Contrary to popular belief, depreciation does not fully eliminate the need to pay taxes… But it can delay them substantially.
The tax code favors real estate investment because the government, as one of its duties to its citizens, is to provide affordable housing. To do so, the government provides incentives to spur on this type of investment. One of the coolest things about investing in real estate is a little thing called depreciation. This accounting expense can seem almost magical, but it is rooted in the truth that since assets tend to wear out over time, we account for that reduction in value, deducting the cost of an asset over its useful life.
But remember: In most cases, this works out to be a way to defer paying taxes until a later date. This is because although part of a property’s value has been written off due to wear and tear, the sale of the property usually ignores the depreciation and sells for the full price as though there has been no decline in its useful value. Despite this, using depreciation is a good way to shield some of a syndication’s profits during the first few years against most taxes. The Modified Accelerated Cost Recovery System (MACRS) is part of the current tax depreciation system in the United States, and is most relevant in this discussion.
With the Tax Cuts and Jobs Act passed by Congress in 2017, investors are able to take advantage of depreciation deductions of up to 100% of their value on properties placed in service after September 27, 2017. This phases out over time. In 2023 this is reduced to 80%, 2024 to 60%, and 20% in 2026.
Prior to the 2017 act, bonus depreciation had some other iterations in the previous decade and a half. 2002 saw the introduction of bonus depreciation at a rate of 30%. In 2033, and again in 2008, a 50% rate was introduced. In 2015, Congress extended the benefit out into the future, but implemented a phaseout over several years. The Act governing where we are at this writing was executed in 2017.
Properties put into place prior to September 27, 2017 do not get to take advantage of this extra depreciation, but everything afterward does. Bonus depreciation has to be booked in the first year that the property is placed in service. Investors are not forced into taking bonus depreciation and can in fact use the long-term method if it is more advantageous to do so.
Cost Segregation Study
Many syndications you will be investing in will be doing what is called a cost segregation study, which reclassifies building costs to permit a shorter, accelerated method of depreciation for certain building costs. Think of this as depreciation on steroids. Though this can cost the project thousands of dollars, it can be justified in the amount of short-term profits that can be shielded from tax – usually shielding all income from taxes in the first 3 years.
The primary goal of a cost segregation study is to categorize all construction-related costs that can be depreciated over a shorter tax life, typically 5 to 15 years, than the building, which is 27.5 years for residential real property.
A simplified example of how a cost segregation study works is as follows: We know that depreciation of a structure can be taken over 27.5 years, but inside that structure are things like carpet, appliances, and kitchen cabinets (the list goes on and even includes landscaping). The useful life of an appliance might be 5 years and will need to be replaced several times within the overarching 27.5 years. The same goes with the carpet and kitchen cabinets.
The study identifies all items that have a shorter life span, classifies them in groups, and allows for the depreciation over each item’s useful life. So, in the case of carpet, appliances, and kitchen cabinets, the study substantiates the items’ value that can then be deducted in the form of depreciation over the 5-year period.
A passive real estate investor in a multifamily syndication invests in an entity, most likely an LLC, that owns the real property. The entity is disregarded for tax purposes by the IRS in favor of its investors. An LLC is considered a pass-through entity, and because of this, allows for taxable events to take place at the investor level. In other words, any tax benefits flow straight through the entity to you, the investor. (This does not apply to REITs.) A passive investor gets all the tax benefits that an active investor would get.
The Downside: Recapture
The downside to a cost segregation study, as well as bonus depreciation, includes cost, the triggering of depreciation recapture and understatement penalties for taxpayers that use cost segregation too aggressively. When a taxpayer sells an asset for a gain after taking deductions for depreciation, depreciation recapture is used to tax the gain. The exception is when a taxpayer takes a loss on the sale of a property, there is no depreciation recapture. But we as investors never want to be in that position. The tax authorities will always get the taxes owed to them in the end, but we as taxpayers can determine the ‘when’ of those tax payments. Sometimes this timing can work to our advantage.
Most investors in a syndication will not be eligible for using a 1031 exchange for a couple of reasons. First, when you invest in a multifamily syndication, you are investing in shares of the LLC that owns title to a property. A 1031 exchange is a like-kind exchange, income property for income property, that allows you to postpone your taxes, essentially kicking the can down the road.
Secondly, if you are investing with a sponsor who is planning on doing a 1031 exchange at the disposition of a property, all or most of the passive investors will need to keep their equity with that continuing investment. In other words, they would not be able to cash out. All of the capital from a project must be used to purchase the next property.
There are workarounds to these limitations, but it is best not to plan on or expect an exchange like this happening.
Depreciation can be a powerful thing, but remember that this is only a tool that should be used within the framework of your wealth-building strategy. It is not a requirement to be wealthy to be able to take advantage of the tax benefits that real estate investing offers. The tax code avails the benefits of real estate investing to all investors. You can take advantage of the substantial write-offs, applying those to other taxes you owe, thereby decreasing your overall tax bill. But remember, the IRS and other tax authorities will still want to get their cut.