The Tax Benefits of Investing in Multifamily Real Estate*
By Ed Rogan, Owner, Co-Founder
The benefits to investing in rental property are undeniable. Owners can take substantial write-offs, including mortgage interest, depreciation, and a host of other expenses to preserve the property’s cash flow.
So why don’t more people invest in commercial real estate? Well, frankly, the barriers to entry can be quite high. The majority of investors do not have the upfront capital needed to buy commercial real estate. Nor do they have the time, resources and wherewithal to successfully operate personally owned real estate.
For these reasons, investing in a real estate syndicate can be a great way to take advantage of the many tax benefits associated with owning multifamily real estate.
A Highly Tax-Advantaged Industry
There are three major tax benefits, in particular, that real estate offers:
1. Depreciation: Under the existing tax code, real estate investors can offset the benefits 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.”
Rental properties are typically depreciated over 27.5 years, which the IRS considers the “useful life” of a residential building. However, it is possible to accelerate depreciation even faster through what’s known as a cost segregation study.
A cost segregation study separates personal property from land and building improvements, and then assigns 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 sidewalks, paving, fences and landscaping), can be depreciated over a 15-year recovery period. Cost segregation studies are complex but can save investors thousands of dollars each year, particularly in the first few years of ownership.
Regardless of whether the investor utilizes a cost segregation study, depreciation is a useful tool for offsetting positive cash flow generated on an investment property. This is true whether the property is owned outright or through a partnership. In both cases, to the extent you have income from the investment, the depreciation will help to reduce the income thus lowering the taxes otherwise owed
2. Tax Rates: Investments of any kind are typically subject to two forms of taxes: ordinary income tax and capital gains tax. You pay ordinary income tax when the investment generates revenue; capital gains tax upon sale of the asset. Depending on your tax bracket at the federal level, ordinary income tax rates can be as high as 37% whereas capital gains taxes usually top out around 20%. These rates do not include a 3.8% net investment tax that would apply to any investor that is passive in nature, which applies to both rental income and gains from sale. States often impose additional taxes, as well.
Real estate cash flows and dividend-producing stocks are both examples of ordinary income property. There’s a key distinction between the two, though, that makes real estate a more favorable asset class for tax purposes: the cash flows generated by real estate can be offset through depreciation and interest expenses (see above), whereas income generated through stock dividends cannot. Put another way: depreciation and interest expense are deductions against ordinary income that can create ordinary losses.
This is one of the reasons many real estate investors opt to hold direct ownership in property (in a fund or otherwise), as opposed to investing in a publicly-traded REIT. The distributions from a REIT, like the distributions from any other stock, are subject to ordinary income tax.
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…
3. 1031-Exchanges: There’s a provision in the tax code that allows real estate investors to defer paying capital gains taxes. It’s known as the 1031-exchange. A 1031-exchange allows a real estate investor to sell real property (i.e. not personal property) 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, the investor takes on a lower tax basis in the new property that typically represents the deferred gain. If the new property purchased has a higher value than what was sold, the investor would in theory have additional basis that can then be depreciated, but it would not be the full cost of the new asset. Investors who play this game in perpetuity can defer paying taxes while building equity along the way.
In reality, although this is an incredible capital preservation tool, the IRS guidelines around 1031 exchanges are so complex that individual investors often shy away from using them. There are tight deadlines investors must meet for the trade to qualify. Typically, professional guidance is needed.
Real estate private equity funds are better equipped to manage 1031 exchanges. The strategy is most commonly used by funds where the fund itself does the 1031 exchange or establishes a Tenant-in-Common structure where the investor has direct title in the asset. A limited partner or LLC member cannot trade the proceeds from a sales distribution from a real estate partnership or LLC under these rules.
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An Additional Tax Benefit to Investing Via a Fund
There’s a fourth, unique benefit to investing in a syndicate or private equity fund vs. direct ownership: better tax treatment for gifting and estate purposes.
4. Unique Gifting and Estate Tax Benefits: Unlike gifting stocks or shares in a REIT, when an investor gifts an LLC interest of a real estate investment to a family member, the investor is generally able to reduce the value of the gift by up to 30% under current gift and estate tax rules.
The value is discounted based on the assumption that the investor has limited control over the LLC interest and therefore, a discount from the underlying real estate asset is provided under IRS rules.
Combined, these tax benefits contribute to another significant benefit of investing in commercial real estate: leverage.
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. debt financing), 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 (or more, with appreciation) while only having to put in an initial $1 million contribution.
Over time, investors build equity in their rental portfolio. They can draw on this equity (by refinancing or through lines of credit) to improve the property, to make additional investments, or for other purposes. It creates an incredible wealth-generating cycle for those who invest wisely.
* This article is not intended to provide tax advice. Anyone who has invested in commercial real estate (or who is interested in doing so) will want to consult with their CPA or tax advisor to ensure they’re taking full advantage of these tremendous benefits.
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