Tax Benefits of Real Estate Investing
What is Depreciation in Real Estate?
The IRS uses depreciation to acknowledge a decrease in value of an asset over time from wear and tear. Depreciation is then used as an expense that investors are able to count against their income. The IRS uses a 27.5 year period when determining the time frame in which residential real estate assets wear down and 39 years for commercial real estate. Depreciation is not unique to real estate, but real estate investing uniquely benefits from deprecation.
For example, a $20mm multifamily property (with $5mm raised from passive investors) depreciated over 39 years provides a tax shelter to the investors of $512,820 per year ($20mm / 39 years). If you invested $100,000 passively into this property, you would receive 2% ($100,000 / $5mm) of the total depreciation benefit, which equates to $10,256 per year. Assuming a tax rate of 20%, your potential tax savings would be $2051 per year.
You can activate your passive depreciation losses in the same year, IF you’re a real estate professional. Among other requirements, the rules require you to spend 750 hours or more with your active real estate activities. However, even if you don’t qualify as a real estate professional, eventually you’ll be able to activate your passive depreciation loss activity at the time of deposition (when the real estate property is sold). The accumulated depreciation can be used to offset the profit split you receive in the year of property sale.
Keep in mind that when you exit a passive real estate opportunity, it’s likely that you’ll have to recapture the depreciation and pay taxes on it. The tax rate on recaptured real estate depreciation is usually 25%. This dynamic creates an incentive to use a 1031 exchange strategy. The 1031 allows you to pay no taxes on your gains by “trading” into another real estate property and “rollover” your capital and profit into the next real estate opportunity.
What is Cost Segregation?
A cost segregation study allows to you break the asset down according to the actual rate in which materials depreciate. For example, carpet might depreciate over a 5 year timeframe, where appliances might depreciate over 7 years. To leverage this strategy, a 3rd party cost segregation specialist must be contracted to perform an engineering study of the property.
What is Accelerated Depreciation?
The Tax Cuts and Jobs Act of 2017 adjusted the existing tax law to allow an incentive for investors deduct 100% of the depreciation expenses in the first year of ownership vs. deducting over a 5, 7 or 15 year depreciation period. This provides a unique opportunity for the passive investor to take advantage of accelerated passive losses in the first year they invest in an investment through the syndication model. Imagine what this looks like when investing passively into a single $20mm commercial real estate syndication!
Capital Gains Tax and Self-Directed IRAs
As of 2022, long-term capital gains tax rates are between 0% to 20%, depending upon your tax bracket. Low capital gains tax rates are an advantage if you build your long-term investment strategy around investing into real estate for purposes of covering living expenses or growing generational wealth.
IRAs and 401K retirement plans are excellent investment strategies to build wealth while minimizing taxes. Most investors think of these vehicles to invest solely into stocks, bonds, and mutual funds. While this is most certainly the norm, it is not the rule. Self-directed IRA accounts allow investors to passively invest into real estate. There is an entire industry of self-directed custodians who allow investors to tap into their IRAs and 401Ks. Reach out for a list of recommended SDIRA firms.
As you can see, tax benefits are a compelling reason to get involved in real estate. The tax benefits should not be the only reason to invest in real estate. The sponsor, market location, and deal economics are the primary factors to consider when choosing your real estate investing strategy.
