This article is part of our passive investors guide on real estate syndications, available here.
Passive investing in multifamily communities has many incredible benefits, such as strong cash flow, the ability to add value, and the natural appreciation that takes place during the hold period of a real estate investment.
Multifamily real estate investing has many advantages, but one of the main ones is the tax benefits of this type of investment property. You may take advantage of the full depreciation or paper loss of a property if you have direct ownership in the LLC (which you receive through a syndication) rather than, for example, the restricted depreciation that comes with investing in REIT.
In this commercial real estate investing guide, we’ll go more in-depth on how multifamily investors who are passive investing can take advantage of these three tax advantages and what it means to compound your wealth moving forward.
Tax Benefits of Real Estate Investing:
Depreciation is the loss in value of an asset (on paper) over time, even as the real value rises. Every year, an apartment building’s depreciation loss might be greater (or nearly equal) to the cash flow it generates. This implies that the taxable amount on that cash flow may be $0 or extremely close to it. These are only a few of the advantages that you can earn if you have direct ownership.
Furthermore, having actual control may allow you to qualify for real estate professional status. If you meet the internal revenue service standards to be considered a “real estate professional,” you may perhaps apply your paper loss from what the IRS considers to be “passive income or loss” toward your active income to lower your personal tax burden even further.
Depreciation and cost segregation allows real estate investors to defer taxes while receiving cash distributions monthly or quarterly. Being able to defer and not having to pay taxes immediately on the sale gives investors the ability to have a more considerable purchasing power for the next deal. There is also the potential tax benefit of performing a 1031 exchange which would allow you to defer the capital gains taxes on the sale of the property in an effort to re-invest the pre-tax profits into an equal or greater value property in a specific timeline.
Why is depreciation so important for returns in real estate investing?
Depreciation in real estate allows investors to lower their taxable income. In some cases, we can depreciate and show a loss “on paper” that is as much or greater than the amount of free cash flow that investors receive.
This means, sometimes, as low as $0 in taxable income. So just as a store of capital, real estate is an excellent way for investors to grow and preserve their hard-earned dollars. In the next section, we’re going to get into the various forms of depreciation in detail but what’s important to note is how many other types of investment vehicles don’t have these same tax advantages.
The two main ways passive investors share in the depreciation
1.) Straight-Line Depreciation
You can only depreciate the value of the building, not the land because the IRS recognizes land to last forever but the building to have a lifespan of 27.5 years. Typically with multifamily properties, 80% of the purchase price will be the value of the building.
Example 1: Let’s say you purchase a building for $10,000,000, and you can depreciate 80% of the building, that’s $8,000,000.
So you would take $8,000,000 / 0.275 years which equals $290,909. That means that you can depreciate $290,909 against the free cash flow that the building produces on an annual basis over 27.5 years.
2.) Accelerated/Bonus Depreciation Rental Property
The above image is an actual cost segregation study example performed on a $1.95M multifamily property.
Accelerated depreciation, also referred to as bonus depreciation, is a tool to depreciate the property faster, grabbing more “paper losses” sooner rather than later. You would hire a private engineer to come out and do what’s referred to as a cost segregation study.
A cost segregation study is performed to establish the value of personal property in or on the building or on the land. Items like plumbing fixtures, windows, asphalt paving, and equipment, to name a few, are considered personal property. The goal is to find the total value of each item and allocate them into 5, 7, 15, and 27.5-year depreciation schedules. The 5, 7, and 15-year properties can be expensed up to 60% in the first year as of 2024 (this will drop by 20% year over year until it phases out on Jan 1st 2027).
Since 2001, the IRS has allowed real estate property owners to access further tax benefits by taking approximately 100% of this bonus depreciation in the same year the property was acquired. Generally, to make sense of performing a cost segregation study on a property, the value of the building should be at least $750,000, as there are costs associated with performing the study.
The above image breaks down an example depreciation schedule from year 1 to 6.
Example 2: Let’s say the same $10,000,000 building used in Example 1. above; after a cost segregation study was performed, we were able to depreciate $2,000,000 of “paper losses” in year 1.
- As a general formula, the cost segregation study would enable us to write off 15%-25% of the purchase price in year 1.
- You can offset that amount against the building’s free cash flow, so if the building’s free cash flow was $325,000, your taxable income is $0. This is calculated by applying the -$2,000,000 of “paper loss” against your +$325,000 of free cash flow.
- The excess, unused “paper loss” of $1,675,000 ($2,000,000 of “paper loss” – $325,000 cashflow= carryover loss) on the year that was over and above your free cash flow can be carried forward to the following year further to offset the loss against next year’s taxable amount.
The above image breaks down an example depreciation schedule for 29 years since the purchase date of the investment property.
Bonus Depreciation Phase-Out Timeline
Even though bonus depreciation phases out on Jan 1st 2027, normal straight-line depreciation will generally still have far excess paper losses to easily shelter the cash flow distributions that a typical investor would receive throughout the entire hold period of a deal or a large percentage of it.
1031 Exchanges for Real Estate Investors
Another one of the tax benefits of real estate investing is 1031 exchanges, also known as “like-kind” exchanges. Real estate investors may defer capital gains taxes on their real estate investments and trade up to more considerable assets with the option to defer these taxes indefinitely through “like-kind” exchanges.
When the real estate investors who own this property pass away, their beneficiary receives all the tax benefits by inheriting the property and avoiding decades of accumulated taxes on all the bought and sold real estate in that trade.
But that may end as President Biden is seeking to close the book on 1031 exchanges as part of its controversial tax plan that would raise capital gains taxes.
The following conditions must be met to qualify for a 1031 exchange.
- A new asset of comparable or greater value than the property being sold
- Both properties must be like-kind
- Within 45 days, a replacement property must be identified
- Within 180 days, a replacement property must be purchased
For example, Let’s assume you bought a multifamily real estate property for $800,000 and made about $200,000 in improvements, giving you a cost basis of $1 million. Let’s assume that after five years, the property is worth $2 million, and you inform property management that you’re going to sell it. You’ll have around $1 million in profit after five years.
- On that $1 million, uncle Sam would take home 20% of the profits for any capital gains taxation, leaving $200,000 in taxes to be paid. To defer taxes and maintain a greater purchasing power by rolling over all of your income into the next real estate deal, you may choose to 1031 exchange the property for a “like-kind” property.
- This means I may roll over and exchange the complete $1,000,000 instead of the $800,000 ($1,000,000 profit – $200,000 capital gains taxes) in after-tax profit.
- Exchanging the $1,000,000 instead of the $800,000 will allow me to invest in a larger valued rental property, so now I would have to find another multifamily property valued at least $2,000,000 within 45 days.
- Then I would have to close on purchasing one of the identified investment properties within 180 days through a qualified intermediary.
- If you don’t fulfill the requirement and do so within the prescribed timelines, you will have failed to comply with the exchange’s requirements, and you’ll be required to pay a capital gains tax of $200,000.
Comparing Real Estate Syndication Vs. The Stock Market
The tax benefits passed down to multifamily real estate investors differentiate real estate investment and the stock market. In the two cases below, I’ll show how investing $1,000,000 at the same 10% pre-tax return before and after tax would look in each investment vehicle.
Example 1: Suppose you put $1 million into the stock market and earned a 10% return. Let’s assume that based on the state you live in and other factors, you’re subject to a 37% tax bracket.
- You’d have to pay $37,000 in taxes for a post-net rate of return of 6.3% or $63,000 after taxes.
Example 2: Let’s say you invested $1,000,000 in a multifamily syndication and got the same 10% return or $100,000. You are entitled to your share of the depreciation or “paper loss” since you have direct ownership of the investment property.
- Let’s assume that, in this example, the “paper loss” tax benefits would shield some of the income from your schedule K-1, displaying a “net rental income” of just $21,000 despite receiving $100,000 in distributions throughout the year.
- Let’s say you’re also in the 37% tax bracket, like the previous example, and your reported profits from the passive investment are $21,000. That would mean you would be subject to paying taxes on only the $21,000. You would owe $7,770 in taxes ($21,000 x 0.37=tax owed), reflecting a post-tax net rate of return of 9.2% or $92,230 after taxes ($100,000 return – $7,770 in taxes= post-tax return).
Frequently Asked Questions About The Real Estate Tax Benefits
You cannot avoid paying taxes on your rental real estate property. Still, there are strategies that real estate investors can take advantage of to lower their taxable income through different forms of depreciation or tax deferral status.
The two main tax benefits of owning rental properties include utilizing the “paper losses” from depreciating the property to shelter taxable income and through 1031 exchanges that allow real estate investors to defer capital gains tax and roll over their profits into larger real estate assets.
Tax Benefits of Real Estate Investing - Conclusion
The tax benefits of multifamily real estate investing allow passive investors to keep more after taxes and park their hard-earned dollars into secured hard assets that provide a solid risk-adjusted return. The tax advantages of rental properties are among the most critical factors when comparing different investment vehicles. As a real estate investor, ensure you keep tax implications in mind when comparing your next passive income real estate investment opportunity.
At Willowdale Equity, we provide passive real estate investment opportunities to select investors; check out our how it works page to learn more about the process from A to Z. Also, you can join our private investor club to gain access to unique investment opportunities and more information on how to develop your portfolio, including exclusive tools and knowledge.
The Willowdale Equity Investment Club is a private group of investors that are looking to passively grow their capital and share in all the tax benefits through multifamily real estate investments.