TAX BENEFITS OF PASSIVELY INVESTING IN MULTIFAMILY
Introduction
Real estate, once considered an alternative asset class, has become more mainstream in recent years. Investors are increasingly drawn to real estate given its stability in the face of otherwise dramatic market swings. Real estate also offers tremendous tax benefits, something that institutional investors have known all along.
In this article, we look at the six primary tax benefits of passively investing in multifamily property.
1. Straight-Line Depreciation
Under the existing tax code, real estate investors can offset the gains produced with income-generating property through an annual tax deduction known as depreciation. The IRS defines the depreciation deduction as “a reasonable allowance for exhaustion or wear and tear, including a reasonable allowance for obsolescence.”
Only the value of the building can be depreciated (including eligible appliances, fixtures, and equipment). Land value is not considered depreciable.
Multifamily properties are typically depreciated over 27.5 years, which the IRS considers the “useful life” of a residential building. It is considered “straight-line” depreciation when an owner takes an equal fraction of the depreciation each year.
This is effectively a paper loss used to offset actual gains. A revenue-generating property could be appreciating in value while being eligible for depreciation. This depreciation helps to lower investors’ tax burden without impacting profits.
Here’s a simple example. Let’s say a $34 million property has a land value of $6.5 million, leaving $27.5 million in improvements to be depreciated. Using straight-line depreciation, it yields $1 million in paper losses each year for the next 27.5 years. Equally dividing that depreciation benefit among 50 investors yields a $20,000 paper loss for each investor to take against the actual gains from the deal.
2. Accelerated Depreciation (i.e., Cost Segregation)
An alternative to straight-line depreciation is accelerated depreciation. Accelerated depreciation requires a cost segregation study. A cost segregation study will separate personal property from land and building improvements, and then assign a useful “life” to each asset segregated. For instance, personal property such as furniture, carpets, fixtures and appliances can be recovered in as little as five or seven years. Land improvements, such as paving, fences and landscaping can be depreciated over a 15-year recovery period. Cost segregation studies are complex but can save investors tens of thousands of dollars each year. Rather than taking 1/27.5 worth of depreciation each year, cost segregation allows investors to front-load deprecation in the first few years of ownership.
Accelerated depreciation is a useful tool for offsetting positive cash flow generated on multifamily investment properties. This is true whether the property is owned outright or through a partnership. In both cases, the extent to which someone receives a distribution from the investment, the deprecation will offset the taxes otherwise owed on those gains.
3. Bonus Depreciation
Bonus depreciation is like an enhanced version of accelerated depreciation. Bonus depreciation had historically been reserved for newly constructed properties, in which up to 50% of the value of certain improvements could be deducted in the first year after the property was placed in service. However, the Tax Cuts and Jobs Act of 2017 made two significant changes to bonus depreciation that impact multifamily investors. First, bonus depreciation has been expanded to all properties—not just new construction. Second, the benefit increased from 50% to 100% through at least December 2022.
In other words, the accelerated depreciation schedules upon which we have come to rely are temporarily being set aside by those taking bonus depreciation. For now, investors can take all of that front loaded depreciation in year one (a cost segregation study is still required). This is particularly helpful for investors who have significant K-1 passive activity gains from other sources, real estate investments or otherwise. This is such a significant benefit that many high-net-worth investors are strategically buying multifamily rental property for the sole reason of taking the depreciation now to offset their total taxable income.
4. Depreciation Recapture
No discussion on depreciation is complete without mention of depreciation recapture. Depreciation recapture is essentially a tax deferral strategy. In other words, investors can typically defer taxes for the time they own their multifamily properties because of depreciation. Due to the time value of money, tax deferral is a significant benefit for investors.
However, when the property is sold, the tax on depreciation will come due. Currently, depreciation recapture rate is 25%. Any gain from the sale in excess of the depreciation recapture rate is taxed at the lower long-term capital gains rate.
In simple terms, here’s what that means for investors. Most accredited investors sit in higher income tax brackets. For those individuals, the depreciation recapture rate is often lower than their tax bracket otherwise. This is known as “tax arbitrage,” a strategy that saves investors money. It’s an additional benefit to the time value of money.
5. Capital Gains
Investments of any kind are typically subject to two forms of taxes: ordinary income tax and capital gains tax. An investor pays ordinary income tax when the investment generates revenue; capital gains tax upon sale of the asset. Depending on someone’s tax bracket, ordinary income tax rates can be as high as 37% whereas capital gains taxes usually top out around 20%.
Real estate cash flows and dividend-producing stocks are both examples of ordinary income property. There is a key distinction between the two, though: the cash flows generated by multifamily real estate can be offset through depreciation (see above), whereas income generated through stock dividends cannot. Ordinary losses can be used to offset ordinary income that would otherwise be taxed at up to 37% depending on someone’s tax bracket.
This is one of the reasons many real estate investors opt to hold direct ownership in property (in a fund, syndication or otherwise) versus investing in a publicly traded REIT. The distributions from a REIT, like the distributions from any other stock, are subject to ordinary income taxes.
Real estate investors do not get off scot-free, though. Instead, they pay capital gains tax on the property when it is sold—which, depending on the original basis, can be steep.
However, capital gains tax can also be deferred, sometimes indefinitely, through…
6. 1031 Exchanges
There is a provision in the tax code that allows real estate investors to defer paying capital gains taxes. It is known as the 1031-exchange. The 1031-exchange allows real estate investors to sell an asset and reinvest the proceeds into a like-kind investment, deferring capital gains tax in the process.
This is particularly useful when an investor has owned a property long enough to run out of depreciation. By reinvesting the sales proceeds through a 1031-exchange, depreciation will begin all over again, this time, on the new asset. Investors who pay this game in perpetuity can defer paying taxes while collecting cash flow and building equity along the way.
Conclusion
As you can see, there are many tax benefits that come along with investing in multifamily real estate. That said, the barriers to entry can be high and not every investor has the interest or wherewithal to personally own and operate a building. For these reasons, investing in a real estate syndicate can be a great way to take advantage of the full breadth of tax benefits associated with owning multifamily property.
Are you ready to maximize the value of your capital? Contact us today to learn how we leverage various tax-saving tools on behalf of our investors.
