in this space.

The most significant benefit is the opportunity to depreciate the value of a building over time, regardless of whether its true value has deteriorated. This allows investors to utilize depreciation — a noncash expense — as a deduction against cash income to reduce or even eliminate the tax burden associated with that income. For example, let’s look at a case of someone who purchased an apartment building for $10 million, with the appraised value of the building at $7 million and the land value accounting for the remaining $3 million. The value of the building can be depreciated evenly over 27.5 years, meaning that the owner can take about $255,000 as a tax expense per year.

Let’s assume further that the net income of the property is $650,000 per year, meaning that if the owner bought the property for all equity, the annual pretax return would equal 6.5% ($650,000/$10,000,000). Without the depreciation benefit, living in a state like New York where the tax rate on income is about 50%, the after-tax cash flow would be $325,000 and the after-tax return would fall by half to 3.25%.

By applying the noncash depreciation expense, the owner would only have taxable income of $395,000 ($650,000 minus $255,000), and would owe taxes of $197,500, making the effective tax rate only 30.3%. With an after-tax cash flow of $452,500, the after-tax yield becomes 4.52%. 

This effect is significantly amplified by borrowing a portion of the purchase price, which is standard practice in real estate. For this example, let’s assume the owner borrowed $6 million from a bank at a rate of 4%, and only invested $4 million of equity to close an apartment building purchase. To calculate the after-tax return, the owner would first reduce the $650,000 of income by the $240,000 of interest that must be paid annually to the bank, which leaves the pretax net income of $410,000, or a pre-tax return on the $4 million of equity equal to 10.25%. Now, the owner would deduct the full amount of the annual depreciation, or $255,000, making the taxable income $155,000, and taxes $77,500, for an effective tax rate of 18.9% . The after-tax return here is now $332,500, which translates into an after-tax return of 8.31%. 

But the benefit doesn’t end there. Let’s say that after 20 years, the owner wanted to sell the property. In that case, he would have taken $5 million of depreciation, leaving the basis in the property at $5 million. If he sold the property for $10 million, he would be left with a $5 million gain. However, as this gain only exists because the owner took a depreciation expense, the IRS would impose a “depreciation recapture tax” of 25% on the $5 million deducted as depreciation. States will also charge tax on this recapture (and any other gain), usually at the same tax rate on ordinary income, which is about 10% in the highest jurisdictions of New York and California.

For federal taxes, this recapture rate of 25% is also a bit of an advantage, as the depreciation deduction would have offset ordinary income taxes in the previous years when the owner deducted depreciation. As the highest ordinary income tax rate is 39.6%, this creates a potential 14.6% savings differential on the depreciation expense.

Despite this advantage, most owners would clearly not wish to sell their asset outright and incur this tax bill. Fortunately for them, there are two strategies that would allow them to greatly reduce the significant tax bill associated with the recapture of the depreciation in addition to whatever capital gains tax might be owed if the property had appreciated beyond its 20-year-old $10 million value. One of those strategies involves the owner refinancing the property with a new mortgage loan equal to 75% of its then value.

The second way an owner can avoid paying the large tax bill associated with the recapture of depreciation is to use a special code in the U.S. Tax Code called the “1031 exchange,” which allows the seller of real estate to completely avoid paying any taxes associated with the sale if he reinvests the proceeds of that sale into another real estate asset within six months.

There are other tax-related benefits associated with real estate ownership, but those are a few the real estate industry should keep at the top of the list when looking for ways to capture the best after-tax returns this year and beyond.