Tax Benefits of Apartment Investing
Updated: Feb 20
*This is not tax advice and should not be taken as tax advice. Please consult a CPA or an attorney to discuss your financial situation.*
There is more to investing than only returns. Some of the benefits are initially concealed but play a major role in wealth creation. This is the case with taxes and real estate. Real estate is notoriously gifted when it comes to taxes. There are several things outlined in the tax code that favor real estate over any other investment.
First, it's important to understand how a real estate syndication is taxed and how limited partners benefit from this structure. When someone invests in a multifamily syndication, they are purchasing shares of the LLC (limited liability company) that owns the asset. An LLC is a disregarded tax entity. This means the income (and expenses) from the real estate investment “pass-through” to the individual investors so that it is only taxed at the individual level. Each year, investors receive a schedule K-1 which details income or losses for the syndication. The trick is to structure the benefits outlined below so that there will be a "loss" from a tax standpoint. This is called a "paper loss". A paper loss is when the depreciation and expenses combined show a yearly loss for the investment, even though there were distributions made. Therefore, an investor collects income throughout the year but shows a loss. This loss can even offset regular income or gains from other investments.
The tax benefits that create this unique situation are depreciation and cost segregation, but there is also the 1031 exchange which defers capital gains as well.
The depreciation deduction allows investors to take a tax deduction each year for the "wear and tear" of the asset. Depreciation is attempting to account for the physical asset and its systems deteriorating each year. This is a non-cash deduction, meaning it can be deducted even if there are no distributions from the investment. The tax code details exactly how much depreciation can be deducted each year. An apartment building is depreciated in a "straight line" over 27.5 years. For example, a property worth $2,000,000 could take $72,727.27 ($2,000,000/27.5) in depreciation per year.
However, there is an advanced feature that allows the team to potentially accelerate the depreciation called cost segregation. Cost segregation is a study performed by a professional in the field. The professional evaluates the property in its entirety to separate the property into four categories: personal property, land improvements, building/structures, and land. Different categories have different depreciation schedules. For example, land improvements can be depreciated over 15 years rather than the 27.5 years of the asset in its entirety. This allows a large portion of the asset to receive accelerated depreciation, which in turn increases the depreciation deduction taken each year, showing a larger loss for investors and increasing tax savings. This is especially helpful for high-income earners that need substantial tax benefits to reduce their taxable income.
Depreciation and cost segregation can be performed during ownership, however, there is a technique called the 1031 exchange that defers capital gains at the sale. When the business plan is completed successfully, there is a large amount of value-added and therefore a tax bill coming at the sale. Capital gains are taxed between 15-20% (as of 2022) depending on the profit realized. However, there is Section 1031 of the Internal Revenue Code that allows investors to defer capital gains by reinvesting the proceeds into a 'like-kind" property. There is no limit to how many times capital gains can be deferred via a 1031 exchange, so technically capital gains can be deferred indefinitely.
Similar to all other tax benefits, there are rules to a 1031 exchange. The primary rules are as follows:
The new property must be "of the same nature and character".
The new property must be "identified" within 45 days of the close of the sale of the initial asset and the transaction must be completed within 180 days of the initial sale.
The new property must have the same or more money invested into it as the first property
These rules make performing a 1031 exchange rather tricky, especially when the supply is tight, so there is a "reality" factor to consider when discussing this option. However, if performed correctly, the investor's income can grow tax-free for a substantial amount of time.
Investing in real estate carries huge advantages that many investors don't weigh into returns. Depreciation, cost segregation, and the 1031 exchange can all be used in tandem to reduce taxable income and/or defer capital gains. Investing in a syndication can provide ongoing cash flow with massive tax savings without the investor having to be a landlord. This is something other investments can simply not offer.
Keep in mind, that these tax strategies are very difficult to calculate and therefore we advise anyone who is considering using any of these strategies to speak with their accountant to see how it can affect them.