DISCLAIMER: THIS IS FOR YOUR INFORMATION ONLY. SINCE I AM NOT A TAX ADVISORY FIRM, I REFER ALL GENERAL TAX-RELATED REAL ESTATE QUESTIONS FROM PASSIVE INVESTORS BACK TO THEIR ACCOUNTANTS. HOWEVER, I WILL SAY THAT INVESTORS OFTEN SEEK REAL ESTATE OPPORTUNITIES TO INVEST IN DUE TO THE TAX ADVANTAGES THAT MAY COME FROM DEBT WRITE OFF AND LOSS DUE TO DEPRECIATION. BUT I DON’T INCLUDE ANY ASSUMPTIONS ABOUT THESE TAX ADVANTAGES IN OUR PROJECTIONS.
In addition to the capital preservation and cash flow benefits, one of the main reasons that passive investors seek to invest in real estate opportunities, and apartment syndications in particular, is because of the tax benefits of rental property.
When a passive investor invests in a value-add apartment syndication, they will generally receive a profit from annual cash flow and the profit at sale. Being a profit, this money is taxable. However, for apartment syndications, there are five pieces of tax information that the syndicator and the passive investor need to understand in order to determine the tax advantages of investing. These are 1) the depreciation benefits, 2) accelerated depreciation via cost segregation, 3) depreciation recapture, 4) bonus depreciation, and 5) capital gains tax at sale.
Depreciation
Investment property depreciation is the amount that can be deducted from income each year as the depreciable items at the apartment community age. The IRS classifies each depreciable item according to its useful life, which is the number of years of useful life of the item. The business can deduct the full cost of the item over that period.
The most common form of depreciation is straight-line depreciation, which allows the deduction of equal amounts each year. The annual deduction is the cost of the item divided by its useful life. The IRS considers the useful life of real estate to be 27.5 years. So, the annual depreciation on an apartment building worth $1,000,000 (excluding the land value) is $1,000,000 / 27.5 years = $36,363,64 per year.
As one of the tax benefits of apartment 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
Cost segregations 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 performed by a cost segregation engineering firm dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 years, the useful life of a residential building. The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7, and 15 years
For example, my company performed a cost segregation on our portfolio for 2017. On one of the properties, we showed a loss from investment property depreciation of greater than 412% than we would have seen with the straight-line depreciation using the 27.5-year useful life figure.
To perform a cost segregation, the syndicator will need to hire a cost segregation specialist. This can cost anywhere between $10,000 and $100,000, depending on the size of the apartments.
Depreciation Recapture
Depreciation recapture is the gain received from the sale of depreciable capital property that must be reported as income. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is “recaptured” by reporting it as income.
For example, consider an apartment that was purchased for $1,000,000 and has an annual depreciation of $35,000. After 11 years, the owner decides to sell the property for $1,300,000. The adjusted cost basis then is $1,000,000 – ($35,000 x 11) = $615,000. The realized gain on the sale will be $1,300,000 – $615,000 = $685,000. Capital gain on the property can be calculated as $685,000 – ($35,000 x 11) = $300,000, and the depreciation recapture gain is $35,000 x 11 = $385,000.
Let’s assume a 15% capital gains tax and that the owner falls in the 28% income tax bracket. The total amount of tax that the taxpayer will owe on the sale of this rental property is (0.15 x $300,000) + (0.28 x $385,000) = $45,000 + $107,800 = $152,800. The depreciation recapture amount is $107,800 and the capital gains amount is $45,000.
Bonus Depreciation
One of the major changes with the Tax Cuts and Jobs Act of 2017 was the bonus depreciation provision, where business can take 100% bonus depreciation on a qualified property purchased after September 27th, 2017. This is definitely one of the tax benefits of rental property you should learn more about, so click here for more information on the qualifications and benefits of the change in bonus appreciation.
Capital Gains
When the 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 long-term capital gain.
Under the new 2018 tax law, the capital gains tax bracket breakdown is as follows:
Taxable income (individual or joint)
- $0 to $77,220: 0% capital gains tax
- $77,221 to $479,000: 15% capital gains tax
- More than $479,000: 20% capital gains tax
Annual Tax Statements
At the beginning of the following year, the syndicator will have their CPA create Schedule K-1 tax reports for each passive investor. The K-1 is a tax document that includes all of the pertinent tax information that the passive investor will use to fill out their tax forms.
If you’re interested in partnering with me and potentially gaining from these tax benefits of rental property, please fill out the form here.
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