Investing in real estate can often lower the amount of taxes you owe even while making great returns on your investments. There's a huge difference in how the IRS views stock market gains versus real estate gains. Here are some incredible tax benefits for you to consider as a limited partner in multifamily and self storage real estate syndications.*
*This is by no means professional tax advice. Contact your CPA for details!
The tax code favors real estate investors
The IRS tax code rewards commercial real estate investors that maintain rental units, upgrade their properties over time, and provide quality housing for their tenants. This is how people can more easily become millionaires, by commercial real estate investing, versus most all other investment paths.
Passive investors get the same tax benefits as active investors
Even though you're not actively involved in maintaining and upgrading the property, you still get the full tax benefits as a passive investor. This is because you’re investing in a “disregarded entity” (typically an LLC or LP) that owns the property. These entities are sometimes called pass-through entities: the tax benefits flow right through the entity to the investors.
The power of depreciation
Depreciation is basically writing off the decreasing value of an asset (excluding the land it’s on) over time, based on wear and tear and its useful life. For commercial real estate, the IRS allows you to write off the value of the property over 39 years.
For example, you purchase a property for $1,000,000 ($825,000 building value + $175,000 land value). With basic straight-line depreciation, you can write off equal amounts of the building value over the course of 39 years ($825,000/39 = $21,153 annually).
On paper (e.g. K-1), you lost $21,153, even if you actually made, say, $5,000 that year in cash-on-cash (cash flow) returns. Translation: you pay ZERO taxes on that $5,000!
This “loss” applies to the returns you’ve made on your real estate investment.
As explained above, standard depreciation occurs over the course of 39 years for commercial real estate. However, the hold time for most of the real estate we invest in is 5 years. A cost segregation study analyzes the lifespan of each individual asset that’s included in the property (outlets, wiring, windows, carpeting, fixtures, etc.) with the intention of depreciating them over a shorter time, say 5 years, which can drastically increase deprecation benefits during the hold. Again, this depreciation would apply to your passive real estate income.
The superpower of cost segregation
While your income is subject to being tax-free during the hold due to depreciation, the sale, and sometimes depreciation recapture, of the asset is subject to capital gains tax depending on the sale price. The specific amount of capital gains depends on the hold time and your individual tax bracket.
1031 exchanges are a way around that. This allows you to swap one investment property for another similar investment property within a certain time frame. Instead of having the profits of Property A paid out to you during the sale, you roll that into the purchase of Property B. Translate: you owe no capital gains tax on Property A.
Not all real estate syndications offer a 1031 exchange. This is something the majority of investors must agree upon and the terms must be included in the terms of the agreement, it cannot apply solely to individual investors. If this is something you’re interested in, be sure to ask the deal sponsor about it.