Over the years, people have built generational wealth and financial independence through real estate investments. Why and how is real estate so good? Besides capital preservation, cash flow benefits and equity growth, one of the main reasons that investors seek real estate investment opportunities is the tax advantage.
People often think that to invest in real estate and get the full benefits you have to search for your own property, find the right agent, consume a lot of your time in the due diligence, financing and closing process, and don’t forget manage the property into the future or manage the property management company that you have to first find and hire. Fortunately, that is just not true. If you have a full time job that won’t allow you the opportunity to build your own real estate portfolio or you simply aren’t interested in those activities, you can still benefit from its superior tax treatment by investing in a real estate syndication, which simply pools investor capital to purchase assets.
When you invest in a syndication, you will typically receive profit from annual cash flow and the profit at sale. As you know, profit from an investment is taxable but here is where the real estate tax advantage comes into play. Please note that this is not professional tax advice and it is for your information only. Always consult with your tax professional to better understand your individual tax situation. Bluefox does not include any assumptions about these tax advantages in our underwriting. Now, take a look at the top tax advantages to investing in real estate:
If you own a property that is being used for business or income-producing purposes, you can depreciate the cost of the property (purchase price less the value of the land, which is not depreciable) over time and deduct this amount from your cash flow. For apartment buildings, the depreciation period or schedule is 27.5 years. Depreciation accounts for a decrease in value from average use and wear and tear but real estate doesn’t deteriorate at such expedited time. In fact, with reasonable maintenance, properties typically will not only last much longer than their depreciation schedule would suggest, but they will likely experience dramatic appreciation over that time period. This decrease in value becomes only a paper loss and offsets your real profit from annual cash flow. Depreciation will typically reduce or even eliminate your tax bill all together until you receive your profits from the sale proceeds at sale.
It is important to know that when the property is sold, the depreciation is recaptured. The depreciated amount is then regained and taxed as ordinary income with a maximum tax rate of 25%. There are methods to avoid depreciation recapture, like a 1031 exchange, which is a legal transaction that allows real estate investors to swap an investment property for a like-kind property and avoid capital gains or depreciation recapture on the sale of the property.
Cost Segregation is a strategic tax planning tool that allows real estate investors who have acquired, built, expanded or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions. A cost segregation study is performed by a cost segregation engineering firm with the primary goal to identify all interior and exterior components of the property that can be depreciated over 5, 7, and 15 years instead of the standard 27.5 years. As a result, the investor receives a greater depreciation benefit in the early years of ownership, further helping to reduce or eliminate your tax bill on the cash flow distributions.
In December of 2017, Congress passed the Tax Cuts and Jobs Act of 2017 which included a bonus depreciation provision. Bonus depreciation is a form of accelerated depreciation but instead, it allows you to take 100% of the accelerated benefit and utilize it all in the first year of ownership. This applies to properties acquired after September 27th, 2017 and before 2023. After that, the benefit declines 20% per year and ultimately gets phased out by 2027. As mentioned, the highly tax advantaged nature of real estate is one of the most important reasons people invest in this asset class. However, bonus depreciation has really taken this advantage to the next level considering it can have a massive impact in lowering your tax bill, especially if you have other sources of passive income.
At the time the asset is sold, initial equity and profits are distributed to the investors. The profit gets taxed as capital gains, which is typically a lower tax rate than ordinary income tax. Long-term capital gains, which are properties held more than one year, are taxed between 0% and 20% depending on your tax bracket. You can utilize certain tax-deferred or tax-free methods of investing in real estate to avoid paying capital gains, like a 1031 exchange previously mentioned or a self-directed IRA.
Until the time of sale, investors in real estate syndications will have largely tax-free use of distributable cash flow. If you are not already taking advantage of the tax benefits this asset class provides, you could be leaving thousands of dollars on the table that goes to the IRS. What other types of investments can you make with this type of tax advantage? Thank you Uncle Sam!