It is pivotal for general partners, sponsors, limited partners, or other real estate investor to understand the nuances of tax depreciation in real estate investments. In this article we will focus on the intricacies of allocating tax depreciation in a non-prorata manner, thereby enabling you to invest less capital while harvesting more tax advantages. We will dissect two distinct scenarios: placing the property in service as soon as possible (ASAP) and stabilizing the asset that allow for general partners or sponsors to receive most of the real estate tax depreciation allocation.
The Importance of Tax Depreciation in Real Estate Investments
What is Tax Depreciation?
Tax depreciation is a fiscal mechanism that permits investors to amortize the value of an asset over a designated period, thereby diminishing their taxable income. This is in accordance with the Internal Revenue Service (IRS) guidelines, which stipulate the useful life of various types of assets.
For commercial real estate properties buildings are depreciated over 39 years and other Qualified Improvement Property (equipment, furniture & fixtures, carpet, etc.) over less than 20 years.
For residential real estate properties buildings are depreciated over 27.5 years and other Qualified Improvement Property (equipment, furniture & fixtures, carpet, etc.) with less than 20 year life.
Why It Matters for General Partners and Sponsors
Tax depreciation is not merely a bookkeeping entry; it has a tangible impact on the Return on Investment (ROI) and cash flow for general partners and sponsors engaged in real estate ventures. By strategically allocating tax depreciation, you can optimize your after-tax cash flow, thereby enhancing the economic viability of your investment.
You will depreciate your real estate property (building or other tangible property), creating additional tax deductions that help you reduce your operating taxable income. There are also accelerated depreciation elections such as bonus depreciation that could be made to even create more meaningful tax depreciation deductions.
This ultimately flows down to the individual partners and these additional losses help you be more tax-efficient by reducing your taxable income and thus you paying less cash tax.
See our real estate tax guide for more how these works, strategies, and planning tips.
Scenario 1: Placing the Property in Service ASAP
Steps to Take
- Personal Guarantee on Real Estate Promissory Debt: This is an indispensable step for activating tax depreciation. You will increase your tax basis by personally guaranteeing the debt, giving you more basis to take more tax depreciation losses.
- Cost Segregation Study: This is vital for maximizing tax bonus depreciation, which stands at 80% for the tax year 2023. You will segregate tangible property into different asset classes with various lives, allowing you take bonus depreciation and basically write-off these assets on year 1. Create massive tax losses.
- Deficit Obligation Restoration (DRO) in Operating Agreement: This provision in the operating agreement permits your partner’s capital accounts to operate at a deficit. This is the KEY for Scenario 1 to work.
- Special Allocation in Operating Agreement: This should encapsulate both profits and losses, as well as distribution percentages. Your profit or loss waterfall will be based on this.
What Triggers the Allocation?
The allocation of tax depreciation is instigated by the real estate property debt that the general partner has personally guaranteed, thereby aligning it with the economic risk of loss.
The Role of the General Partner or Sponsor
The DRO provision enables the general partner or sponsor to receive a non-prorata or more generous allocation of tax depreciation. This aligns with the highest layer of the waterfall promote, thereby optimizing the financial structure.
Scenario 2: Stabilizing the Real Estate Property First
Why a DRO is Unnecessary
In the context of a stabilized asset, an unconditional guarantee to repay the debt is not necessary. We would want the debt to be recourse in this type of scenario.
Steps to Take
- Cost Segregation Study: Like above, you segregate the tangible property in the real estate property into different asset classes in order to maximize your tax depreciation with a shorter asset life. This should be conducted post stabilization of the property.
- Cash-Out Refinance: This aligns with the highest layer of the waterfall promote as stipulated in the operating agreement. You will want to distribute capital back to your limited partners immediately as the deal becomes stabilized. The goal is to minimize your limited partner equity balance by paying out distributions from the cash-out refinance, and that way you maximize the potential of your minimum gain that you are going to have.
- Minimum Gain Language in Operating Agreement: This optimizes the latent potential of your minimum gain.
Understanding Minimum Gain
Minimum gain is just to the extent your non-recourse debt exceeds your net basis of the collagenized asset (building less accumulated depreciation), that is a stabilized asset you will be able to get a large debt balance. That represents that amount that your capital account can be on a deficit (negative) with a DRO.
Operating Agreement Nuances
Your operating agreement should be meticulously crafted to include both non-recourse language and DRO provisions.
Allocating tax depreciation in real estate investments requires a nuanced understanding of various financial and legal mechanisms. By leveraging the scenarios above you can maximize tax depreciation to general partners or sponsors creating massive tax losses that you can potentially use to offset other classes of income.
Disclaimer: For further information or guidance you should contact an experienced CPA or practitioner who is familiar with all of the above tax legislation and applicability. Any information or articles presented on this website is for educational and informational purposes. The opinions stated on this website represent my own and not the opinions of any other person or organization. No information contained on this website is to be interpreted as financial, tax, investment, and or any other form of advice.