
I hate paying taxes.

It’s only fair for me to be upfront about this.

If you’re the kind of person who really likes paying taxes, I think it’s probably best you click out of the article now. It’s really not my intention to offend anyone.

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Ok, now that it’s just us, I want to tell you how I gave my investors over 20 grand in tax deductions last year.

To explain this, we need to start with depreciation.

## Depreciation 101

Simply put, depreciation is the opposite of _appreciation_.

When an asset depreciates, it loses value.


A truck used by a business is a good example. When you buy a truck, it’s only useful for a period of time before it needs to be replaced. It’s therefore less valuable as time goes on.

Because an asset like this loses value, its owner (the business) lists a _depreciation expense_ to make up for the (negative) difference in the asset’s value.

Depreciation expense is truly an expense, and the business will count it as a loss for tax purposes; it offsets revenue that the business makes for the year.

Buildings are also depreciable assets.

Notice that I just said _buildings_. Land does not depreciate.

But buildings have a usable life, so as an owner of an investment property, you can list a depreciation expense on taxes. Specifically, you can depreciate a building equally for 27.5 years using **straight-line depreciation**.

> Example: you have a property worth $1M. Using straight line depreciation, you can deduct $36,363, which is 1M divided by 27.5.

## Cost Segregation

Being able to deduct 3.6% of the value in depreciation is ok, but it’s not how we do depreciation on my team.

Straight line depreciation works well for simple assets, but for more complex ones it’s best to use **cost segregation**.

Here’s what cost segregation (cost seg for short) means practically.
An asset like a building is not one solid piece, but is made of many component parts.
For example, you might have a roof, HVAC system(s), and a pool — and all have a different useful life.

Here’s the really important part.
Since some components depreciate faster than others (and most depreciate before 27.5 years), you can take a larger depreciation expense every year if you _depreciate components separately_.

## Bonus Depreciation

Oh, we’re not even done.

On top of cost seg, right now investors can also take **bonus depreciation**, meaning we can depreciate a percentage of any money we spend _improving_ the property (AKA capital expenditures) _in the year that we make that improvement_.

> Example: Your apartment building needs a new roof. If the roof costs $50,000 to replace and you're allowed to take 100% bonus depreciation, you can take another **$50K** of depreciation expense in that year.

Bonus depreciation is currently allowed (at the time of this writing) under the [2017 Tax Cuts and Jobs Act](https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-a-comparison-for-businesses).

The bonus deprecation allowed under this law won't be around forever, though -- the 100% allowance has been _decreasing by 20%_ for every tax year after 2022, meaning that we were allowed to take 80% bonus depreciation on our capital expenditures from last year.

> Want to take advantage of current bonus depreciation before it expires? [Join the Ursa Capital Investor Club](/join) to get access to our deals.

## Putting it all together

By combining the benefits of
- Bonus depreciation
- Cost segregation for components that made sense
- Straight-line depreciation for everything else

We were able to provide **a paper loss of $667,000** for our $1.5M of equity on this deal.

That means that at a $50,000 position (the minimum), an investor would be able to deduct just over $22,000 on their taxes. 

Important disclaimer: There are limitations on how an investor can _use_ this deduction. The side benefit, though, is that even if an investor couldn't use it to offset their income for the past tax year, they can carry much of it forward to offset _future gains_.

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Tax savings is a huge reason why we do what we do at Ursa Capital. I'm looking forward to many more examples of helping investors keep their money, because remember:

**_It's not what you make, it's what you keep._**

How I helped investors deduct $22,000 or more from their taxes

How do I get started investing in real estate?

Generally, the real estate market is split into two sectors, _residential_ and _commercial_.

Residential real estate is what most people are familiar with – mostly because [65.5% of American households own](https://www.statista.com/statistics/184902/homeownership-rate-in-the-us-since-2003/) a piece of residential real estate: a home. Commercial real estate, on the other hand, is real estate used exclusively for business purposes. This can be retail, office space or multifamily apartment properties (above 4 units).

## Residential Valuation
Residential property valuation is pretty easy to grasp: _similar properties in a similar area have a similar value_. That’s the underlying principle for any residential appraisal. If you want to know the market value of a 3 bed, 2 bath built in 1990, you’ll look at other 3 beds, 2 baths in the area built around the same time. These similar properties are called **sales comparables**, or sales comps for short.

While this is pretty easy to grasp, it means a residential property’s value is mostly _intrinsic_, as opposed to being based on how much money it makes for its owner. This makes sense, as most people who buy a residential property don’t buy it as an investment only.

## Commercial Valuation
Intrinsic value gets a lot harder to gauge when you look at commercial properties. If we were to take the residential valuation approach, how would we compare a high-rise apartment building with the Walgreen’s next store?

Because of the diversity in commercial real estate, we have to use a different metric to determine market value: **how much money the property generates** (or can be reasonably expected to generate).

The formula for calculating fair market value for a commercial property is:
> Value = Net Operating Income / Cap rate

Let’s get into the components.

### Net Operating Income (NOI)
The NOI of a business is all revenues minus all operating expenses. For example, the NOI of an apartment community could be all collected rents minus any expenses like maintenance, utilities, etc.

> Note: mortgage payments (AKA debt service) are not included in NOI. That’s because financing for a commercial property can take many different forms or simply might not exist at all (if the property was bought in cash).

### Capitalization Rate (Cap Rate)
Cap rate is the more difficult half of this formula to understand. By definition, it’s the percentage of the fair market value that the NOI generates each year — which you’ll notice is just an inversion of the valuation formula above.

**So then, how is cap rate determined?**

This is the small overlap that commercial valuation has with residential valuation. To determine what might be a reasonable cap rate to use for a property, sales comps from the surrounding area are used.

Once a commercial broker pulls recent comps from the market to establish a baseline, they can start adjusting. If the subject property is a 1990s B-class property and the comparable is a 1970s C-class property, they would adjust the cap rate down (translating to a higher valuation). If the comparable is an A-class built in the last 10 years, they would adjust the cap rate up (translating to a lower valuation).



The above example also illustrates that as **perceived risk goes up, cap rate also goes up**. Our C-class comp would likely need more maintenance and attract tenants that are less likely to take care of the property than the A-class comp.

## Leveraging the commercial formula
The formula for commercial valuation is the reason that value-add investing works so well – if you can **increase the NOI** of a property and sell at the same cap rate, you’re able to **force appreciation** on it and create equity! For more on how this works, see [my post on value add investing](/blog/value-add-investing).

How are commercial properties valued?

Years ago, my dad showed me an old Steve Martin bit where he said “You can be a millionaire and not pay taxes!...First, get a million dollars. Then, when the taxman comes and says ‘Why didn’t you pay your taxes?’ you just say two simple words in the English language: ‘I forgot.’”

It’s unclear if this has ever worked for Mr. Martin. But here’s something that does work: real estate can help you legally keep much more of your money than almost any other asset class.

We should note at this point, for our friends reading this at the IRS, that we don’t condone illegally avoiding taxes. At the same, as Learned Hand, a judge for the US 2nd Circuit Court of Appeals, once put it: “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.” I can therefore assume that you, a law-abiding citizen who’s read this far, would be interested in paying as little in taxes as possible.

> Another important note: this article is not financial or legal advice! It’s crucial that you consult your CPA and/or attorney to validate any claims of tax benefits that an operator offers you.

## Terms
Since a lot of this is dense, potentially confusing content, we should define some terms first:

**Ordinary income tax**: This is the regular progressive income tax we all know and love.

**Capital gains tax**: This is a tax on the profit made from selling an asset. Like ordinary income, it’s progressive, but at a lower rate.

**Cost basis**: This is the original cost of acquiring an asset. This can be used interchangeably with Tax basis, which is an asset’s cost basis at the time it’s sold. Cost basis is important because it determines what is taxable as a capital gain. If you bought something for a dollar, then sold it for 5 dollars, your cost basis is 1 dollar, making your capital gain 4 dollars.

**Return on capital**: For the purposes of this discussion, this is any money you get in return that’s over and above your tax basis.

**Return of capital**: This is money you get that can be seen as paying you back your original investment, which lowers your tax basis.

## How to pay less taxes
Real estate, and real estate syndications in particular, offers some excellent tax advantages. The three we’re going to cover today are

- Depreciation
- Return-of-capital distributions
- 1031 exchange

### Strategy 1: Depreciation
Depreciation expense is a non-cash expense that a business takes as an asset’s value declines. Since it’s accepted that buildings will need repair or replacement over time, the IRS allows real estate investors to depreciate the buildings (not the land) that the business is run with. This is done with straight-line depreciation:

Depreciation expense = Value of asset / depreciation period

The depreciation period for real estate differs based on the type: a commercial non-residential property is depreciated over 39 years, while a residential property is depreciated over 27.5 years.

Example time:
Let’s say you had an apartment building worth $1M. The depreciation expense you would take out each year is $36,363.64.

To write off even more depreciation, **cost segregation** can be done, where instead of depreciating the whole building at once, you depreciate different components that make up the building. Since different components can have depreciation periods less than 27.5 years, it’s possible to take more depreciation expense than you would depreciating the whole building.

**The result**: Depreciation greatly offsets the taxable income from a real estate investment.

### Strategy 2: Return of Capital
Since we’re buying cash flowing assets in our model, our investors can expect to receive regular distributions from a property’s cash flow. _How they_ receive those distributions, though, can make a big difference in how much they pay in taxes.

Let’s say you make $250,000 a year. You’ve invested $100,000 into an offering on which you get a 10% annual return every year. Since the hold period in this example is five years, you can expect to receive $50,000 in distributions over the period.

Now, imagine that $10,000 a year was distributed as ordinary income. Since you’re already making $250k a year, this money would be taxed at 35%, meaning that by default, $3,500 of your distribution would go to the government. In total, you’d pay $17,500 on those distributions.

However, generally real estate syndications make distributions to investors as a **return of capital**. Essentially, the managing partner is saying to you, “You invested $100,000 with me, so here’s $10,000 of that money back. These return of capital distributions are _not taxed when they are distributed_. However, they do reduce your **tax basis** in the asset — once the hold period is up, your $100,000 cost basis would be reduced to $50,000.

**The result**: So then, what’s the difference? You’re either paying now or later, right? True, your tax basis does go down. If the property sold at the end of the hold period for the same price as it was bought (which would be an awful return), you would have a capital gain of $50,000. The difference is, _that would be taxed at the long-term capital gains rate of 15%_. You’d end up paying $7,500 on those distributions instead of $17,500.

That being said, you might not have to pay any taxes at all at the sale of the property, because of

### Strategy 3: The 1031 Exchange

So now you’re at the end of a hold period and it’s time to sell your cash-flowing asset for a sizable profit. Your managing partners have done everything they can above to reduce your tax burden, but you, as a limited partner in the deal, are now subject to Uncle Sam knocking on your door and asking for some of your money.

Unless of course, you used the 1031 exchange to defer those taxes.

Under the IRS Code Section 1031, the owner of a property can choose to defer taxes after the sale of an asset by doing a **like-kind exchange** —essentially, taking the proceeds and using them to buy another like-kind asset. Like-kind, in this context, refers to any other piece of real property in the United States.

This situation, though, has a couple of caveats that must be addressed.

First, taxes deferred with a 1031 exchange must eventually be paid. However, it’s a mathematical certainty that _your money grows faster if it’s not taxed while it’s growing_. This works because of compound interest: if you don’t have to pay taxes every time your wealth grows, it can grow at a much faster rate.

Second, in the context of a real estate syndication, a limited partner doesn’t have the ability to take their share of the proceeds and 1031 it into another asset that they own themselves. The sponsor can, however, decide with the consent of the limited partners to do a 1031 exchange into another asset with the proceeds from a sale. It’s important to ask a sponsor about this situation before you give them a single dollar; you need to start with the end in mind.

**The result**: doing a 1031 exchange to defer capital gains taxes can greatly increase the rate at which your wealth grows.

## Conclusion

Taxes are generally not fun to talk about and never fun to pay. Using the tax benefits of real estate, though, can help you legally pay less in taxes. This is one of the many reasons that real estate is a great wealth building tool, and even more so if you can use it to build your wealth passively.


Ursa Capital Blog

How I helped investors deduct $22,000 or more from their taxes

How do I get started investing in real estate?

How are commercial properties valued?

Tax Advantages of Multifamily Real Estate