There are methods of reducing taxes for self-storage owners, but they come with great risks that are rarely discussed. In this Self-Storage University podcast we’re going to explore the often misunderstood subject of tax deferral methods and their potentially harmful implications.
Episode 136: The Dangers Of Tax Avoidance Transcript
The headlines in many real estate publications are chock-full of things about cost segregation and bonus depreciation, all kinds of tax deferral strategies, but they never mention the risks involved with those. And if you don't understand those, you can get in some real trouble. This is Frank Rolfe, the Self-Storage University podcast. We're going to talk about all about tax deferral concepts and what the dangers are with those. And we're going to break it into two categories, the two most common methods that Self-Storage owners use to try and defer tax. And one is cost segregation or rapid depreciation, and the other is the 1031. So let's start off with rapid depreciation methods. In this concept, what you're doing is you're using faster depreciation than what was the normal standard to shelter your income on the front end. Because typically with any property, part of it is ascribed to land which can't be depreciated, and the other portion is to improvements which can be depreciated. And depreciation is a wonderful thing because it allows you to shelter your taxable income. So we all love depreciation, and on a typical property that depreciation is spread over many, many years, often decades.
So that's kind of the classic form. And what you'll find most of the time is that depreciation serves a very important purpose. Because when you make your mortgage payment, part is interest and part is principal. And the part that is principal is taxable income, it's a profit, but you don't get to put it in your pocket. You have to give it to the bank to pay down your loan. That's how a fully amortizing mortgage works. Unlike an interest only mortgage where there is no principal payment, with most mortgages out there, by far the majority, part of your regular monthly check to the bank is part interest and part principal. And normal depreciation shelters that principal portion. But then you have these new concepts out there like cost segregation and bonus depreciation ways that you can take the depreciation that would be spread out over the decades and roll them much greater intensity at the very start. And some people think that's fantastic. They say, oh my gosh, I'm going to write off all this money on the front end with my storage facility. I am a rocket scientist. And here's the problem. No, you're really not.
You got to really think through what you're doing. If you were going to go ahead and keep that storage facility for a year or two and then dump it. Well, okay, that might be fine. But instead what's going to happen is once you blow through all your depreciation and you're only maybe five years or so into the deal, and you've got a 25 year mortgage, you've got 20 years with no sheltering and no depreciation. And that means every time you pay your principal on your mortgage at the end of the year, you're going to be taxed on that and you don't have the money to pay it because it all went to the bank. And that is called fandom income. It's income that will show up when it's tax return time. But you didn't show up in your bank account. You never saw a penny of it because you were using it to pay down debt. Now, if you just have one small storage facility, you can probably handle it. But if you've got more than that, if you have a large facility or large facilities or even a larger portfolio, it can be absolutely crushing.
Back in my first business, the billboard business back in Dallas Fort Worth, that was the great problem with owning billboard, because billboards depreciated down faster than what you could cover. So what would end up happening is, we would have these billboards on amortization plans that were fast and I would blow up my depreciation and suddenly I had phantom income coming out my ears. It drove me absolutely nuts. So I've been there, done that. I don't have any interest in ever going there again. So before you jump into cost segregation, bonus depreciation, these type of things you got to talk about to your CPA and make sure you fully understand the ramifications because most people jump into it and they don't realize what they've done until it's too late, when in the future they start having to pay tax on money that they don't have in their account. The other tax deferral strategy that never comes with any warnings on the label is the good old American 1031. Now, the 1031 exchange allows you to sell a storage facility and then buy another one or another piece of real estate that's similar and not pay any tax on your profits.
It's rolled into the next property. I guess it's assumed by the government they're going to get paid in the end anyway. So they don't care if you want to defer that for a while, they're going to get paid no matter what, at least in their mind. But here's the problem with the 1031, most people get so obsessed with saving the money in tax, they make stupid purchases of the replacement property. Because when you sell your property, you have a certain timetable that's very short, very short window to find the replacement property. Here's the typical scenario. You bought a storage facility cheap. You increase the occupancy, you increase the rents, you contain the costs. And now you've got a great offer to sell that storage facility. And let's say you're going to make $1 million of profit on it. That was a job well done. But now you say, well, I don't want to pay the tax on that million. I'll go ahead and buy another property and roll that million dollars into it. But the problem is that second property wasn't of the same quality. It really wasn't a good deal. Why do you buy it?
Because it was the only thing you found at the moment that fit the parameters of the 1031 exchange. And so with a very short time frame, you pulled the trigger. So you made a million on the first park, but the second, the larger park, you lost a million. What does it all mean? It means you would have been way better off just paying the tax. You hear this from many, many people who've engaged in 1031s. Ultimately, they regret it because they took their profit and then they threw it in the trash can with the replacement property. You got to remember that typically if it's a good time to sell a property, it's not a good time to buy them. You're going to be selling a property when cap rates are low and values are high. That is not the timing you want when you buy it. You want to buy the mobile home park when the interest rate and the cap rates are attractive from a buyer's perspective. But often, when it's time to sell is not the time to buy. So as a result, the deck is kind of stacked against you. You have a very short time frame and you're now going out deliberately waiting into the market to find the replacement property.
Pretty much maybe the worst time ever to be doing that. So how can you do a better job? Well, I wouldn't do a 1031 on a property unless you would buy it even if there was no tax deferral system. Do not relax your standards one iota. If you cannot find a replacement property that's as good or better than the one that you are selling, just pay the tax. Remember right now that capital gains tax is among the lowest it's been in American history. There is no guarantee of where it's going to go in the Future. We've got 35 trillion-plus in debt growing to 50 trillion and well on its way to 100 trillion of debt. If the government is ever to get back in the black, tax rates will have to go up substantially. And most Americans are not in your court when it comes to taxes. All you have to be to be the top 10% of Americans is have a net worth of a million dollars. So most Americans, at least 90% of Americans have very little mercy on those who are high earning because under their argument, hey, most of Americans are not.
And we need your money in tax to help spread the wealth around all the rest of us. So it's a very good likelihood capital gains tax will go up in the future. If you just pay your tax now at these low rates, you never have to worry about it again. The bottom line to it is, if you're going to do anything to delay to defer tax, get with a professional. Make sure it makes sense for you. Many of the people selling these ideas, they're compensated by doing it. Someone who does cost segregation accounting of course will tell you it's the best idea of all time. But get the complete picture. Get the 360 degree view. Talk to your CPA in advance of doing these things and make sure that on a long term perspective that it's the right decision. This is Frank Rolfe, the Self-Storage University Podcast. Hope you enjoyed this. Talk to you again soon.