The Tax Cuts and Jobs Act of 2017 had a clause that expanded accelerated depreciation allowing depreciation to be accelerated up to 100%. This was a departure from previous laws which had limits for how much depreciation could be accelerated.
Many real estate investors have taken advantage of the new rules that came in during the Trump Administration to accelerate depreciation for their real estate assets up to 100 percent. This is particularly true for real estate investors, who used cost segregation studies to deduct depreciation.
The allowance of 100% accelerated depreciation is something that was generally looked on favorably by most real estate investors because it opened the door for them to take a large amount of deductions right away. However, now, the rules for deducting bonus depreciation that were set up in the Tax Cuts and Jobs Act of 2017 are due to expire.
This means that instead of being able to deduct 100 percent of bonus depreciation, soon, real estate investors will only be able to deduct 80 percent. Shortly after that it will drop down to 60 percent. By the year 2026, it will drop all the way down to 20 percent.
Many real estate investors are disappointed that they will not be able to deduct as much bonus depreciation as they have been able to in the past four years. However, 80 percent is still a large amount of money that can be deducted in bonus depreciation. This means that cost segregation studies will still provide a substantial amount of value for the near future, and possibly longer depending on what additional policies and changes come down the road.
What Should Real Estate Investors Do About the New Rules?
The first thing that real estate investors should do is to remain calm and not panic. Just because you might not be able to accelerate bonus depreciation up to 100 percent, it doesn’t mean that real estate is all of the sudden not a good asset class to invest in.
On the contrary, you should just focus on looking at the real estate investment first. If the investment makes sense by itself, then you can just figure out the tax piece later. You should never go into an investment simply because you are looking for depreciation anyway. With good real estate investments, the cash flow is still there and as long as the other aspects of the deal make sense, you will still get good ROI.
Secondly, you should start to generate a plan on how you can use the losses of real estate transactions. Many high net worth individuals and investors have “suspended losses.” Suspended losses are losses that you can’t necessarily take advantage of right away in year one, unless you have other passive income.
If you have other sources of passive income, you can couple your suspended losses from your real estate with your gains from your other income. Doing this will allow you to still reduce your tax burdens significantly. So, even though you might not be able to get the same amount of deductions as you got before, you can still get quite a lot of loss-related deductions. Historically real estate investing is one of the very few investments that provides significant tax advantages, and that’s not changing.
Action Steps That Real Estate Investors Should Take Now
The number one thing that real estate investors should do in order to adapt to the new rules is to first just sit down with your tax advisor or your CPA to figure out how the new rules will apply to your specific situation. Different investors are going to have different implications from the tax changes depending on how they are earning their money.
Once you figure out exactly how the tax changes will apply to you, the next step is to create a strategy that enables you to profit as much as possible and save as much in taxes as possible under the rules. For example, we still have several months left of the old rules, so you should take advantage of this while you still can.
As you go beyond that, remember that 80% bonus depreciation is still very valuable. So, you should use it. You should also look for other opportunities for tax-free cash flow and combine those two together. This will enable you to optimize your deductions and your profits.
Will the New Rules Affect Hold Times?
Even though bonus depreciation is scheduled to drop down to 20% by 2026, it is unlikely that this will have a material impact on hold times. It is more likely that the real estate market in general will dictate that.
It is also important for real estate investors to remember that they shouldn’t want to accelerate depreciation for assets that they plan on holding only for a short period of time such as a year. Otherwise, they could trigger things like a depreciation recapture.
If you plan on holding your assets for at least three years or more, on the other hand, then accelerating bonus depreciation can be a great tool to use. You can think of three-to-five years as a good sweet spot for holding an asset because you get to accelerate depreciation in the first few years. The asset will also appreciate in that time and you will have cash flow that comes back in distributions, and there is also a refinance that might happen around that time. When you go to sell, sure, there will be capital gains taxes, but if you have suspended losses, these can help to offset the capital gains taxes. Or you can take advantage of a 1031 exchange to defer those gains, by purchasing a “like kind” asset if done within a specified amount of time.
The bottom line is that yes, it is slightly unfortunate that real estate investors will not be able to accelerate bonus depreciation as much anymore. However, this doesn’t mean that real estate investing is still not highly profitable and a logical place to put your money.
In fact, real estate investing still remains one of the best ways to grow and preserve your wealth over time. Many high-net-worth individuals, and families in the U.S. and around the world have been using real estate to grow their wealth over time for many years. So, don’t be afraid of slight tax changes and don’t let them slow you down. Just adjust your investing strategy to the new rules and carry on!
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About the Author
Ellie is the founder of Blue Lake Capital, a commercial real estate investment firm specializing in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial investments with the full capabilities of today’s technology.
Ellie is the host of REady2Scale, a podcast that highlights the assets, processes, and strategies for the multiple approaches to successful real estate investing.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.
You can read more about Blue Lake Capital and Ellie Perlman at www.bluelake-capital.com.