Planning Without A Purpose — Oops

Posted @ 11:18 am - Filed under 1031 Exchanges, Real Estate Investing, Purposeful Planning, Cost Segregation

So I’m talking with this cost segregation guy today, very experienced, and absolutely a southern boy through and through. He’s talking about how so many investors using his company’s service will be saving so much money in taxes not paid. Of course, that’s what CS does for you. It ramps up the annual tax shelter provided by depreciation. CS is kinda nuclear vs conventional.

Anyway, it dawns on me. So many investors are going to be really irked at their accountants on the first day of the sixth year of their depreciation schedule. Why? Because though they thought they were planning, their approach wasn’t really purposeful - if you follow.

Their purpose was to cover all the property’s income so as to avoid paying taxes on it. Simple enough. But now it’s been five years of bragging to whoever will listen about all the shelter you were so clever to acquire, and the gravy train is over. Most of the time the sixth year is when the party begins to peter out, so to speak. The tax shelter doesn’t go away, it just shrinks — in many cases alarmingly so.

Usually by then the income has increased, and now the poor guy is standing out their in his BVD’s with his cash flow showing. So he gets the bright idea to get out of that property via a 1031 tax deferred exchange. Just a doggone minute there, cash flow breath. Since you’ve taken some pretty impressive depreciation against some very nice cash flow for the last five years, your adjusted cost basis is now hovering around two Snickers Bars and a half eaten rolled taco. Oops.

In plain English this means when you sell, your profits will be magnified. Instead of say, your actual purchase price of $1Mil, your capital gain will now be computed on an adjusted cost basis of about $700K! If you sold it for a net $1.5Mil — you’re on the hook for a taxable gain of around $800K. Now you guys who actually know what I’m talking about — don’t get your panties in an uproar. I know this is simplified to the nearly absurd. It also doesn’t take into account the concept of recapture which will cost you more in taxes in terms of tax rate than capital gains. Recapture is an expensive item — another post another day.

Of course, you’re now screaming that the guy said he was going to make use of a tax deferred exchange. Fair enough. Let’s take a ride down that road.

He’ll take his net sales proceeds and find another property to execute the exchange. No big deal, right. Maybe — maybe not. Since his adjusted basis has been so radically reduced by his five year use of magnified depreciation, his new basis will be the much lower than if he hadn’t used CS. He can only increase his adjusted basis only by the increase in debt. If he’s going for cash flow, he’s trying to limit debt, right? The bottom line here is that his depreciation for the new property, even with another CS study, could fall short of sheltering is new cash flow.

Now he’s possibly in a position where he’s living the punchline of a good news/bad news joke. What’s the good news? Dude, you gotta lot of cash flow. What’s the bad news? Dude, you gotta lot of cash flow. What’s the really bad news? Your new depreciation schedule, even with another cost-seg study may fall woefully short of sheltering the new cash flow — which over time will only increase, exacerbating the problem.

This could happen in the first exchange or not. It will happen though — and most likely sooner rather than later. There are solutions to this — but they need to be in place — you guessed it, before and not after you find yourself hanging out in your BVD’s.

Back to the main point. The investor didn’t have to end up this way. His plan needed more of a purpose. And merely sheltering cash flow to avoid taxes isn’t a stand-alone purpose. When was the last time you saw the government give something without eventually taking something away? Right — never.

So understand what you’re doing, and ensure all parts of your Purposeful Plan play nice with each other. The IRS very rarely calls you up to tell you what a great job you’re doing.

Finally, this isn’t to steer investors clear of making prudent use of Cost Segregation studies. Used within a comprehensive, well thought out Purposeful Plan CS can make a hugely positive difference. Just don’t find yourself looking at the immediate tax benefit then charging into battle. CS is like any tool in your chest — use it wisely or suffer the consequences.

Note: I’m closing in on the recapture dilemma solution. It’s ah, complicated. But the experts are one and all telling me it’s a very cool way to look at the problem. The firm with whom I’m talking is, in my opinion, one of the elite in the business. Makes me feel tingly all over.

This entry was posted on Wednesday, May 9th, 2007 at 11:18 am and is filed under 1031 Exchanges, Real Estate Investing, Purposeful Planning, Cost Segregation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.