Commercial Real Estate Tax Benefits
Commercial Real Estate Tax Benefits | Photo by Giorgio Trovato
Here is a hypothetical story about David to illustrate commercial real estate tax benefits.
David is a pilot for a major airline based in Denver. Over the past decade, he has worked his way up to becoming a Captain on the A320, earning an impressive $400,000 on his W2 in the previous year. Under normal circumstances, David would expect to allocate around $140,000 of his last year's earnings to taxes, leaving him with roughly $260,000 in after-tax income.
However, David possesses a portfolio of real estate properties and a keen understanding of how to utilize it strategically.
Through the use of accelerated and bonus depreciation, David can generate substantial paper losses within his real estate portfolio.
What's more, he continues to reap profits from his rental properties, which not only sustain his lifestyle but also contribute to property acquisition. Notably, the "losses" he's reporting are not tangible; they exist on paper. While his bank account benefits from the augmented cash flow generated by real estate, his tax documentation paints a different picture – one that could potentially lead to him paying no income taxes for the year 2022.
At the outset of the previous year, David invested in a four-unit property in Tampa, acquiring it for $1 million. He subsequently underwent a cost segregation study for the property. A cost segregation study is a straightforward concept. It involves a report approved by the IRS, prepared by a construction engineering firm, and presented to a CPA. The report breaks down the building's various components, allowing them to be classified under accelerated depreciation categories.
Here's the crux: Residential property depreciation spans 27.5 years. It's important to note that land is not depreciable. So, if the structural value of the $1 million four-plex amounts to $800,000, David can write off 1/27.5th of $800,000 – which equals $29,091 – every year until the structure's depreciation reaches zero on paper.
The cost segregation report, however, introduces a compelling twist. It discloses that of the $800,000 value attributed to David's Tampa property, $430,000 pertains to items the IRS classifies as 5, 7, and 15-year property. These items include roofs, countertops, cabinets, appliances, and more. These components can be appraised individually, allowing them to be separated from the overall structure and placed under their respective depreciation schedules.
For instance, although each of the four-unit's kitchen refrigerators may account for approximately $2,000 of the $1 million purchase price, these appliances wouldn't realistically last close to three decades. Consequently, the IRS permits these items to be removed from the structural value, placing them into a 5-year depreciation category, effectively rendering them nearly worthless after 5 years.
The same approach applies to other items categorized under 5, 7, and 15-year depreciation schedules.
David's cost segregation study reveals $430,000 in individual component values eligible for accelerated depreciation. Remarkably, this entire amount qualifies for Bonus Depreciation.
Bonus depreciation, briefly explained, allows an asset's full cost to be written off in the year it's put into service. For example, if you purchased a $100 printer for your business, standard depreciation would enable you to claim a $20 expense annually for 5 years, until the printer's value is theoretically nil. Bonus depreciation, on the other hand, permits you to claim the full $100 depreciation expense in the very first year.
Introduced by the Tax Cut and Jobs Act of 2017, bonus depreciation applies to any business asset with a lifespan of less than 20 years. It grants a 100% depreciation write-off in the asset's first year of service.
After being in effect between 2017 and 2022, bonus depreciation is now being phased out progressively:
80% for assets placed in service in 2023.
60% for assets placed in service in 2024.
40% for assets placed in service in 2025.
20% for assets placed in service in 2026.
Considering David's property was put into service in 2022, his entire $430,000 in individual component values qualifies for bonus depreciation. This means David can claim the full $430,000 loss for his Tampa four-plex on his 2022 tax return. Assuming the property generated $30,000 in positive cash flow for the year, David ultimately incurs a net loss of $400,000 on his Tampa property for 2022.
Moreover, David invested $200,000 as a down payment for the property, securing a loan for the rest. Importantly, the ability to cost segregate and depreciate an asset isn't contingent upon the amount of debt incurred. In David's case, he utilized $50,000 from his cash savings, secured a $50,000 general-purpose loan from his 401k, and drew $100,000 from his primary residence's HELOC (Home Equity Line of Credit). It's worth noting that the interest on the HELOC is tax-deductible since the funds were directed toward purchasing rental real estate.
Now, let's examine how David can employ the $400,000 phantom loss to offset his ordinary income for 2022.
Ordinarily, David would be unable to use the loss to offset his W2 income. Rental real estate is classified as passive, and a passive loss cannot offset active income.
In essence, passive losses can solely offset passive income, while active losses can exclusively offset active income – the type generated from David's flying activities, also known as ordinary income. The two streams of income remain distinct and cannot be commingled.
However, this situation is far from dire. In fact, the goal for everyone should be transitioning from significant active income to substantial passive income, as the latter is much easier to offset. Notably, it doesn't require continuous labor. The ideal trajectory involves channeling as much active income as possible into the realm of passive income, where it can consistently generate cash flow.
Several avenues exist for David to shift his real estate activities from passive to active, thus enabling him to apply the $400,000 loss against his ordinary income for 2022.
In conclusion, the case of David, our hypothetical pilot, illustrates the remarkable potential of leveraging real estate to strategically navigate the realm of taxes and income. By astutely employing accelerated and bonus depreciation techniques, David was able to generate substantial paper losses within his real estate portfolio, subsequently using them to offset his sizeable W2 income.
This intricate dance between passive and active income, facilitated by the intricacies of real estate investing, offers an inspiring lesson for individuals seeking to optimize their financial standing. David's journey underscores the importance of understanding the intricacies of tax regulations and investment strategies to achieve long-term financial goals.
Moreover, David's example underscores the broader value of real estate as a dynamic vehicle for wealth creation, demonstrating that investments in tangible assets can yield both immediate and long-term benefits. While the intricacies of tax law and real estate investing may seem daunting, they can yield substantial rewards when harnessed effectively.
As you explore the world of real estate and navigate the nuances of tax planning, the case of David serves as a testament to the power of knowledge, strategy, and prudent decision-making. By aligning financial objectives with astute investment choices, one can move closer to the coveted realm of financial freedom and security.
Turbine Capital specializes in commercial real estate syndication deals for pilots and other high-income w2 professionals. If you’d like to learn more about commercial real estate investing, please join our investor club.