Updated: Apr 24, 2020
It’s not about how much you make, it's about how much you keep. Taxes are often the last consideration most people take into account when evaluating an investment. However having the tax scenario embedded in your business and/or investment plan is critical in ensuring you’re reaping all the benefits the tax code has to offer. In this article we will briefly talk about the tax benefits in an investment in commercial multifamily. This article requires a disclosure: By no means are we certified public accountants, individual tax implications can vary widely depending on you, the investor. Consult your CPA for definitive advice on your particular tax strategy.
If I’m a farmer, I can choose to plant a variety of crops, Everything from corn and soybeans to kale and broccoli. Which crops I choose largely depends on the market price per quantity of the crop in comparison to how much it costs to grow. Kale currently demands a great price in the market, and it's relatively cheap to produce. So I should grow kale right? Wrong. Even though Kale is extremely profitable and demand is surging, I would be leaving a tremendous amount of money on the table if I didn’t choose corn. Why is that? Because every year the federal government provides 20 Billion dollars a year in tax subsidies for farmers, with the vast majority of those subsidies going to corn growers.
When it comes to your investments, it would be wise to choose the crop with the most tax benefits, because as we mentioned:
It’s not about how much you make, it’s about how much you keep
So what are some of the unique tax benefits of real estate and in turn commercial multifamily that we feel make it the best asset class when choosing an investment vehicle? Here are a few we’ll touch on:
Annual Tax Statements
Every asset is said to have a ‘useful life’, as time moves forward, this useful life diminishes until ultimately the asset must be replaced. In a sense, a portion of the value of the asset is lost every year due to age. The IRS recognizes this concept and allows investors of certain assets to deduct that yearly loss in value against the taxpayer’s income.
As investors, we understand that a dollar today is worth more than a dollar tomorrow.
So naturally we are interested in paying as little in taxes today as possible for one simple reason: Those tax savings can be reinvested earlier to provide larger returns in the long run.
Real estate enjoys favorable tax treatment by the IRS, and taking advantage of depreciation should be a core strategy of your CPA. A basic understanding of how depreciation works is important to understand the more complex and additional tax treatment of real estate.
Generally, the IRS says a Single Family Home (SFH) has a useful life of 27.5 years. So a property worth $1M should be able to write off $36,364 per year ($1,000,000 / 27.5) in taxes. This is called straight line depreciation and is one of the benefits of an investment in real estate. Straight line depreciation is available to any asset class within real estate including commercial multifamily.
Cost segregation is a somewhat advanced depreciation strategy typically reserved for larger assets. A cost segregation (‘cost seg’) engineer or consultant is hired to perform a comprehensive study of the property to break up the property into different groups which receive different depreciation treatments. The goal is to shift faster depreciating assets from that 27.5 time horizon to a shorter 5, 7 or 15 year time horizon. In that way, a larger depreciation deduction can be realized earlier in the life of the investment.
For example, when looking at a large commercial multifamily property, at a very basic level, the walls could be constructed of concrete, the roof constructed of wood & tar shingles, and the pool furniture constructed of plastics. Each of these 3 types of material have a different useful life and as such, are able to receive different tax treatment under an accelerated depreciation schedule.
Commercial multifamily investment general partnerships take full advantage of these important parts of the tax code and pass those tax savings along to the limited partners in the form of an annual K-1 tax statement. The result is significant tax benefits and deductions for our limited partners. Smaller rental property investments typically don't partake in cost seg studies because of their cost.
Depreciation Recapture & Capital Gains
Depreciation Recapture is the process of the IRS recouping some of that lost revenue by ‘recapturing’ those earlier tax write offs. In order to understand Depreciation Recapture, you need to know 3 basic terms:
Original Cost Basis - the price that you paid when you purchased the property
Adjusted Cost Basis - the Original Cost Basis minus depreciation
Realized Gains - selling a property at a higher price than the original purchase price
Depreciation recapture is assessed when the price you sold your property for exceeds either the Original Cost Basis or Adjusted Cost Basis. The difference between these amounts is “recaptured” by reporting it as income, which is reported as a capital gain. Here’s an example to illustrate how depreciation recapture works:
An apartment was purchased for $5,000,000 and its annual depreciation is $181,818. After 5 years, the property is sold for $6,000,000. The Adjusted Cost Basis is the purchase price minus total depreciation over 5 years, or $5,000,000 - ($181,818 x 5) = $4,090,910.
The Realized Gain on the property’s sale will be sale price minus Adjusted Cost Basis, or $6,000,000 - $4,090,910 = $1,909,090.
Capital gain on the property is Realized Gain minus total depreciation, or $1,909,090 - ($181,818 x 5) = $1,000,000. The depreciation recapture gain is $181,818 x 5 = $909,090
Assuming that there is a 15% capital gains tax and that you are in the 32% income tax bracket, the total amount of tax owed on the sale is 15% capital gain plus 32% on the depreciation recapture, or (0.15 x $1,000,000) + (0.32 x $909,090) = $150,000 + $290,909 = $440,909.
Ultimately, the IRS will get its taxes (Death & Taxes right), but if we can postpone the timetable in which that happens, that can translate to significant tax savings over the long term. Couple that with gains from reinvested funds, and you begin to experience an accelerated timeline for wealth creation.
Recent tax law changes as a part of the Tax Cuts and Jobs Act of 2017 have made it possible to accelerate depreciation timetables.
With these new changes, it is now possible to deduct 100% of certain kinds of depreciation in the very first year of an investment. Certain portions of our assets identified as a part of our cost seg study are now shifted from 5, 7 and 15 year time horizons down to 1 year. By this simple shift, we have seen increases in year 1 tax deductions of 300% - 500%.
Annual Tax Statements
Ultimately every tax strategy a commercial multifamily investment enjoys can be boiled down into one tax statement - the K-1. K-1’s are issued at the end of every year and are passed along to the limited partner’s CPA for inclusion on the investor’s tax return. It is not uncommon for these K-1’s to show a significant loss during the hold period. This loss can be counted against the monthly cash distributions received by the investor, as well as the capital gains experienced upon sale. Below is an example of an actual K-1 issued in Year 1 from an investor’s $50,000 investment. To protect the privacy of the investor, we have blurred out any personally identifiable information:
As you can see, this investor received a K-1 statement showing a $-37,726 loss in year 1. This loss is incorporated in your annual taxes to reduce taxable income and is the end result of the tax savings found in our commercial multifamily investments.
When evaluating the profitability of an investment or business, it is often said, ‘It’s not about how much you make, it’s about how much you keep.’ Commercial multifamily investments offer significant tax advantages over both other investment vehicles and other real estate asset classes. Depreciation, Cost segregation, Bonus Depreciation & Annual Tax Statements are some of these advantages. Tax savings are encompassed in an annual K-1 tax statement issued by our accountants to you, the limited partner.
Invest with fyre CAPITAL
fyre CAPITAL is a commercial multifamily investment firm. We purchase and/or partner in 150-600 unit, value-add apartment communities in fast-growing Tier 1 & 2 U.S. markets. Together with our strategic partners, fyre CAPITAL represents over 500 Million Dollars of successful real estate acquisitions. Our developers, sponsors and capital partners have amassed a network of over 1,500 unique investors. We provide new opportunities to invest in projects targeting a 14%-21% Internal Rate of Return . If you would like to join us on our next project, your first step is to Submit an Interest Card. We look forward to partnering with you.