When we talk about investing in multifamily properties most people tend to steer their minds towards the consistent cash flow generation and how it accentuates long-standing generational wealth. But, what is most often overlooked by most potential investors are the huge tax benefits associated with multifamily investing. Here, we will explore the major tax benefits that are associated with passive investing in multifamily real estate.
Depreciation
The most common tax benefit associated with passive investing in multifamily real estate is depreciation. Depreciation is the decrease in the total value of the multifamily property due to ‘wear and tear’, physical damages, maintenance, and renovations over time. It accounts for massive tax savings making it the biggest tax benefit to passively invest in a multifamily real estate.
Three types of depreciation are
Straight-Line Depreciation
This is the simplest, age-old form of depreciation presuming that the cost of the property will depreciate and decrease in value constantly in ‘a straight line’ over the years. Taking this into account, the IRS judges that the lifespan of a residential property is 27.5 years, and 39 years for commercial property. Therefore, reasonable allowances are made by the IRS which account for a big chunk of money saved in the name of deferred tax.
Straight-Line depreciation = Cost basis/Useful life
The cost basis of the property includes the property value deducting the land’s value. This is done because the IRS considers land to ‘last forever’, having an unlimited lifespan, and does not give reservations against land depreciation.
Thus, after deducting land value from the property’s value, and adding the closing costs, the cost basis of the multifamily property is obtained.
Cost Segregation
Cost segregation is an advanced technique used to accelerate the depreciation value of a property thereby providing large tax savings. Unlike the straight-line depreciation method, cost segregation acknowledges that not all components of the property have the same life span and are prone to depreciate separately like parking spaces, pavements, carpeting, stairs, fencing, garbage disposal area, kitchen appliances, etc.
To calculate cost segregation, an analyst is employed who investigates the property from top to bottom, observes and creates a detailed report taking into account all the asset classes that would depreciate independently of each other. Assets are usually segregated into 5, 7, 15, 27.5, and 39-year slots, depending upon the useful life of the asset under inspection.
Making a cost segregation report and thereby accelerating the depreciation leads to monumental tax benefits for the passive investor. Since a multifamily property consists of multiple units, cost segregation turns out to be the perfect fit for it.
Bonus Depreciation
Bonus depreciation allows 100% deduction of the depreciation cost of a qualifying asset which has a maximum useful life of 20 years or shorter in one year. It means you can combine cost segregation and bonus depreciation benefits to write off the total in year 1 itself. With cost segregation studies, the value of the assets with 5, 7, or 15 years of useful life can be obtained and 80% of the total deduction can be leveraged to increase tax savings.
Until 2022, the Tax Cuts and Jobs Act of 2017 permitted 100% bonus depreciation for assets purchased after 2017.
In 2023, bonus depreciation is permitted at a rate of 80% ensuring hefty tax savings.
1031 Exchange
Another strategy through which a passive investor ends up saving taxes is the 1031 Exchange. It saves that big dreadful tax bill that is received by the seller upon the sale of the property. During the sale, the investors reinvest the proceeds into another ‘similar’ property while deferring the payment of capital gains taxes. This is the 1031 Exchange.
These transactions can be done as many times as the seller wishes with no maximum limit to it, enabling tax-free capital growth. Because of the 1031 exchange, the money of the multifamily passive investor ends up rotating property after property, generating huge capital gains without having to pay taxes on it.
Considerations like 1031 Exchange allow passive investors to drive more capital in multifamily syndications ensuring more cash flow thereby observing a surge in their net worths.
Tax Benefits for W2 Income Group
One crucial benefit of passively investing in multifamily real estate is that for the W2 income group. Just by simply incurring a ‘loss’ on the schedule K-1 document, a passive investor in multifamily real estate is able to offset tax liabilities due for their investment. Keeping in mind that, this ‘loss’ in real estate is merely just a ‘paper loss’ and not an ‘operational loss’. These are losses only for tax purposes and in hindsight, the investor’s net worth actually grows.
Investors have leveraged them for many years resulting in big tax savings and an overall increase in their total net worth.
Conclusion
Above mentioned tax considerations make passive investments in the multifamily real estate market very appealing. Passive investments in multifamily real estate are a powerful vehicle for high-net-worth individuals. This is why it is an age-old belief that investing in multifamily real estate is the wisest decision for tax benefits. Surely, one of the best, most financially sound ways to create wealth and save tax is through investing in multifamily real estate!
