How will our returns be "taxed"?..... is the #1 question asked by our investors when considering an investment into multi family real estate.
I will start off with the standard caveat that your CPA or accountant is the only one qualified to give you tax advice based on your unique situation. Please consider everything that follows as general information and not specific to your tax situation.
Over the last twenty years multi family real estate investment has become one of the most tax advantaged opportunities available for capital appreciation and wealth creation.
Here is a brief overview of these tax saving opportunities:
1. Deductions - Just like with your personal home , there are many deductions available to you. These include: property tax, insurance, mortgage interest, property management fees, property repairs, capital improvements, or ongoing maintenance.
2. Depreciation - Depreciation can only be used on investment properties, making it a huge tax advantage available only to real estate investors. Depreciation is the method of deducting a property's loss in value over its expected life, which for residential property is 27.5 years.
For example, if you purchased a single-family rental for $300,000, you could deduct an annual depreciation of $10,909 each year ($300,000/27.5 years). You can also depreciate certain capital expenses like replacing a roof or installing a new HVAC system over a period of years.
Additionally, multifamily investment has a significant advantage over single family investment because of something known as cost segregation. This process involves hiring an engineering firm to do an analysis that converts a 1250 property, which is a residential rental property (subject to 27.5-year straight-line depreciation) into 1245 property (tangible personal property), which can accelerate depreciation on certain interior and exterior components of the property over five, seven, or 15 years. Items eligible for accelerated depreciation are carpets, appliances, fixtures, HVAC units, electrical systems, hot water systems etc.
The Tax Cut and Jobs Act (TCJA) passed in 2017 made this even more beneficial by allowing investors to take a bonus depreciation of 100% for qualified assets in the first year (as defined by a cost segregation study) rather than depreciating the assets over a longer period of time.
In line with the previous example, let's say you invested $300,000 into a multifamily property and we used cost segregation to identify that 20% of the property was eligible for five or seven year depreciation. We could use bonus depreciation to take $60,000 in depreciation loss in the first year, which could be more advantageous.
It is important to note that depreciation doesn't last forever. When the property is sold, the depreciation is recaptured and taxed as ordinary income with a maximum tax rate of 25%. There are methods to avoid depreciation recapture, like a 1031 exchange, which we cover next
3. 1031 Exchange - 1031 Exchanges allow you to defer both the capital gains tax and depreciation recapture from the sale of a property and invest the proceeds into another “like-kind” property, often called “trading up.” While you ultimately have to pay tax at some point, with the notable exception of inheritance, this allows you defer the tax generated by capital gain and depreciation recapture and use the entire proceeds to purchase a new property, thereby increasing the size of your portfolio at a faster pace than would otherwise be possible if you were paying capital gains taxes upon each sale.
4. Passive Income and Pass through Deductions - Real estate is praised for its ability to produce passive income, which is cash flow that is earned without having to continuously work for it. Before 2018, the only way to offset passive income was with passive losses. But when the TCJA was passed, it allowed businesses who earns qualified business income (QBI) which includes rental income, to pass up to 20% of taxable income using a pass-through deduction.Not all income types qualify for this deduction, which is currently available until 2025. In addition, this deduction is subject to your annual income and starts phasing out at higher incomes.
5. Capital Gains - Since we sell multifamily properties after holding them between 3-5 years the net profit will be taxed as long term capital gains. The tax rate for that is 0% - 20% based on your income bracket.
Let's now put all of this together using a simple example
Example - You invest $100K with us and alongside other investors we raise a combined equity of $2M. You own 5% of the property. We use that equity to acquire a property worth $10M by taking a loan of $8M, at a 3.5% interest rate. You will be paid 5% cash annually and upon exit 4 years later we expect to deliver a 100% return on your equity inclusive of the cash payments.
For ease of analysis let us assume we owned the property effective Jan 1st and that we completed a cost segregation analysis that allowed us to take $1M in bonus depreciation in the first year.
Year 1
In the first year you will receive $5,ooo in cash dividends. Your 5% share of the bonus depreciation will be $50,000 for Year 1. Your 5% share of the regular straight line depreciation for the remaining $9M will be 5% of $9M / 27.5 years = $16,364.
So, your K-1 for the first year will show a passive loss of $5,000 - $50,000 - $16,364 = ($61,364). If you have other passive income coming in you could offset it against these losses to significantly reduce your overall tax burden.
Assuming you are in a 35% tax bracket that is a potential tax savings of 35%*($61,364) = $21,477 in the first year.
Year 2,3 and 4
You will receive $5,ooo in cash dividends. Your 5% share of the regular straight line depreciation for the remaining $9M will be 5% of $9M / 27.5 years = $16,364.
So, your K-1 for the second and third year will show a passive loss of $5,000 - $16,364 = ($11,364). Again you could offset against other passive income to reduce your tax burden. That is a potential tax savings of 35%*($11,364) = $3,977 in the second, third and fourth year.
Sale
Let's assume we sell on Jan 1st of year 5. You will receive $80,000 in profit upon the sale of the property. Including the cash of $20,000 already paid over fours years that is a net return of 100% on your equity.
Let's now look at a few scenarios for how that profit will be taxed:
Scenario 1 - You were able to use all of the depreciation losses in your K-1 over the four years. You decide to cash out your profit.
You will pay depreciation recapture on the entire profit of $80,000 (up to a max rate of 25%) since you used up a greater depreciation amount of $115,456
Scenario 2 - You decide to do a 1031 exchange and invest these profits into a new acquisition
You can now rollover your entire profit and can now potentially buy an asset worthy $20M without paying any depreciation recapture or capital gain taxes. That is how you can take advantage of the compounding power of returns.
Hope you found this useful. Please speak to your tax consultant or CPA for advice before making any investments.
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