Updated: Jan 9, 2021
When developing this blog I promised myself I wouldn’t bog down readers with boring details. After all, not everyone is a tax enthusiast! And while many readers may initially want to avoid this topic completely, be assured that it’s crucial to understand some tax benefit basics if you’re going to be a successful passive investor.
Before we begin, I’d like to post a disclaimer: We’re not a tax advisory firm and we refer all general tax-related real estate questions from investors back to their individual accountants. Some investors seek real estate investment opportunities due to the tax advantages that may come from debt write off and lass due to depreciation, but we don’t include any assumptions about these tax advantages in our projections.
The beauty in real estate, and why it’s my absolute favorite investment vehicle, is unparalleled tax benefits that significantly reduce my tax bill (sometimes to zero!). So let’s start --there are several key topics you’ll need to familiarize yourself with. To make them easy to understand, I’ll identify and explain each one.
First thing First: What is Capital Gains?
Understanding capital gains is important as it impacts your taxable income as a real estate investor. When the property is sold at the end of the business plan for a higher price than what you bought the property for, the gains from the sale are distributed to passive investors. The IRS classifies the profit from that sale as “long-term capital gains”.
Here’s the new tax laws for 2019:
Use Depreciation to Lower Your Taxable Income
You’ve heard the term a hundred times, but a simple definition is that depreciation is the amount that can be deducted from income each year as the depreciable items at the multifamily property age. The IRS classifies each depreciable item accord to its “useful life”. Investors can deduct the full cost of the item over that period of time.
The best way to understand this concept is by example. According to the IRS, the useful life of real estate is 27.5 years. With straight-line depreciation, you can deduct equal amounts each year. As the annual deduction is the cost of the property divided by its useful life, the annul depreciation on an apartment building valued at $5,000,000 is $5,000,000 divided by 27.5 years, or $181,818 per year. That means that instead of paying tax for, say, $300,000 from the property’s income, investors will pay only $300,000- $181,818 or $118,181. When you invest in a syndication, you get your pro rate share of the depreciation, and can deduct it not only against your income from the property, but also from other sources of income. Isn’t that a beautiful mechanism?
Cost Segregation – Depreciation on Steroids
Cost segregation, or cost seg, is what I like to call “depreciation on steroids”. It’s a strategic tax planning tool that allows investors to increase cash flow by accelerating depreciation deductions and deferring income taxes.
Here’s how it works: sponsors get an engineering report that segregates the property into four categories: personal property, land improvements, building components and land. The main value of cost segregation is the value of front-loaded depreciation deductions, along with write-offs of specific building components that need replacement.
Cost segregation increase savings by compressing the timing of deductions. How is it being done? Instead of seeing the entire property as one building that depreciates over 27.5 years, the report dissects its different parts; the carpeting, light fixtures, cabinetry doors, for instance, depreciate over 5 years, the parking lot and landscaping over 15 years, etc. This way, investors can capture a larger amount of depreciation and get higher deductions in a shorter period of time. Thanks to the new tax reform in 2017 these deductions can be front-loaded all in the first year by using something called 100% Bonus depreciation. A cost segregation study can cost anywhere between $5,000 and $10,000, depending on the size of the property. We use cost segregation on every deal.
Defer Capital Gain Tax with 1031 Exchange
While a 1031 exchange doesn’t yet enjoy the same widespread understanding, it is becoming a common term, especially among those who invest in real estate. A 1031 exchange is a swap of one investment property for another, allowing you to defer your tax on capital gains from a property sale. While most profits from property sales are taxable as capital gains, if you meet the IRS requirements of a 1031 exchange, you’ll be able to defer that tax. So in effect you can change the form of your investment without it being considered “cashing out” as a capital gain.
This is important because it allows your investment to continue to grow tax deferred. In addition, it doesn’t matter how many times you do a 1031. You are able to roll over the gain from one real estate investment to another to another, etc. While you may have a profit with each property, you will not have to pay any tax until you sell the property for cash years later.
The only requirement is that a replacement property on the 1031 exchange must be identified within 45 days of the sale, and that property must be closed on within 180 days of the sale.
In order to understand Deprecation 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 the Adjusted Cost Basis. The difference between these amounts is “recaptured” by reporting it as income, which is reported as a capital gain.
If you add improvements or major renovations, you can add those expenses to the Adjusted Cost Basis. This will reduce the capital gains when you sell the property.
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 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 20% capital gains tax and that you are in the 28% income tax bracket, the total amount of tax owed on the she sale is 20% capital gain plus 28% on the depreciation recapture, or (0.20 x $1,000,000) + (0.28 x $909,090) = $200,000 + $254,545 = $454,545.
It’s crucial that you familiarize yourself with the terms and information in this article, as understanding tax benefits and how they impact your passive investments is important to your success. Knowing how to front-load depreciation helps to decrease tax payments during the early period of a tangible personal property’s life, freeing up cash for investments or to meet operating expenses. Also, understanding 1031 exchange allows you to defer your tax payments. Learning the basics of tax benefits can help maximize your return on investments over the long term.
Thank you Yonah Weiss from Madison SPECS for your editorial comments on Cost Segregation.
About the author
Ellie is the founder of Blue Lake Capital, a real estate company specializing in multifamily investing throughout the United States. She is also the host of a Unbelievable Real Estate Stories, a podcast that brings the true stories behind the deals, from the most successful real estate investors around the globe. Ellie started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100,000,000. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations. She holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.