The Tax Advantages of Multifamily Real Estate Investing
If you are considering investing in multifamily real estate for its passive income and capital gains, there are additional benefits to be aware of. Read this article to learn about the tax advantages offered to multifamily real estate investors.
What Is Multifamily Real Estate Investing?
Multi-dwelling units and multifamily real estate are terms traditionally used to describe apartment complexes, mainly buildings with multiple rentable living spaces. Investors look to diversify their portfolios by investing in multifamily real estate for several reasons. Let’s take a closer look at the benefits of this type of investment opportunity.
Why Do Investors Look To Multifamily Real Estate?
Some of the primary benefits that draw people to invest in multifamily real estate are that it offers cash-on-cash returns to investors from rental income, along with upside capital gains as the property increases in value over time. However, the impact on taxes must be considered when making any type of investment. There are tax advantages to investing in multifamily real estate that make this asset class attractive to investors.
How Can Depreciation Shield Real Estate Earnings From Taxes?
One of the biggest and most beneficial real estate tax advantages for multifamily property owners is depreciation. Now let’s understand what depreciation is and how exactly you can benefit from it. In the simplest terms, depreciation is the reduction of an asset’s value as it ages. The Internal Revenue Service (IRS) allows individuals to depreciate the cost of a property over its life expectancy.
To illustrate the simplest form of depreciation, imagine an investor purchased a 200-unit apartment complex for $50 million. The land upon which this complex is built has a value of $10 million. Since land is a non-depreciable asset, $40 million will depreciate. By dividing $40 million by 27.5 years (the useful life of a residential building as defined by the IRS), there will be approximately $1.45 million in depreciation per year for the next 27.5 years to be written off as an expense against returns to offset taxes.
When you purchase a property, not only does it include the building itself, but all its interior and exterior components. Each of those components has a different useful life, and accordingly, depreciation is calculated differently. Many of those components fall into tax categories where depreciation can be accelerated and written off faster than 27.5 years. For those purposes, a cost segregation analysis is performed. Now let’s explore how cost segregation analysis can be utilized to accelerate depreciation, increasing the amount of depreciation expense to be written off earlier in the life of the asset.
Cost Segregation Analysis
The primary goal of cost segregation analysis is to identify all of the property-related depreciation expenses that can be accelerated over shorter time periods, to allow the maximum amount to be taken as early as possible. Depreciation expenses are then passed through to an investor on a pro rata basis on the annual K-1 form. A Schedule K-1 is an IRS form to report investors’ share of earnings, losses, deductions, and credits. Sequoia Equities uses accelerated depreciation and cost segregation analysis to maximize these tax advantages for investors for all of the properties in our portfolio.
Taxes Are Deferred On The Sale Of A Property With A 1031 Exchange
Another benefit of multifamily real estate investing is the ability to defer capital gains taxes while selling a property by using Internal Revenue Code Section 1031, often referred to as a 1031 exchange. So, what is a 1031 exchange, and how does it help investors? It refers to a type of transaction where the owner of a property sells it and then reinvests the capital into another property, deferring capital gains taxes by rolling them over to the new property. Note that a 1031 exchange is intended for business and investment property, or property used for earning income, and not for personal residential properties.
After the 1031 exchange, the tax is rolled over until the replaced property is sold in the future. Another benefit of the 1031 exchange is that there is no limit on how many times investors can exchange properties; the capital gains can continue to be rolled over accordingly from property to property.
Real Estate Investments Shield Heirs From Taxes Upon Inheritance
Multifamily real estate investing can also play an important role in estate planning and generational wealth preservation. Real estate is passed on to heirs on a stepped-up basis, shielding them from inheritance tax. Let’s discuss this stepped-up basis further to understand all the advantages it offers.
In simpler terms, the stepped-up basis reflects the adjusted value of an inherited asset. When you invest in a real estate asset, there is a basis of value at the time of purchase. For example, if an investor purchases a property for $50 million, that is the basis. If the property increases in value over time to $75 million, this means there is a gain of $25 million. When this individual passes away, the heirs will inherit the property with its value stepped up to the fair market price of $75 million. If the beneficiaries want to sell the asset, they will avoid capital gains taxes on $25 million. A stepped-up basis is one of the reasons real estate investments are desirable to include in estate planning.
Plan Your Real Estate Investments With Sequoia
With over 35 years of experience, Sequoia Equities has extensive knowledge of the multifamily real estate market and its benefits for investors. Here at Sequoia, we know the importance of focusing on the individual needs of our investors. We are always ready to assist our clients with any questions they may have regarding opportunities and advantages of investing in multifamily real estate.