Tax Benefits of Investing in Multifamily

There are many benefits to investing in multifamily properties, but one of the most eye-catching benefits, especially when compared to stocks, is the tax benefit. Investors who take advantage of these tax benefits can see higher cash flows, which allows them to invest more today and see greater returns tomorrow.

Depreciation

A large tax benefit with multifamily property is the depreciation deduction. Depreciation is the decrease in value of an asset over time. For residential property, an investor can depreciate the value of the building, excluding the value of the land, over 27.5 years using straight-line depreciation, which is the standard form of depreciation. For taxes, depreciation is a deduction against the income from the property. If your depreciation deduction in a year is greater than your income from the property, then the remaining depreciation will carryover to the next year until you have more passive income to deduct from, or you sell the property.

Let's say you bought a multifamily property, and the building value was $2,000,000. The annual straight-line depreciation would be $2,000,000 / 27.5, or $72,727.27!

Since many apartment syndications operate through LLCs that pass depreciation benefits down to the investors, passive investors in syndications can benefit from depreciation as well.

Cost segregation

The depreciation benefit is significant, and it is possible to make it better using a cost segregation study to accelerate the depreciation. A cost segregation study is a review of the components of a property, such as the appliances, landscaping, and flooring, to determine how much of the building value can be depreciated faster than the 27.5 years. Many of these components can be depreciated in 5, 7, or 15 years, so an investor would see a larger depreciation in the first few years of owning a property

To perform the study, you or your investors would hire a firm that specializes in cost segregations. Since the cost of the study can be tens of thousands of dollars, it only makes sense to do them for larger properties, such as those worth over $1,000,000.

Capital gains and 1031 exchanges

When a property is sold, there are two kinds of tax on your proceeds. The first is capital gains tax on the profits, which is the difference between the sales price and the purchase price. If that $2,000,000 property sold for $2,500,000 at the end of the investment, then you would have $500,000 of profits. As of the writing of this article, the capital gains rate is 0%, 15%, or 20% depending on your income level. For most passive investors, this rate will be less than your income tax rate, which puts more of the profit into your pockets.

It is possible to defer this capital gains tax using a 1031 or 721 exchange. A 1031 exchange is more common and involves finding a like-kind asset, such as another residential investment property, to purchase using the proceeds from sale. This exchange involves tight deadlines for finding and purchasing the new property, and should be done with a qualified intermediary to handle the exchange. If done correctly, you will not have to pay the capital gains tax until you sell the new property. It is even possible to "chain" 1031 exchanges to continue deferring the accumulated capital gains taxes, even until your death.

A 721 exchange is another way to defer capital gains by transferring ownership of a property to a REIT or Operating Partnership for shares in that REIT or Operating Partnership.

Some syndicators try to use a 1031 exchange on selling a property, and others do not. If this is a strategy you want to use, make sure to look for multifamily syndicators who are willing to use a 1031 exchange. You should also consult your tax professional for more details on what a 1031 or 721 exchange is to determine whether it is the right strategy for your situation.

Depreciation recapture

The second tax when selling a property is depreciation recapture. Although the IRS lets you deduct depreciation while you hold the property, it is counted as income that must be paid at your income tax rate at sale. For instance, if you held the $2,000,000 property for 5 years and depreciated $72,727 annually, then you would have $363,635 in depreciation recapture. At the 28% income tax bracket, this would be $101,817 in taxes. While it's not fun to have that large tax bill, you were able to offset that amount while owning the property and a dollar today is worth more than a dollar tomorrow. As a smart investor, you could deploy that extra income in other investments to make more money while you held the multifamily property.

Operating expense deductions

Passive investors who own and operate their own residential investment properties, such as single family houses, may be familiar with deducting operating expenses associated with the property. Since passive investors do not actively participate in the operations of a multifamily property, they do not get to deduct a share of the operating expenses.

Summary

The primary tax benefit of multifamily investments is the depreciation deduction. In many cases, especially with accelerated depreciation, the depreciation to investors is greater than the passive income, so they don't have to pay taxes on the income. It is also possible to defer capital gains taxes using a 1031 exchange. Other investments, such as stocks and bonds, do not provide these wonderful tax benefits. If you want to learn about other reasons to invest in multifamily properties, check out this article.