The Tax Benefits Of Investing In Multifamily Real Estate
Real estate, once considered an alternative asset class, has become more mainstream in recent years. Investors are increasingly drawn to real estate given its stability in the face of otherwise dramatic market swings. Passive real estate investing also offers tremendous tax benefits, something that institutional investors have known all along.
In this article, we look at the six primary tax benefits of investing in multifamily real estate.
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.
Pros Of Buying A Multifamily Property:
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Taxes Are Deferred On The Sale Of A Property With A 1031 Exchange
Another benefit of multifamily real estate investing is the ability to defer capital gains taxes while selling a property by using Internal Revenue Code Section 1031, often referred to as a 1031 exchange. So, what is a 1031 exchange, and how does it help investors? It refers to a type of transaction where the owner of a property sells it and then reinvests the capital into another property, deferring capital gains taxes by rolling them over to the new property. Note that a 1031 exchange is intended for business and investment property, or property used for earning income, and not for personal residential properties.
After the 1031 exchange, the tax is rolled over until the replaced property is sold in the future. Another benefit of the 1031 exchange is that there is no limit on how many times investors can exchange properties the capital gains can continue to be rolled over accordingly from property to property.
Tax Benefits Of Investing In Multifamily
If youre looking to generate passive income through investing, one crucial factor to consider is how much youre required to share with Uncle Sam.
The taxes you pay vary quite a bit from one asset class to another, with multifamily emerging as the clear winner.
So, what are the tax benefits of investing in apartment buildings? And just how much more will you owe the government come April if you choose the stock market as an alternative?
In this video I share with you the extraordinary tax benefits of multifamily investing.
What Im presenting to you I learned from Tom Wheelwright, author of the book Tax Free Wealth a must-read BTW if you havent read it already.
I walk you through the US tax laws, explaining how they work in our favor as real estate investors.
Then I evaluate two equal investments, one in the stock market and another in multifamily, calculating the taxable income in each scenario.
Spoiler alert: real estate wins hands-down but do you know why?
Watch the video below .
If youre looking to generate passive income through investing, one crucial factor to consider is how much youre required to share with Uncle Sam. The taxes you pay vary from one asset class to another, with multifamily emerging as the clear winner. So, what are the tax benefits of investing in apartment buildings? And just how much more will you owe the government come April if you choose the stock market as an alternative?
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Tax Benefits Of Real Estate Investing Conclusion
The tax benefits of multifamily real estate investing allow passive investors to keep more after taxes, park their hard-earned dollars into secured hard assets that provide a strong risk-adjusted return. The tax advantages of rental properties are really one of the most important factors when comparing different investment vehicles. As a real estate investor, make sure you keep tax implications top of mind when comparing your next passive income real estate investment opportunity.
At Willowdale Equity, we provide passive real estate investment opportunities to select investors, check out our how it works page to learn more about the process from A to Z. Also you can join our private investor club to gain access to special investment opportunities get access to more information on how to develop your portfolio, including exclusive tools and knowledge.
One Final Benefit: Leverage
Combined, these tax benefits contribute to another significant benefit of investing in multifamily real estate: leverage.
See, unlike buying a stock or bond, with leverage, you can invest in multifamily property for a fraction of its actual cost.
Lets say an investor has $1 million of free cash on hand to invest. They can spend $1 million on stocks, or they could spend $1 million on $4 million worth of real estate thanks to leverage. With leverage , that investor can, for example, spend as little as $250,000 to invest in four different million-dollar properties. The rents collected from leasing the units will pay down the mortgage, and over time, the investor will own $4 million worth of real estate despite only contributing $1 million to its cost.
Then, using a tool like the 1031 Exchange, the investor could sell that $4 million property to purchase a $12 million property creating a virtuous cycle that allows investors to grow their rental portfolios with minimal up-front investment.
Sound too good to be true? Its not. Tens of thousands of people invest in multifamily real estate each year to take advantage of these tax benefits.
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Real Estate Depreciation Tax
Arguably, depreciation is one of the biggest and best real estate tax shelters for rental property owners. Depreciation works on the principle that properties depreciate over time.
Therefore, the depreciation amount is a tax deduction that covers the propertys exhaustion or wear and tear over the years.
Now, you might be wondering how a property can decline while its value increases throughout time.
Well, the IRS treats properties like any other type of asset. Therefore, to them, the real estates quality diminishes progressively. Think about owning a car, its the same principle.
Although, in reality, its rare for that to happen. In fact, with proper maintenance and a growing neighborhood, the propertys value is bound to increase.
Therefore, regardless of whether the property is making profits or appreciating in value, owners can deduct a depreciation expense from their real estate income tax. Clearly, its evident that depreciation offers investors a massive tax break.
So, how does depreciation work?
According to the government, residential property is only useful or profitable for 27.5 years . Therefore, the IRS allows rental property owners to deduct a depreciation expense for that amount of time.
To calculate your propertys depreciation amount, all you have to do is to divide its worth by the number of years. Here is an example:
For instance, if the property above generates an income of $80,000 per year, your tax obligations would be:
Why Real Estate Tax Benefits Exist
In summary, weve seen our multifamily properties provide a wealth of tax benefits to our investors. Those incentives are in the tax code because the government wants investors to provide housing for others. If they are determined to pay me for making sound investment decisions then Im just fine with that. After all, who likes to pay more taxes than they have to?
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Single Family Investing Benefits
A single-family property, otherwise referred to as a single-family home , is defined as a free-standing residential dwelling built on a single lot with no shared walls. Unlike a multi-family home, these properties contain only one unit, neither attached nor built-in unison with any other type of structure. Also, a single-family home will generally include a front and backyard, as well as a garage.
Traditionally used for owner occupancy, single-family homes can also be used as an investment vehicle to generate monthly income. Record-low mortgage rates and fast-rising rental rates offer many advantages compared to multifamily properties, especially for beginner investors. The following examines the benefits of investing in single-family properties:
Plan Your Real Estate Investments With Sequoia
With over 35 years of experience, Sequoia Equities has extensive knowledge of the multifamily real estate market and its benefits for investors. Here at Sequoia, we know the importance of focusing on the individual needs of our investors. We are always ready to assist our clients with any questions they may have regarding opportunities and advantages of investing in multifamily real estate.
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How Proposed Tax Changes Could Impact Multifamily Investment Profitability
Rod Khleif Real Estate Investor, Mentor, Coach, Host, Lifetime Cash Flow Through Real Estate Podcast.
As multifamily investment coaches and mentors, we are often quick to cite the tax advantages of an investment in a multifamily asset, and there are many. But, a slate of proposed tax changes under the new presidential administration could reduce or eliminate some of these advantages. For this reason, it is important that investors increase their awareness of the proposal and start to formulate a game plan should it ultimately be passed into law.
Note: To be clear, this article does not offer tax advice. The changes discussed are still in the proposal stage and there is much uncertainty about whether they will ultimately become law.
In order to understand how the proposed tax changes could impact multifamily profitability, it is first important to understand the tax advantages under current IRS rules.
What Are The Current Multifamily Tax Advantages?
There are two prominent tax advantages to a multifamily investment. One has to do with the long-term capital gains tax rate, and the other has to do with a type of transaction known as a 1031 exchange.
The Following Conditions Must Be Met To Qualify For A 1031 Exchange
- A new asset of comparable or greater value than the property being sold
- Both properties must be like-kind
- Within 45 days a replacement property must be identified
- Within 180 days a replacement property must be purchased
For example, Lets assume you bought a multifamily real estate property for $800,000 and made about $200,000 in improvements, giving you a cost basis of $1 million. Lets assume that after five years, the property is worth $2 million and you inform property management that youre going to sell it. Youll have around $1 million in profit after five years.
On that $1 million, uncle Sam would take home 20% of the profits for any capital gains taxation, leaving $200,000 in taxes to be paid. To defer taxes and maintain a greater purchasing power by being able to roll over all of your income into the next real estate deal, you may choose to 1031 exchange the property for a like-kind property. This means I may roll over and exchange the complete $1,000,000 instead of the $800,000 in after-tax profit.
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Challenges Of Multifamily Investing
There are difficulties in everything. And so also there are challenges of Multifamily Investing too.
- Complexity of Management Intensity – Multifamily Investing and Multifamily property requires dealing with many individual leases, different types of tenant profiles, diverse and multiple repair and maintenance demands, requests, different modes of bill payment. This requires a complex, efficient and intensive management structure to cater to all demands and all profiles.
- Cost Challenges – Depending on the location, a Multifamily property may prove to be expensive. High cost is one of the primary, and biggest challenges investors face in Multifamily Investment options of Multifamily dwellings. All the prime locations that offer good rental potential, come at an extremely high cost. Arranging finance for Multifamily dwellings can be very daunting. Also, investors competing for the same Multifamily property, hike up the cost.
Real Estate Investment Tax Deductions
Another great way to lighten your tax burden is by taking advantage of tax deductions.
So, what are tax deductions? Basically, a deduction is an expense thats written off from a rental property owners taxable income. The law allows you to deduct the expenses you incur to manage, maintain, and repair your multi-family property from your total taxable rental income.
Generally, this means that you can reduce your tax obligation by writing off expenses from your total taxable income. Some expenses are:
- Insurance premiums
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Chander Mishra Md Mba Cpe Fase Fasa Faacd
Division Manager I Medical Director of Anesthesiology at Medical City Fort Worth, TX I US Anesthesia Partners of TX I Physician Leadership Mentor
Many passive investors are drawn to real estate syndication for tax advantages, cash flow, capital preservation, and consistent growth prospects. Real estate investing has several significant tax advantages, but the biggest one weve noticed so far is probably the substantial deductions.
Being a limited partner in the partnership that owns and controls the commercial real estate asset qualifies you as a passive participant, which makes investments in multifamily syndications a passive activity. Each investor is entitled to a portion of these deductions based on their proportionate share of ownership in the limited partnership. Due to this, buying multifamily real estate is incredibly tax-efficient.
The following are some of the most significant tax advantages of using a syndicate to invest passively in real estate:
Earn A Preferred Return
This one only applies to people who invest in private equity real estate funds , but its worth exploring.
Investors in private equity real estate funds typically earn whats known as a preferred return. That means that theyre first in line when it comes to earning a return on their investmentso if you invest in a real estate fund or syndication that offers a preferred return of 8%, then that fund needs to pay you 8% before it takes a single cent in profit for itself.
The return that the fund needs to hit before it starts to earn a share is known as a hurdleand over and above that hurdle, profits are split between investors and the fund itself.
Thats a significant extra protection for those who invest in multifamily residential properties via private equity investment funds such as re-viv. Its commonly referred to as aligning interest simply meaning the investment companys payment is contingent upon performing or outperforming projections.
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How Important Are The Tax Benefits Of Real Estate Investing
The greatest expense that many Americans face is taxes, which makes the subject of tax-advantaged investments so critically important.
In fact, the Tax Foundation estimates that in 2017, Americans will pay $3.5 trillion in federal taxes and $1.6 trillion in state and local taxes for a total tax burden of $5.1 trillion. That is 31% of the nations income. Therefore, Americans will spend more on taxes than they will on their basic needs .
Given the progressive nature of our tax system, high-income and high-net-worth individuals like our investors typically shoulder a much heavier tax load than the average American.
Therefore, it should come as no surprise that they are looking for highly tax-efficient investments. Many have heard about the tax benefits of real estate and they want to learn more.
In fact, one of the most common questions I get from investors is about taxes. Now I always preface these conversations with the disclosure that I am not a CPA or a tax attorney and that they should always seek advice from their trusted tax professional as to whether or not a particular tax strategy will work for their individual situation.
Having said that, Im not a novice either. In my years working and investing in the multifamily apartment world, Ive had the opportunity to see what really works.
Multifamily real estate carries some of the strongest tax benefits out there, and the cornerstone of those advantages is depreciation.
Accelerated Depreciation Aka Cost Segregation
Most countries allow some form of real estate depreciation. The US takes the cake by putting normal real estate depreciation on steroids via the cost segregation. Accounting nerds understand this as being simply accelerated depreciation.
This truly is one of those items that is too good to be true and only available in the US. So how does it work?
Depreciation works on the principle that properties, like other assets, depreciate over time. This is the accounting allocation for the wear and tear on properties over the years. However unlike most assets, in reality real estate values can progressively increase with proper maintenance for the asset located in the right area.
Regardless of the profitability of the property, investors can deduct a depreciation expense from their real estate income to reduce, mostly or completely, their real estate based income tax.
So how do you do this magic trick?
The IRS considers the useful life of a residential property to be 27.5 years . Therefore, residential property owners can deduce a depreciation expense for that amount using the straight-line method.
e.g. Lets assume that a property is valued at $5.5M. Therefore the annual depreciation expense would be $200K . This means that you can deduct up to a maximum of $200K against taxable real estate income .
Hence if the property generates $300K income and the tax rate being 30%, the taxes owed would be:
- Without depreciation: $300K * 30% = $90K
- With depreciation: ) * 30% = $30K
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