A Powerful 1031 Exchange Alternative: Bonus Depreciation in Mobile Home Park Investments
Investors love mobile home parks (MHPs) because of their recession-resistant qualities and their ability to deliver stable cash flow. MHP investments also provide a lesser-known, yet equally compelling advantage: tax efficiency.
When evaluating an investment, investors typically focus on how much money they can make. However, it’s important to not overlook another key element: an investment’s tax efficiency, which impacts how much money investors get to keep.
Why are mobile home parks more tax efficient than other types of real estate, and therefore, more favorable for investors? Let’s take a look.
Delving into Depreciation
“Depreciation” is an accounting term that refers to the reduction in a property’s value over time, particularly due to wear and tear. Essentially, depreciation assumes that everything has a limited useful life and that things tend to gradually wear out.
The U.S. tax code assigns a useful life to commercial real estate, generally 39 years. For tax purposes, a property is assumed to wear out, or depreciate, a little bit each year over that period of time. Depreciation is treated as an expense, so by expensing a portion of the property each year, investors reduce taxes on the income they earn, allowing them to keep more of what they make.
The faster a property can be depreciated, the greater the property’s tax efficiency, and the greater tax advantage. The U.S. tax code allows some types of real estate to be depreciated faster than others. This is where mobile home parks gain such a significant advantage.
The Mobile Home Park Investment Advantage
For accounting purposes, when a property is purchased, the property’s value is generally divided into three buckets, based on useful life expectancy.
Bucket #1: Land
Land has an indefinite useful life, so the portion of the property’s value allocated to land is not depreciated.
Bucket #2: Building
Commercial buildings have a longer useful life and are depreciated at a slower pace, generally over a period of 39 years.
Bucket #3: Land improvement
Improvements like roads, underground pipes, electrical lines, pads, and pedestals have a shorter useful life and are depreciated at a faster pace, generally over a period of 15 years.
Unlike most other types of real estate, a large portion of a mobile home park’s value often comes from land improvements, allowing depreciation at a much faster rate. Herein lies the powerful tax advantage of MHPs that investors love.
A Real-Life Example of Mobile Home Park Investment Tax Efficiency
Let’s look at an extremely simple example of a mobile home park compared to a commercial building. For comparison purposes, we’ll assume both properties are in a similar neighborhood, with the same purchase price of $3 million and non-depreciable land value of $600,000, leaving $2.4 million that can be depreciated.
With the commercial building, most of the remaining $2.4 million would be allocated to the building bucket and depreciated over 39 years, meaning about $61,500 could be expensed each year.
With the mobile home park, most of the remaining $2.4 million would be allocated to the land improvement bucket and depreciated over 15 years, meaning about $160,000 could be expensed each year.
Although this is an overly simplified example, you can see the enormous difference between the two real estate types in terms of tax efficiency. With a greater portion of the property expensed each year, mobile home park investors can dramatically reduce their taxable income and keep more of what they make.
The benefits of depreciation became even more attractive in recent years when the Tax Cuts and Jobs Act of 2017 increased first-year bonus depreciation to 100%. Applied to a mobile home park, this means the entire land improvement bucket can be expensed in the first year of ownership, instead of over a 15-year period.
This can be immensely attractive for investors seeking tax losses to offset passive investment gains they have received in that same calendar year. Due to the time value of money, tax deferral is extremely valuable. Every tax dollar deferred contributes to a greater return on investment.
Depreciation and bonus depreciation defer taxes until the property is sold. In other words, investors pay less tax on the income while they’re invested and are able to offset passive investment income from other sources. The use of bonus depreciation can be an alternative strategy for investors who are not able to successfully execute a 1031 exchange.
Investors in higher tax brackets will realize a lower tax rate when the property is sold than they would have if depreciation was not utilized. This “tax arbitrage” strategy lowers their overall tax bill and is an additional benefit beyond the time value of money.
Appreciation for Depreciation
The accelerated depreciation afforded to mobile home parks makes them one of the most tax-efficient real estate investments. With bonus depreciation, investors get to enjoy “tax-free” income from a predictable strategy while they are invested, and offset qualified passive income from other sources.
Mobile home parks are already known for their recession resistance and ability to deliver consistent cash flow, but their tax efficiency is yet another reason they are one of the most attractive investments in real estate.
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Original published on 52ten.com on August 2, 2021.
This content is the perspective of the author and is not intended to be relied upon as a forecast, recommendation or investment advice, and is not an offer or solicitation to buy any securities or to adopt any investment strategy. The information and opinions contained in this content are derived from experience, historic data, and other sources deemed to be reliable, are as of the date of this content, and may change as subsequent conditions vary.