Passive investing in multi-family syndications is an excellent option for many reasons, but you could be overlooking some additional benefits.
In some of our previous articles, we discussed how multi-family is a steady investment option during times of inflation and the opportunities that 506(b) offerings open up for nonaccredited investors. However, there are also several tax benefits available, and it’s important to know how they work to get the biggest bang for your buck.
Read on for the top tax incentives for multi-family real estate investments and learn how these techniques can save you significant money in the long run.
A reasonable allowance for the wear and tear of a property over time is known as “depreciation.”
Because multi-family properties consist of a complex web of mechanical systems (electrical, plumbing, heating/cooling systems, etc.) that physically deteriorate over time due to regular use and exposure to elements, depreciation allows the property owner(s) to write off a portion of the property’s value as an “expense” annually to account for the expected level of deterioration.
This technique reduces the owner’s tax liability by reducing its net operating income. According to the IRS, a multi-family property has a “useful” life of 27.5 years. Let’s break the numbers down below.
Say you own a multi-family rental property worth $1,500,000. This property would have a depreciation expense of $54,545.45 ($1,500,000/27.5) per year.
If the property mentioned above generated $200,000 in income in a given year, the tax obligation would breakdown as follows:
- Taxes owed without depreciation = $200,000 x 0.25 (federal income tax) = $50,000.
- Taxes owed with depreciation = ($200,000 – $54,545.45) x 0.25 = $36,363.64
With depreciation, the owner of this property will save $13,636 in taxes.
You may also want to accelerate the depreciation rate through a cost segregation study.
With a cost segregation study, expenses are itemized under several categories (personal property, land improvements, buildings/structures, and land) to provide additional tax savings.
Because items depreciate at different rates, some may depreciate faster than others. A cost segregation study helps you determine which items depreciate at a quicker rate which may reduce your taxable income further for a shorter period of time. Items that fall under the category ‘personal property’ depreciate over 5 to 7 years and ‘land improvements’ (sidewalks and parking lots) depreciate over 15 years.
While this strategy may help save on taxes more quickly, it involves more complex math and should be completed by an experienced professional to ensure accuracy.
A 1031 exchange may be used upon sale to defer capital gains taxes indefinitely. Deferring taxes that range between 15%-28% is a financially savvy way to look out for your bottom line.
Section 1031 of the Internal Revenue Code says that a property investor may defer capital gains taxes when they invest those earnings in another property. This exchange must meet the following guidelines.
- The new property must be of equal or greater value to the property sold.
- Both properties are of “like kind.” Meaning they are of the same nature and titled similarly.
- The amount invested in the new property is the same as the profits made on the previous property.
- The investor identifies the new property within 45 days of closing, and they complete the purchase transaction within 180 days.
If you are looking to reinvest your earnings after parting ways with one investment property, a 1031 Exchange is a no brainer.
Passive Income Tax
Passive income taxes are not nearly as steep as federal income tax rates. If your involvement in real estate investing is not considered to be as a real estate professional, your passive income will be taxed at a lower rate.
Real estate professionals are recognised as individuals who spend at least 500 hours per year working in their real estate venture. The average passive investor comes nowhere near this mark and will pay passive income and capital gains taxes as opposed to federal income taxes on their investment earnings.
Gifting and Estate Tax Benefits
When you invest in a real estate syndication as a passive investor, you have limited control over the LLC’s earned interest. Because of this, you can reduce the value of a gifted investment by as much as 30%. This will reduce the tax liability of the individual(s) receiving the gift.
Using these tax breaks correctly has the power to significantly lessen the impact of taxes on your bottom line. Applying your knowledge and the support of a professional will allow you to leverage these tax benefits and make the most out of your multi-family real estate investment.
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