A client recently asked me to prepare something that explains the effect of using leverage to buy real estate, and this provided the inspiration for this month’s article. A question I get a lot is “I have owned real estate for a long time. My loans are paid off, and the property is fully depreciated. If I sell this property and do a 1031 Exchange, should I buy a replacement property all cash or with a loan?” This month, we’ll walk through the potential benefits of leverage to see which answer is right for you.

Most Real Estate Investors are Familiar with the Benefits of Leverage

Most of us originally bought our first house with leverage. We were able to put 10-20% down and secure a loan to pay for the balance. This allows us to buy a property with a smaller amount of upfront cash. In many cases, purchasing a house would be impossible without the availability of home loans.

Loans Can Offer the Investor More Appreciation Potential

Buying a property with a loan can allow more appreciation potential because you have the opportunity to earn on the bank’s money.

When we buy a property with a loan, we’ll put up some cash to buy the property and our lender will put up the remainer of the cash needed. When we sell the property in the future, our lender just takes back the remainder of the money he lended to us – we get to keep “his share” of the profit!

This is how your $28,000 down payment on a $140,000 duplex in 1986 can become $1 million of sales proceeds today – through the power of leverage. Your return on appreciation alone (excluding cashflow) is 9.3% annually – compared to a 5% annual rate had you paid with all cash.

Loans Can Offer Substantial Tax Savings

A great feature of owning investment real estate is that the IRS lets us write off a portion of the property’s value every year as “depreciation.” On residential properties, a property is depreciated over 27.5 years, while commercial properties take 39 years. The effect of this deduction is to defer (perhaps forever) taxes on a portion of our income from that property (or from other properties we own.)

Since using leverage allows us to buy more depreciable property by using “someone else’s money,” it therefore allows us to gather more depreciation deductions. A $2 million apartment property purchased with no loan will create (assuming an 80% improvements value) an annual depreciation deduction of $58,181, ($2 million X 80% / 27.5), resulting in deferring taxes at a rate of 2.9% annually on equity. If your annual cash-on-cash return on the property is 5%, that means 2.9% is deferred (potentially forever) and 2.1% is taxable.

If we use moderate, 50%, leverage and use that $2 million to buy $4 million of property, we’ll get double the annual deduction at $116,362 or 5.8% of equity. If we are receiving the same 5.0% annual return on equity; this will defer ALL income taxes (again – potentially forever) from this property. The extra 0.8% (in this example, $16,000 per year) can be used to offset income from other real estate or is carried forward to future years until it can be used.

Leverage and a 1031 Exchange Can Create Depreciation Benefits for Fully Depreciated Property

Many of my clients own fully depreciated real estate free and clear – the loan was repaid over their long ownership period. Because their properties are fully depreciated, they cannot enjoy the annual tax savings from their depreciation deduction any longer.

A 1031 Exchange into a property with leverage can solve this tax problem. Using a loan will allow us to buy more property, and the IRS will call this additional portion of the property “new basis.” The IRS says that we need to start depreciating this new basis immediately. (Taking a depreciation deduction is not optional – the IRS says we must take it.)

For example; years ago, a client approached me with a $1 million 1031 exchange involving his fully depreciated property. I showed him how, by using moderate 50% leverage, we could borrow $1,000,000 to buy him $2,000,000 of property, therefore purchasing $1 million of New Basis. Assuming that this property’s improvements are 80% of it’s value, we created $29,090 of annual depreciation deductions by using this leverage. ($1,000,000 X 80% / 27.5) We created a new stream of income for this client and were able to defer taxes on most of it!

Loans Do Add Some Risk

As with any loan, if we don’t make the payment, the bank will take our property back. We can manage this risk by using moderate leverage: 40-50% rather than 70-80%. My partial interest investments and whole ownership NNN properties come with non-recourse loans that mean the bank can only take the property to satisfy the loan. This sort of financing is described as “off balance sheet.” Because the investor is not personally responsible for the loan, it does not appear on any credit report and therefore does not affect his ability to apply for credit in the future.

Is Leverage on Your Investment Real Estate Right for You?

Since I help my clients complete tax-deferred exchanges full time, leverage is a topic that comes up constantly. Many clients need to replace debt as part of 1031 exchanges, while others may not need debt – but choose to use it in order to access these benefits. Is using leverage when buying new properties right for you? My office number is (877) 313-1868.

By Christopher Miller, MBA

Christopher Miller is a Managing Director with Specialized Wealth Management in Tustin, California and specializes in tax-advantaged investments including 1031 replacement properties. Chris’ real estate experience includes work in commercial appraisal, in institutional acquisitions for a national real estate syndicator, and as an advisor helping clients through five hundred and fifty 1031 exchanges. Chris has been featured as an expert in several industry publications and on television and earned an undergraduate business degree and an MBA emphasizing Real Estate Finance from the University of Southern California. Call him toll-free at (877) 313 – 1868.

Securities offered through Emerson Equity LLC, member FINRA/SIPC. Emerson Equity LLC and Specialized Wealth Management are not affiliated. All investing involves risk. Always discuss potential investments with your tax and/or investment professional prior to investing.