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When evaluating an apartment investment opportunity, it is not uncommon for investors to only focus on the property's cash flow return metrics such as the property's IRR (internal rate of return) or the CoC (cash-on-cash return). When used alone, these evaluation metrics are insufficient because they ignore the tax benefits associated with an apartment investment, which can be a material part of an investor's returns.
Apartment investors who have awareness of their tax liability and who proactively manage their tax liability, in most cases, are positioned to realize higher returns than investors who don't. To maximize earning potential and allow profits to grow tax-free over time, we urge investors to leverage the following tax strategies: Depreciation, Cost Segregation, and the 1031 Exchange.
DEPRECIATION
The IRS understands that assets wear down over time, and because of this, they offer an allowance for a property's physical deterioration through depreciation. Depreciation enables owners to "expense" part of the property's physical value every year to account for its wear and tear over time. Investors can deduct depreciation for 27.5 years on a residential property and 39 years for a commercial real estate property.
Depreciation appears on the income statement and reduces the property's NOI (net operating income), which reduces or sometimes eliminates the net taxable income generated by the property.
Depreciation is considered a "non-cash expense" which means that depreciation reduces income but does not reduce the cash available for distribution. An investor's potential tax benefit and depreciation are directly correlated. Taking more depreciation in a given year results in a greater potential tax benefit for the investor.
COST SEGREGATION
The IRS controls how much depreciation can be taken in a given year, and the current tax code states that residential properties, which include multifamily properties, can be depreciated in a "straight line" over 27.5 years. See below for a quick example:
A cost segregation study is a top-to-bottom property inspection conducted by a consultant or engineer with the purpose of separating the property into the following four categories:
Personal Property
Land Improvements
Buildings/Structures
Land
Depending on the classification, the depreciation can be accelerated by taking it over a shorter period of time. The net outcome of a cost segregation study is that depreciation can be materially increased in a given year, resulting in additional tax savings for investors! See below for an example:
Leave it to the qualified experts to execute the exact math as it can be quite complicated, but the main takeaway for investors is this: Investors can achieve significant tax savings and bolster their investment returns by performing a cost segregation study to accelerate the allowable depreciation in a given year. Cost segregation is extremely valuable for multifamily investors as the typical holding period ranges between 5 to 10 years.
Now that we've covered two tax savings techniques that can be leveraged during the holding period, let's look at another tax mitigation technique that can be used upon the asset's sale to defer capital gains taxes, the 1031 Exchange.
1031 EXCHANGE
One of the most exciting milestones for real estate investors is when they sell their property for a profit. However, this milestone comes with a less exciting component: a massive tax bill on their capital gains. Capital gains are calculated by subtracting the property's cost basis (the purchase price) from the property's sales price, and capital gains tax can range anywhere between 15% to 28%. To defer paying taxes on capital gains, savvy real estate investors utilize the 1031 Exchange. The 1031 Exchange is a process through which capital gains taxes are deferred by reinvesting sale proceeds into another investment property of "like-kind."
As an example, let's assume an investor earned $500,000 on the sale of a multifamily property. After capital gains tax on the state and federal level, depreciation recapture, and net investment income tax, the investor may only be left with $167,000.
However, if this same investor decided to reinvest their earnings with a 1031 Exchange, they would be able to use the entire $500,000 to invest in another real estate property. In theory, this same investor could repeat this process indefinitely to defer their capital gains, which would allow their income to grow tax-free over a long period of time.
Now, as is typical with the IRS, there are rules governing the 1031 Exchange process. Always consult with your tax professional, but here are a few key points to remember:
The new property must be identified within 45 days of the sold property's closing, and the new property must be purchased within 180 days of the sold property's closing.
The new property must be of "the same character or nature" as the sold property (i.e., an apartment building for an apartment building).
The new property must be of equal or greater price to the old property.
A qualified intermediary must perform the exchange.
The old and new properties must be titled similarly.
It's important to work with a qualified intermediary (an experienced professional) to assist you with this process. Any issues with the transaction or violations of the 1031 Exchange rules will make the transaction taxable.
TAKEAWAY
Apartment investors who look beyond the typical return metrics and who proactively manage their tax liability, in most cases, are positioned to realize higher returns than investors who don't. To maximize earning potential and allow profits to grow tax-free over time, investors should maximize depreciation through cost segregation analysis and defer their capital gains taxes through 1031 exchanges.
Are you ready to take advantage of these tax mitigation strategies and watch your income grow tax-free over the long term? Click on the link below to join our investor group and schedule a call with our team for more information.
SOURCES
Khleif, R. (2020, July 7). Council post: Understanding the tax benefits of multifamily investment. Forbes. Retrieved February 27, 2023, from https://www.forbes.com/sites/forbesrealestatecouncil/2020/07/08/understanding-the-tax-benefits-of-multifamily-investment/?sh=11a532b35352
Tax benefits of investing in multifamily. Apartment Building Investing with Michael Blank. (2020, May 11). Retrieved February 27, 2023, from https://themichaelblank.com/videos/tax-benefits-of-investing-in-multifamily/