The advantages of renting out a home are apparent. To protect the property’s cash flow, owners can take significant write-offs, including mortgage interest, depreciation, and a variety of other charges.
So, why aren’t there more commercial real estate investors? To be honest, the entry barriers might be rather high. The majority of investors lack the initial capital required to purchase commercial real estate. They also lack the time, finances, and know-how to successfully manage their own properties.
As a result, investing in a real estate syndicate offers many tax advantages associated with multifamily real estate ownership.
In particular, real estate offers three major tax benefits:
Real estate investors can offset the benefits created by the income-generating property through an annual tax deduction known as depreciation under the current tax code. The depreciation deduction is defined by the IRS as “a reasonable allowance for wear and tear, including a reasonable allowance for obsolescence.”Rental properties are normally depreciated over 27.5 years, which is the IRS’s definition of a residential building’s “useful life.” However, by doing a cost segregation study, it is feasible to accelerate depreciation even more.
A cost segregation study separates personal property from land and building upgrades before assigning each asset a functional “life.” Personal property (furniture, carpets, fixtures, and appliances, for example) can be reclaimed in as little as five or seven years. Over a 15-year recovery period, land improvements (such as sidewalks, paving, fences, and landscaping) might be depreciated. Cost segregation studies are difficult to do, but they can save investors thousands of dollars per year, especially in the first few years of ownership. Depreciation is a valuable tool for offsetting positive cash flow created on an investment property, regardless of whether the investor uses a cost segregation study. Whether the property is owned wholly or through a partnership, this is the case. In both circumstances, if you have revenue from the investment, depreciation will help you reduce that income, cutting the taxes you’d otherwise have to pay.
Rates of taxation
Ordinary income tax and capital gains tax are two types of taxes that apply to most investments. When the investment generates income, you pay regular income tax; when the asset is sold, you pay capital gains tax. Ordinary income tax rates can be as high as 37 percent depending on your federal tax band, although capital gains taxes are normally around 20 percent. These rates do not include a 3.8 percent net investment tax, which applies to both rental income and gain from sale for any investor who is passive in nature. Additional taxes are frequently imposed by states.
Ordinary income property includes both real estate cash flows and dividend-paying equities. However, there is one major difference between the two that makes real estate a more tax-friendly asset class: the cash flows created by real estate can be offset by depreciation and interest charges (see above), whereas income earned by stock dividends cannot. To put it another way, depreciation and interest expenditure are ordinary income deductions that might result in ordinary losses.
This is one of the reasons why many real estate investors choose to own property directly (through a fund or otherwise) rather than participate in a publicly traded REIT. Ordinary income tax applies to REIT distributions, just as it does to any other stock distribution.
The tax code has a provision that allows real estate investors to postpone paying capital gains taxes. The 1031-exchange is what it’s called. A 1031-exchange allows a real estate investor to sell real property (not personal property) and reinvest the proceeds in a like-kind transaction, effectively delaying capital gains tax.
This is especially handy when an investor has owned a property for a long time and has used up all of the depreciation. The investor takes on a lower tax basis in the new property that often represents the deferred gain by reinvesting the sales proceeds through a 1031-exchange. If the new property purchased is worth more than the old one, the investor will have greater basis that can be depreciated, but it will not cover the entire cost of the new asset. Investors who play this game indefinitely can avoid paying taxes while accumulating wealth.
In actuality, despite the fact that 1031 exchanges are an excellent strategy to preserve capital, the IRS guidelines surrounding them are so complicated that many individual investors are hesitant to use them. Investors must meet strict deadlines in order to qualify for the trade. Professional help is required in the majority of cases..
Private equity funds that specialize in real estate are better positioned to handle 1031 exchanges. The method is most typically employed by funds that perform a 1031 exchange or set up a Tenant-in-Common structure in which the investor has direct ownership of the asset. Under these restrictions, a limited partner or LLC member cannot trade the proceeds of a real estate partnership or LLC’s sales distribution.