Being able to discern a good deal from a bad one is part of making money in real estate – although some of it comes down to luck. The luck in timing and the ability to determine whether a property has enough potential to meet your investment goals are also crucial. However, a sometimes-overlooked component is tax law that can benefit your cash flow.
You are likely familiar with 1031 exchanges and bonus depreciation. The first lets you defer certain taxes when exchanging one property for another, as long as they’re “like-for-like.” The second involves accelerated depreciation expenses for specific parts of a property. While the building itself remains on a standard depreciation schedule, you can claim immediate depreciation for improvements to parking lots and facility equipment.
When combined, 1031 exchanges and bonus depreciation can help real estate investors maximize returns. The strategy frees up cash flow by reducing or deferring your overall tax burden. With extra cash, you can plan for portfolio expansion, additional improvements to an existing property, and building wealth. Let’s look at each of these tools in detail and their potential benefits.
How Bonus Depreciation Works
Bonus depreciation works in tandem with cost segregation. Say you own a commercial building and operate a restaurant out of it. The building has a useful life of 40 years. You’re going to depreciate the building over the course of its expected lifespan, deducting a smaller amount each year for 40 years.
But what about the restaurant equipment? It’s only expected to have a useful life of five years. You can depreciate the equipment’s cost much faster. The same goes for improvements to the interior, such as the flooring and furniture. By segregating your depreciation costs, your deductions will be higher than if you used a standard schedule for everything.
Lifestyle Investing expert Justin Donald points out that some properties, like mobile home parks, benefit more than others from bonus depreciation. “Specialized properties depreciate faster. Top performers include car washes, mobile home parks, specialized manufacturing facilities, and medical offices. Almost all components of these types of properties can be reclassified into shorter depreciation schedules.”
To be eligible for bonus depreciation, the property’s useful life must be 20 years or less. And if you bought the property and started using it after January 19, 2025, the bonus depreciation rate is 100%. If you bought property after January 19, 2025, plan to have a cost segregation study done. It could significantly reduce your tax burden, which could allow you to plan for next year’s operational and investment activities.
The Basics of 1031 Exchanges
When you sell a piece of real estate, you ideally make a profit. Hopefully, the dollar amount meets your expected return rate. One aspect of the sale that could cause the amount to fall short is capital gains tax. The capital gains tax is what you owe on the profits of the sale.
In other words, you don’t always get to walk away with 100% of the return you make. However, your capital gains tax will depend on your income from all sources and on the property’s initial purchase price. The year you bought the property will also influence how much you pay in capital gain taxes. You could end up paying both short-term and long-term capital gains taxes plus a next investment income tax if you have substantial income.
1031 exchanges, where you swap or sell property for similar (like-for-like) property, let you defer capital gains taxes. You can also defer the net investment income tax, state income tax, and the depreciation recapture tax. The depreciation recapture tax applies when you sell a depreciated property for more than its adjusted value.
Say you sell a condo building for $1 million. According to the building’s depreciation schedule, its adjusted value is $500,000. The IRS is going to recover or recapture a portion of the tax benefits you gained through depreciation. A portion of your profit from the sale will be taxed at ordinary income rates, and a portion will be taxed at long-term capital gains rates.
1031 exchanges allow you to plan for tax deferrals if you meet specific requirements. You have to use a Qualified Intermediary and, within 45 days of the sale of the original building, spell out in writing the like-for-like property. You must also buy a similar property within 180 days of closing on the original.
There are other rules, such as having the Qualified Intermediary hold the sale proceeds. The replacement property can’t be valued less than the original. Plus, you have to report the exchange to the IRS. But a 1031 exchange can be a valuable tool for reducing your tax burden if you plan to sell and buy in the same year.
Using Both Strategies
Combining a 1031 exchange and bonus depreciation strategies isn’t too tricky if you plan on acquiring a replacement property. Both strategies can apply to the replacement property if you meet all the qualifications. Yes, you do need to ensure your ducks are in a row.
Consulting with a tax advisor before you seal the deal is strongly advised. Don’t try to wing it or assume you’ll check all the regulatory boxes. Nonetheless, say you’ve got your eye on a replacement property.
A 1031 exchange will let you defer taxes on the building you plan to sell to acquire the replacement. You can then perform a cost segregation study on the property you plan to buy. The study should reveal which components can be placed on shorter depreciation schedules.
With this information, you can calculate your depreciation deductions. Once you’ve acquired your replacement property, you can claim the bonus depreciation rate within the first year of ownership. You’ve not only deferred taxes on the property you sold, but you’ve also boosted your cash flow on the replacement.
You can use this additional cash flow to increase the value of your portfolio. You may also choose to reinvest a portion of the proceeds into the replacement property to increase its functional output or market value. Another possibility is investment in additional property if expansion is one of your goals. Combining 1031 exchanges and bonus depreciation strengthens your returns in both the short and long run.
Leveraging Real Estate Tax Strategies
Multiple factors influence the returns you gain on real estate investments: some you can control and others you can’t. Knowing which tax laws can benefit you, when, and how you exchange property is a factor you can control. 1031 exchanges and bonus depreciation are examples of how leveraging more than one strategy simultaneously can help you meet your investment goals faster. With planning and professional tax guidance, your return potential won’t be left to chance.
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