Direct investments in multifamily real estate remains an effective strategy to protect and build wealth. Its many benefits include cash flow distributions, non-correlated returns compared to public equities and fixed income, and long-term appreciation. Investment offering memorandums, as well as quarterly and annual reports, generally focus on the industry’s most prevalent pre-tax return metrics such as cash on cash return, equity multiple, and the Internal Rates of Return (IRR). What is rarely discussed is how highly tax-efficient these investments are. The following are a few of the benefits enjoyed by direct equity investors with the following disclaimer: Always consult your CPA or tax professional before making any investment decisions.
No FICA or Self-Employment Tax on Rental Income
Suppose that one wished to supplement their current income by starting another business venture. The earnings from this new trade or business are subject to Social Security and Medicare taxes. The tax to fund these programs is 15.3 percent, 7.65 percent from both the employee and employer. Self-employed individuals are responsible for the full 15.3 percent. Rental income, however, is classified as passive income, and unlike earnings from another trade or business, it is not subject to Social Security and Medicare taxes. Passive income is subject only to ordinary income taxes, and even this amount, as we’ll show, can be reduced.
Deduction of Non-cash Charges
The distributions made from the net cash flow from operations (rent revenues less all operating expenses and debt service) are not taxable. All distributions are shown on the annual Schedule K-1 and reduce the tax basis of the investment. The taxable income or loss that is reported annually on an individual’s tax return is the cash flow from operations (defined above), less the non-cash charges of depreciation of the property and the amortization of deferred financing costs. These non-cash charges reduce and, oftentimes, eliminate the taxable income in any given year. In addition, taxable losses generated from an investment can be carried forward to be used in future years or be used to offset other passive income from other investments in the current year.
One of the largest tax benefits of investing in private real estate is the ability to shelter income earned on investment properties by using the depreciation deduction. Depreciation accounts for the wear and tear on the buildings and personal property over time, and the IRS allows apartment building owners to take this deduction over a 27.5-year life of the property. The tax code allows real estate owners to use this deduction to smooth out the cost of future capital expenditures. It should be noted that the cost of land is not considered when computing this deduction and that personal property and land improvements are depreciated on a much shorter term.
To illustrate, assume that an apartment property was purchased for $5.5 million. Included in this price is land valued at $500,000. The owner is allowed to deduct $181,818 ($5.5 million cost, less $500,000 land, divided by 27.5 years) in depreciation each year against the net income on this building, thus reducing the taxable income from the investment. Depreciation is used to reduce the tax burden on passive income in the current year, and taxable losses are carried forward to future years and used when applicable.
The second non-cash deduction typically taken each year is the amortization of the deferred financing costs incurred on the acquisition loan. Examples of these costs include, but are not limited to, the loan origination fee, appraisal, title and closing costs, and legal fees. These costs are typically paid from the loan proceeds at acquisition and not from the operating cash flow. The tax code allows the owner of the real estate to deduct these costs over the life of the loan. Like depreciation, this deduction also reduces taxable income in the years following the property purchase.
Tax-deferred borrowing (Refinance)
When a property is refinanced, the owner can borrow against the appreciated value of the asset and access the increased equity tax-deferred. This strategy can allow investors to build additional wealth by harvesting equity earned in a long-term real estate investment and reinvesting those proceeds in other income-producing assets without paying capital gains taxes in the current year.
Using the example above, let’s assume that we’ve owned the building that cost $5.5 million for six years and it is now worth $10 million. Placing a new mortgage on the property based on the $10 million appraisal would pay off the original loan balance, and the remaining proceeds, say $2 million, could be distributed to the owners without a tax consequence in the current year. Note that we are using the term tax-deferred, meaning that the taxes are not avoided altogether. The $2 million distribution reduces the tax basis in the original asset and becomes part of the capital gain calculation at the time the original asset is sold. This distribution will consequently increase the capital gain on the eventual sale of the asset if the property is not exchanged.
1031 Exchange
Another tax strategy provided to real estate investors is found in Section 1031 of the United States tax code. The section allows owners of direct investments in real estate to defer the recognition of capital gain generated from the sale of the property along with its corresponding tax liability if the proceeds on the sale are reinvested into another “like-kind” replacement property.
The code requires that the value of replacement property be equal to or greater than that of the relinquished property. If there was debt outstanding on the relinquished property, the debt on the replacement property must also be equal to or greater than the debt on the relinquished property. In addition, the investor is required to identify the replacement asset within 45 days of the sale of the relinquished asset and close on the purchase of the replacement property within 180 days. Finally, to meet the definition of “like-kind” the replacement property must be held for productive use in a trade or business or for investment.
To be clear, the utilization of a 1031 Exchange does not eliminate the capital gains tax altogether. Rather, it is another tax deferral strategy. The deferred capital gain from the sale reduces the income tax basis of the replacement property. Capital gains tax is eventually paid when the replacement property is sold without completing another exchange.
This strategy can be an extremely effective tool when it is time to sell an older, more tired property and redeploy the proceeds into a higher caliber asset that has potential for steeper returns over a subsequent investment period.
Estate Planning
As with all assets, if an investor holds real estate until their death, whoever inherits the property, inherits the property only and not its tax burden. The recipient inherits the property with a “step-up” in basis equal to the fair market value of the property as of the date of death and their subsequent tax liabilities are taxed as if they purchased the property at the current value.
This is an excellent strategy if you are inclined to transfer wealth to future generations as it allows for the tax deferral strategies discussed previously to become permanent. Given the current federal exemption for taxes on an estate at $11.58 million, a considerable amount of appreciated real estate can fall into this category.
Timberland Partners will always underwrite investment opportunities using cash-on-cash return, IRR, and others as metrics as necessary, and only invest in properties that we believe can meet or exceed our investment objectives. We look at the many tax benefits associated with owning these assets as very valuable “fringe benefits” but maintain the discipline to not let the fringe benefits influence our investment decisions.
