072: A Tale of Two Tax Strategies – 1031 Exchange & Cost Segregation
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If you’re tuning in today, we may know a couple of things about you already…
You’re a high-level entrepreneur dedicated to putting an end to those 2 am night sweats, dedicated to securing wealth preservation, building an inflation hedge, and reaping alllll the tax benefits in the process. 🙌🙌
You’re also probably lowkey obsessed with all things real estate. And from one real estate nerd to another, we know the euphoric feeling that washes over when you realize your investment deal is about to pay off… and big.
You know the feeling when you can see the finish line so clearly. You’re about close on a deal, sell the property, and be rewarded with a hefty return. Cue the movie montage of popping champagne bottles surrounded by friends, family, and teammates all in celebration of this massive win. Liquid gold is in abundance glass after glass.
Then, you’re hit with a punch in the gut, when you realize you’re about to be hit with a massive tax bill to the tune of 30-40% of gains. Talk about a party crasher.
Then comes the frantic call to your CPA where the conversion probably starts with “help” and ends with “me out of this situation.”
Can anyone relate to what we’re talking about here? 😅😅
How do we know so much about this? Wellll we might have been there a time or two ourselves, so here are three things we wish someone would have told us from the get-go.
- Tax strategies are a foundational component of any wealth planning.
- You need a good CPA who understands real estate
- A well-thought-out tax plan at the onset of the investment, scrambling once the problem is already solved is not advisable. Don’t work backward.
So to help you avoid your party coming to an abrupt end once you close a deal, today we’ll be going over two different types of tax-efficient strategies that can be deployed on your next real estate investment.
Basically, we’re going to help you keep the champagne flowing without the shadow of taxes lingering over your head. Before we begin, here is your friendly reminder that we are not CPA’s. Please always consult your legal and tax professional for your specific financial circumstances.
Here’s another disclaimer. You do not have to be a family office or have billions in the bank to cash out on the tax benefits the IRS intends for us to have. All that is required is for us to be educated and take the appropriate actions. 🙌🙌
The two strategies we will be doing a deep-dive on today, many sophisticated real estate investors before us have deployed. Learn from the best, right?
Sure, but with a critical eye. We wouldn’t be the Kitti Sisters without giving you Cashflow Multipliers some pros and cons for each strategy. It’s our belief that informed investors are the best investors.
These strategies are used by family offices as well as ordinary investors like us to save billions of dollars in taxes. Yes, billions with a b. This is what we like to call an equal opportunity tax avoidance plan.
The 1031 Exchange
Have you ever heard of the 1031 exchange? The 1031 is defined as a like-kind exchange in which one swaps an investment property for another. According to the IRS “Whenever you sell a business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale.”
That makes sense, right? Paying a tax on what you gained from the sale?
Buuuut not through the IRC Section 1031 which provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.
Another way to look at this is any gain that is deferred in a like-kind exchange under the IRC section 1031 is tax-deferred but not tax-free.
Exactly. With this provision, the property your gains are being deferred into must have an equal or higher value. Therefore, you can not sell a $500,000 property and buy another one that is $300,000.
For a long time, the 1031 exchange was the best vehicle for taxable burden at the time of sale, and was used to maximize the gains; however, there are a few more caveats a real estate investor must consider before using this strategy.
The first is that a 1031 can be on the complicated side to complete. At the time of the sales, the sales proceeds must be transferred to a qualified intermediary, the funds can not be transferred to your bank or your entity’s bank account. 😌😌
This makes timing crucial in this scenario. If you go this route, you are required to identify the property you want to buy and sell in 30 days. This means you have 30 days post-sale to identify the property you’ll be purchasing next and only 180 days to complete the transaction for the 1031 exchange to be completed.
If you want to see how fast a month can really fly by, this is the strategy for you. If you exceed the 30-day timeframe, then the taxable gain from your property’s sale will become overdue.
The second reason why we advise thinking twice about the 1031 exchange is that a lot of apartment syndicators aren’t too keen on this strategy in general. 1031 exchanges are much more complicated to execute within multifamily syndication which is why most general partners avoid accepting 1031 exchange funds. Thus limiting your options in investing in only the best-in-class properties.
The third reason is you are rolling all of your gains, aka profits, from the sale into another property, you are not allowed to access any of the funds for your personal use. And there’s simply no fun in that. The dream holiday with the family… the goal of paying off debts… with 1031 exchange proceedings, this simply isn’t possible. 🤓🤓
The fourth reason why you should do a double take on the 1031 exchange is that as stated earlier, this is a tax-deferred strategy, not a tax-free strategy. Meaning as you continue to roll over from one investment property to the next and beyond, your taxable burden will continue to snowball.
Okay, we’re at the last point as to why the 1031 exchange isn’t favorable– in case that wasn’t obvious to you at this point! The rumor around the real estate world is that 1031 exchanges are nearing the end of its time. If that ever happens, it will effectively eliminate the ability to continue rolling gains into new investment real estate assets.
To sum this all up, the clear benefit of the 1031 exchange is the ability to avoid paying taxes on the gains, however, you’ll have to follow strict rules and be able to find the like-kind exchange that fits your investment criteria. After all, your criteria is the only one that matters. 😉😉
At the same time, you will have to recognize at some point in the future, the tax bill will eventually become due.
Bonus Depreciation
We said we were going to dive deep into strategies that top real estate investors use, the second one is called Bonus Depreciation.
If you think this term sounds familiar that’s because we’ve dedicated a whole episode to this topic expanding on what Bonus Depreciation is. Check out episode 34, Your Tax Savings Playlist for Keeping More Money in Your Pocket.
For a quick review, Bonus Depreciation became available to us Multifamily Apartment investors as part of the 2017 Tax Cut and Jobs Act passed into law by former President Trump. 😘😘
This law allows for investors in existing properties to push up the 5 and 15 years depreciable accounts into the first year of ownership. What this did was allow for almost $80 to 100% depreciation benefits for our passive investors.
Let’s break this down in more granular terms. Let’s say you invested $100,000 into a Multifamily Apartment and you received 100% depreciation. This means that the syndicator’s CPA will provide you with a K-1 Statement with a paper loss of $100,000.
So, what can you do with this loss? Consider it a win. Because for passive investors, you can apply that loss to other passive income gains. The other benefit is the paper loss can be rolled over to future years when you do have the gains to offset it.
Here’s the best part of Bonus Depreciation, it’s not a tax deferment strategy like the 1031 exchange. Bonus Depreciation is tax-eliminating. On a typical Multifamily apartment investment, imagine your overall return on investment is 100%. 😍😍
This means that you’ve made $100,000 profit from this investment. Since this property already generated the $100,000 K-1 paper loss upon the sales gains, you can use your paper loss to offset the taxable gains… thus walking away and paying zero in taxes even though you just pocketed $1000K.
Amazing, isn’t it? And since this was a tax elimination strategy and not a tax-deferred strategy, that dream vacation with the fam, those debts you want to pay off can happen right away and not be waited on like what would happen with the 1031 exchange.
Soooo in case it wasn’t clear we’re bigger fans of the Bonus Depreciation strategy rather than the 1031 exchange. Any chance we get, we utilize it for ourselves and our passive investors. We get to keep the entire profit tax-free and get to use that profit as we see fit without having to deal with the cumbersome rules like timelines and property hunting as we would with a 1031 exchange. ✨✨
The last note we want you Cashflow Multipliers to be aware of has to do with what the plans of the current administration are. The Biden Administration has proposed a limit to the gains that can be deferred under a like-kind exchange of real estate under section 1031. The new deferred number is $500,000 a year for individual taxpayers and $1 million a year for married individuals filing jointly.
Our prediction is that this will most likely create even more supply constraints as less and less people are willing to sell their homes so they don’t have to pay a tax on it.
So. The 1031 exchange and bonus depreciation. Two tax strategies, two ways to save, but only one that gives you more control. Again, we are not CPAs but we have been around this apartment block a couple of times and have learned not only from our own mistakes but from investors who have gone before us. So now the choice is yours as to what makes sense for you and your investments.
Either way, you can guarantee we’ll be cheering you on and giving you the best, most practical advice when it comes to all things high-level investing, apartment real estate, and more! 🙌🙌
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