While many people tend to dread tax season each year, those who are proactive with multifamily real estate investing (specifically real estate syndications) are likely excited about it. That is because there are tons of multifamily syndication tax benefits and incentives that arise for passive investors that enable them to gain max profits from this dynamic stream.
In short, investing in multifamily syndications offers much more than a lucrative passive income stream; it is also one of the most tax-favoured investing avenues.
Before we dive into these benefits, here’s a quick disclaimer. Since we’re not tax professionals, the information in this article is from our experience and understanding only. You should speak to a qualified CPA for details and advice about your specific situation. This article should not be construed as tax advice.
Below are the leading multifamily syndication tax benefits that every investor should be knowledgeable of so they can be fully prepared to capitalize on their opportunities.
Depreciation is a huge tax deduction and is often overlooked. In tax terms, depreciation is an accounting method that calculates the cost of tangible business assets’ declined value over time and allows the owner to write it off. The most common form is called straight-line depreciation, which is a system that takes the annual deduction cost of items and divides it by its useful life. As for real estate, the IRS states that the useful life of residential properties is 27.5 years, and 39 years for commercial.
For example, if you have a property valued at $1 million. You can divide that by 27.5 years, which comes out to about $36K. That means that you can deduct $36K in depreciation each year for up to 27.5 years. The reason this is such a significant deal is because, hypothetically, let’s say you make about $10K profit in a year on your invested property. In such a case, you do not have to pay taxes on that $10K and you get to keep it completely tax-free. On paper it may look like you lost $26K, but in reality, you earned $10K.
Cost Segregation and Bonus Depreciation
Cost segregation is very similar to depreciation but accelerated. Cost segregation takes into account that some parts of the property depreciate much faster than 27.5 years. For example, flooring such as carpet has a much shorter life span.
You can have an engineer do a cost-segregation study where they evaluate the individual elements of a property and calculate the life span. This can allow you to depreciate many items over a much shorter time frame, for example, 5-15 years.
What’s the benefit of taking the depreciation deduction at a must faster rate?
You see, the hold time for most multifamily real estate syndications is about 5 years. That means that you may only get 5 years of those depreciation benefits listed above (5 out of 27.5 years), meaning you’d miss out on over 22 years of depreciation benefits.
So, if you have something that depreciates in 5 years instead of 27.5 years, and you only hold that property for 5 years, you may end up deducting the full depreciation amount for that part of the property. By being able to take a larger depreciation deduction earlier, you get more of the depreciation benefits and make a higher profit.
When a property is sold, capital gains tax is owed, and in some cases, deprecation recapture.
Another depreciation option, which is a result of new tax bills, is “bonus depreciation”, which gives the option to depreciate the entire value of a property in the first year. This way you can carry forward losses until the property is sold, which can offset capital gains.
1031 Exchange Tax
If you do not want to embark on capital gains just yet, a 1031 exchange would be an ideal alternative. A 1031 exchange is what allows investors to sell one investment property, and in an allocated amount of time, swap it for another. Essentially, instead of having the gains be rolled out to you, you would have the ability to invest them in a new real estate syndication. That all equates to you not needing to owe any capital gains tax to the IRS when the first investment property is sold. Note that not every real estate syndication offers a 1031 exchange outlet, but it is something to be mindful of and ask about during your venture.
It is not uncommon for multifamily real estate investors to invest in a property for about 1-3 years and then refinance the property after the value has increased due to renovations and rent increases. Doing this does not come with any tax obligations because it is not a taxable event when you return part of the investor’s equity.
Other tax benefits
Rental income is not subject to social security tax or Medicare tax, so that is a benefit as well.
Summary – The Tax Code Favors Real Estate Investors
In summary, multifamily real estate syndications can be a great investment that optimizes tax breaks and has been a proven channel to grow and preserve wealth. With the various multifamily syndication tax benefits, combined with typically excellent returns, it is clear how investing in real estate syndications can add up to significant short and long-term gains.
All in all, for any investor looking to convert their hard-earned capital to passive income in one of the most tax-friendly ways, then multifamily real estate syndication is certainly a prime avenue to think about.