Although reading tax code information may not be very exciting, it is crucial to have a basic understanding of what types of investments are treated more favorably from a taxation standpoint. Real estate is one of those investment classes that have great tax benefits.
The biggest tax benefit of real estate investment is depreciation. Most properties can be depreciated over 27.5 years, and that depreciation can offset income and reduce tax liability. Depreciation is based on the idea that the property has a useful life and therefore the value of the property declines over time. So every year, the owner can deduct 3.64% of the purchase price on taxes. Land cannot be depreciated, so any depreciation calculations need to be based on the value of the building alone.
We can go one step further and do what is called a cost segregation study. When we do a cost segregation study, we split out all of the different property components and depreciate them on different schedules. That means having an accelerated depreciation for items like carpets, appliances, plumbing, and roofs because those components have a shorter lifespan than the building itself. The benefit to the different depreciation schedules is an accelerated write-off in the earlier years of the ownership which can lead to larger tax deductions.
Of course, we don’t get anything for free from the IRS, so when the property sells the depreciation needs to be recaptured. However, it is still beneficial to defer tax payments to a later time due to the time value of money. If we can save on taxes now, that money can be reinvested for future growth.
Operating an apartment building has a lot of associated costs. There are expenses such as maintenance, taxes, utilities, and property management. Of course, those expenses reduce our income from the property and can therefore be deducted from the gross income to reduce our tax liability.
Most properties are purchased with a mortgage. As part of the mortgage, we pay interest on the outstanding principal. This expense can also be deducted from the gross income on the property. This has the biggest impact early in the ownership period because the interest payments are higher with a larger loan balance. Of course, principal payments cannot be deducted as an expense because they are used to pay down debt.
Passthrough of Expenses in a Syndication
These benefits extend beyond individual ownership of properties. Many people are passive investors in syndications and all the tax deductions are passed through to the investor on their annual K1 tax return from the partnership. This often results in negative income on the tax return, or a so-called “paper loss.” So, while the investor receives monthly or quarterly distributions, the tax return may show a loss. This is much more favorable than most other investments because they are taxed as regular income or as capital gains.
Real estate investing and syndications have a very favorable tax treatment that should be carefully considered when comparing different investment opportunities.
Disclaimer; This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or investment advice. You should consult your own tax, legal, and investment advisors before engaging in any transaction.