Those who invest in real estate generally tout three main benefits of the asset class: diversification, attractive returns, and income generation. But a fourth, oft-overlooked benefit could become more relevant: tax advantages.
Real estate is one of the most tax-friendly investment options available. And with taxes on high-net-worth individuals potentially increasing, any tax savings investors can realize become more valuable.
This post is the first in a series of blogs explaining some of the tax benefits inherent in direct real estate investing and explores how depreciation reduces the taxable income from a property, without reducing an investor’s cashflows.
The concept can seem counterintuitive: How can a profitable investment in a multifamily rental real estate property (“multifamily property”) generate positive cash flows (for distribution to investors) while at the same time generating rental real estate losses (reducing taxable income for investors)? In a word: Depreciation.
Through depreciation, investors are allowed to recognize an expense against actual income earned for a small part of the value for which the property was purchased over a period of several decades. Over time, the tax law assumes, physical deterioration of property occurs, reducing the property’s value. For example, roofs deteriorate, appliances break, and air conditioners need to be replaced. In recognition of this deterioration, state and federal tax laws permit multifamily property owners to expense a portion of the property’s value each year through depreciation.
How Depreciation Works – An Example
As a noncash expense, depreciation reduces the taxable profit from the property but does not reduce the cash available for distribution. For example, assume that Property A has $200,000 in income and $50,000 in expenses, not including any depreciation. The resulting taxable income and cash available for distribution (before taxes) is $150,000. Assuming a tax rate of 25%, tax due would equal $37,500. Next, assume that Property A has $25,000 in depreciation each year. The resulting net operating income (NOI), after depreciation, is $125,000. But cash available for distribution (before taxes) is still $150,000. Again, assuming a tax rate of 25%, tax due would equal $31,250, a savings of $6,250 in one year. A substantial tax savings, compounded over a multiyear investment holding period.
Annual depreciation amounts differ for various types of assets. For example, buildings for multifamily properties are depreciable ratably either over 27.5 or 30 years while other assets, such as appliances, pool furniture and land improvements, are fully depreciable much sooner. To maximize the depreciation deduction amount, multifamily property managers will engage outside experts to perform a Cost Segregation Study.
Tax Changes Could Provide Higher Depreciation Levels
A change was made in 2021 federal tax legislation to convert the depreciable lives of certain multifamily property buildings from 40 to 30 years. Investors will receive a catch-up depreciation deduction in the year of conversion to the 30-year life.
As an example: Assume a $10 million multifamily property building was placed in service on January 1, 2017. Federal tax rules in 2017 required that the building be depreciated ratably over 40 years, a $250,000 depreciation deduction per year ($10 million / 40 years). In 2021, the year of conversion, the annual depreciation deduction per year will now be $333,333. In addition, an annual depreciation catch-up of $83,333 ($333,333 less $250,000) for years 2017 through 2020 (or $333,333) will also be available. So in 2021, investors will share $666,666 of building depreciation deductions ($333,333 annual depreciation plus $333,333 catch-up).
One caveat –previous depreciation deductions may subject investors to higher capital gain rates on a future sale of the property. This concept is called depreciation recapture. An example follows:
Assume the multifamily property that was originally purchased in 2017 for $10 million was sold on December 31, 2021 for $15 million. Capital gains are calculated on the sale price of $15 million, less the original purchase price of $10 million reduced by total depreciation deductions. If total depreciation from purchase through sale date is $1 million, capital gains tax will be due on both the $5 million profit from the sale ($15 million sale price less $10 million purchase price) plus the $1 million of depreciation deductions. While depreciation recapture means that depreciation does not eliminate the taxes on property income, it can defer the need to pay those taxes by as long as you own the property and it changes the type of tax due from ordinary income taxes to capital gains taxes (which has historically been a lower rate).
Reducing Taxes on a Property Sale
One way to avoid or reduce taxes on the sale of a multifamily property is by completing what is known as a 1031 exchange. In a 1031 exchange, the proceeds from the sale of the original multifamily property are used to purchase another property without triggering a capital gains tax obligation. This tax advantage, and the rules that surround it, will also be discussed in a future tax series article.
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