- Photo Credit: KW Utah
When you’re considering investing in a particular type of asset, you have to ask yourself a very simple question: What are the unique benefits of this investment? Why this type of asset?
For example, if you’re considering investing in an index fund of stocks, you might look at the long-term growth in stock values. If you’re exploring bond investments, the safety and certainty of fixed income products can be a real positive.
Multifamily real estate is no different. Buying apartment buildings offers numerous unique advantages. These include reliable cash flow, long-term appreciation, stability, and tax benefits. The tax benefits of multifamily investing are not well known to the public. For this reason, we’re going to take a closer look.
Before we get started, we should note that this is only informational advice. You should consult with your CPA on all tax matters. If you plan on investing in real estate, it is absolutely critical that you work with a qualified tax professional.
Standard Depreciation
In most parts of the United States, over the long run, the prices of most apartment buildings tend to increase. This is even after adjusting for inflation. If you’re investing in large coastal metropolitan markets with limited rental supply and strong economies (think Los Angeles, New York City and San Francisco), long-term appreciation has been incredibly strong.
Yet, we also know that as properties become older, various physical aspects of the apartment drop in value. For example, the floor in each unit, as well as the property’s roof and plumbing, is worth less in 3 years, than it is today. At some point in the future, each of these items will require repair or replacement.
This isn’t true of the land, where the properties are located. Land doesn’t suffer from wear and tear, in the same way that a physical building does.
Apartment buildings with 2 to 4 units are considered residential, non-commercial properties. Those with 5 or more units are treated as commercial properties.
For the purposes of this conversation, we’ll be focusing on commercial properties. However, we should note that residential rental properties also offer considerable tax benefits.
For the rest of this article, we’re going to keep using an important word: depreciation. Depreciation is an accounting term, which refers to a reduction in the useful life of an asset, over time. Essentially, the property is treated as having a lifetime, after which it is “used up.” For tax purposes, commercial multifamily properties are treated as having a life of 27.5 years.
It’s important to understand what exactly can be depreciated. The land on which a building is located, cannot be depreciated. However, the building, as well as acquisition costs, can be considered in calculating depreciation costs. Acquisition costs include escrow, title, inspections, attorneys fees and lender fees.
The cost of the building (plus acquisition costs) is known as your cost basis. This is the number you’ll be depreciating from, over 27.5 years.
Let’s use a concrete example. An apartment building is selling for $2.1 million. The assessed value of the land on which the property was located, was $1 million.
This means the cost of the building only was $1.1 million. Let’s say that the acquisition costs were $22.000. This means that the cost basis (value of building plus acquisition costs) is $1,122,000.
Thus, the amount we can deprecate each year is $1,022,000 divided by 27.5, or $40,800. Now, let’s say that after all expenses (including taxes, insurance, repairs property management and mortgage principal and interest), this property generates $43,000 in rental income each year.
Normally, this $40,000 would be taxable as income. However, thanks to depreciation, $40,800 of that amount is deducted from your taxes. You thus only pay taxes on $2,800 of income.
What if the apartment building only generated $35,000 in income? In this situation, you’ve got $5,800 of tax deductions, which was not used up by that year’s income. Is there another way to benefit from this tax loss?
Carrying Forward Passive Losses
You’re in luck. You are allowed to carry forward the loss from this year, and apply it to future years of rental income from the property. This means that you can deduct $5,800 the next year, and going forward.
What if you have other sources of investment income? For example, let’s say that you own another residential rental property, which generates cash flow. Or, perhaps you own some stocks and bonds, and recieve dividend payments from those investments.
Each of these streams of income is considered passive income. A passive loss from one source of passive income can be deducted from other forms of passive income. Therefore, the rental property deduction could be used to offset income from other rental properties, or stock or bond dividends.
Deducting Passive Losses From Your Salary
What about deductions from your regular wages or income? For example, let’s say that you are paid $100,000 each year in salary, from your full time job. You’re a W2 employee. Or, maybe you’re an independent contractor, who is paid a 1099. Can you deduct your passive depreciation losses from this salary?\
For most jobs, the answer is no. If you’re working as an engineer, or a physician, or an actor, you won’t typically be able to reduce your taxable income from your job, with your real estate losses.
There is one exception: If you’re a real estate professional, you can offset your income with depreciation losses. Let’s take a look at how you qualify as a real estate professional, below.
The Real Estate Professional Rule
For most of us, the answer is no. In most situations, you cannot deduct passive losses from your work earnings. However, there is one exception worth noting: If you qualify as a real estate professional.\
Let’s say you’re a realtor. Or, maybe you work as a property manager. In these situations, you may qualify as a real estate professional (for tax purposes), and thus be able to deduct your passive income losses against your ordinary income.
To qualify as a real estate professional, the IRS requires that more than 50% of the personal services that you perform each year are in a real estate business, where you “materially participate.” Also, you must work 750 hours in a real estate trade or business.
Let’s consider the first test, that you spend more than 50% of your working time in real estate. This typically means that if you work in a non-real estate full time job, you won’t qualify as a real estate professional.
What about material participation? There are 7 different ways that you can qualify as materially participating. If you meet any of these tests, you will qualify.
Secondly, you must work at least 750 hours in a real estate trade or business. This means that if you’re mostly retired, but work a few hundred hours a year as a realtor, you probably will not qualify.
If you’re not a real estate professional, don’t worry. Being able to use depreciation and reduce passive income is still very beneficial.
Obtaining Extra Depreciation Through Cost Segregation
You can take a more active approach to depreciation through the use of a cost segregation study. In a cost segregation study, you’re basically compressing several decades of depreciation into 5, 7 or 15 years (depending on what is being depreciated). This allows you to enjoy massive tax benefits much earlier.
This is done by taking account of various individual items within a property, such as electrical systems, appliances, plumbing, lighting fixtures and more. The study considers what the individual lifetime of each of these items is, and depreciates them over that lifetime.
Thus, the value of a bathroom fixture or other personal property might be depreciated over 5 to 7 years, while a fence (which is an improvement to the land), would typically be depreciated over 15 years.
In the example we used above, cost segregation might make it possible to depreciate $200,000 in the first year you own the property, and smaller amounts in the future years. Obviously, these are very large tax benefits, in just the first few years of your investment.
Thanks to changes to US tax law, cost segregation has become even more attractive. Under the Tax Cuts & Jobs Act of 2017, used property became eligible for 100% bonus depreciation, through 2022. This means that in the example above, a property owner might be able to depreciate even more property (perhaps $300,000 or so) in the first year.
Cost segregation studies are typically conducted by experienced tax professionals, who can document their work carefully, and understand how the IRS views cost segregation. In the event that you’re audited, you want a cost segregation firm which can justify their work.
Recapture Of Depreciation Upon Sale
Whenever we’re talking about the US tax code, there’s always a catch. Real estate depreciation is no different.
If you decide to sell a property which you depreciated, the IRS will attempt to recapture (basically, claw back) the depreciation deductions which you took over the years. If you’re going to depreciate your property, and perhaps someday sell, you need to understand how this process works.
If you hold a property for at least one year, and then sell it, you will have to pay capital gains tax on your profit. Depending on how much you earn in yearly income, this amount will vary from 0% to 20%.
As part of the sale, the IRS will examine the portion of the gain which can be attributed to depreciation deductions. Recall that depreciation reduces the taxable basis of the property.
Let’s return to our earlier example. You purchased an apartment building for $2.1 million, with a building cost of $1.1 million, and acquisition costs of $22,000. As stated, you’re entitled to $40,800 of depreciation each year, on a basis of $1,122,000.
Let’s say you hold the property for 7 years, and then sell. After 7 years (assuming you sell exactly at the 7 year mark), you’ll have depreciated $285,600, and have a new basis of $814,400.
Suppose the property sells for $3 million. $3 million minus $814,400 is $2,185,600. This is your total recognized gains.
This is where things get a bit complicated. You’ll need to think of the gains from the sale of this property in two ways: Gains attributable to depreciation, and all other gains.
You depreciated $285,600. This amount will be taxed as ordinary income, with a maximum rate of up 25%. How much you’ll pay depends on your total income for that year.
The remaining gains will be taxed as capital gains. Capital gains taxes (depending on your annual income) range from 0% to 20%.
In the example above, your total gains were $2,185,600. If we subtract the $285,600 from depreciation (which you’re paying ordinary income taxes on), we’re left with $1,900,000. This amount you’ll owe capital gains taxes on.
Of course, there is one way to avoid postpone gains taxes, and sell your property: The 1031 exchange. Let’s take a look at that next.
The 1031 Exchange
In short, a 1031 exchange is a way to defer capital gains taxes, by selling one property and purchasing another. The profits you made from the sale of the apartment complex will be deferred, since you purchased a new property (known as a replacement property).
You don’t have to purchase within the same asset class. So, in the examples above, you could sell your apartment complex and purchase a hotel (or a strip mall or office building).
What is required is that you purchase a property of equal or greater value as the one you sold. A 1031 exchange isn’t an open ended transaction – there are strict deadlines.
Within 45 days of selling the property, you must identify (in writing) up to 3 potential replacement properties, which you’re considering buying. Within 180 days of the sale, you’ll need to close on one of these properties.
1031 exchanges are typically completed with the sake of qualified intermediaries. A qualified intermediary is a third party (someone who is not part of the transaction) who holds onto the proceeds from the first property, until the replacement property is ready to close. They also handle the extensive paperwork involved with a 1031 exchange.
1031 exchanges allow you to defer taxes, while trading up to larger properties. This allows you to increase your cash flow, and the total value of your holdings. It’s not uncommon to hear stories of investors who purchased a duplex, completed a 1031 exchange into an 8 unit property, then traded up into a 20 unit, and so on.
To be sure, 1031 exchanges do also present certain challenges. Since you’re on the clock to purchase a new property, you can’t always be as selective in the deals you choose.
Sometimes, to complete the exchange, you’ll need to acquire a property which you might not have otherwise chosen. As a result, you could end up overpaying.
1031 exchanges also require cooperation amongst several different parties. Remember, you’re selling one property, and acquiring one or more as replacements. You’ll thus need to time when the purchase of your existing property closes, and coordinate to ensure a smooth close of the replacement properties.
There are many more rules governing 1031 exchanges, which we won’t go into here. You’ll certainly want to do your homework. Just know that the 1031 exchange is a tool to defer capital gains taxes, and keep growing your real estate holdings.
The Final Word
Clearly, multifamily investing offers massive tax advantages. There are very few other investments where you can make your earnings essentially tax free (through depreciation and cost segregation), and where you can use depreciation to offset other income.
Simply consider depreciation and cost segregation – how many other investments allow you to take tax losses on an asset which is (usually) gaining in value? We’re passionate about the stock market, but this typically isn’t something you can do with your shares of Apple or Citibank.
To be clear, you should always do your homework. You want to purchase the best apartment deal possible, and seek out the strongest tax advice you possibly can. Assuming you do those things, you’re paving the way for a brighter financial future.
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