In our latest Webinar, we shared insights on the tax advantages produced by investing in Multifamily properties. The key takeaways are below.
A dreaded tax season just finished after the delay by the federal government. If you are a passive investor in real estate, you received your K-1 and realize the paper loss created by real estate provides lucrative tax benefits.
A key addition to the core benefits of multifamily investing, capital preservation, and cash flow are the tax benefits that relate to investing in real estate. The key tax benefits that investors value most are deductions. The most common deductions are as follows:
- Accelerated Depreciation
- Property Tax
- Operating Expenses
- Mortgage Interest
An equity investor through syndication is typically considered a passive investor or limited partner in the partnership. Therefore, the investment is allowed to share in the above deductions based on their proportional ownership interest in the investment partnership.
During the K1 season, real estate companies like Yankee Capital Partners issue K-1 for tax reporting purposes. This does not reflect the overall well-being of the investment. You’ll often receive a paper or passive loss that can offset passive gains in other areas of your portfolio.
An important question we often get is why real estate investors attain so many great tax benefits. The biggest reason is that the government wants us to invest and accelerate the economy. In turn, the government has paved the way to create tax loopholes for active and passive investors to benefit themselves. These benefits go to entrepreneurs, founders of these entrepreneurs, and real estate investors. The government offers tax incentives in the form of tax deductions to promote their pursuits, thereby stimulating the economy.
The key difference for real estate investors is the gift of Depreciation, which is unique to real estate since it’s an extra write-off. The benefit of depreciation may look odd since it’s common for a cash-flowing property to look like it’s losing money. However, because of depreciation or paper loss, your property generates real income that you take to the bank without paying any taxes on it! The government provides this overall benefit to real estate investors since it needs them to keep building and managing (rental) commercial properties around the country.
Depreciation is an accounting method of allocating a tangible asset’s cost over its useful life and accounting for declines in value. A common form of depreciation is straight-line depreciation. This allows for equal amounts of depreciation each year. The annual deduction is divided by its useful life, which the IRS considers 27.5 years for Multifamily real estate. This is different from office, retail, and industrial, which have a useful life of 39 years.
So, the annual depreciation on a commercial real estate asset worth $1,000,000 is $1,000,000 / 27.5 years = $36,363,64 per year. This does not include the land value
As one of the tax benefits of commercial real estate syndications, the depreciation amount is such that a passive investor won’t pay taxes on their monthly, quarterly, or annual distributions during the hold period. They will, however, have to pay taxes on the sales proceeds.
Depreciation often accelerates on large commercial assets through cost segregation study.
Cost Segregation (Bonus/Accelerated Depreciation)
Cost segregation is a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes. A cost segregation study performed by a cost segregation engineering firm dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 years, the useful life of a residential building. A cost segregation study’s primary goal is to identify all property-related costs that can be depreciated over 5, 7, and 15 years. As a result, we’ll see significant deductions, which can result in a sizable “paper loss” in the early years of owning the asset.
- Bonus Depreciation: One of the major changes with the Tax Cuts and Jobs Act of 2017 was the bonus depreciation provision, where businesses can take 100% bonus depreciation on a qualified property purchased after September 27th, 2017.
- Accelerated Depreciation: Accelerated depreciation is any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of an asset’s life.
When you sell the asset, and the partnership ends, passive investors receive the initial equity and profits. Thus, the IRS classifies the profit portion as a long-term capital gain.
Under the new 2018 tax law, the capital gains tax bracket breakdown is as follows:
Taxable income (individual or joint)
- $0 to $77,220: 0% capital gains tax
- $77,221 to $479,000: 15% capital gains tax
- More than $479,000: 20% capital gains tax
It’s common for value-add syndicators to optimize a property’s value (i.e., an apartment) over ~2 years once renovations are completed (higher rents are achieved), go to the bank, and refinance the property since the value most likely increased and pull equity out. There is no taxable event when you return a part of an investor’s equity.
A 1031 exchange allows one to swap like-kind properties and defer the capital gains tax on the first property’s sale. Most syndications are not set up to take in a 1031 exchange from an investor’s personal property. However, you could do a 1031 exchange from one syndication deal to another syndication deal. This can take place under the same sponsor if that type of opportunity presents itself down the road. Most syndicators will try to make this happen because deferring your investment gains many years into the future is highly beneficial to investors.
A growing number of retirement savers are becoming aware that they can choose investments other than the traditional offerings of stocks, bonds, mutual funds, ETFs, and CDs within an Individual Retirement Account (IRA). Self-Directed IRAs offering non-traditional investments had increased in popularity in recent years and are somewhat more accessible for investors compared to 1974, when the IRA was first introduced. These Self-Directed IRAs allow you to invest in real estate, precious metals, notes, tax lien certificates, private placements, and many more investment options.
Investing in real estate through a Self-Directed IRA can be a great way to diversify your retirement account. Traditional and Roth IRAs can change to Self-Directed IRAs, where the individual has more control over what to do with the cash and still has the tax-deferred benefits that an IRA offers. 401(k) plans work a little differently; if the individual is still working for the company that sponsors the 401(k) plan, he or she can’t move the money around. If it’s an old 401(k), a rollover is completely possible. That’s what I did for my first two multifamily investments, having rolled over a traditional IRA to a Self-Directed IRA. The process was fairly easy and straightforward. It allowed me the opportunity to begin investing in multifamily syndication deals as a limited partner.
Commercial real estate syndications are highly tax-efficient investment vehicles. The IRS has provided ways to keep more profits in your pocket. These ways can also defer paying the taxes for some time in the future. The ways provided by the IRS applies to:
- Standard property tax
- Loan interest
- Accelerated depreciation opportunities
- Potential 1031 exchanges, and
- Qualified plans.
As a person involved in real estate syndications, these are brief summaries and not recommendations or advice. Consult a tax professional regarding your investment situation to learn more about these strategies and how they apply.
Access our video on Tax Strategies HERE
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