This two-part series, brought to you by CrowdStreet and Trent Baeckl, CPA, walks new real estate investors through the tax information you can expect to receive in the coming months.
The Internal Revenue Code contains numerous provisions that encourage investment in real property. The first article focused on the fundamentals of investing in real estate via partnerships and LLCs which highlighted the ability to use qualified nonrecourse debt to take distributions and losses. This article will focus on opportunities to accelerate tax deductions and beneficial tax rates when real estate is sold.
Depreciation deductions can often lead to taxable losses for rental real estate investments that have positive cash flow. Depreciation, for tax purposes, is the method by which the cost of an asset is recovered overtime periods set forth by the IRS–27.5 years for residential rental property and 39 years for commercial rental property. This cost recovery is applied evenly, or on a straight-line basis, over that time period. (It’s worth noting that this only applies to buildings, depreciation is not allowed on the cost of the land.)
Example 1: On 1/1/18, XYZ LLC purchased a commercial building for $5,000,000, with $1,000,000 of the purchase price allocated to land. The net operating income on the building is $300,000 The depreciable life of the building is 39 years. The annual depreciation deduction is $102,564 ($5,000,000 purchase price less $1,000,000 land value = $4,000,000 depreciable basis / 39 years). The net rental real estate income allocated to the LLC investors is $197,436 ($300,000 net operating income less $102,564 depreciation deduction).
Cost Segregation Study
Many real estate owners will opt to perform a cost segregation study on their building in order to accelerate depreciation deductions. A cost segregation study is an engineering-based study that analyzes individual components of the building that may qualify for shorter depreciable lives, such as flooring. The IRS rules allow for less permanent flooring, like carpeting or vinyl, to be depreciated over five years as opposed to the 39 needed for the whole building. The opportunity to accelerate depreciation varies based on building type. Manufacturing facilities and auto dealerships generally benefit more than warehouses or shopping centers, for example, because of their inherent specialized improvements that qualify for shorter depreciation lives.
The benefit of having a shorter life on depreciable assets increased significantly after the Tax Cuts and Jobs Act (“TCJA”) which passed in 2017. As part of the major tax reform legislation, bonus depreciation was increased from 50% to 100% for assets acquired and placed in service after 9/27/2017 and before 12/31/2022. The act also eliminated the “original use” requirement. Prior to TCJA, bonus depreciation was only allowed for assets with a depreciable life of less than 20 years and represented the original use of the asset. In other words, only new assets were eligible for accelerated bonus depreciation. With this requirement eliminated, the benefits of a cost segregation study increased for new ground-up construction but also became applicable for existing buildings.
Example 2: Same facts as Example 1 except XYZ LLC obtains a cost segregation study on the building. Per the report, the basis of a 39 year property is $3,000,000, a 15 year property is $250,000 and a 5 year property is $750,000. As a result, depreciation expense in 2018 is $1,076,923 ($3,000,000 / 39 years + $250,000 bonus depreciation + $750,000 bonus depreciation) and $76,923 in 2019 and thereafter ($3,000,000 / 39 years). The net rental real estate loss allocated to the LLC investors is $776,923 ($300,000 net operating income less $1,076,923 depreciation deduction).
Tangible Property Regulations
The IRS passed a sweeping set of regulations in 2014 that provides guidance on when costs incurred on real and personal property are required to be capitalized and depreciated or can be expensed as repair costs. The regulations require capitalization of costs when the project is considered a betterment, adaptation or restoration of a unit of property in one of nine potential building systems. The analysis behind these regulations is some of the most complex in the tax code and beyond the scope of this article. They do provide a significant opportunity to deduct capital expenditures as repairs and reducing the tax burden for rental real estate investors.
Sale of a Building
Calculating the gain or loss on a sale is derived by comparing the net sales price after closing costs to the adjusted basis in the building. The adjusted basis is the amount of basis remaining after factoring in depreciation deductions. The fact that the gain is partially due to prior depreciation deductions is a concept called depreciation recapture. During the life of the building, the depreciation deductions reduced the taxable income from the building, so upon sale, those benefits increase gain (or reduce loss) to be allocated to the investors.
Example 3: In 2025, XYZ LLC from Example 1 sells the building for $6,200,000 and incurs $200,000 closing costs. The adjusted basis in the building is $4,200,000 ($5,000,000 original cost less $800,000 of accumulated depreciation deductions). Therefore, the gain on the sale is $1,800,000 ($6,200,000 sales prices less $200,000 closing costs less $4,200,000 adjusted basis).
The tax treatment of the gain for the individual members of the LLC will depend on how the gain was calculated. There are three different tax rates that may be applied to the gain on the sale of rental real estate: Section 1231 gains, Section 1250 depreciation recapture or ordinary rates on depreciation recapture. The lowest rates are on Section 1231 gains, which are taxed at capital gain rates of 15% of taxable income for married filing joint (MFJ) couples is less than $425,800 in 2018 and 20% above. This beneficial rate will apply to the amount of gain attributable to appreciation while the property was held. The rate on Section 1250 depreciation is 25% and represents the gain attributable to the straight-line depreciation on the building. Ordinary depreciation recapture is taxed accordingly to the marginal tax bracket the investor falls in, which could be as high as 37% for MFJ couples that have taxable income in excess of $600,000. This rate is applied to gain attributable to accelerated depreciation deductions on shorter-lived assets.
Example 4: Same as Example 3. The $1,800,000 gain is comprised of $1,000,000 of Section 1231 gain ($6,000,000 net sales price less $5,000,000 original purchase price) and $800,000 of Section 1250 depreciation recapture. If you owned 10% of XYZ LLC and are in the highest tax bracket, your tax liability on the 10% gain allocation would be $46,840 ($1,000,000 x 10% = $100,000 1231 gain x 20% + $800,000 x 10% = $80,000 Section 1250 gain x 25% + 180,000 total gain x 3.8%).
Example 5: Same as Example 4, except XYZ LLC obtained a cost segregation study from Example 2. The adjusted basis of the building is $3,400,000 after factoring in the accelerated depreciation deductions. Therefore the gain on sale is $2,600,000 ($6,000,000 net sales price less $3,400,000 adjusted basis). The Section 1231 gain is $1,000,000 ($6,000,000 net sales price less $5,000,000 original purchase price). The Section 1250 depreciation gain is $650,000 and the ordinary depreciation gain is $950,000. Your tax liability would be $81,280 ($1,000,000 x 10% = $100,000 1231 gain x 20% + $650,000 x 10% = $65,000 Section 1250 gain x 25% + $950,000 x 10% = $95,000 ordinary depreciation gain x 37% + $260,000 total gain x 3.8%).
The beneficial tax rates on a sale apply to the extent that tax deferral opportunities are not explored. Section 1031, or like-kind, exchanges for real estate assets survived the TCJA allowing for a full deferral of tax if the proceeds are reinvested in another real property acquisition within 180 days. The TCJA also introduced Qualified Opportunity Zone Funds as another program for the tax liability on the gain to be deferred.
It’s worth noting that investors may not receive their Schedule K-1s by the individual filing deadline (April 15), requiring you to extend your tax return. While extending a tax return is a relatively common practice, this can be an unexpected change for new real estate investors.