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The Depreciation Dilemma: Advanced Real Estate Tax Strategies | Ep 20

James and Jessi thinking and laughing
In this episode, we delve into the complexities of real estate investment, focusing on taxes, depreciation, and the strategy of 1031 exchanges. James shares a personal experience about considering selling a property and the tax implications involved, explaining the benefits of 1031 exchanges, how depreciation factors into taxes, and strategies to minimize tax liabilities. The discussion includes technical explanations of capital gains tax vs. ordinary income tax rates and how depreciation recapture works.

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Show Notes

00:00 Welcome

01:08 Diving Into Taxes and Real Estate Investments

11:06 Strategic Tax Planning with Real Estate Transactions

Key Lessons

  1. Understand the game behind depreciation: When selling properties, always account for the potential tax implications of depreciation recapture, as it might impact your financial outcomes more significantly than anticipated.
  2. Plan for depreciation's payback: The tax breaks from depreciation today lead to recapture at sale, impacting your profits. Factor this into your exit strategy as a financial reconciliation, not a penalty.
  3. Prioritize your tax strategy: When selling a property, depreciation recapture taxes are applied first to the portion of your profit equivalent to the depreciation claimed. This is taxed at a higher rate than most long-term capital gains.
  4. Choose a CPA who knows real estate: Partner with a CPA who specializes in real estate to navigate complex scenarios like depreciation recapture. Their expertise isn't just a service; it's a strategic asset that can save you substantial money in taxes.

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Read the Transcript

James: Welcome to the Furlo Capital Real Estate Podcast where we talk about the intricacies of passive real estate investing. And our mission is to equip people to invest wisely in both properties and people so that together we can build our wealth while improving communities. I'm James and this is my wife, Jessi.

Jessi: I'm here and it's baseball season. It is baseball season. If we ever get to play baseball. I was, I was, scheduled. So I guess games haven't started yet.

James: Correct. Those start in May.

Jessi: Right. And for our son. I mean, I have no idea about like.

James: Real baseball? Yeah, real baseball's already started. All

Jessi: right. That's what I figured.

James: Or it's spring camp or spring training or training or I don't know. Yeah. Recruiting or whatever. It's started.

Jessi: Anyways, it's baseball season. So I was like pumped to take Samson to practice and it got rained out and I'm like, we live in Oregon. Like, when are you ever going to play baseball if you cancel everything when it's raining in the spring?

James: Well, the hard part isn't necessarily the kids. It's the fact that it will destroy the field.

Jessi: Yeah. And you just

James: don't, you just don't want a bad field.

Jessi: I'm like, just. Let's put in some AstroTurf so we can actually play some baseball. Yeah,

James: just talk to the city and tell them to get on that.

Jessi: Yeah, right. Well, we are talking about taxes.

I mean, it's a different type of taxes, but I feel like taxes could be used for that.

James: Yeah. Yeah. I'd rather them not. This is your son

Jessi: we're talking about. I don't know, he'll

James: survive. Make him a muddy mess. He'll survive. Yeah, I played on a regular field, so it's all good.

Jessi: Yeah.

James: But yeah, we are going to talk about taxes, because I had a really interesting conversation earlier in the week, where I learned something, and that doesn't happen very often.

Imagine that. I know. You learn

Jessi: new things all the time.

James: Yeah I do, and so I just wanted to share it, because I like to think that I know a lot about real estate and the numbers behind it. Yes. And this one, somewhere I missed it all together. Okay. And I was totally surprised by it. This is

Jessi: not like a new tax code or something like that.

This has been around for a while. No,

James: it's been around for a very long time. Okay, all right. Yeah, yeah, yeah. So so here's the situation. I'm considering selling one of my buildings set of warehouses. It's on I five. It's got a super sweet mural with a bald eagle and an American flag behind it. I'm hopefully by the time this airs, I've already got it on the contract and we're moving forward to be awesome.

But I, when I bought it, I did a 10 31. And here's where things get a little bit complicated. So we owned three other properties and those properties all went up in value and you got to pay taxes on that value. Typically when you sell,

Jessi: right, but it'll gains, right? Gains. I understand that.

James: Yep. And, and so.

You can, instead of paying your taxes on those gains, you can roll those into a future property and just kind of keep rocking and rolling. And the game that some investors play is they just, they never outright sell. And so they always like, cause once you, once you die, It kind of, everything gets reset for your kids essentially which is super nice.

And so then they can sell and they don't have any capital gains technically. It's a weird, it's one of those tax legal tap tax loophole things that help the wealthier get wealthier type things. So here's what I learned. Super interesting is so we bought those properties and we had about 200, 000 worth of equity in each one.

Jessi: Okay. And so

James: I was able to roll 600, 000 into this warehouse. And so even though I bought it for like 2. 6 million, it was as if I bought it for 2 million. It's kind of the math to think about it. So I already had a built in 600, 000 worth of. Equity. Equity carryover.

Jessi: All right.

James: Essentially. Kind of how to think about this.

And so then if I were to sell that one outright and just do nothing with it, and so I would, again, it would be the delta between the new sales price and essentially 2 million, not the 2. 6. Roughly speaking is how to think about it. So here's what I learned because with this warehouse, I also have a piece of land, which is technically separate and was outside of this initial exchange.

So when I rolled over that 600, 000, I did that to the warehouses and then I separately bought a piece of land. And didn't roll anything over. It wasn't part of this exchange thing. And so we were talking with them and I was like, well, it'd be nice to take out some cash from this and not just roll over a hundred percent of it.

Did you give us some working capital to do some other projects and things that we want to do? And so the question I had was, okay, how do I structure this to minimize my taxes? And I talked to a CPA. And it was really interesting because I was like, does this even matter? Like, can I just bundle them all together and just sell it all as at one and I just pay my capital gains tax as is.

And he went, I would not do that. And I was like I don't know. Okay, cool. Tell me more. He goes, you want to separate these things out and whatever cash you take out, take out from the land,

Jessi: not from the

James: 1030, not from the 1031. And here's why I didn't know this. So that 200, 000 in each property is there's two parts to it.

There's the genuine, the value of the property went up, but then there's also depreciation that happened. Okay. So, all right. So stick with me. I'm going to use a hypothetical example here just to kind of help us out. So we bought our very first duplex for, let's just say 200, 000. I'm going to round here just to help out with the numbers.

We bought it for 200, 000. We then sold it for 100, 000. Again, I'm going to, I'm going to exaggerate some numbers to help this work. Okay. We then sold it for three 50.

Jessi: Okay.

James: Okay. But in that process we had depreciated 50, 000 from the property. Okay. So our, is that, is that math going to work for me? No, that math isn't going to work.

I don't want to think about this. Okay. Another way to think about it. So bought it for 200, 000. Sold it for 400, 000. And that's that 200, 000 that was in there, right? That's that 200, 000 of capital gains that we were talking about. That you could roll over. That I could roll over. Well, it turns out that's not the only thing that rolled over.

That was the cash that I was able to apply to roll over. Okay. But there was also depreciation that happened in that property in the time that we owned it. Okay. And so even though we bought it for 200, 000. It was as if, and here's where I'm going to exaggerate some numbers just to make it easy. It was as if we had depreciated 50, 000 for it.

And so what actually rolled over from a tax perspective wasn't. The 200, it was two 50.

Jessi: Does that make sense?

James: From a tax perspective, the cash was 200, which is what I ultimately used to buy the place.

Jessi: Yeah,

James: but there's this, this phantom depreciation that continues to carry over. So here's what's interesting.

Let's pretend there's no 10 31 at all that happened. Okay. And let's just say we, we bought that duplex for 200 and we sell it for 400. Okay. And we had depreciated 50, 000. Okay. Here's what's interesting. That first 200 capital gains is taxed at the capital gains tax rate of

Jessi: 15%,

James: but that depreciation called depreciation capture is not taxed at the capital gains rate.

That is taxed at your ordinary income rate at a max of 25%. So let's say that you're a high income earner and your normal tax rate is 34 percent and you're That 50, 000 recapture is taxed at, in this case it would be 25%, because it's that max amount. Not the 15%. Okay, you're giving me squinty eyes.

Jessi: Yeah.

I just don't understand why they tax depreciation. Doesn't make any sense to me. Because depreciation isn't taxed. Income.

I mean, I maybe from a tax perspective, they count it as income. Well, it's as if it were, it

James: is. So what it does is it offsets your regular income when you, so, okay, good. Okay. I see where you're going with this.

So during that time where you depreciated the 50, 000, you had tax returns and you were paying your taxes and, and what they were doing is saying, Hey, you had a job. Congratulations. You had to pay taxes, but then you went, Oh, but I had depreciation and it decreases.

Jessi: The amount of taxes you had to pay.

James: Yeah.

And so it's essentially, it's, it's re rebalancing that out. So when you pay depreciation or when you take depreciation. Here's what I'm learning about this whole process, and again, I don't know how I missed it, but whatever. It's as if you are, it's an expense, but, you know, and so you get to treat it as such, so you pay less in taxes, because you had a bigger expense.

But then when you sell, it's, they're like, well, we want to like, that expense, now it like reconverts into income, and you have to pay for it. It's an interesting, like,

Jessi: I didn't realize that's how depreciation worked.

James: I didn't realize that you were taxed at the ordinary income tax rate. That, to me, was the surprise.

I always thought it was all going to be, like, considered capital gains at 15%. I was like, oh, this is an extra 10 percent here that I gotta think about. Plus whatever organs. But only on the depreciation amount. Only on the depreciation amount. And what I'm, what I'm still trying to square, my CPA didn't have a great answer for me.

I said, well, there was this whole bonus depreciation thing that everyone's getting all excited about. You can depreciate up to 100 percent of the property at once in like a single year. Yay! I was like, that sounds great, but like, you're telling me. Except on the flip side. Yeah, when I sell, like, I gotta pay all that back.

And that could dramatically change it. And he goes, well, it was that. It is even more nuanced than what everyone's saying because what he's talking about with bonus depreciation is like, it's not just on the entire building, it's like, it's because he goes, that's way more complicated on what that is. And I was like, huh, that's interesting that it's not.

the panacea that everybody thought it was outside of the thought being, well, if I save the money on the taxes now,

Jessi: that gives

James: me more money to invest now

Jessi: today.

James: And so if I can get a higher return, cumulative return, then it's totally worth it. It's

Jessi: like such a game to play though. I mean, that's, that's the whole thing that.

I didn't like about considering depreciation when we were initially investing because you were like, oh, there's this other magic number here that you can factor in and it makes the property look better because you can lower your expenses. And I was like, no. I kind of, like, let's take that out of the equation for a minute.

Does it make money without that magical thing? Because then it will be even better if it does.

James: Which, by the way, I still underwrite it that way. I still don't consider it, but mostly because now it's all about, on your personal taxes, like it's not necessarily the property itself. Yeah. It's super interesting.

I'm just offsetting expenses. You are required, there is a minimum amount of depreciation that you are required to take. You don't have a choice. Sure. But if you wanted to do more, government would let you. It's kind

Jessi: of interesting. Okay, so for this 1031,

James: So, yeah, yeah, yeah, so here's the relevance behind it.

So, had I, thank you for that. I'm still going,

Jessi: okay, like, back to the warehouses. So,

James: let's just say we want to take out 100, 000 to do something with

Jessi: it,

James: right? Yeah, reinvest, whatever. Get a new roof or something on this house, whatever. So, what he says is, the way that it works is, you, they, how do I say it, they start with whatever the biggest tax thing is first.

Ooh. So, you pay taxes on the depreciation first. Cause I was like, oh, you know, I was like, well I'll pay my capital gains tax on the 100, 000. He goes, no you won't. You will pay the depreciation recapture first. And then, if there's any left over, you'll move into the capital gains rate. And so he's like, so you will pay the 25 percent on it.

He goes, however. If you do the land, you don't depreciate land. Cause in theory, it never wears out. He goes, so you have no depreciation on the land. That would be the pure capital gains amount. Interesting. It's like, so whatever it is that you want to take out, sell the land for that amount and pay your 15 percent capital gains.

He goes, that is your cheapest way to go. It was because if you bundle it all together. You wouldn't have a choice, you'd have to do the depreciation recapture first.

Jessi: So, question, if you have, if you have the warehouses and you're 1031ing, I just made that a verb. Sure, that's a thing. If you turn 31 those into a different property, and you have the land, let's say you have the same buyer.

James: Okay, yeah. Is it two separate

Jessi: transactions?

James: Essentially. Yeah.

Jessi: Interesting.

James: And I could take the land and like add it to a future, like I could 1031 the land into a new deal.

Jessi: Huh.

James: That is combined with the warehouses. Like I could. Like

Jessi: our three properties that we did together.

James: Correct. So

Jessi: you could do both of those and the value would go towards this other property.

And if I

James: wasn't taking any cash out, none of this would matter. Right. They'd be like, yeah, I just bundled it all together. Just bundle it. Doesn't matter. But the fact that I. Okay. I floated the idea of taking some cash out. That's where all of a sudden everyone went, Okay, hold on. Like, how you do this is important.

We're talking about an extra 10 percent in taxes here. That you gotta worry about. Yeah. Yeah, yeah. Oh yeah, I know. This is why you have CPAs and they, you pay them money to have conversations. Ha ha ha. Yeah, dude. I get it. It's a thing.

Jessi: I didn't think I was gonna understand that, but I understand the math.

I'm glad that you

James: did. There's one other interesting thing thing. No, I'm gonna let it go. Oh I'm trying to think. Yeah, I'm gonna let it go. You cannot, I guess the one thing is if you're, if you're doing a syndication, you are technically not owning the property. You are owning a business that owns the property.

Jessi: Right.

James: And so that 10 30, wanting into a new thing doesn't exist. Right. The business, right. Could 1031 if you and all the other investors decided to stay, but if you are just like, if the business buys and sells, then all you're getting is income from the business. And it's not even a capital gains thing.

It's I mean, it is, but but you don't have the option to 1031 cause you don't own land or property. You own shares in a company. Now the income is still capital gains or depreciation recapture. It's one of those two. But you can't 1031 it. Which is kind of an interesting subtlety.

Jessi: With this other property that you're working on the pre foreclosure that you're like, you're essentially flipping it, that doesn't count as a 1031 either, does it?


James: that is a, that is wholly separate because I'm going to own it for less than a year.

Jessi: Right.

James: And so, yeah, so it's only capital gains if you own the property for longer than a year.

Jessi: Okay. If

James: you own it for less than a year, they consider it as like inventory in a business. Yeah. And so you're taxed at like a regular 1031.

The ordinary tax rate.

Jessi: So flipping the

James: flip is maybe better than it's more expensive from a tax perspective. Cause it's ordinary income. So, Oh,

Jessi: Oh, not capital gains. It's just because

James: ordinary income is going to be, what is it? You know, you're 22 percent tax bracket. Yeah. Yeah. Which for like what we're selling it for, it'll bump us to a higher tax bracket.

Yeah, so it's not as, and I had this problem when I was not a problem, had this happen when I flipped the piece of land in Indiana as a similar thing. It's counts. Cause I was like, Oh dude, I'll pay my 15 percent plus 9 percent the Oregon. And he was like, yeah, about that. Like you sold it too soon. And so there could be some strategies where you say, Hey, I'm going to hold onto this thing for over a year, pay less taxes, but then you got to offset that withholding costs both in terms of, you know, interest in all that other stuff and stuff.

So. I could see a strategy where you go, well, I'm going to buy it, turn it into a rental, hold on to it for a year or two, and then sell it. And then, and then you're not, you're not losing money to the holding costs. Cause even if that's breakeven,

Jessi: that

James: could be worth it. And you say, yeah, I'm going to save my 10 percent that way.

Maybe. I don't think it's, nobody does that. And so I don't think it's worth it based on what I've, if

Jessi: there's, yeah. If plenty of people are, it's

James: either you're going to fix it and flip it, or you're going to turn it into a rental and then you're holding down to it. You're in it to win it for a long haul.

Yeah. That's been my observation. But yeah, anyways, that's what I learned today. Just kind of, or earlier this week, just kind of an interesting yeah, just an interesting new little wrinkle. I'm

Jessi: glad you talked to the CPA. I didn't know. I didn't just be like, all right, here we go.

James: Yeah, I know. And he was definitely like, oh, this is why you call ahead of time.

I remember I called, first I called a 1031 person and I was like, hey, do you care? And she's like, nope, don't care at all. She's like, but you should probably talk to your CPA about this. I was like, oh, all right, cool. So interesting. So yeah. Yeah. There you go. There you go. The more you know right? Is that?

That's G. I. Joe. Right? That's half the battle? Knowing is half the battle?

Jessi: Knowing is half the battle. Yeah,

James: something like that.

Jessi: The more you know. I feel like that's Is that Reading Rainbow? Is it?

James: I don't think. We're gonna let whoever's listening, you can look that up on your own, I'm not gonna figure it out.

The more

Jessi: you know. The more you read, the more you know. I don't know.

James: That sounds reasonable. The more you listen to us, the more, you know. Yeah. So thank you so much for listening to that relatively technical numbers, deep dive. We really do appreciate it and we would love it. If wherever you listen to your podcast, you leave us a quick rating, that would be awesome.

Again, thank you so much for listening and have a great day.

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Furlo Capital Podcast

Furlo Capital
Real Estate Podcast

A conversational podcast between James and Jessi Furlo that dives into the intricacies of passive real estate investing. Our mission is to equip people to invest wisely in both property and residents so that, together, we can build wealth and improve housing.

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