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We strongly recommend to our clients that not only should they have a diversified stock portfolio, but also a diversified real estate portfolio. Traditionally that is very hard to do inside a qualified plan like a 401k or IRA, not only because it is expensive to do so, but most qualified plans prohibit ownership of physical real estate inside them. Therefore, investors typically turn to REITs to obtain exposure to real estate inside their portfolios. The downside to this tactic is that a REIT does not provide investors physical ownership of real estate and the benefits that come along with it (i.e. depreciation), just shares of the company that owns the real estate. Therefore, you will see constantly volatility in price and income.
Instead, we advise out clients to carve out a portion of their qualified accounts and look towards alternative investments to achieve diversification in real estate and maintain physical ownership of the assets. Not only is that achievable with a relatively smaller commitment of capital, but many more opportunities and access to high quality properties present themselves.
DEPRECIATION GENERALLY
Real property includes both land and the things we do to improve the land, such as the construction of infrastructure, parking lots, buildings, etc. While the tax law recognize that land may appreciate in value – something most real estate investors are familiar with and have long enjoyed, the law also assumes that improvements (buildings, etc.) depreciate – we consume them, they age and become obsolete. While the assumption that real property improvements depreciate might not always hold true in actuality, it is an established principle in federal income tax laws.
These competing processes – the appreciation of land versus the depreciation of improvements, is what often results in real estate investors achieving long term gains with low effective tax rates. The income derived from the property over many years is offset by depreciation expenses that effectively reduce the tax burden of their investment – an impact that compounds over time to create a net benefit to investors that few asset classes can match.
Importantly, appreciation and depreciation do not involve cash, they are paper gains and losses. While the laws do not tax unrealized appreciation, they do allow the real estate investor to depreciate a portion of the improvements each year, offsetting the income produced by the property.
Depreciation schedules have been set for most property types, broadly classifying residential rental properties (excluding land) as having a 27.5-year useful life and commercial rental properties (also excluding land) as having a useful life of 39 years. Thus, the amount of depreciation an investor can claim each year is most simply the amount of improvement cost (purchase price less land) divided by the useful life each year the investment is held until the entire improvement cost has been depreciated to zero.
LEVERAGED DEPRECIATION
Depreciation, as powerful as it is, becomes even more impactful with leverage. Most real estate is purchased with some form of loan in place – an investor buys property with a greater value than their cash on hand by borrowing additional funds from a lender. The amount borrowed and the increased value because of the amount borrowed, generally increases the investor’s cost basis in the property. If an investor buys property with greater value, the investor typically has more improvements that can be depreciated and thus more income that can be offset.
BONUS DEPRECIATION
In 2024, an investor can elect to take bonus deprecation of 60% of the improvement cost of certain real property acquired with a scheduled depreciation period of 20 years or less along with certain other property. Otherwise eligible properties acquired in 2025 will only be eligible for 40% bonus depreciation and the benefit continues to phase out annually (20% in 2026) through December 31st, 2026, when it will drop to zero unless otherwise extended by Congress.
Without making some other elections, most real property will not qualify for bonus depreciation because the scheduled depreciation is greater than 20 years – this is where cost segregation studies are often employed with significant impact as some percentage of every property will have a shorter useful life than the entire property (e.g., site improvements are typically 15-year assets – which include improvements like sidewalks, roads, sewers, fences, landscaping, etc.).
A relatively small percentage of real estate has been granted a depreciation schedule shorter than 20 years and are therefore able to take 60% bonus depreciation (excluding land) without completing a cost segregation study, if acquired in 2024. Retail Motor Fuel Outlets (gas stations) are one such property class that has a 15-year depreciation schedule and therefore qualifies without the need of further engineering studies or analysis, as provided for in Internal Revenue Code (IRC) Section 168(e)(3)(E)(iii).
BRINGING EVERYTHING TOGETHER
In 2024, a sophisticated investor can invest in gas stations, take on leverage, bonus depreciate the non-land portion 60% in the first year and claim depreciation expenses greater than the amount of cash used to acquire the property.
APPLICATIONS
Since the depreciation in this case is so much greater than a property will reasonably be expected to generate in cash flow over a typical investment horizon of 5-10 years, the investor would ideally be able to use these dramatic depreciation expenses to offset income from other sources – the question then becomes what income can investor offset? Buckets of income used for determining federal income tax liability include the following:
1. Active
2. Passive
3. Portfolio
Failed 1031 Exchange – An investor that is unable to complete an orderly 1031 exchange would, in many cases, have passive income that is either capital gains or recapture taxes – both of which can often be offset by depreciation expenses. An investor with a failed 1031 exchange should consult with their tax preparer to determine how the gains from sale will be characterized and if this strategy may be applicable.
Real Estate Investors – Income or loss from rental real estate is, for most investors, a passive activity. Investors with large portfolios of rental real estate, particularly real estate that has been owned for a long time and has significant unrealized potential gains, likely generate significant passive income that is currently being taxed as ordinary income.
While converting to a Roth IRA can provide future tax-free growth and income, doing so creates a taxable event. Investing in a Fund that utilizes a Valuation Discount study can provide a significant tax saving when doing the conversion.
ROTH CONVERSION WITH VALUATION DISCOUNT PROCESS
VALUATION DISCOUNT TIMELINE CHART
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All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future performance. There can be no guarantee that any investment or strategy will achieve its stated objectives. Speak to your tax and/or financial professional prior to investing. Securities and advisory services through Emerson Equity LLC, member FINRA and SIPC and a registered investment adviser. Emerson is not affiliated with any other entity identified herein.
There is no guarantee that any strategy will be successful or achieve investment objectives; Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments; Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities; Potential for foreclosure – All fnanced real estate investments have potential for foreclosure; Illiquidity –These assets are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments;Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions; Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefts. Stated tax benefts – Any stated tax benefts are not guaranteed and are subject to changes in the tax code. Speak to your tax professional prior to investing.
Investing in opportunity zones is speculative. Opportunity zones are newly formed entities with no operating history. There is no assurance of investment return, property appreciation, or profits. The ability to resell the fund’s underlying investment properties or businesses is not guaranteed. Investing in opportunity zone funds may involve a higher level of risk than investing in other established real estate offerings. Long-term investment. Opportunity zone funds have illiquid underlying investments that may not be easy to sell and the return of capital and realization of gains, if any, from an investment will generally occur only upon the partial or complete disposition or refinancing of such investments. Limited secondary market for redemption. Although secondary markets may provide a liquidity option in limited circumstances, the amount you will receive typically is discounted to current valuations. Difficult valuation assessment. The portfolio holdings in opportunity zone funds may be difficult to value because financial markets or exchanges do not usually quote or trade the holdings. As such, market prices for most of a fund’s holdings will not be readily available. Capital call default consequences. Meeting capital calls to provide managers with the pledged capital is a contractual obligation of each investor. Failure to meet this requirement in a timely manner could elicit significant adverse consequences, including, without limitation, the forfeiture of your interest in the fund. Leverage. Opportunity zone funds may use leverage in connection with certain investments or participate in investments with highly leveraged capital structures. Leverage involves a high degree of financial risk and may increase the exposure of such investments to factors such as rising interest rates, downturns in the economy or deterioration in the condition of the assets underlying such investments. Unregistered investment. As with other unregistered investments, the regulatory protections of the Investment Company Act of 1940 are not available with unregistered securities. Regulation. It is possible, due to tax, regulatory, or investment decisions, that a fund, or its investors, are unable realize any tax benefits. You should evaluate the merits of the underlying investment and not solely invest in an opportunity zone fund for any potential tax advantage.