Solution: The Lazy 1031 Exchange
I talked about my reluctance to pursue either the 1031 or the QOZ with Nate, and he had two comments. First, he said, “Sometimes when you are fortunate enough to have made tremendous gains on an asset, you just have to suck it up and pay the taxes.”
He might have been right about that, but it wasn’t what I wanted to hear. Next, he said “Or because you are a passive investor in real estate syndications, you could just do a ‘Lazy 1031’ and not pay any taxes on your gains at all”. I didn’t know what he meant, but I liked the “lazy” part and the “not paying any taxes” part!
He went on to explain the “Lazy 1031”. I am a passive investor in real estate syndications, and many of those (especially multifamily apartments) come with significant tax benefits because of bonus depreciation and accelerated depreciation from cost segregation.
Bonus Depreciation & Cost Segregation
In short, bonus depreciation allows you to deduct much of the depreciation in the first year of an investment rather than over the entire expected life of the asset. Created by The Tax Cuts and Jobs Act of 2017, it’s scheduled to gradually phase out between 2023-2027. It may well get extended however, before it shuffles off this mortal coil.
Cost segregation is where the asset manager hires an engineering firm to analyze the property and to reclassify parts of the property into fsater depreciation rates. That allows you to take more depreciation over the first few years that you own the investment.
The bottom line is that bonus depreciation and cost segregation can give the asset and the investor a much larger paper depreciation loss in year one than they would otherwise have. This passive loss can be used to offset passive gains from real estate which can come from cash flow or capital gains.
However, when you take all of that depreciation in year one, you will eventually have to “recapture” the depreciation when you sell. Because of this, the strategy works best when you reinvest in new deals and start the cycle all over again.
Bonus Depreciation Example
If I bought a single-family home for $100,000 all cash and sold it several years later for $150,000, I would have a $50,000 capital gain.
Assuming that the property was used as a rental and my accountant used straight-line depreciation, I would have some depreciation recapture, but we will ignore that for simplicity in this example. If I do nothing, I will have to pay tax on the $50,000 gain. Assuming a 20% capital gains tax rate, I would pay $10,000 in taxes and be left with $140,000, including the original capital of $100,000.
However, if I took the $150,000 and invested it into a multifamily syndication that used bonus depreciation and cost segregation, I would show a paper loss in year 1.
For this example, we will assume the passive loss from bonus depreciation is 50%. I would have a $75,000 paper loss that would completely offset the $50,000 gain from the property I sold. I would also have $25,000 of passive loss that would carry over into subsequent years until it is used up.
If I received an 8% cash-on-cash return on this $150,000 investment, I would earn $12,000 per year. During the first two years of the investment, my cash flow would be tax-free because it would be offset by the $25,000 of carryover losses.
In this example, not only have I deferred the entire capital gain from the sale of my single-family home, I have also deferred paying tax on the cash flow from the first two years.
Each operator does cost segregation differently. Some deals have resulted in a 20% loss in year one and others much more – in fact, one of my investments of $50,000 resulted in a paper loss of $60,000 in the first year!