Happy Friday. This is The Shake 🤝: the weekly newsletter that simplifies real estate jargon for all of us that got 1000 on our SAT scores.

Here’s what we got this week:

• Depreciation & The Gotcha Tax 😨 

• 007 Bonds… and Relation To CRE 📊 

MARKET RADAR

Depreciation & The Gotcha Tax 😨 

Real estate investing is a game of wits.

Many investors hold their heads high on avoiding paying large sums of money to taxes through depreciation methods like straight-line, bonus, and cost segregation studies. Kudos to avoiding the IRS!

While it’s a savvy strategy, things can backfire if plans change and you need to sell a property.

Don’t get me wrong, depreciation is your friend in real estate as it represents the decrease in the asset’s value over time.

The juicy part is that decrease in value can be quantified & deducted from your rental income based on its useful life - aka the amount of time (in years) the asset is depreciated over.

FYI different types of assets have different lifespans for depreciation:

• Residential real property = 27.5 years

• Nonresidential (commercial) real property = 39 years

• Appliances and furniture purchased for a rental = 5 years

• Fences = 15 years

• Improvements on residential real property (like a new roof) = 27.5 years

• Structural leasehold improvements on nonresidential (commercial) real property = 39 years

• Nonstructural leasehold improvements on nonresidential (commercial) real property = 15 years

For cash flow investors, it allows you to write off rental income on a yearly basis so your taxable amount is adjusted according to the depreciation schedule for that asset.

Quick example:

Say you buy a residential rental property for $325,000.

Step 1 is to allocate the assessed building value vs the land. Let's assume the land is valued at $50,000 leaving you with a building value of $275,000.

Using the straight-line method (a fancy way of saying depreciated equally year over year), the $275,000 building can be depreciated over 27.5 years.

So $275,000 over 27.5 years gives you $10,000/year of depreciation expense.

Ok cool, what can I do with that?

Well, let’s say this rental property spits out $800/month in cash flow after all actual expenses. After a year, you’d be sitting on $9,600 ($800 x 12 months) of taxable rental income.

Bring in your $10,000 friend named depreciation and now you’ve completely wiped out your taxable income for the year and even have a ‘loss’ of $400 that can be applied to other incomes (*depending on certain factors).

What’s amazing is that investors can leverage debt to purchase these properties with 5%,10%, and 20% down yet still deduct 100% of the building value.

Nice job, you managed to avoid Uncle Sam… (for now).

Wave goodbye to the bright side of depreciation 👋 as the dark side tends to catch most investors by surprise.

This dark side is called Depreciation Recapture and it is designed to prevent taxpayers from benefiting from lower capital gains tax rates on previously depreciated assets, which can lead to significant tax burdens and complexities.

Think of this as a ‘Gotcha Tax’.

You think you’ve made out like a bandit, reaping the benefit of lowering your taxable income year after year by claiming depreciation. But now it’s time to sell, and if you don’t execute a like-kind exchange (1031), you’ll be in for a tax treat since the IRS wants a piece of the pie 🥧 back.

That piece can be up to 25% of the recaptured portion.

To me, it epitomizes a scene from King of New York where Christopher Walken revisits his old mafiosos and hits them with a reminder about who runs sh*t. Kind of like the IRS asking for their money back from all that depreciation you utilized!

Let's revisit the previous example:

Original Purchase Price: $325,000

Land Value: $50,000

Building Value: $275,000

Yearly Depreciation: $10,000 (residential property over 27.5 yrs)

Let’s say you sold the property after just 3 years for $340,000 💵 

First step is to calculate your basis (purchase price + improvements - accumulated depreciation) in the property.

$325,000 + $0 (no improvements made) - $30,000 (depreciation on the building after 3 years) = $295,000 basis.

Now time to see what them #gainz look like. Btw, a gain = sale price - basis.

So $340,000 - $295,000 = a $45,000 GAIN

Not so fast though, remember you depreciated $30,000 over those 3 years…*depreciation recapture has entered the chat*

$30,000 of that $45,000 gain must be ‘recaptured’ and taxed at ordinary rates up to a max of 25%. The leftover $15,000 is taxed at a long-term capital gains rate.

Since you’re a baller and in the 32% income tax bracket, you’ll pay $7,500 in recapture (25% on that $30,000) and $2,820 in tax on the $15,000 (18.8% long-term cap gain rate + investment income tax).

In total, you owe $10,320 back to Uncle Sam. If the gotcha tax didn’t exist and you only had to pay long-term capital gains tax (18.8%) you’d owe $8,460.

It may not seem like a huge difference in this example but when you’re talking about hundreds of thousands or even millions in profits, depreciation recapture can be a b*tch!

Want to avoid this dark side?

Good news - if you lose money on a deal, you aren’t liable for recapture. The bad news is… well, you lost money.

The best way to avoid it when you have them #gainz is to defer it through a 1031 exchange - one of the most valuable tax-saving strategies in the US tax code.

We’ll have to tackle that 101 on another day!

007 Bonds… & Relation To CRE 📊 

Many don’t understand the correlation between commercial real estate and the good ole’ boring bond market. Did someone say bond?

I promise this isn’t another call-out session on investors, but it’s so abundantly clear that the game is being flooded with people who have oversimplified it for so long that we have to make mention why commercial real estate investing isn’t as easy as joining some mastermind or watching a few Youtube videos.

No one has a crystal ball, but there are tried and true best practices in the game. One of the main indicators of whether or not the market is ripe for commercial real estate investing.

How you might ask? Allow us to show you a comparison of the bond market and the captivating world of commercial real estate investing.

Picture this: two worlds colliding like distant cousins at a family reunion. One, a market of debt and fixed income, and the other of bricks and mortar.

We are all victims of recency bias. I’m not going to go full psychologist on you, but real estate professionals (like us as The Shake) may be the worst of them all.

Is it our fault? Not entirely. Will we pay for it? Many will.

The reason we’re mentioning recency bias is that it made a ton of people look at the real estate game through a short-term scope, rather than seeing where the recent market stacked up compared to the traditional world of investing. Low-interest rates combined with more “information” on the internet and social media created a whole new wave of investors. Think back to 2020-2021 when everyone and their mother suddenly became an expert on real estate overnight.

So what happened? Well, people saw commercial real estate as a far safer investment than it really is, especially when compared to the tried and true, old-school, and traditionally boring bond market.

Remember my analogy above about the distant cousins? Picture this:

First up, we have the bond market, that old-timer who loves to play it safe and steady. Think of it as the reliable grandparent who insists on giving you those low-risk gifts on every birthday. Bonds are like the slow and steady tortoise of the financial world - they might not win any races, but they rarely lose either. You can count on them to generate a consistent income stream but don't expect any wild excitement.

Now, enter commercial real estate investing, the young and adventurous rebel who's always looking for the next big thrill. This market is more like a high-speed chase through the bustling city streets - fast-paced, unpredictable, and full of adrenaline rushes. Sure, it comes with its risks, but where's the fun without a little gamble, right? With commercial real estate, you've got a chance to hit the jackpot, flipping properties and scoring big-time returns. But be warned, the stakes are high, and it's not for the faint of heart.

We write in this newsletter frequently about all of the benefits of investing in real estate, especially how it pertains to taxes. With that, we’ve recognized that many people involved in the CRE investing world seemingly forget the root of all investing: the yield of the investment. Many people with recency bias are still taking a peek at deals at insanely low CAP rates of 4-5%, and not realizing that there are far better vehicles today to put their money in for this return. It just doesn’t make sense. Our buddy Jerome just raised rates again, so what’s the play here? Wait and hope for rates to come down? Somehow we still aren’t seeing any pricing correction based on what’s going on.

Liquidity is another aspect that people are somehow forgetting about in today’s game. When it comes to liquidity, the bond market is the clear winner, always ready to cash out when you need it. You can easily buy or sell bonds with just a snap of your fingers. Commercial Real Estate on the other hand? That can take months or years to move, especially if your pricing is unrealistic. On top of it, there are a ton of fees associated with moving a piece of CRE, as we all know (and this is a broker writing this).

That 4-5 CAP sounded a lot better when the rates were sub 4%, but without a nice basis point spread, how can anyone make sense of some of these investments today versus something easy like a treasury note? Hard to say.

Just another daily reminder that research and thorough understanding wins, not worrying about the guy you went to high school with bragging about all of his units 😉 

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^{DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.}