In the world of real estate investing, taxes can actually work in your favor. Unlike stocks and mutual funds, real estate investments often result in a lower tax bill while yielding significant returns. For many people tax benefits are one of the reasons they choose to invest in multifamily syndication, and with Viking Capital.
The disparity in tax treatment between real estate gains and stock market gains is substantial and noteworthy, especially for those who prefer passive investments in real estate syndications. In this article, we’ll explore the nuances of this tax treatment and its benefits to passive investors.
7 Ways Real Estate Investing Benefits Taxes
Here are seven key insights every passive investor in a real estate syndication should consider regarding taxes:
- The tax code is favorable towards real estate investors.
- Passive investors receive the same tax benefits as active investors.
- Depreciation is a powerful tool in real estate investing.
- Cost segregation is a more powerful form of depreciation.
- Investors should plan for capital gains and depreciation recapture taxes.
- 1031 exchanges are a valuable tax-deferral strategy.
- Some investors prioritize real estate solely for its tax benefits.
Let’s dive into each of these a bit more, and why Viking Capital investments are a great option to defer taxes.
The Tax Code is Favorable for Real Estate
Real estate investing has been known to create more millionaires than any other investment avenue. The role of tax code in facilitating this phenomenon cannot be overlooked. The IRS acknowledges the significance of real estate investing in providing good quality housing to the populace. As a result, the tax code is designed to incentivize real estate investors to invest in property, maintain their units, and improve them over time.
Tax Benefits for Passive Investors
The tax implications of being a passive investor in a real estate syndication are significant. Unlike in the case of active investors who engage in property management, passive investors receive the full range of tax benefits. This is because, as a passive investor, you invest in a pass-through entity such as an LLC or LP, which owns the property. Therefore, any tax benefits resulting from the property ownership flow directly to you as the investor. Conversely, investing in real estate investment trusts (REITs) does not provide the same tax benefits since you are investing in a company and not directly in the underlying real estate.
Common tax benefits of investing in real estate include the ability to write off expenses related to the property, such as repairs, utilities, payroll, and interest, as well as the opportunity to depreciate the property value over time. Depreciation, in particular, is a powerful tool for reducing tax liability.
Depreciation
Depreciation is a tax benefit that allows you to write off the value of an asset over time, based on wear and tear and the useful life of the asset. The IRS acknowledges that over time, every property will succumb to natural wear and tear and become uninhabitable. For residential real estate, the IRS allows you to write off the value of the property over 27.5 years, but only the property itself is eligible for depreciation benefits, not the land.
For instance, if you purchase a property for $1,000,000, with the building worth $825,000, you can write off an equal amount of that $825,000 every year for 27.5 years using straight-line depreciation. That means each year, you can write off $30,000 due to depreciation. The real benefit is that instead of paying taxes on the cash-on-cash returns you make on the property, you can keep it tax-deferred until the property is sold, as that $30,000 in depreciation means that, on paper, you actually lost money, while in reality, you made money.
It’s important to note that this depends on your individual tax situation, and you should consult your CPA. Bonus depreciation is also available for properties acquired after September 27, 2017, which can further enhance the tax benefits in the first year. All in all, depreciation is an incredibly powerful tool for real estate investors.
Cost Segregation, and How to Use It
There are additional benefits to be gained through cost segregation.
In our previous example, we discussed straight-line depreciation, which entails deducting an equal portion of an asset’s value every year for 27.5 years. However, most real estate syndications have a holding period of around five years. This means that if we follow the same process and deduct an equal amount every year, we would only receive five years of depreciation benefits, leaving the remaining 22.5 years on the table. This is where cost segregation can be advantageous. Cost segregation acknowledges that not every asset in a property has the same lifespan. For instance, the printer in the back office will have a shorter lifespan than the roof on top of the building. During a cost segregation study, an engineer identifies the specific components that make up a property, including outlets, wiring, windows, carpeting, and fixtures.
Some of these items may be depreciated on a shorter timeline, such as 5, 7, or 15 years, rather than 27.5 years. This can significantly increase the depreciation benefits in the early years.Let me illustrate this with an example. This one is based on a true story. A few years ago, a real estate syndication group bought an apartment building in December of that year. This means that the investors held the asset for only one month of that calendar year. However, thanks in large part to cost segregation, the depreciation schedule was accelerated for many items that were part of the property, such as landscaping and carpeting.
The K-1 that was sent out to investors the following spring revealed that if you had invested $100,000 in that real estate syndication, you would show a paper loss of $50,000. That’s a 50% loss of the initial investment, even though you owned the property for only one month during that tax year. Furthermore, if you qualify as a real estate professional, this paper loss can be applied to your other taxes, including taxes based on your salary, side hustle, or other investment gains.*
How to Plan for Capital Gains and Depreciation
Real estate investing, while providing many benefits, is not exempt from taxation. The Internal Revenue Service (IRS) requires taxes on capital gains when a real estate asset is sold, and sometimes on depreciation recapture, depending on the sale price.
In a real estate syndication, capital gains taxes and depreciation recapture are typically incurred upon the sale of the property after a hold time of five years. The amount of tax owed varies based on the length of the hold time and the individual’s tax bracket.
Under the 2018 tax law, the capital gains tax brackets and percentages are as follows: 0% for those earning between $0 to $77,220, 15% for those earning between $77,221 to $479,000, and 20% for those earning more than $479,000. It is recommended to consult a certified public accountant (CPA) for more detailed and up-to-date information on tax laws.
1031 Exchange Tax Benefits
As mentioned earlier, capital gains taxes (and sometimes depreciation recapture) are due when a real estate asset is sold. Nevertheless, a 1031 exchange offers a way around this tax obligation. This type of exchange enables an investor to sell an investment property and, within a stipulated timeframe, use the proceeds to acquire another similar investment property.
By doing so, the investor can defer paying taxes on the profits made from the sale of the initial property by rolling them over into the new investment. However, not all real estate syndications offer 1031 exchanges, and the majority of investors in syndication must agree to it for it to be feasible.
It’s worth noting that individual investors cannot initiate a 1031 exchange on their shares in a real estate syndication. Instead, the sponsors must decide to perform a 1031 exchange on the entire property. Each sponsor has a unique approach to 1031 exchanges, and interested investors should directly inquire with the sponsor about this option.
Tax Benefits Through Passive Investing
Real estate investment offers significant tax benefits that can reduce overall tax bills for investors. Wealthy individuals, in particular, can leverage these write-offs and apply them to other taxes they owe, enabling them to owe next to nothing in taxes despite making millions of dollars. This is a perfectly legal strategy and a powerful wealth-building tool. However, it is worth noting that one does not need to be wealthy to take advantage of the tax benefits of investing in real estate. The tax code makes these benefits available to every real estate investor and at Viking Capital we will help you strategically implement investments that will make the most sense in the short, and long-term financial plan.
Disclaimer
Please note that I am not a licensed tax professional, and I have no intention of becoming one. The information and opinions presented in this article are based solely on my personal experience and research. It is highly recommended that you consult with a certified public accountant (CPA) for a more thorough and accurate analysis of your individual circumstances.
