Benefits of Tax Alpha Strategies

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Benefits of Tax Alpha Strategies

Unlocking Value: How Tax Alpha Strategies Enhance Your Real Estate Investment Returns

Tax Implications of Selling Fully Depreciated Property

Taxes are crucial not only for revenue generation but also for wealth retention. Different investment options carry varied tax implications, and sometimes, an investment with lower returns but more favorable tax treatment can be more beneficial than one with higher returns but substantial tax burdens. For instance, capital gains taxes, which might seem insignificant, can result in a taxpayer facing a total tax burden of up to 42.1% on their gross proceeds in some states due to combined taxes.

IRC

Tax Rate

Depreciation Recapture

Section 1250

Up to 25.0%

Federal Capital Gains Tax

Section 1231

Up to 20.0%

Net Investment Income (NIIT)

Section 1411

Up to 3.8%

State Capital Gains Tax

N/A

Up to 13.3%

Total Tax Burden

Up to 42.1%

1. Depreciation Recapture Tax: Recovers tax benefits from property depreciation deductions upon sale, often capped at 25% for real estate.

2. Federal Capital Gains Tax: Levied on profits from asset sales, with lower rates for long-term gains.

3. Net Investment Income Tax (NIIT): Adds a 3.8% tax on investment income for high earners, primarily to fund Medicare.

4. State Capital Gains Tax: Varies by state and can significantly impact net investment proceeds (see next slide for details).

2024 State Tax Rates on Long-Term Capital Gains

1. Higher Rates: California (13.30%), New York (10.90%), and New Jersey (10.75%) have high rates on long-term capital gains.

2. Lower Rates: Arizona (1.875%) and New Mexico (3.54%) tax capital gains at lower rates than ordinary income.

3. No Tax: Texas, Florida, and Nevada do not tax long-term capital gains.

4. Same as Ordinary Income: States like Illinois and Colorado tax capital gains at the same rate as ordinary income.

Tax Impact on Financial Returns

When fully depreciated real estate is sold, the proceeds are taxed asSection 1250recapture or long-term capital gains.Depreciation recapture can be taxed up to 25%, significantly reducing reinvestment funds and future income potential.

Additionally, sellers face a net investment income surtax of up to 3.8% and state capital gains taxes, which can reach 13.3%in states like California. Combined, these taxes can result in a total liability of $421,000, or an effective tax rate of 42.1%.

Illustrative Scenario

When a fully depreciated $1 million asset is sold with a total tax burden of 42.1%, deferring the taxes results in an additional $421,000 in net sales proceeds. By reinvesting this amount at a 6% capitalization rate, the investor could see:

An increase of $25,000 in annual cash flow
A 2.5% boost in Return on Investment (ROI)

This is achieved simply by deferring the taxes.

Additional Annual Cash Flow ($000s) Sensitivity Analysis

Step-Up in Tax Basis Rule

Tax-deferred strategies like 1031 Exchanges and 721 Exchanges let investors reinvest all proceeds from sold properties into new ones, treating deferred tax as an interest-free loan from the government. This can boost cash flow and property value. However, the tax is postponed, not waived.

The tax basis of an asset is its initial purchase price plus capital expenditures, minus depreciation. When sold, capital gains taxes are based on the difference between the asset’s tax basis and its sale price.

Real estate can be held for generations, passing to heirs without incurring capital gains taxes if not sold. When heirs sell, taxes are based on the property’s value at inheritance, reducing the tax burden. The step-up in basis rule adjusts an inherited asset’s cost to its market value at the owner’s death, significantly lowering capital gains taxes for heirs.

Savvy investors use the “defer ’til you drop” strategy, deferring taxes until death, allowing heirs to benefit from the step-up in basis, which erases the deferred tax liability. This doesn’t affect estate taxes, but it eases capital gains tax responsibilities.

'Defer 'Til You Drop' Strategy

Consider a fully depreciated asset valued at $1 million sold with an effective tax rate of 42.1%. Through a tax-deferred exchange, an investor defers the $421,000 tax liability, effectively receiving an interest-free loan from the government. This deferred amount can be leveraged to generate additional returns and is not due until the asset is sold in a taxable transaction.

If the asset owner dies before selling it, the heir inherits it with a basis stepped up to its fair market value (FMV) at the date of death. This adjustment eliminates the $421,000 tax liability, effectively forgiving the interest-free loan from the government. If the heir sells the asset immediately at its FMV of $1 million, they owe no taxes and receive the full proceeds.

The full benefits of tax-deferred strategies often become apparent with the basis step-up, a key aspect of the “defer ’til you drop” strategy. This highlights the importance of timing and inheritance in maximizing tax advantages.

Long Term Tax Impact on Financial Returns

Tax-deferred exchanges are among the most advantageous provisions in the tax code, providing real estate investors a significant opportunity to grow their wealth. The tax burden from selling an investment property can be substantial and varies by state. By utilizing a tax-deferred exchange, investors can defer their tax obligations if they comply with IRS rules, acquire replacement property of equal or greater value, and reinvest all sale proceeds.

Assumptions

Initial Cain

$1.0M

Cap Rate

6.0%

Cash Flow Growth y/y

3.0%

Tax Burden

42.1%

Time Horizon

30 yrs

Number of Transactions

3 Basic Step Up

No