When investing in alternatives such as real estate, rates of return are not as straightforward as glancing at the stock ticker. Many only consider the internal rate or cash-on-cash return to measure investment quality. This oversimplification does not consider the tax advantages of real estate, which can dramatically impact the upside potential.
When you (or the investment sponsor) proactively manage the tax liability, you can realize higher returns. Below are the primary sources of tax benefits to consider:
The IRS allows the depreciation of buildings and personal property from taxable income. Depreciation is an accounting function enabling owners to deduct a portion of the structure’s value each year to account for the decline in the asset’s value. It lowers tax liability without increasing direct expenses.
Multifamily real estate has many independent assets that qualify for depreciation. A few include stand-alone garages or carports, swimming pools, gym equipment, HVAC units, electrical systems, plumbing, and other property or buildings that deteriorate over time.
According to the IRS, each asset has a useful life ranging from one to 27.5 years. Multifamily properties can use straight-line depreciation, deducting the same amount each year for 27.5 years to fully depreciate the asset.
Use of Cost Segregation
IRS rules govern when and how much depreciation you may take for each qualified asset. Cost segregation accelerates allowable deprecation on qualified assets increasing deductions and reducing tax liability. The method is especially beneficial for multifamily syndications with shorter holding periods.
To qualify for cost segregation, a consultant or engineer must perform a detailed analysis separating assets into four categories:
- Personal property
- Land improvements
- Buildings and structures
- Land (not depreciable)
Using these categories, you can accelerate depreciation based on the useful life of the specific asset rather than the property as a whole. Personal property tends to depreciate over five to seven years, whereas land improvements range from 10 to 15 years. Converting to the faster depreciation schedule provides greater tax benefits earlier in the property ownership.
Recent legislation not only allows you to use cost segregation but may qualify you to take bonus depreciation in the first year of ownership. For instance, in 2022, instead of spreading amortization over a five to fifteen-year period, you could qualify to take 100% of bonus depreciation upfront. For a more in depth article on Bonus Deprecation click here.
While depreciation lowers tax liability during the ownership years, a 1031 exchange can delay taxation at the time of the sale.
Selling investment real estate creates a taxable event. The IRS taxes real estate owned more than a year at the capital gains rate of 15 to 28%. While this is significantly lower than your wage tax rate, it can result in a large tax bill.
Section 1031 of the IRS code permits you to defer taxes, provided you purchase a “like” property within the established timeframe. The IRS does not put a limit on the number of exchanges, allowing you to postpone taxation as long as you remain invested in qualified real estate.
Delaying taxation gives you a tax-deferred investment regardless of the source of your original investment. To qualify, you must follow a complex set of IRS rules.
Ready to Learn More
If you are ready to capitalize on the tax benefits of multifamily housing, ownership through a real estate syndication gives you access to larger deals without forfeiting any of the tax benefits. Learn more here.