In this second weekly edition in a series of newsletters, I’m going to highlight one of the big time tax benefits of investing in Opportunity Zones – depreciation recapture is eliminated upon sale of certain properties.
Most of us are quite familiar with how Master Limited Partnerships (MLPs) work in regards to distributions. In a typical MLP structure, investors receive a share of the distributed income along with a portion of depreciation and depletion allowances. Generally speaking, for every dollar of distribution per unit that is paid out, the cost basis of that same unit is reduced by $1.00 as well, making for a higher capital gains tax upon the sale of that MLP unit. Hence, the IRS recaptures depreciation in this manner in exchange for taxed advantaged income.
How does depreciation recapture apply in real estate? It is the Internal Revenue Service procedure for collecting income tax on a gain realized by a taxpayer when the taxpayer disposes of a property that had previously provided an offset to ordinary income for the taxpayer through depreciation. Depreciation recapture most commonly applies when dealing with the sale of improved real estate (such as rental property), as the value of real estate generally increases over time while the improvements are subject to depreciation.
Let’s use the renovation of a multi-family housing apartment project as an example. Rental properties are popular investments for good reason. An investor can enjoy steady cash flows and build equity while the property appreciates over time. There are also tax advantages. The IRS allows for the deduction of legitimate expenses related to rental property, including:
- mortgage insurance
- property taxes
- operating expenses
Investors take these deductions during the same year the money is spent and report them along with any rental income.
They can also deduct the cost of buying and improving the rental property, but it works differently. For multifamily properties, IRS depreciation schedules allow for the deduction of the cost of acquiring a property over a period of 27.5 years, considered the useful life of most commercial properties. Instead of claiming one huge deduction when the property is purchased, the cost is spread, or depreciated, over the useful life of the property.
In a conventional transaction, if the rental property is sold, the IRS is going to want that depreciation back. This is known as depreciation recapture. When qualified properties held in a Qualified Opportunity Fund (QOF) are sold, after a 10-year holding period, the IRS does not require the return of any depreciation-related deductions received. Hence, there is no depreciation recapture and investors enjoy the full benefit of receiving 100% of the depreciation tax credits claimed.
This is just one of the many tax advantages of investing in Opportunity Zones, but one that matters greatly in the exit and sale of properties that have been depreciated over several years. Such a feature can result in substantial tax savings in what is truly a unique structure that is becoming one of the most popular real estate transactions conducted for clients looking for strategic alternatives.
Don’t hesitate to contact me if you have any questions regarding Opportunity Zones and/or investing in Qualified Opportunity Funds.