Nobody likes to pay taxes. Absolutely nobody. And in America today, taxes are just a part of our life. There's an old saying that the two certainties of living are death and taxes. And as a result, since none of us like to pay taxes, over the years, people have tried to find loopholes or methods to reduce their tax bill or avoid their tax bill. And in the world of real estate, there's three typical ways people do that: 1031 exchange, accelerated depreciation, and opportunity zones. But sometimes, in search of lower taxes, we can cause other problems that are often even bigger than those tax savings. This is Frank Rolfe with the Commercial Real Estate Mastery Podcast. We're gonna talk about the dangers of chasing after tax benefits.

Now, let's start off with the 1031 exchange. In a 1031 exchange, you are able, in selling a property, to buy something of a similar size and defer your ultimate payment of tax. I'm not sure why they started doing 1031s. It was meant to stimulate, I think, property buying and investment. But in so doing, they put a time clock on it. When you do a 1031 exchange, you don't have an infinite open door to when you buy that replacement property. Instead, you only have a matter of days. So as a result, there's this time clock running from the minute you start that 1031 until you complete it. And I think that's where much of the danger happens, because when you're racing to meet the demands of the clock on that replacement property, you often lower your standards, and that is the big issue.

So let's say that you sold a duplex and you did tremendously well on it. You bought it perfectly, you fixed it up, you raised the rent, and let's assume now you make a half a million dollars profit. You found a buyer, and you're gonna make half a million dollars profit, but instead you decide you're gonna roll that into a 1031 exchange. Now you're gonna go out and buy a replacement property. But this next thing you buy, you're not as good a shopper. You're under the gun. You gotta get it done before that 1031 window of opportunity closes. So you go out and buy another thing. Let's say you buy a fourplex, but this fourplex isn't that good a deal. And ultimately, at the end of the movie, the fourplex is worth half a million less than you paid for it. And you lost all your savings.

And that's a common thing that happens with 1031s is people in their race to find the replacement property, they lower their standards. They're moving fast, playing it loose, don't do as good due diligence, or simply accept things which really are not as good. So you've gotta be very careful. If you're gonna do a 1031, do not do it unless you would buy that property without the tax deferral. So if this is a property that meets all of your regular standards and you would buy that thing no matter what, even if there was no 1031, okay, then go forward. But if you're only doing it to save on the taxes, that is the tail wagging the dog. That is a terrible idea. In that case, you would never want to do it.

Then you have accelerated depreciation, also known as bonus depreciation or cost segregation, methods to speed up the amount of depreciation you can write off on the property. And it sounds good on paper because gosh, who doesn't like to have giant amounts of money they don't have to pay in taxes this year thanks to all of these bonus things that the government's giving you on accelerated depreciation? But the problem they don't tell you about on these is you only get so much depreciation. It doesn't expand the amount you get. It just speeds up how fast you get to use that depreciation. And here's where you can get in trouble.

Let's assume that you just use everything at your disposal, the most rapid depreciation possible on that property. And then what happens? Well, then you got no more depreciation. And in most commercial real estate, what your depreciation does is it covers your principal payment on your mortgage. Not in all cases, talk to your tax professional, but normally that's how it works out is the depreciation on the property is just enough so that you don't have to pay tax on your principal payment. Because otherwise, you do. Your principal payment, that component of your mortgage of the interest and principal, just the principal part, that amount is profit, and that amount will be taxed.

So it can be a pretty big amount of principal on your mortgage payment and therefore be a pretty big amount on tax. And you get to hide from that issue the entire time you own the property if you use standard depreciation normally. But when you ramp it up, when you go accelerated, you end up with what's called phantom income. That's where you have profitable taxable money on paper, but you never got it. And you didn't get it because you had to give the principal portion to the bank, so you have no money to pay the tax. Therein lies the problem. So make sure you understand on those rapid depreciation schemes what happens at the end of the movie once you've burned through all the depreciation, because then it seems a little less fun.

Then you have opportunity zones. Now, the opportunity zone is a new kind of tax deferral strategy brought to you via the government trying to get people to invest in blighted areas. And the key question on many people who dabble in opportunity zones are, is it really gonna work? Do people really want to live there? Because some of these areas that are in opportunity zones, it's hard to fathom how there are any customers. You can build apartments there, sure, we can build a retail center, but is anyone really gonna want to take occupancy there? How is that exactly gonna work? So once again, people chasing after tax deferral are often getting themselves into a trap by getting involved in markets where there is no demand for what they're trying to do. So once again, in search of the tax, the tail has wagged the dog and got you into trouble.

Now, on opportunity zones, one thing I have noticed, there's a loophole in them, and that is some of them are not in blighted areas. Look at the opportunity zone map. Pull it up on the computer. It's in the public domain. It's there for all the world to see. You'll see it's not always in areas of town that are considered bad. Some of them are in areas considered good. I don't know how they made it in on the opportunity zone front. It makes no sense to me. I have to assume it was someone in government who owned some land over there and thought they'd just throw a little extra money their own way. I'm not sure how that worked, but once again, be very, very careful on opportunity zone investing that you're doing it not because just of the tax advantages, but because you would do it even in the absence of any type of tax benefit at all.

The bottom line is that it's not always bad to pay tax. Right now, our nation has among the lowest tax rate ever on real estate sales via capital gains tax. It was something the Biden administration wanted to take away. They wanted to remove capital gains. Fortunately, it never happened. Trump recently in the Big Beautiful Bill made them permanent. But it's low. It's very low. Your ancestors paid far more in taxes than you do today on these real estate deals. So maybe paying the tax and being done with it forever is not a bad thing. We don't know what will happen in America going forward. It may be the tax tables are rapidly changed. The people who voted in those tax changes as being permanent could easily vote to have them undone. Who knows what'll happen? Maybe capital gains tax 30 years from now will be 80%. I have no idea.

But if you pay the tax, you do lock on its current rate forever. And so you gotta really think twice on many of these tax deferral schemes because you're not abating tax forever. You still ultimately have to pay the tax. Just a question of when and how that will occur. But make sure it does not flavor your decision-making to get involved in marginal deals just chasing those tax savings. This is Frank Rolfe with the Commercial Real Estate Mastery Podcast. Hope you enjoyed this. Talk to you again soon.