Sheltering From Depreciation with David Foster

Sheltering From Depreciation with David Foster

Welcome to the Real Estate Espresso podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor ~~Menasse~~ 📝Menasce. This is the weekend edition where we interview notable people from the world of real estate investing.

Today is no exception. We have a great guest, all the way from St. Petersburg, Florida. Welcome to the show, Dave Foster.

Thank you, Victor. It’s great to be here.

Well, great to have you here. Now, Dave, you come from the world of 1031, which is a topic near and dear to certainly my heart. But maybe before we dive into the details, perhaps give a little bit of your backstory and how you got to this point in your journey.

Right. Well, I’ve always been a real estate junkie. When you couple that with a small case of ADHD, it means that I’ve dabbled in everything. Never met a real estate deal I didn’t want to try to make work. But along the way, just like you and I, we’re all very familiar with that age-old axiom: you make money in real estate when you buy it. And typically that’s proven true for decades and decades of people, that if you buy it right, you can ensure your success on the end.

But a number of years ago, one of my mentors challenged me to twist that around and say, “Dave, the true test of wealth is not how much money you’ve made in real estate. It’s how much you’ve kept.” And that sent me on a journey. After paying a couple of painful tax lessons, it sent me on the journey of finding the 1031 exchange.

Very unique to the U.S. tax code, but what it does is it allows real estate investors to sell either highly appreciated or highly depreciated real estate—investment real estate—replace that with new real estate, and indefinitely defer paying the tax on the profit that you normally would have. When I saw that and the power that it had for my own portfolio 30 years ago to shut the back door of the barn and keep those profits with me, that’s when we started doing that for others. And it has been a very, very powerful tool that we’ve used over the years.

I love what you said there. Because when we often think about the 1031, most people think automatically about sheltering from capital gains. But you said also sheltering from highly depreciated property, where you’re now going to be facing a large recapture that would, in fact, be coming in as ordinary business income, potentially a much higher tax rate. Let’s go down the rabbit hole of depreciated real estate and using the 1031 for that.

Yeah, that’s absolutely correct. As a matter of fact, what makes that so relevant for today is, with the Tax Cuts and Jobs Act extension now put permanently into the tax code in the… I always forget what order it comes in, but that big, beautiful new bill, we are able to take investment real estate and, using bonus depreciation and the opportunities in that, to write off 100% of those assets—the construction side of those assets—in year one that we purchased them.

So for companies that are very multifaceted in terms of numbers of projects and staggering time of projects, the ability to harness that depreciation immediately is immense. Now, because you can use the 1031 exchange and take that…

Let’s say you were selling a $5 million facility that you had just bonus-depreciated out $4 million of it. Well, instead of having to pay the recapture on $4 million at ordinary income tax rates, you’re able to defer that into your replacement property.

Now, if you were to be buying a property, let’s say, for 10 million—an identical property, only twice as big—you’re not only going to be deferring all of that, what could be $1.5 to $2 million of depreciation recapture into the new property, but you’ll also be getting another $5 million in depreciable basis. So you could start to daisy-chain that forward as long as you’re in growth. And it’s incredibly powerful just for that alone.

Let’s talk a little bit about what happens on the recapture side. So let’s say for the… I’m gonna just come up with a very simple example. Say you’ve done your cost segregation study, and you’ve got the vast majority of that property—the improvements, of course, land doesn’t depreciate—so those improvements happen to fall just magically within that five-year property category.

So at the end of five years, that depreciable property would be used up. That means that your recapture would be reduced at the end of that five-year period. So let’s say you’re halfway through that five-year period. You’re at the two- or three-year mark. Now, instead of having, in your example, a $4 million recapture, you might have a $2 or $2.5 million recapture, because part of that has been used up.

But now you’re going to take that, you’re going to shelter it, 1031, you’re going to go buy another property. And with that new property, you’re also going to apply bonus depreciation to that property. So you’ve sheltered the recapture, and you’ve taken another big business write-off to have it.

Right? That’s exactly right. And you can keep that rolling forward. Now, in the game of musical chairs here, when does the music stop? Whenever you sell that piece, that brand-new piece of property without doing a 1031 exchange. So as long as the company is alive, it can be doing that forever.

The beauty of the 1031 exchange is that you can reposition into any type of investment real estate asset anywhere in the United States. So you can pivot whenever and whatever the market cycle is telling you. If you need to move from, say, self-storage into commercial strip center, it’s very easy enough to do.

In particular, what we will see people doing is they have to have… Now, why they should change their model, Victor? Because the 1031 exchange is only available for real estate that you have purchased with the intent of holding for productive use. So if you’re simply a developer who’s wanting to develop, patch into ~~estim~~ 📝assets, 1031 is not going to work for you.

No, because that’s dealing in… that’s dealing in land as inventory.

That’s exactly right. But if you can tweak your model ever so slightly to product use long enough for a year or two, to demonstrate your intent, then the 1031 door is wide open. And so you can then go from whatever that asset is into new assets of any number, of any type. So our clients, we use it to pivot quite frequently, depending upon what the cycle is telling them to do.

Now, let’s imagine for a moment—I know your role here, tax advice, because you’re not an accountant. But let’s say that you sell a property that you’ve depreciated. You’re crystallizing at that point, let’s say again, to use your example, $4 million of recapture that is going to carry, you’re going to defer that recapture. But that’s going to stay with you.

Let’s say you go buy a cattle ranch or something like that that doesn’t depreciate. Is that $4 million of recapture gonna carry with you till the end of time?

Generally, the consensus ruling right now… I am an accountant, but I don’t do taxes, because I… so why do them? And the consensus right now—and it’s got to be played out with the adoption of this new bill and the solidifying of that—is that moving it into non-depreciable assets is going to trigger that depreciation.

However, moving into a mixed use… Let’s say a cattle ranch once again, break into segregated aspects, then the outbuildings, the facilities, the oil wells that are on it, those types of things can also… That’s actually something we’ve seen quite a bit. Because the movement: raw land is a beautiful hedge against everything. And the idea of oil and gas that’s on that land then starts your depreciation, or it keeps your…

I love it. How has the introduction of this new legislation, how has it affected your strategy as an intermediary, your clients’ strategy as investors, when it comes to 1031, if at all?

Well, I would say the biggest impact, beyond just the depreciation aspect, has been with our higher net worth individuals who, looking for tax abatement and needing it quickly, are moving from regular rental portfolios into the vacation rental markets, because tax rulings will allow vacation rentals to be used as an active investing category.

Oh, interesting.

So instead of only being able to harness a small chunk of that depreciation, you’re able to, akin, write off the entire amount in that year, as long as you’re showing substantial hours of management—managing your vacation rentals.

So, you know, we’ve seen in America just this huge boom anyways that started with COVID, because everybody were looking for places to go. But they needed to stay close, they needed quarantine. And then just from there, vacation rentals all over the country—from the Smokies to the ~~Pananda~~ 📝Panhandle of Florida and everywhere—have just mushroomed. And now everybody’s catching on to the fact that that’s an active investment activity. So we’re seeing that being used as a hedge more and more for our high net worth individuals.

Love it. Well, Dave, if folks want to connect, if they want to learn more, what’s the best way?

Yeah, education is where we live, because the IRS ain’t gonna advertise what you can do. So we’ve created a great site, our 1031investor.com, ~~72,~~ 📝our YouTube channel of these topics and others, opportunities to use our… our calculators, interface directly with us. You know, tax planning doesn’t happen overnight, it takes time. And the greatest 1031 exchanges are cooked up over time as well.

Absolutely. They don’t happen in 45 days. Well, Dave, great to connect. For the listeners at home, definitely want to connect at the 1031investor.com. Link to connect will be in the show notes. And in the meantime, have an awesome rest of your weekend. Go make some great things happen.

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