The after-tax return math most underwriting skips

Almost every institutional real estate model quotes returns pre-tax. There is a good reason for it. A fund with limited partners in different states, different entities, and different personal tax positions cannot compute one after-tax number that is true for all of them, so the property-level pre-tax return is the only figure everyone can compare. Pre-tax is the right convention for a syndicated deal.

It is also the wrong number for a decision, and the gap between the two is not small. For an individual or a family office buying in their own name or through a pass-through, the after-tax return can land well below the headline. The worked example at the end of this piece gives up about 250 basis points of internal rate of return, and how wide that gap gets depends on asset class, leverage, hold period, and how much of the basis is land. Two deals with the same pre-tax internal rate of return can be quite different investments after tax.

Here is the mechanism, piece by piece.

Depreciation is the whole reason real estate shelters income

The depreciable basis is the purchase price plus capitalized closing costs, less the value allocated to land, plus every capital dollar you spend afterward. Land is never depreciated, because it does not wear out. Improvements are, on a straight line, over a statutory recovery period: 27.5 years for residential rental property and 39 years for nonresidential real property.

The land allocation matters more than people expect. A deal where land is 20% of basis depreciates 80 cents of every dollar; at a 35% land allocation it depreciates 65 cents, which is about 19% less deduction in every year of the hold on the same purchase price. That difference flows straight through to taxable income. It is also one of the few tax variables you can influence at closing, through the purchase price allocation and an appraisal that supports it.

Taxable income from operations is then:

net operating income, less interest, less depreciation

Two things in that line surprise people the first time. Principal is not deductible, only interest is, so a fully amortizing loan produces taxable income that grows faster than cash flow as the amortization curve shifts. And depreciation is not cash, so a property can distribute money every quarter while reporting a tax loss. That is the shelter, and it is the reason levered real estate is a tax-efficient asset in the first place.

Cost segregation and bonus depreciation move the deduction forward

A cost segregation study reclassifies part of the improved basis out of the 27.5 or 39 year bucket and into shorter-life personal property and land improvements, typically 5, 7, and 15 year property. Under bonus depreciation rules, the eligible slice can be expensed heavily or entirely in the year the property is placed in service rather than spread over decades.

The applicable bonus percentage depends on the placed-in-service year and on current law, which has changed repeatedly. Do not model a rate from memory. Use the rate your accountant gives you for your tax year, and use the eligible fraction your study actually supports rather than a rule of thumb.

There is a real cost to the acceleration, and it is the part most cost segregation pitches move past quickly. The 5 and 7 year personal property is section 1245 property, and when you sell, its recapture is taxed at ordinary income rates, not at the 25% ceiling that applies to straight-line depreciation on real property. The 15 year land improvements are section 1250 property rather than 1245, but they are written off on a 150% declining balance schedule, so the depreciation taken above straight line comes back as ordinary income as well. Either way, most of what you accelerated returns at your ordinary rate. A cost segregation study converts a deduction taken at your ordinary rate today into a recapture at your ordinary rate later. The benefit is time value and nothing else.

Time value usually wins, especially on a long hold or when the deduction offsets income taxed at a high marginal rate. But it does not always win, and a model should show you the crossover rather than assume it. If you plan to sell in three years, the deferral window is short and the recapture arrives fast.

A loss you cannot use is not lost

When depreciation drives taxable income negative, a passive investor generally cannot deduct that loss against wage or portfolio income. It is suspended under the passive activity loss rules and carried forward.

Suspended losses are not wasted. They do two things:

1. They offset future positive taxable income from the same activity as the shelter thins out later in the hold.
2. They release on a fully taxable disposition of the activity, offsetting the gain when you sell. A 1031 exchange is not one, so an exchange carries the suspended losses forward alongside the deferred tax.

This is why a five-year cash flow table showing zero tax in years one through three is usually correct rather than a modeling error, and why the tax bill lands almost entirely at the sale.

The exceptions matter and are individual. Real estate professional status, material participation, the short-term rental treatment, and the special allowance for an actively participating small landlord, which phases out as income rises, all change the answer. None of that is knowable from the property, which is precisely why an after-tax model should take rates and treatment as inputs rather than assert them.

The bill at sale has three parts

At disposition, the taxable gain is the net sale price less the adjusted basis, where adjusted basis is your original basis reduced by all the depreciation you took. That gain then splits:

• Unrecaptured section 1250 gain. The portion of the gain attributable to straight-line depreciation on the real property, taxed at a federal rate capped at 25%.
• Section 1245 recapture. The portion attributable to the short-life property from a cost segregation study, taxed at ordinary rates.
• Capital gain. Everything above that, which is genuine appreciation, taxed at long-term capital gains rates.

Layered on top, depending on your situation: the net investment income tax, and state income tax, both of which can be folded into the rates you use rather than modeled separately.

The point worth internalizing is that depreciation is a loan, not a gift, unless you never sell. You deduct at your ordinary rate during the hold and pay it back at up to 25% on the straight-line portion, which is still a good trade for most taxpayers, but it is a trade rather than free money.

The 1031 exchange defers, it does not forgive

A properly executed like-kind exchange defers both the recapture and the capital gain by carrying your old basis into the replacement property. The tax is not eliminated. It is moved.

Two consequences follow, and both are routinely left out of models:

• The replacement property inherits a low carryover basis, which means less depreciation on the new asset for the rest of its life. You have traded a tax bill today for a smaller shelter tomorrow.
• The deferred liability is still yours. It reappears on a future taxable sale, and it compounds across a chain of exchanges.

An honest model reports the deferred amount rather than quietly deleting it. Deferral is worth a great deal, sometimes an enormous amount, but what it is worth is the time value of the deferred tax, not the tax itself.

A worked example

Round numbers, a residential asset, one investor, interest-only debt, held five years. This is an illustration built to be arithmetically consistent, not a market forecast, and the rates are placeholders for whatever your own situation produces. It also takes a full year of depreciation in year one instead of applying the mid-month convention, which a real return would not.

Setup

Operations

Taxable income is negative in every year, so no operating tax is due, and $484,520 of suspended passive losses accumulate. The investor collects $970,025 of cash over five years and reports a cumulative tax loss. That is the shelter working exactly as intended.

Sale

Accumulated depreciation over five years is $1,454,545, so the adjusted basis is $8,545,455. Net sale price after a 2% cost of sale is $11,760,000. Total gain is $3,214,545.

The suspended losses release against that gain, leaving $2,730,025 taxable. At a 25% recapture rate on the $1,454,545 of accumulated depreciation and a 20% capital gains rate on the $1,275,480 balance, tax at sale is $618,732.

Result

A 250 basis point drag, all of it at the sale, on a deal that paid no tax at all for five years.

Note what the example leaves out: the net investment income tax and state income tax, either of which widens the drag. Note also a convention it does apply. The released suspended losses are netted against the gain before the gain is split into its recapture and appreciation slices, which is how the model treats them, and it means the losses land against the 20% slice here. A released passive loss is an ordinary deduction, so a taxpayer with other income to absorb it may do better than this table shows. Each of those moves the number, which is the argument for computing it against your own facts rather than estimating it.

What after-tax math changes about a decision

Once you can see both numbers, several comparisons stop being close calls.

• Asset class. A residential asset depreciating over 27.5 years shelters more per dollar of basis than a commercial asset over 39. Two deals at the same pre-tax return are not the same deal.
• Land allocation. A high-land-value urban site generates less depreciation than a suburban asset at the same price. This is a real and permanent difference in after-tax yield.
• Leverage. Interest is deductible, and depreciation does not shrink because you borrowed, so the same dollars of shelter sit on a smaller slice of equity. Leverage does more for the after-tax return than the pre-tax comparison suggests.
• Hold period. A longer hold accumulates more depreciation and therefore more recapture, but it also defers that recapture further into the future. The two effects run in opposite directions and the crossover is deal-specific.
• Exit strategy. Whether you plan to exchange, sell, or hold indefinitely changes the answer more than most operating assumptions do, and it is usually decided last.

Where a model has to admit what it does not know

After-tax analysis is only honest when it is explicit about its inputs. Your marginal rate, your entity, your basis, your participation status, and your state are not properties of the building. A model that hardcodes a tax rate is producing a number that is wrong for almost everybody.

That is the design Altyst uses. The pre-tax underwriting stays the headline, because it is the comparable figure and the institutional standard. The after-tax view is a per-deal overlay that is off until you turn it on, and it uses the rates you enter. The depreciation schedule, the after-tax internal rate of return, the total tax over the hold, and the tax due at sale each open into the formula and the terms behind them. The year by year table shows net operating income, interest, depreciation, taxable income and tax for every year of the hold. And if you elect a 1031, the deferred amount is stated on screen rather than deleted.

Altyst produces model outputs for screening and analysis. It is not tax advice, and no model replaces your accountant. What a model can do is put the after-tax number next to the pre-tax number so you know how big the gap is before you sign, instead of after.

Read the full calculation methodology, see how the modeling engine works, or open the sample deal.