DISCLAIMER: This article is for informational purposes only and should not be construed as tax advice. We are not CPAs or attorneys, nor do we represent ourselves as such. Consult a professional tax advisor before you engage in any real estate transaction.
Tax season is all year long if you are planning strategically. It’s not as terrible as it sounds, it’s actually a good thing! The actions you take throughout the year create financial rewards recouped on tax day. If you are a passive investor in multifamily syndications, you might find yourself looking forward to receiving your K-1s with the promises of “paper losses” to reduce your tax liability.
Passive real estate investing has many benefits that range from capital preservation to cash flow. Real estate syndication can be superior to other types of passive investing, but arguably the most valuable benefit is deductions investors can take advantage of.
An equity investor in a syndication is a limited partner, meaning a part-owner. Investments in syndications are generally considered “passive” activities and each partner, or investor, receives a share in these deductions based on their proportional ownership.
A K-1 is an IRS mandated form that reports each partner’s share of earnings, losses, deductions and credits. As a passive investor, you receive a K-1 for tax reporting purposes. In many cases, it’s a passive loss that can be used to offset passive gains in other areas of an investment portfolio. There is often not a direct link between the health of your investment and passive losses taken for tax benefits. Learn to embrace the passive loss and the tax savings it brings.
There are four key components passive investors should understand to determine tax advantages:
- Depreciation
- Cost segregation
- Depreciation recapture
- Capital gains
Depreciation
As an asset ages, it declines in usefulness and value. Depreciation is an accounting method to allocate the costs of assets over their useful life as determined by the IRS. A common depreciation method is straight-line, which creates an equal deduction amount for each year of useful life. The IRS considers the useful life of real estate to be 27.5 years. Annual depreciation on a commercial real estate asset worth $1,000,000 (excluding the land value) is $1,000,000 / 27.5 years = $36,364 per year.
As one of the tax benefits of commercial real estate syndications, the depreciation amount is such that a passive investor won’t pay taxes on their monthly, quarterly, or annual distributions during the hold period. They will, however, have to pay taxes on the sales proceeds.
Cost Segregation (Bonus/Accelerated Depreciation)
Depreciation is often accelerated on large commercial assets through what is known as cost segregation. Cost segregation is a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes.
A cost segregation study is performed by an engineering firm that dissects the construction cost or purchase price of a property that would otherwise be depreciated over the full 27.5 years of useful life. The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 15, 7 and even 5 years. As a result, accelerated deductions can be realized with significant “paper losses” in the early years of owning an asset.
A major change created in the Tax Cuts and Jobs Act of 2017 allows for bonus depreciation where businesses can take 100% bonus depreciation on a qualified property purchased after September 27, 2017. Cost segregation is a wonderful tool that should be embraced to save on your taxes, but bonus depreciation really takes things to a new level.
Depreciation Recapture
When it’s time to sell a real estate investment, that depreciation you took during ownership reduced the value, or basis, in your investment. Depreciation recapture is when you realize the gain between the original investment value and what you have taken as depreciation. You report this as income in addition to the appreciated value.
When the sale price of an asset exceeds the tax basis, or adjusted cost basis, you have a gain. Consider a multifamily asset purchased for $1,000,000. For simplicity, let’s take annual straight-line depreciation of $35,000. After 8 years, the property is sold:
Original Purchase Price: $1,000,000
Depreciation Taken: $35,000 X 8 years = $280,000
Adjusted Cost Basis: $1,000,000 – $280,000 = $720,000
Sale Price: $1,300,000
Realized Gain: $1,300,000 – $720,000 = $580,000
Of the realized gain, $280,000 is depreciation recapture. Let’s assume you fall into a 28% federal tax bracket. You’ll pay that 28% on the depreciation recapture tax. The remaining gain is escalation in value from the original purchase price and is considered a capital gain taxed at 15% in this example:
Depreciation Recapture Tax: $280,000 X 28% = $78,400
Capital Gain Tax: $300,000 X 15% = $45,000
Total Tax Liability: $78,400 + $45,000 = $123,400
Capital Gains
When an asset is sold and the partnership is terminated, initial equity and profits are distributed to the passive investors. The IRS classifies the profit portion as a long-term capital gain.
Under the new 2019 tax law, the capital gains tax bracket breakdown is:
Taxable income (married filing jointly)
- $0 to $78,750: 0% capital gains tax
- $78,751 to $488,850: 15% capital gains tax
- More than $488,850: 20% capital gains tax
Multifamily syndications are highly tax-efficient investment vehicles. The IRS has provided ample ways to keep more profit in your pocket and defer paying the lion’s share of taxes until the asset is sold.
Written by:
Agnes Wong
-San Francisco Chapter Leader
