Christopher Miller, MBA | Specialized Wealth Management
Originally Appeared in Apartment Management Magazine
Many of my clients have owned real estate for a long time and enjoy great income from their holdings. Their depreciation deductions, however, are either based on a much lower value or are gone completely. This month, I will talk about how you can possibly gain more depreciation income through selling your property and accomplishing a completely tax deferred 1031 Exchange.
Buying New Basis With Leverage And Creating New Deductions
The investor in our case study purchased his property in 1980 for $200,000. Today, that property is worth $1.3 million, and the loan he purchased the property with has been fully paid off. At a 4% CAP Rate (common here in Los Angeles and Orange Counties), his Net Operating Income is $52,000 annually – fully taxable.
If that investor sold his building and bought a moderately-leveraged (say, 52% loan-to-value, or a 48% down payment) replacement investment, he could buy a $2.7 million building. The IRS would consider the amount of the property funded by debt ($2.7 million X 52% = $1.4 million) to be new basis. If we assign 80% of this value to improvements and depreciate it over 27.5 years, this gives us an annual depreciation deduction of $50,909.
Apply That New Deduction Against Potentially Higher Income Out Of State
If we were able to use positive leverage to buy a property out of state and earn a potential 5% cash on cash return on that $1.3 million of equity, we could generate $65,000 per year of net income. When we subtract our new $50,909 deduction from that, the IRS will only see $14,091 of taxable income. Under this scenario, our investor increased his spendable income by 28% while decreasing his taxable income by 72%! Would you be interested in the potential for a decent increase of income with a substantial decrease in taxes?
More Appreciation Potential Through Moderate Leverage
Us real estate investors understand the power of leverage. The investor in our example saw his property value increase from $200,000 to $1.3 million in just under 40 years – an increase of 650%. Our investor, however, bought this property with a 20% down payment. Therefore, he turned $40,000 into $1.3 million over the same time period – that is an increase of 3250%! That doesn’t even take into account the income that he has enjoyed over the years. By replacing our paid-off property with a moderately-leveraged one, we are giving ourselves a chance to enjoy more appreciation over our ownership period.
A Tax Deferred Is A Tax Disappeared At Your Death
I have heard investors tell me that their heirs will need to pay back their deferred taxes upon their death. Under the current tax code, this is not correct – all these accumulated depreciation and capital gains taxes will disappear when your heirs get a stepped-up basis upon your passing. As I often say – when you die and go to taxpayer heaven, your taxes die with you. Why not maximize your income and minimize your taxes until then?
We all began buying real estate to enjoy the potential for tax-advantaged income and appreciation of our investments. Does the potential to increase both of these interest you? My toll-free number is (877) 313-1868.
