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. Passive real estate investing 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 investing in multifamily real estate.
1. Straight-Line Depreciation
Under the existing tax code, real estate investors can offset the gains produced by investing in multifamily properties 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.
When investing in multifamily properties, depreciation is typically calculated 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 earned from the asset. A revenue-generating property could otherwise be appreciating in value while still 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 passive real estate 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, another tax benefit associated with investing in multifamily real estate. 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 when investing in multifamily properties. 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. Investors should expect a cost segregation study to cost anywhere from $5,000 to $25,000 depending on the size of the property.
Accelerated depreciation is a useful tool for offsetting positive cash flow generated by multifamily investing. This is true whether the property is owned outright or through a syndication. In both cases, to the extent 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 that investors can take advantage of when passive real estate investing, particularly when multifamily investing.
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 those investing in multifamily properties. 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 deprecation schedules upon which we have come to rely are temporarily being set aside by those taking bonus depreciation. For now, multifamily investors can take all of that frontloaded 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, syndication real estate or otherwise. This is such a significant benefit that many high-net-worth investors are strategically investing in multifamily properties 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 for those investing in multifamily properties. 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 multifamily investors.
However, when the property is sold, the tax on depreciation will come due. Currently, the 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 passive real estate investors. Most accredited investors sit in higher income tax brackets. For those individuals, the depreciation recapture rate from multifamily investing 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 (including investing in multifamily properties) 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 the 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%. Cash flows from multifamily investing and dividend-producing stocks are both examples of ordinary income. There is a key distinction between the two, though: the cash flows generated by investing in multifamily properties 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, real estate 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 taking the sales proceeds and investing in multifamily properties again 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.
1031 Exchanges are strictly regulated by the IRS. Anyone interested in leveraging this capital preservation tool will want to consult with a 1031 expert to ensure they are meeting all IRS guidelines (and deadlines) in order for the trade to qualify.
One Final Benefit: Leverage
Combined, these tax benefits contribute to another significant (albeit not tax-related) benefit of investing in multifamily real estate: leverage.
See, unlike buying a stock or bond, with leverage, you can invest in multifamily property for a fraction of its actual cost.
Let’s say an investor has $1 million of free cash on hand to invest. They can spend $1 million on stocks, or they could spend $1 million on $4 million worth of real estate thanks to leverage. With leverage (i.e. a bank loan), that investor can, for example, spend as little as $250,000 to invest in four different million-dollar properties. The rents collected from leasing the units will pay down the mortgage, and over time, the investor will own $4 million worth of real estate (either entirely, or $4 million worth of more expensive assets if investing in a syndication) despite only contributing $1 million to its cost.
Then, using a tool like the 1031 Exchange, the investor could sell that $4 million property to purchase a $12 million property – creating a virtuous cycle that allows investors to grow their rental portfolios with minimal up-front investment.
Sound too good to be true? It’s not. Tens of thousands of people invest in multifamily real estate each year to take advantage of these tax benefits.
As you can see, there are many tax benefits that come along with investing in multifamily properties. That said, the barriers to entry can be high, and not every investor has the interest, experience, or wherewithal to personally own and operate a building. For these reasons, investing in a real estate syndication can be a great way to take advantage of the full breadth of tax benefits associated with multifamily investing.
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 passive multifamily investors.