Updated: Apr 8, 2018
I’d like to start with a disclaimer – I am not a CPA nor am I a tax strategist. The content that follows is simply my opinion based off of my experience and knowledge I’ve gained through extensive research. None of what follows is meant to server as advice to any who read it, and I strongly recommend that you seek the counsel of licensed professionals.
Now that we’ve gotten that out of the way… I briefly touched on the topic of the tax advantages of an investment in commercial multi-family (MF) in an earlier blog, but I will dive a bit further in to the topic here. This topic can be and is covered in great length through different platforms, there are entire books dedicated to it, but I’ve condensed what I view as the most powerful tax advantages of MF investing for a high level overview that any passive investor should understand.
Depreciation & Accelerated Depreciation
There are a number of possible expenses that you can write off on your taxes; property tax, loan interest, property depreciation, and many more. The biggest and most common depreciation deduction that can be made on a MF investment though, is depreciation on the physical property. The IRS has ruled that resident occupied real estate has a reasonable life span of 27.5 years and that land value cannot be depreciated as it theoretically has a life span of forever. So let’s look at an example of what your “paper loss” may show. Assume you own a MF asset worth $37.5M, of which the land accounts for $10M. That leaves the value of the physical property at $27.5M. Depreciated at 27.5 years, that equates to an annual deduction of $1M. Now assume your property has net operating income (NOI) of $800K. Your “paper loss,” the amount of income that you will pay taxes on, is then -$200K. Pretty powerful, right? It gets better.
Non-permanently affixed items – appliances, paint, roofs, carpet, cabinets, etc. – can be depreciated over a shorter time period; this is the concept of accelerated depreciation. You can see how powerful this is when you consider the fact that a lot of value-add Sponsors only hold assets for 3-7 years. Let’s look at an example where we lump all of those permanently affixed items into one category with a total expense of $500K and a lifetime of 10 years. By depreciating these items over 10 years instead of 27.5, you are able to deduct $50K/year as opposed to ~18K/year. Assume a hold period of 5 years and that’s the difference of deducting $250K versus $90K.
The gains or losses from your investment in MF will likely be transferred by the Sponsor to you, the passive investor, through the use of a K-1 tax form. Looking back at the above examples, it’s easy to see how you may show a LOSS on your taxes, all while receiving a healthy annual distribution. But again, it gets better. The IRS allows you to apply these losses to other areas of your portfolio, so an investment in MF could also lower your tax exposure from other investments you hold. Keep in mind that what I’ve discussed above is not complete elimination of taxes, but rather tax deferral, and depreciation recapture may come in to play at a later date (namely when the asset is sold) and thus reintroduce your tax liability. But fear not, taxes on capital gains, aka profits at the time of sale, can also be deferred through the 1031 exchange.
A 1031 exchange allows you to roll over your capital gains in to a new investment without paying taxes on them. Now you might think “I’m going to pay taxes on my gains eventually, so it makes no difference if I pay them now or later, right?” Wrong. I’ll use this extremely powerful example from Paul Moore’s The Perfect Investment as it’s forever etched into my brain. “If you take $1.00 and double it [daily] tax-free for 20 days it’s worth $1,048,576… Take that same $1.00, taxed [every day] at 30%, it will be worth only $40,640 – A LOSS of a MILLION DOLLARS!” This example illustrates the power of tax-free compounding, where earnings accumulate not only on the principal amount invested but also on tax-free gains. While this example is a small dollar amount and a short period of time, it is a perfect analogy for your portfolio over your pre-retirement years.
The 1031 is an amazing tool and should be taken advantage of by anyone who invests in real estate, but there are a few things to keep in mind. First and foremost, the exchange must be like-for-like. That is, the new property must have similar characteristics to the old property; size, intended use, etc. Guidelines on like-for-like are fairly loose, however, and you should consult a professional to ensure you are operating within the bounds of the law. Another stipulation to consider is the timeline restriction. There are two timeline events that must be met in order to qualify for a 1031 exchange: (1) after close, a new property must be identified (which includes communicating your intent to purchase to the seller) within 45 days, and (2) you must close on that property within 180 days. Lastly, you are not to touch the cash gains or else face tax liability. Instead, an intermediary should hold on to these funds to invest in your next deal.
Supplemental Loan/Refinancing to Pull Out Equity
After your Sponsor has implemented the value-add strategy that was laid out in the initial offering, there should be a healthy amount of equity in the property. The Sponsor can then place a supplemental loan on or refinance the asset and return a significant portion, if not all, of the initial capital to the passive investors. This money, referred to as “lazy equity,” is considered by the IRS as a return of investor capital and is not a taxable event. You might be thinking, “That all sounds great, but how does this REALLY benefit me?” Well, you maintain your equity position in the property and thus continue to receive monthly/quarterly/annual distributions as well as profits at the time of sale, all with money that was never taxed and is now back in your possession.
Investing in MF Using a Self-Directed IRA (SD-IRA)
Many of you are already aware of the tax benefits of an IRA. However, with a traditional IRA, investing in private placement real estate deals is prohibited. In comes the SD-IRA. Unlike traditional IRAs, SD-IRAs allow you to invest in early-stage companies raising capital through private placement. That sounds a lot like MF syndication, right? That’s because it is.
So how is this a tax benefit? Well, when investing in MF with SD-IRA funds, you are required to place your gains immediately back in to your account. These gains are not taxed prior to be placed back in to your IRA and thus are able to compound on principal and earnings tax free (see example under “1031 Exchange” for how powerful this is). One thing to be aware of is that your SD-IRA may be subject to unrelated debt-financed income (UDFI) and/or unrelated business income tax (UBIT). Both of these are dependent on your account type (SD-IRA, 401k, etc.), the business structure (partnership, LLC, etc.) and the financing/loan placed on the property, so be sure to consult a professional who can help navigate your particular situation; said professional will also help you follow all rules and regulations as to not put the tax-deferred status of your account at risk.
In conclusion, depreciation, the 1031 exchange, regaining initial capital through an equity event, and using a self-directed IRA are all incredibly powerful tax advantages of commercial multifamily investments. Each one can and should be taken advantage of when investing in this asset class. If you invest with a proven Sponsor as well as spend a bit more money on knowledgeable tax strategist with experience in commercial multifamily, it is reasonable to assume that you could defer paying ANY taxes on your gains until years or decades down the road, thus allowing the power of compounding to work to your full advantage. The U.S. tax code is so extremely complex that it might as well be written in an alien language. There are seemingly endless guidelines to be met and rules to be followed, or else face financial penalty or even jail time. So again, seek the advice of a savvy CPA or tax strategist to best navigate your personal financial situation.