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Multifamily Tax Benefits You Should know
Investing in multifamily real estate offers not only the potential for significant returns but also various tax benefits that savvy investors can leverage to enhance their overall profitability. This post explores key tax strategies and benefits associated with multifamily real estate investments. Let’s go!
Depreciation
Depreciation serves as the systematic allocation of a property’s cost over its anticipated useful life. Essentially, it serves as a means to account for the gradual wear and tear that a property naturally undergoes over time. Annually, a segment of the property’s value can be designated as an expense against rental income, thereby diminishing the taxable income an investor must declare. It’s important to note that while these tax savings are immediate, they may be repaid in the future if the property is sold without an exchange. For passive investors in multifamily syndications, understanding the basics of depreciation is important. The tax benefits can be substantial, leading to increased after-tax profits for future investments. Now, let’s cover the types of depreciation you can take advantage of.
It’s good to note that the depreciation process doesn’t imply an actual loss in the property’s market value. Rather, it operates as an IRS-sanctioned accounting method enabling a property to undergo depreciation across a 27.5-year lifespan through a straight-line approach. The property’s value, excluding the land, is evenly distributed over this period, providing a yearly deduction amount.
Example: Consider a multifamily property valued at $2 million. With a depreciation period of 27.5 years, the annual depreciation deduction would be approximately $72,727 ($2 million / 27.5 years). This means that an investor could potentially reduce their taxable income by $72,727 each year through depreciation.
If the investor is in a tax bracket of 30%, the annual tax savings due to depreciation would be $21,818 ($72,727 * 30%). Over a five-year period, this could result in total tax savings of $109,090 ($21,818 * 5 years).
Accelerated depreciation comes into play for specific asset improvements, allowing for faster tax savings. Different improvements have varied depreciation rates, with some items depreciable over a shorter period, resulting in valuable tax benefits sooner. For instance, building components such as interior fixtures and finishes may be eligible for accelerated depreciation. By doing a cost segregation study, real estate owners can identify and reclassify certain components of a property for accelerated depreciation.
Example: Suppose you bought a $2 million multifamily property, and a cost segregation study revealed $500,000 in components eligible for accelerated depreciation (e.g., flooring, fixtures, landscaping). Without cost segregation, you’d depreciate the entire $2 million over 27.5 years. With cost segregation:
$200,000 (flooring) depreciates over 5 years.
$150,000 (fixtures) depreciates over 7 years.
$150,000 (landscaping) depreciates over 15 years.
In the first year, the accelerated depreciation would be approximately $71,429, providing upfront tax savings compared to standard depreciation. Actual figures may vary based on property specifics and the cost segregation study.
1031 Exchange
A 1031 Exchange, named after Section 1031 of the Internal Revenue Code, allows real estate investors to defer capital gains taxes when selling a property by reinvesting the proceeds into a like-kind property. As a reminder, it’s important for investors to work closely with tax professionals and adhere to the specific guidelines outlined in the tax code to ensure a successful and compliant 1031 Exchange.
Like-Kind Property Requirement: To qualify for a 1031 Exchange, the replacement property must be of like-kind to the property being sold. The term “like-kind” is broad, encompassing various types of real estate.
Timely Identification and Closing: There are strict timelines associated with a 1031 Exchange. The investor must identify potential replacement properties within 45 days of selling the original property and complete the purchase within 180 days.
Intermediary Involvement: A Qualified Intermediary (QI) is often involved in facilitating the exchange. The QI holds the proceeds from the sale and ensures they are used to acquire the replacement property.
Equal or Greater Value: The value of the replacement property must be equal to or greater than the property being sold to defer the entire capital gains tax.
Use in Real Estate Investment: While the term “like-kind” is broad, it generally applies to real estate used for investment or business purposes. Personal-use properties, like primary residences, usually do not qualify.
Potential for Multiple Exchanges: Investors can engage in multiple 1031 Exchanges, continually deferring capital gains taxes as long as the rules are followed.
Passive Tax Income
The taxation of income derived from multifamily investment properties is governed by what is termed as a passive income rate. This rate is distinct from employment taxes and is consequently lower than standard income tax rates. It is crucial to note that this favorable tax treatment applies exclusively to investors who genuinely utilize real estate as a passive income source and does not extend to individuals classified as real estate professionals.
Taxation Distinction: The passive income rate is applicable to income generated from multifamily investments, offering a reduced tax liability compared to regular income tax rates.
Exclusion of Employment Taxes: Passive income is exempt from employment taxes, providing an additional advantage in terms of reduced taxation.
Eligibility Criteria: To benefit from the passive income rate, investors must genuinely engage in real estate as a passive income stream. This categorization excludes those identified as real estate professionals.
Real Estate Professional Exemption: Individuals actively involved in the real estate profession may not qualify for the passive income rate, emphasizing the importance of accurately determining one’s status.
Qualified Business Income (QBI)
Investors engaged in real estate through structures like LLCs, sole proprietorships, and S Corporations have the opportunity to leverage the Qualified Business Income (QBI) deduction. This provision, introduced under the Tax Cuts and Jobs Act (TCJA) in December 2017, provides a substantial 20% deduction specifically designed to favor owners of pass-through entities.
Pass-Through Entities: This deduction primarily benefits income generated through pass-through entities. Pass-through entities do not pay income taxes themselves; instead, the income “passes through” to the owners, who report it on their individual tax returns.
Eligible Real Estate Income: Real estate investors, particularly those earning rental income, may qualify for the 20% deduction. However, there are certain criteria and limitations. The deduction is limited for certain service businesses, but real estate activities are often treated more favorably than some other service-oriented businesses.
Income Limitations: The deduction is subject to income limitations and is generally available to individuals with taxable income below a certain threshold. For married individuals filing jointly, the threshold is different from those filing as individuals.
Important Reminder: Given the complexities and nuances of tax law, it is advisable for real estate investors to seek professional tax advice to ensure they fully understand the eligibility criteria and can optimize their deductions.
Learn more by visiting IRS: Qualified Business Income Deduction