There are many reasons why multifamily investing is a great option, but what is most attractive about this asset option are the tax benefits of purchasing a rental property. To begin to understand how this benefits you as the investor, let’s first break it down into easy to understand sections. As a multi-family investor with several years of experience, I have good working knowledge of this topic. However, I am not an accountant. As such, do not construe this information as tax advice; it is for educational/familiarization purposes only. Consult your own professional advisors before you engage in any real estate transaction.
DEPRECIATION DEDUCTIONS TAX BENEFITS
In any business, there are materials and machines that wear down and lose value over time. Therefore, when we consider investment property depreciation, it refers to an allowable asset with a determined value that lowers with age.
Additionally, the IRS sets the number of useful years that they will allow depreciation on any one item. This is known as the useful life of the item. And, rather than deducting it all in one year, it spreads out evenly over a set number of years which are the useful life of the item.
This method of tax deductions is a straight-line depreciation and refers to the equal amounts that are deducted each year for an item. To determine the annual deduction, you must divide the cost of the item by its useful life.
⇒ HOW TO CALCULATE ANNUAL DEPRECIATION RATE
For example, according to the IRS, the useful life of commercial or business real estate is 39 years. So, if an apartment complex is worth $3,000,000, then, you divide $3,000,000 by 39 years to get the annual deprecation deduction for that property.
- $3,000,000 / 39 = $76,923.07
For a passive investor who is taking part in multifamily syndication, the depreciation often zeros out the taxes on their distribution, so they end up paying little or no taxes. However, they will still have to pay taxes on the proceeds at the time of sale. There will be more about that later in this article.
An important thing to note at this point is, that to determine depreciation, you must understand that the structure is separate from the land on which it’s built. That’s because land, by itself, cannot be depreciated because it isn’t something that wears out over time. Makes sense, doesn’t it? However, it can be difficult to determine the separate value of the building and the property it sits on. That’s when your syndicator will call on the services of a tax assessor or property appraiser to determine those values.
COST SEGREGATION • ACCELERATED DEPRECIATION
Cost segregation is a tool used in tax planning for investors who construct, expand, remodel, or purchase real estate. With the use of this tool, real estate cash flow increases by the acceleration of depreciation deductions and deferment of income taxes.
In multifamily apartment syndication, your syndicator must employ the services of a cost segregation engineering firm who then identifies all property-related costs that can be depreciated over 5, 7, and 15 years. This is an extensive and expensive undertaking and depending on the number of apartments in your investment property, it can cost upwards of $10,000 to $100,000.
Still, there are good tax benefits with cost segregation accelerated depreciation if you chose to go this route with your investments, and the greater the NOI, the more cost-effective it is to get it done.
DEPRECIATION RECAPTURE
⇒ WHAT IS DEPRECIATION RECAPTURE?
Depreciation recapture is the gains you report as income when you sell a depreciable asset. You will report depreciation recapture on IRS Form 4797. To break it down into understandable pieces, here are the steps to determine depreciation recapture.
First, determine the original purchase price of the property. Next, factor the allowable depreciation cost. Then, subtract the allowable depreciation cost from the original purchase price to get the adjusted cost. Next, determine the total of the proceeds from your sale. Finally, subtract the adjusted cost from the proceeds.
The purpose of depreciation recapture is for the IRS to collect income tax from the gains a taxpayer receives from the sale of a property that had previously been used to offset income through depreciation.
⇒ EXAMPLE OF DEPRECIATION RECAPTURE
- You purchase an apartment complex for $3,000,000 with an annual depreciation of $76,923.
- 9 years later, you sell it for $3,600,000 (excluding land).
- The adjusted cost basis is: $3,000,000 – ($76,923 x 9) = $2,307,693
- The realized gain from the sale is: $3,600,000 – $2,307,693 = $1,292,307
- The capital gain is: $2,307,693 – ($76,923 x 9) = $1,615,386 and the depreciation recapture gain is $76,923 x 9 = $692,307
Next, let’s assume that you as the investor fall into the 28% income tax bracket and there is a 15% capital gains tax. Finally, to determine the amount of taxes you then owe on the property sale: (0.28 x $692,307) + (0.15 x $1,615,386) = $193,845.96 + $242,307.90 = $436,153.86.
Therefore, in this scenario, the capital gains total is $1,615,386 while the depreciation recapture total is $193,845.96.
LONG-TERM CAPITAL GAINS
Simply said, a capital gain is what you call the profit you receive when your property sells. Therefore, when a multifamily property sells and the syndication is dissolved, the passive investors then receive their initial equity plus the profits. The profit is a long-term capital gain because it was invested in the property for more than one year.
While there are no special tax breaks for short-term capital gains, the long-term capital gains are quite helpful. For short-term capital gains in 2019, the tax rates range from 10% to 37%, the exact percentage of which depends on the income of the investor.
However, long-term capital gains can be 0%, 15%, or 20%. The percentage amount depends on your income tax bracket. Below is a table that shows more details about the income brackets for capital gains tax as it stands under the new tax act.
| Income (Single filers / Married, filing jointly / Head of Household) | Capital Gains Tax |
|---|---|
| $0 to $39,375 / $0 to $78,750 / $0 to $52,750 | 0% |
| $39,376 to $434,550 / $78,751 to $488,850 / $52,751 to $461,700 | 15% |
| $434,551 or more / $488,851 or more / $461,701 or more | 20% |
NEW TAX BENEFITS • TAX CUTS AND JOBS ACT OF 2017
Under the new Tax Cuts and Jobs Act of 2017 (TCJA), if you purchased your property after September 27, 2017, you can now take 100% bonus depreciation on qualified property. This is good news if you invest in multifamily units. However, please note that the 100% bonus depreciation deduction is only for single filers who earn no more than $157,500, or joint filers who earn no more than $315,000.
There are also excellent tax benefits for passive investors. First, passive investors do not pay self-employment tax on their cash flow. Another benefit that is affected by the tax act is the 1031 like-kind real estate transfer exchanges which offer even more interesting tax benefits.
⇒ 1031 EXCHANGES
TCJA made some changes to the existing 1031 Exchange rules. Basically, only real property such as land and buildings are eligible for like-kind exchanges. Personal property for personal property such as equipment exchanges is not allowed under TCJA.
Through the use of a 1031 exchange, you invest your capital gains from the sale of one property into the purchase of a similar property with a higher price. This allows you to avoid paying tax on the capital gain from the sale of the first property. By doing this you use the tax savings from the first property to invest in the second property.
However, there are rules in place for the 1031 exchange that are rather stringent. In fact, you run the risk of being disallowed at which point you then have no recourse but to pay the tax.
Here is a synopsis of the rules governing the 1031 exchange.
- The 1031 exchange must involve a like-kind asset.
- If your investment is in real estate, then your exchange investment must also be real estate.
- For instance, you cannot use the exchange to sell property, then invest in a restaurant franchise because that’s a business rather than real estate.
- If your investment is in real estate, then your exchange investment must also be real estate.
- You must adhere to the 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.
- You may identify up to 3 different properties.
- When you decide on the property, you must close on it within 180 days of the sale of your first property.
- 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.
- The money you make on the sale of the first property never crosses your hands. Instead, there is an intermediary who holds the money. You may, however, use some of your profit, but you will have to pay the taxes on the amount you take out.
⇒ THE 1031 CAVEAT FOR SYNDICATION DEALS
Investors of multifamily (MF) syndications are part of an LLC which is the owner of the real estate. However, a 1031 exchange investor can also be part of the real estate purchase by entering into a Tenant In Common (TIC) agreement with the LLC to mutually own the property.
⇒ THE OPPORTUNITY ZONE
This is a bill that promotes incentives for investments in developing pre-determined low-income regions in the United States. Like the 1031 exchange, it provides capital gains tax deferment when you sell a property. Additionally, there is the option of a 10-year property hold for tax-free growth. This is a very lucrative opportunity if you want to concentrate on areas that are in desperate need of revitalization. This is both rewarding for the residents of the newly developed area and potentially a great opportunity for investors.
THE DEATH TAX BENEFITS OF MF SYNDICATIONS
Incredibly, in this instance, death becomes a huge benefit for real estate investors. That’s because when your properties transfer to your heirs, the government applies a different type of tax wherein the accumulation of gains disappear and your family gets the property at fair market value.
⇒ EXAMPLE OF DEATH TAX BENEFIT
- The fair market value of your property at your death is $6,000,000.
- Your heirs will get the $6,000,000 piece of property without the $4,138,640 tax basis or the capital gain of $1,861,360.
- Literally, the capital gains vanish, and the tax basis resets to $6,000,000 for your heirs.
IN CONCLUSION
I hope this has given you good information you can use with regard to the incredible tax benefits to real estate investments. Of course, you probably have questions so if that is the case, contact me right away and I will be happy to go over any additional information you might need to better understand the intricacies of the real estate investment tax benefits.