Today’s question is very quick and simple. And so I’m going to give a quick, simple answer. And interestingly enough, this is not a question that comes up very often at all. And the reason is, is because the question has to do with something that is 27 and a half years down the road. So John writes in with a question and he says, I’ve been searching for the strategy planning for approaching end of depreciation, life of rental property. 27.5 years was always so far out there. I didn’t expect to still have the property as you get into the twenties, meaning 20 years and on of ownership, not your age of twenties, should you start looking to exchange the property or just disregard and only look at the income potential though, there will be similar units, but at higher-end depreciable cost basis.
So good, good question, John. The answer to the question is really two parts. Really, it depends if you’ve held a property for 27 and a half years, which by the way, for listeners that are not aware, the IRS allows you to depreciate the improvements of your property, which means everything, but the dirt over a 27 and a half year period, and this depreciation is essentially a phantom write-off. It means you can deduct it from your taxes, your income, your passive income each and every year. And it lowers the taxable income from your property. Now, although it’s not actually lowering the income in dollar terms, it just looks like it’s lower on paper. So you don’t have to pay tax on that. What it is doing is it’s giving you essentially a free write off to lower the tax impact, or probably even eliminate the tax impact from the income coming from that property for 27 and a half years.
It’s a beautiful thing. It’s a powerful thing. It’s a great thing that the IRS or the tax code allows us property investors, real estate investors to do with our income properties. It’s a beautiful thing. Now what happens is after 27 and a half years, the depreciation has gone. You’ve effectively written off the entire property, the improvements, and now going forward, you continue to get the cashflow. You continue to benefit from the property. Nothing really changes other than the fact that you lose this depreciation tax write-off. So you have two choices. One, you sell the property well more specifically, you wouldn’t just sell it for the sake of selling it. You would sell it under a 1031 exchange, meaning you can sell it and have a tax-deferred exchange and use that equity in the property to buy more that you could leverage. You could finance. You don’t have to, but generally speaking, you’re going to build up or leverage up from that initial property. And what that does is it gets rid of the old property, but it allows you to step up or move up into more properties, probably increasing your cash flow and you don’t lose any equity because all you’re doing is moving equity from that first property that you were depreciating for 27 and a half years into two or more properties elsewhere or in the same market. And now you start the clock all over again. You now start that 27.5-year clock on depreciation, right from the beginning. And now you have those phantom deductions once again, but this time probably multiple properties and you have the multiple income streams.
That’s generally speaking. Each individual situation is different. And you need to certainly talk to your tax advisor about what makes the most sense, but conceptually and fundamentally, it really comes down to a, do you need that tax write off? Do you need the depreciation or are you happy with the portfolio of properties that you’ve built that you now have that has given you a passive income stream? Because you’ve been investing for however long, 10 years or more. I mean, if you’ve got the property for 27 and a half years, you’ve clearly started a long time ago and you probably have a lot of property under your belt and you have a good passive income stream. So there may not need to be a need to sell the property. So you got to look at your own personal situation and just take an analysis of how much income you have coming in. How much of it is passive income and what other tax write-offs you have. If any, that you can use to defer or reduce the tax impact on your existing passive income. And if you have a professional status, you may be able to use all your passive losses against all your income, both passive and income, which is even a better situation.
So the answer to the question of whether you should sell the property in order to just get another property or more that you can depreciate or not comes down to two things. One are you in a point in your life where you have enough passive income and a large enough portfolio and a large enough net worth that continuing to exchange and trade up and build your portfolio just for the sake of that depreciation is important to you or are you fine where you’re at and really if you’ve got property and you’ve got a lot of income that you do need the tax depreciation write-offs for, then go ahead and do a 1031 exchange and get yourself some more property and take advantage of that depreciation because it’s a great thing. And hopefully, it doesn’t go away anytime soon. I mean, we’ve got elections around the corner and I know there’s talk about increasing taxes, changing the 1031 exchange rules, all kinds of things who knows, I guess time will tell and we’ll find out next year and as the years unfold. So anyway, John, thanks for the question. I really appreciate it. Thank you to everybody for listening and tuning into the show. Remember to subscribe, share the show with all your friends and I will see you on our next episode. Thanks
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