One of the most sought-after benefits of real estate investing is the tax advantage it can provide. Many high-net-worth clients are drawn to the tax-efficient nature of real estate investments. This article highlights four major tax advantages to real estate investments. [The benefits pertain to private real estate investments where members have a direct interest in a limited liability company that holds the title to the property or similar structures; these benefits do not apply the same to REITs or non-traded REITs.]
Depreciation refers to the decline in monetary value of an asset over the course of its life expectancy due to wear and tear or obsolescence. In a practical example, a new car is worth its peak value on the car lot; once purchased, the car loses value over time due to mileage, engine wear, a dent, a couple of scratches, and interior damage caused by the kids and the dog; the value of the car depreciates. The same concept applies to rental properties. The “life expectancy,” based on IRS Publication 527, for Residential Rental Properties is 27.5 years.
Let’s apply the concept of depreciation to a hypothetical property. Suppose an apartment building (and its property) is valued at $10,000,000. Depreciation applies only to the building per IRS standards, not the land on which the apartments are built. For our $10,000,000 example, let’s assume the building is worth $8,000,000 and the land is worth $2,000,000. This $8,000,000 building, by IRS rules, can be depreciated for 27.5 years, which equates to $290,909.09 per year in depreciation expense [$8,000,000/27.5 = $290,909,09].
The $290,909.09 is reported through a K-1 as a passive activity deduction to Members of the LLC. (Each Member would receive a pro-rata share. If there were three equal Members, each could claim a $96,969.70 deduction for tax purposes based on the scenario above.) Because of the significance of depreciation of real estate investments, a net loss can be generated for tax purposes in the same year that the investor benefits from actual cash distributions. Clients who are business owners and have passive activity gains each year are thrilled to learn that these paper losses can offset their gains, thus reducing their overall tax obligation.
A couple of notes regarding depreciation:
Ideally, the $10,000,000 apartment building is sold for profit. As mentioned above, owners are legally obligated to pay Depreciation Recapture; however, Section 1031 of the tax code allows for the sale of property to be exchanged, through a qualified intermediary, to purchase a like-kind property and defer the taxes that would otherwise be required to be paid in connection with the sale. This is more than just kicking the tax can down the road; a savvy investor employing this strategy can reinvest tax savings to compound equity growth and increase yield.
1031s allow real estate investors to magnify their returns. In a profitable sale and 1031 scenario, the difference between net sales proceeds and your basis (original investment) is new equity. This new equity can be reinvested, conceivably at similar economic returns as the original investment. Only now, you have MORE equity than you did in the original transaction; the same percentage cash on cash return produces…more cash.
Contact us if you would like us to run a specific simulation of this in our Excel model. There are numerous considerations and variables to consider before taking this approach; however, this is our preferred strategy when selling higher valued real estate.
We at Evergreen are long-term holders of cash-producing assets; refinancing these assets is one of our key strategies. A refinance allows real estate investors to return large portions--or sometimes even all--of the originally invested capital to investors. Even after being repaid the initial investment, investors continue to earn cash on cash return and the appreciation that comes with ownership of the asset.
Refinances are not taxable events; we, therefore, generally see investors re-deploy returned capital into another property to enhance their returns.
Coordinating the decision to refinance at the right time is vital. Doing so requires several considerations:
The fourth tax advantage applies to a benefit gained through inherited assets: stepped-up basis. Stepped-up basis refers to a tax policy that re-assesses asset value at the time of inheritance rather than the market value of the asset when the owner originally purchased it. An example will illustrate the advantageous nature of this policy. Suppose a property was purchased in 1992 for $1,000,000. The property appreciated over time, increasing to a market value of $1,500,000 in 2013 when the asset was passed on to heirs. The heirs retained the property for another decade; appreciation continued, raising its value to $1,600,000. For the sake of illustration, the heirs decide to sell the asset. Will the gains for which they will be taxed be $600,000--the difference between the current market value and the original purchase price? No, the taxable gains would be $100,000--the difference between the current market value and the re-assessed value of the asset at the time of inheritance. In this example, $500,000 worth of gains goes untaxed thanks to the stepped-up basis of inherited properties. Unlike depreciation which is a tax deferral strategy, stepped-up basis is a tax elimination strategy for the benefitting heirs.
Tax advantages gained through solid investments are one of the most attractive benefits of real estate investing. We encourage you to consult your tax professional to see how these advantages can benefit your financial portfolio. We would welcome the opportunity to partner with in making real estate investing a part of your financial plan.
We would love to talk more about investing in multifamily properties. If you are interested in learning more please contact our office at (724) 900-0009 or e-mail Mark Brooks at mark@evergreen-pgh.com.
