Tax Advantages of Multifamily Real Estate

[Jorge Abreu]

Let’s look at the great tax advantages of investing in multifamily real estate. These benefits fall into five main categories – Depreciation, Cost-Segregation, Passive Income Tax Treatment, 1031 Like-Kind Exchanges, and Death.

NOTE: I am not a CPA, tax attorney or tax expert in any way, so this article may contain erroneous information. Do not rely on it as accounting, taxation, or legal advice. The article is based on an interview Chris O'Neal of Moody & O'Neal CPAs LLC of Mt. Pleasant, South Carolina, whose contact information is provided with his permission. Please consult a licensed professional before making any investment decisions, particularly in the complex area of taxes.

Depreciation

Of all the great tax benefits for multifamily real estate investors, the first and perhaps best is depreciation. Multifamily properties often rise in market value over time. And, with proper maintenance, their useful lives are practically unlimited. However, without proper maintenance and capital spending, buildings will eventually become uninhabitable.

Money spent on capital items comes from after-tax dollars, which owners might be reluctant to spend. So to encourage multifamily real estate owners to undertake necessary capital spending, the government permits them to take a depreciation deduction against current income equal to 1/27.5 (or 3.6%) of the building’s value at purchase each year.

In other words, even though buildings practically have a limitless useful life, the government allows you to treat a multifamily property as if the property will become obsolete in only 27.5 years. And, what’s more, regardless of the actual age of the property, the depreciation clock resets every time the property is sold to a new owner.

For Example: If you purchase a property for $5,000,000 and the land is deemed to be worth $250,000, each year a multifamily property owner is permitted to deduct 1/27.5th of $4,750,000, or $172,727, from current income each and every year. In most cases, particularly early in the investment's life, this deduction eliminates most or all of the current income. The investor might even put cash into her pocket and show a loss on their tax return. The depreciation in your passive investment LLC will flow through to investor's prorata according to their ownership percentage.

Cost-Segregation

The ability to undertake a cost-segregation study is another great benefit of multifamily real estate investment.

While the government considers the useful life of a multifamily apartment building to be 27.5 years, it considers the useful lives of certain items on the property, like cabinetry, appliances, and fixtures, to be much shorter – as little as 7 years or less

A professional cost-segregation study will separate these items out from value of the building, meaning you may realize even greater tax savings from the depreciation deduction.

In the earlier example, if you conduct a cost-segregation study, you may find that $1,000,000 of the value of your $4,750,000 building comes from cabinetry, appliances, fixtures, etc.

In that case, your depreciation deduction would be even greater for the first 7 years – $136,363 from the building depreciation ($3,750,000/27.5) and $142,857 ($1,000,000/7) from personal property depreciation, for a total of $279,220 in depreciation expense annually.

You’d almost certainly have tax “losses” during those first five years that you could offset against other investment income.

Cost-segregation sounds great, doesn’t it? However, consider its use carefully, because aggressively taking depreciation deductions early could possibly result in a tax bill greater than the cash proceeds you generate when you sell. (See 1031-exchange section below.)

Passive Income Tax Treatment

Another great advantage of multifamily real estate for investors is passive income tax treatment. As long as you are not a “real estate professional” (defined as someone who spends more than 500 hours a year working on real estate), your income from an investment in a multifamily real estate is taxed at passive income rates, which are not subject to employment taxes and therefore are lower than current income tax rates. Thus, even if there is taxable income left over after the depreciation deduction, it will be taxed at the lower passive income tax rate. In addition, appreciation is taxed at capital gains tax rates, which are lower than current income tax rates.

So, as long as you are not a “real estate professional,” any income and gains you receive from participating in a multifamily real estate investment will receive favorable tax treatment. Again, this is true even if you participate passively in a deal.

Section 1031 Like-Kind Exchanges

The depreciation deduction discussed above is subject to “recapture” on sale. That means your gain on sale is increased by the amount of depreciation deductions you took earlier. However, the government lets you defer taxes on the recaptured depreciation through what’s commonly known as a “1031 like-kind exchange,” after Section 1031 of the US Tax Code. On sale, your gain is calculated by subtracting your “basis” in the property from the sale price. The “basis” is the purchase price minus the accumulated depreciation over the life of the investment.

So, let’s assume that after five years you sell the property for $6,000,000. Over that time, you take $172,272 annually in depreciation deductions, totaling $861,360. Your basis in the property would drop from $5,000,000 to $4,138,640. Subtracting that from the $6,000,000 sale price would give you a taxable gain of $1,861,360. (If you did cost segregation, your taxable gain would be $2,396,100.) The government allows you to defer paying these taxes by using the proceeds for the purchase of a more expensive, higher-basis property within a set period of time. (A complicated process that requires a professional 1031 intermediary.)

Though your basis in the next property is reduced by the amount of the taxable gain that was deferred, you are permitted to repeat this process as many times as you wish until you die. And, when you die, something very interesting happens . . .

Death . . . your taxable gains go “poof” and evaporate into thin air!

Yes, death is a tax benefit for multifamily real estate owners and investors!

Almost unbelievably, when you die, the government assigns a new tax basis to the properties when they are transferred to your heirs – the fair market value at the time of your death – meaning that all those accumulated gains disappear.

Thus, let’s assume that, instead of selling the property for $6,000,000, you die when its fair market value is that amount. Your heirs do not inherit a $6,000,000 property with a $4,138,640 tax basis and a built-in taxable capital gain of $1,861,360 (more if you did cost segregation).

Instead, the tax basis is reset to the $6,000,000 fair market value, and all the previous capital gains vanish for your heirs! Looked at this way, death is a benefit for real estate investors, and real estate is an excellent estate-planning tool!

An Important Caveat For Syndication Deals

Investors in syndicated multifamily real estate investments should beware of one thing. Their individual proceeds from a sale of the property are not eligible for a 1031 exchange. To avoid taxes on their capital gain, investors in a syndicated deal must keep their funds in the LLC. The LLC is the actual owner of the real estate, and is the only party eligible to attempt a 1031 exchange. Keeping

funds in the LLC may not be an option under the circumstances. Investors contemplating investment in a multifamily real estate syndication deal should keep in mind that, while they will receive tax-advantaged income during the life of the investment, it may not be possible to defer taxes on capital gains after the property is sold via a 1031 Exchange.

However, you can use a Deferred Sales Trust to help them gain tax deferral, liquidity, diversification and freedom to buy qualified real estate at any time tax deferred with your funds so you can create and preserve more wealth. What is the Deferred Sales Tax Trust you ask?

A Deferred Sales Trust (DST)

The DST offers an attractive and flexible tax deferral alterative to a 1031 Exchange. The DST is a type of IRC Section 453 installment sale, also known as a "seller carry-back". Using this strategy, the seller can achieve significant tax deferral benefits by not receiving actual or "constructive receipt" of the proceeds at the time of the sale, instead receiving payments made to them over time. This is a complicated strategy that requires a qualified trustee to handle. In a nutshell, you as the owner would transfer the ownership of the asset to a dedicated trust. The trust then would sell the asset to the buyer. As a result, there is no capital gains tax immediately owing from the initial transfer to the trust because of Section 453, and no capital gains tax liability from the sale from the trust to the buyer because there is no capital gain. You then become a note holder (creditor) and the trust makes the agreed upon payments to the note holder, pursuant to a payment agreement called an "installment sales contract." The only capital gain that will be recognized and paid to the IRS and the State is only that portion of the overall capital gains due from the taxpayer's sale to the trust, based upon the proportion of principal repayment established in the terms of the installment agreement. Upon the demise of the seller, the note payments and the capital gains tax deferral from the DST will continue to the next generation.

Death Tax Benefit

The Death Tax Benefit is available to real estate syndication investors, and your heirs’ tax basis in your shares will be their fair market value at the time of your death. While these great tax advantages are available to other forms of real estate besides multifamily real estate, they are not available for most other investment assets. This is one reason why multifamily real estate is such an attractive investment vehicle.

Next: What to Expect After You Invest In a Deal

[Colton Hahn]

One thing to note, I have had many conversations with a Deferred Sales Trust expert and from their perspective it becomes advantageous around 1m in capital gains tax deferred. Less than that, you are running the risk of not gaining much practical benefit of the structure, or even losing money when you consider fees. Great post!