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 associated with investing in real estate. The key tax benefit that investors value most are the deductions. The most common deductions are as follows:
- Accelerated Depreciation
- Property Tax
- Operating Expenses
- Mortgage Interest
An equity investor through a syndication is typically considered a passive investor or limited partner in the partnership. The investment is therefore allowed to share in the above deductions based on their proportional ownership interest in the investment partnership.
During K1 season, real estate companies like Yankee Capital Partners, issue K-1 for tax reporting purposes. This does not reflect the overall wellbeing of the investment. Most of the time, you will receive a paper or passive loss that can be used to offset passive gains in other areas of the investor 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 to us invest and accelerate the economy. In turn, the government has paved the way to create tax loopholes for active investors to benefit themselves as well as other passive investors who choose to invest. 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 true benefit of depreciation may look odd to the common man since its common for a cash flowing property to look like they are losing money each year. However, because of depreciation or the 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 country.
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account 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 is considered by the IRS to be 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 (excluding the land value) is $1,000,000 / 27.5 years = $36,363,64 per year.
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 is often accelerated on large commercial assets through what is known as a 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. The primary goal of a cost segregation study 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 business 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 the life of an asset.
When the asset is sold and the partnership is terminated, initial equity and profits are distributed to the passive investors. The IRS classifies the profit portion as 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 the value of a property (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 a like kind property for another like kind property and defer the capital gains tax on the sale of the first property. Most syndications are not setup to take in a 1031 exchange from an investor’s personal property but you could do a 1031 exchange from one syndication deal to another syndication deal under the same sponsor if that type of opportunity presented 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 have 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 be converted into 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 employed by 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. In fact, 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 and allowed me the opportunity to begin investing in multifamily syndication deals as a limited partner.
In closing, commercial real estate syndications are highly tax efficient investment vehicles. From the standard property tax, loan interest and accelerated depreciation opportunities to refinances, potential 1031 exchanges and qualified plans, the IRS currently has provided ample ways to keep more profits in your pocket or defer paying the taxes for some time in the future.
As a person involved in real estate syndications, these are brief summaries and not a recommendation or advice. Please consult with a tax professional regarding your tax and real estate investment situation to learn more about these strategies and how they may apply to you.
As always, if you’d like to discuss any of these point further,
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