In addition to cash flow, capital preservation, and steady growth prospects, many passive investors find themselves gravitating to real estate syndication for another reason – the tax benefits! There are a number of powerful tax benefits that come with investing in real estate; it’s likely the number one benefit that we’ve noticed are the massive deductions.
Some of the most common deductions are:
- Depreciation (Accelerated)
- Mortgage Interest
- Property Taxes
- Operating Expenses
Investments in multifamily syndications are considered to be “passive” activities since you are a limited partner in the partnership that owns and controls the commercial real estate asset. Each investor gets to share in these deductions based on their proportional share of ownership in the limited partnership. This makes an investment in multifamily assets very tax efficient.
Why do apartment investors get all of these great tax benefits?
The first thing you have to do is switch your mind around the tax code. Most think of tax laws as a sort of punishment, when in fact, it is a series of incentives. The government offers great tax benefits to real estate investors because they are dangling a carrot in front of us. They’ve targeted entrepreneurs who start businesses, investors who fund those businesses, and real estate investors as folks who create wealth not only for themselves, but for others as well. These tax incentives are there to stimulate the economy by encouraging these sorts of activities. The resulting tax deductions and incentives from this government mindset can be powerful.
Specific to real estate is the gift of depreciation, which makes it common for a cash-flowing property to look like it is losing money every year. As a result, your properties can generate real income for your bank account, and you don’t pay any taxes on it.
As a passive investor, you’ll receive a K-1 tax form for reporting purposes that outlines this “paper” loss (due to lucrative tax benefits), which can be used to offset passive gains in other parts of your portfolio. Many high-net worth individuals begin investing in syndications simply to resolve their tax problems. The benefits are just too good to ignore!
But, isn’t avoiding taxes wrong? Why would real estate investors get this kind of special treatment? Well, since the government isn’t in the market of supplying housing and commercial space to the public, they need someone to do it. If it weren’t for real estate investors building and running commercial properties, there would be no one to provide for and manage this unique marketplace. This is the reason for the incentives. These benefits are in place to push individuals into this type of investment.
Breaking Down the Tax Benefits
This is the accounting method of allocating the cost of a tangible asset over its useful life. It is used to account for declines in value over time. Think of your car: it is a depreciating asset, that declines in value the longer you own it.
The most common form of depreciation is straight-line depreciation, which deducts an equal amount for each year of useful life. In real estate, the IRS considers the useful life to be 27.5 years. So the annual depreciation on a commercial real estate asset worth $1,000,000 (excluding the land value) is: ($1,000,000) / (27.5 years) = $36,363.64 per year.
Depreciation is one of the major benefits of commercial multifamily syndications, as it allows a passive investor to avoid paying taxes on their monthly, quarterly, or annual distributions during the hold period. A passive investor will have to pay taxes on the sales proceeds, though.
Depreciation can be accelerated on large commercial assets through what is called a cost segregation study.
Cost Segregation (Bonus/Accelerated Depreciation)
Cost segregation is a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes. A cost segregation study is performed by an engineering firm that specializes in dissecting the construction cost or purchase price of the property and all property-related costs.
- Bonus Depreciation – The Tax Cuts and Jobs Act of 2017 (TCJA) held some major benefits for real estate owners. The Bonus Depreciation provision allows a business to take 100% bonus depreciation on a qualified property purchased after September 27th, 2017. This deduction is only for single filers earning no more than $157,500 or joint filers earning no more than $315,000.
- Accelerated Depreciation – This is any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of the life of an asset.
Personal property such as furniture and fixtures, carpeting, and window treatments is depreciated overacted 5- or 7-year depreciable life. Land improvements such as sidewalks, paving, or landscaping are subject to a 15-year depreciable life. The actual buildings or structures are depreciated over 27.5 or 39 years, depending on the type of property. Land is not depreciated.
Speeding up the depreciation of these individual items on the commercial property will generate additional depreciation deductions for income tax purposes, leading to “paper” losses that allow an investor to keep more of their income.
When the asset is sold and the partnership is terminated, initial equity and profits are distributed to the limited partners (passive investors). The IRS classifies the profit portion as long-term capital gain, which is still tax-advantaged compared to regular income.
Under the new 2018 tax law, the capital gains tax brackets are:
Taxable Income (Individual or Joint)
- $0 to $77,220: 0% capital gains tax
- $77,221 to $479,000: 15% capital gains tax
- More than $479,000: 20% capital gains tax
It is common for value-add syndications to optimize the value of the multifamily property around the 2-3 year mark. Renovations are completed and higher rents and occupancy are achieved. At this point, the sponsors will go to the bank to refinance the property and pull the value-added equity out to distribute to investors (often 50% or more of their initial equity is returned). This is considered to be a return of investor equity, and thus is a non-taxable event.
This is so powerful! The funds from a refinance can be placed into another investment deal, leading to even more cash flow since the original investment is still providing the same monthly or quarterly cash flow. See the example below:
Original $100,000 investment with 7.5% distributions provides $7,500/year, or $625/month.
Cash-out Refinance in Year 2 puts $60,000 of your initial equity back in your hands. You choose to invest it in another deal that also happens to provide 7.5% distributions, equaling $4,500/year, or $375/month.
Now your original $100,000 is working for you in two deals producing $12,000/year, or $1,000/month. You are earning 12% distributions on your initial equity amount.
And so on, and so on. Many call this the Snow Ball Effect of Multifamily Syndication, or the idea of Infinite Returns.
A 1031 exchange allows an individual to swap a like kind property for another like kind property and defer the capital gains tax on the sale of the first property. Most syndications are not set up to take a 1031 exchange from an investor’s personal property, but you can do an exchange from one syndication deal to another syndication deal under the same sponsor if that opportunity presents itself. Most syndicators will encourage this because deferring your capital gains several years into the future proves to have many useful benefits for investors.
Under the TCJA of 2017, you must adhere to time limitations.
- The IRS only gives you 45 days from the sale of your first property to identify the property you want to buy within the 1031 exchange. (Side note – You can identify up to 3 different properties)
- When you decide on the property, you must close on it within 180 days of the sale of the first property.
In addition, the money you make from the first property sale must never cross your hands. Instead, it must stay with an intermediary (ie. your sponsor) prior to deployment for another property. You may use some of your profit if you wish, but you will have to pay taxes on the amount you take out.
Investors with retirement accounts are growing tired of a volatile stock market, and they are looking for more stable investments. Traditional brokerages only allow the exchange of stocks, bonds, mutual funds, ETFs, and CDs. Luckily, Self-Directed IRAs offer investors the flexibility to invest in non-traditional investments such as real estate crowdfunding and syndications, notes, precious metals, tax lien certificates, and much more. These self-directed accounts have increased in popularity in recent years, being that they are much more accessible in the last decade.
Utilizing a Self-Directed IRA is a wonderful way to diversify your retirement portfolio. Traditional and Roth IRAs can be converted into Self-Directed IRAs to provide more control over investment decisions while still enjoying the tax-deferred benefits that an IRA offers. If you have an old 401(k), you can roll that over into a Self-Directed 401(k) if you desire. My wife has invested in two multifamily properties with her Self-Directed IRA, and the process was straightforward once the accounts are set up.
Death Tax Benefits
While largely viewed in a negative light, death can become a huge benefit for the heirs of real estate investors. When your multifamily properties transfer to your heirs, the government applies a different type of tax wherein the accumulation of gains disappears and your family gets the property at fair market value.
Example: The fair market value of your property at death is $6,000,000. Your heirs will get the piece of property without the $4,138,640 tax basis or the $1,861,360 of capital gain. The capital gains literally vanish, and the tax basis resets to $6,000,000 for your heirs.
Now you can see why tax deferral can be such a powerful tool!
Maybe taxes don’t have to be such a sure thing in your future. As you can see, multifamily syndications are highly tax efficient vehicles for your investing dollars. From the standard property tax, loan interest, and accelerated depreciation opportunities to refinances, 1031 exchanges, and qualified retirement plans, the IRS has provided multiple ways for you to keep more of your profits or defer taxes for some time into the future.
Please know that everyone’s tax situation is different, and these brief summaries are not meant to be misconstrued as tax recommendations or advice. Many tax policies are different between the federal and state levels, so please consult with a tax professional regarding your individual situation to learn more about how these strategies may apply to you.
On Call Capital, LLC