Investing in cash flowing multi-family properties is one of the most tax efficient investment strategies available
Following a tax efficient investment strategy can, clearly, reap higher investment returns—and, best of all there are many ways to achieve this. When it comes to cash flowing multi-family properties, investing in such an asset class is one of the most tax efficient investment strategies available.
Like it or not, taxes are unavoidable and here to stay… but a major question for any active or passive investor is how to mitigate the amount of taxes paid—and, of course, boost the investment returns.
But let’s take a moment to consider what taxes are and what they are used for.
What are taxes and tax breaks?
Taxes are financial charges or some other type of levy or duty imposed on a taxpayer by a governmental organisation. They are applicable to both individual and corporate entities and, whilst payment might be involuntary, it is compulsory by law!
The amounts raised from taxes are in order to fund local and central government and various other public expenditures on a regional, local or national basis. However, policies are in place aimed at ensuring that taxpayers are not only paying the right amount of tax at the right time, but also obtaining any appropriate tax allowances and tax relief or rebates (“tax breaks”).
Real estate and taxation
Real estate investment has always had favourable treatment when it comes to tax breaks, partly as successive governments have actively encouraged home or property ownership. Yet, not everyone is aware of how to take advantage of tax concessions available or how to create a tax efficient investment strategy and it’s well worthwhile speaking with a professional advisor to obtain the appropriate advice when investing in multi-family properties.
Real estate syndication
One of the most popular ways for many passive or even active investors to invest in real estate is via real estate syndication.
Syndication allows investors to pool their money together and share the profits of, typically, those multi-family apartment transactions without having to worry about matters such as managing tenants and attending to repairs and maintenance issues.
Not only are the investment benefits of this type of syndicated investment attractive (usually higher investment returns from the operational cashflows) but, with an effective tax mitigation strategy in place, there may also be lucrative tax benefits.
What are some of the key components to consider when looking at a tax efficient investment strategy for real estate syndications?
As a passive investor or a limited partner in a syndication transaction, it’s still possible to enjoy many tax-perks which such partnership enjoys. As mentioned, over the years, successive governments have rewarded real estate investors with tax breaks in order to encourage productivity in the real estate sector as a benefit for the national economy.
There are a wide variety of tax advantages, concessions and benefits which can be secured or enjoyed and these include the following:
Property depreciation recapture
One of the ways in which real estate investors obtain special treatment when it comes to paying taxes is because of the extra advantage of depreciation. The IRS accepts that the structure of real estate properties reduces in value and, without regular ongoing maintenance, would lose most of the value it had when new. So, the IRS allows property owners to write off the value of a property (of course, excluding the land it’s built on), over 27.5 years.
The effects of depreciation on a tax bill mean that the IRS will regard a property that is usually earning money or has positive cashflow as having negative cashflow with the end result being that an investor doesn’t have to pay any taxes on their annual returns.
Building cost $2,000,000
Net annual rental income from the property $50,000
Depreciation (cost/27.5 years) $72,727
Net income after depreciation – $22,727 (or a loss)
After September 27th, 2017, it is possible to enjoy bonus depreciation (see below), further increasing the tax benefits for the first year.
Bonus depreciation (Cost Segregation)
One of the major changes enacted by the Tax Cuts and Jobs Act of 2017 was the bonus depreciation provision, where businesses can take 100% bonus depreciation on a qualified property purchased after September 27th, 2017.
Property owners may choose to accelerate depreciation by arranging a “cost segregation study”, which allows them to break down the cost of the asset into different components and depreciate them at an accelerated rate. Obviously, such a form of “bonus depreciation” can reduce taxes further.
Cost segregation is a strategic tax planning tool which allows companies, individuals and accredited investors who have constructed or purchased or expanded or remodelled any kind of real estate to enhance their positive cash flow by accelerating depreciation deductions and deferring income taxes.
Many owners commission and a cost segregation study by a specialised cost segregation engineering firm to analyse the construction cost or purchase price of the property that would ordinarily be depreciated over 27.5 years (see above) which is deemed to be the useful life of a residential building. Such cost segregation study aims to identify all property-related costs which can be depreciated over 5, 7, and 15 years to secure more significant depreciation deductions in the early years of owning the asset.
Lower tax rates on Capital Gains
Whenever an investor makes a profit from the sale of an investment, or sees an increase in the capital deployed, this is known as “capital gains”.
Capital gains taxes are taxes on any profit realised from the sale of a non-inventory asset. These only occur when an asset is sold and/or the gain “realised”. An unrealised gain is a “potential profit” which may exist on paper, that is an increase in the value of an asset or investment which the investor owns but hasn’t yet sold.
The most common types of capital assets from which capital gains are realised are from the sale of stocks or bonds but also include: gems and jewellery, a sale of real estate, gold, silver, and other metals or coin and stamp collections.
Typically, such taxes are levied on both short-term or long-term capital gains, but are a “one-off” tax which are not due every year.
Depending on the amount of taxable income, the IRS levies capital gains tax at 0%, 15%, or 20%. Under the most recent 2018 tax law, taxation is as follows:
Capital gains tax:
0%: $77,220 and under;
15%: $77,221 to 479,000
20% above $479,000
Investing in real estate syndications attracts a maximum of a 20% tax rate, which is far better than, for example, the rate for taxpayers in the 37% marginal tax bracket.
Investors in real estate syndications can also enjoy tax benefits by refinancing. Essentially, an investor can borrow against the increase in the price of an asset or capital value appreciation and arrange to refinance without having to pay taxes.
For those value-add syndicators who are able to enhance a property’s value over a 2-3 year period after acquiring a property, renovating and achieving higher rents, by adopting the refinancing withdrawing equity, it’s possible to keep increasing their passive income sources without paying more in tax.
As an example:
A multi-family apartment building is acquired by a syndicator for $ 2 million.
The property was renovated and rents increased so that the capital value was enhanced to around $ 2,700,000.
The investor decided to execute a cash-out refinance and take out $700,000 towards purchasing another building.
Based on IRS rules, this process is entirely tax-free as any money received in a cash-out refinance is considered to be a loan, not income, so that may not be taxed.
Almost all commercial real estate assets are financed with commercial mortgage debt, and there may be some other tax benefits when this debt is refinanced. The deduction rules may be complex, but owners can, in some cases, deduct certain interest and closing costs.
Having said the above, any deductions available from a refinance can vary from one deal to another.
Mortgage Interest Deductions
Investors may deduct money paid as mortgage interest during the tax year from their taxable income.
As with a deduction for depreciation, mortgage interest deductions are a tool for investors in real estate syndications to obtain lucrative tax benefits. In the early years of a mortgage loan, most of the repayment goes into the interest but real estate syndication investors can deduct the interest on a mortgage loan as a line item expense on the income statement. As with depreciation, such deductions reduce the amount of taxable income produced by the property.
This creates the potential to save thousands of dollars over the duration of a mortgage.
Even though current tax law requires investors to pay long term capital gains taxes, when there are gains on the sale of a property, by using a “1031 Exchange”, it’s possible to defer such capital gains taxes. A key condition to this is that the sales proceeds are reinvested into another similar property within a certain time frame.
In fact, there is no limit on the number of 1031 Exchanges which can be utilised so it is possible, in theory at least, that an investor can continue to move from one property to the next, allowing their money to grow tax free over a long period of time.
In reality, not all real estate investments are profitable and there may be occasions when a loss is incurred. Whilst this is not something which investors may want to focus on, losses can, in fact, reduce an investor’s taxable income. Of perhaps greater significance is that, if the loss is large enough, it can be carried forward into future years and help reduce taxable income in those years.
However, the calculations and the rules from the IRS can be complicated and there may be certain limits on the amount of losses which can be deducted each year, and it’s wise to consult a tax professional.
In some cases, where an investor incurred a large, much larger loss than the typical annual taxable income there may be potential to carry forward such losses for up to 10 years, thereby reducing taxable income to $0 in each year.
It’s now more common for savers to choose investments other than the traditional stocks, bonds, mutual funds, ETFs and CDs offerings within an Individual Retirement Account (“IRA”).
Self-directed IRAs offering non-traditional investments have become more popular in recent years, being more accessible than when IRAs were first introduced over 45 years ago. Such Self-directed IRAs allow investors to invest in real estate, precious metals, notes and tax lien certificates amongst other investment options.
Investing in real estate through a Self-directed IRA is an excellent way to diversify a retirement account, providing the opportunity to begin investing in multi-family syndication deals as a limited partner.
In fact, Traditional and Roth IRAs are able to change to Self-directed IRAs, so that the investor has more control over what to do with the investment, and still with the tax-deferred benefits that an IRA offers. Rolling over a Traditional IRA to a Self-directed IRA is relatively easy and straightforward.
How is the income from Real Estate Syndications taxed?
It may be possible to mitigate the amount of taxation payable on income from real estate syndications. But first it’s useful to know how such income is derived.
Commercial properties such as multi-family apartments, obviously, produce income from rentals charged to tenants who occupy the units. From such income, expenses needed to operate the property such as property taxes, insurance, maintenance, legal fees, etc. are deducted The resulting figure, ie the difference between income and expenses is known as “Net Operating Income” or “NOI”.
As most syndicated properties have a loan, the required debt service is subtracted from the NOI and the resulting amount left to distribute to investors. After distribution, the money received by investors is combined with their regular income and taxed according to the taxation bracket into which they fall. The exact calculation varies by individual and can be quite complicated; hence the need for a tax professional to be involved to ensure the optimum result.
Real Estate Professional Status
For those investors able to qualify as a real estate professional, it may be possible to reduce the amount of taxable income by writing off significant passive losses, including depreciation, from real estate activities. In some cases it may be possible to reduce the amount of tax payable from 35% to 15% or even lower.
Other ways to reduce taxable income in real estate investment
Apart from the aforementioned ways to reduce the amount of income likely to attract tax, there are plenty of others. These include the following, some of which may be used in tandem with others:
- retain ownership of properties for more than 1 year;
- maximise deductions, including the 20% pass-through Deduction;
- live in the property for at least two years;
- arrange an instalment sale;
- avoid paying double FICA taxes.
When CPI Capital is assessing investment opportunities, we are well aware that one of the key benefits of syndicated multi-family commercial real estate investment is its ability to lower an individual’s tax burden.
Fortunately, this can be arranged in a number of ways including to accrue tax benefits for multi-family investing such as: depreciation, cost segregation, mitigating capital gains and using 1031 Exchanges. Each of these items in isolation or combined can work to reduce the amount of taxes paid by an investor.
Obviously executing many of these strategies can be complex, and will continue to become more so as an investor’s portfolio grows. Accordingly, it is important that the right tax professionals are consulted to make sure tax benefits are maximised—and this is something which CPI Capital ensures happens.
We don’t just look at the numbers behind investment returns but with any syndicated real estate investment we make, we focus on creating an effective strategy for our passive investors to reduce the amount of taxes that must be paid each year.
CSO, COO, Co-Founder CPI Capital