Updated: Jan 9
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