A unique aspect of real estate as an investment asset class is the potential for significant tax benefits. Investors can see positive cashflow while still claiming a loss during tax season.
We’ll take a look at three of the most readily available tax advantages real estate provides investors.
Depreciation
Depreciation
Real estate is a tangible asset, and therefore depreciates in value over time. The IRS allows owners of capital assets (real estate included) to write off the value of the assets over their expected useful life. According to the IRS, an asset must meet the following criteria in order to be deemed depreciable:
- It must be property you own (partial ownership counts), regardless of debt held
- It must be used for income-generating activity
- It must have a designated useful life
There are a number of different methods of depreciation, but here we will focus on what is specific to real estate. The designated useful life for most real estate is either 27.5 or 30 years using the straight-line method. The depreciation period is 30 years if the owner fully deducts interest on taxes, while it is 27.5 years if they decide to abide by limits on interest deductibility.
As an example, an investor buys an apartment building at $10MM. The property yields $1M annually in gross revenue, with $500k in operating expenses (maintenance, property management, insurance, etc.). This yields $500k in Net Operating Income. If this investor chooses not to deduct interest from debt service, they can deduct $363,636 ($10MM / 27.5) from $500k, and only report $136,364 of income to the IRS.
Now, if this investor does deduct interest from their net profit, which we’ll say leaves them with $250k of reportable income, they can deduct $333,333 from this number, and report a LOSS of $83,333 to the IRS, and can use this to counter taxes on other income made that year.
Cost-Segregation
Cost-Segregation
Now that we have covered depreciation at its core, we will dive into a more advanced tax mitigation technique called cost-segregation that can lead to increased tax savings each year.
Here, an expert performs a cost-segregation analysis by inspecting the property and segregating its value into separate categories (personal property, buildings/structures, land improvements, land, etc.).
Many of these categories have shorter depreciable lives than the property as a whole. For example, certain land improvements like curbs and parking lots may depreciate over 15 years, meaning you can divide the cost of these improvements by 15 instead of 27.5 or 30, claiming a much higher percentage of these capital improvements as losses on your taxes.
For example, the investor above got a cost segregation study done on their $10MM apartment complex. It yielded the following:
| Category | Value | Depreciable Life | Annual Depreciation |
| Land | $300,000 | Unlimited | $0 |
| Buildings/Structures | $7,500,000 | 30 years | $250,000 |
| Personal Property | $1,000,000 | 5 years | $200,000 |
| Land Improvements | $1,200,000 | 15 years | $80,000 |
| Total: | $10,000,000 | $530,000 |
This means this investor can claim $530k of depreciation loss every year on their taxes. Performing a cost-segregation analysis can lead to substantially increased tax savings.
1031 Exchange Tax Benefits
1031 Exchange Tax Benefits
While both of the first two tax strategies dealt with depreciation, this last method pertains to deferment of capital gains taxes. Outlined in Section 1031 of the U.S. Internal Revenue Code, a 1031 Exchange allows you to defer paying capital gains tax by buying a like-kind property within set time limits.
Like-kind property is defined by its nature or characteristics, and it also must be of equal or greater value than the property you just sold. This means you can exchange an apartment complex for a mobile home park but not for a luxury car.
Additionally, in a 1031 exchange, a qualified intermediary (QI) must facilitate the transaction. What is a qualified intermediary? This is someone who temporarily holds the proceeds from the sale until it can be signed over to the seller of the replacement property. The QI also cannot have any formal relationship with the parties involved in the 1031 exchange.
Some things to remember with a 1031 exchange:
- The replacement property needs to be identified within 45 days of the closed sale. In addition, the transaction needs to be concluded within 180 days of the sale.
- The amount of money put into the new property needs to be equal to the proceeds from the old property
So, instead of paying capital gains tax upon every selling transaction, an investor can defer these while capitalizing on theoretically increased cash-flow from larger assets.
Conclusion
Conclusion
Tax benefits are one of the many reasons you should consider multifamily investing.
Understanding and proactively taking advantage of these tax mitigation techniques can increase your profit and tax savings over time.To learn more or hear updates from us, you may like and follow us on our social media accounts.
