Potential Tax Benefits of Owning Multifamily Real Estate
Table of Contents
1. What are the Potential Tax Benefits of Owning Multifamily Real Estate?
2. Operating Expenses
3. Mortgage Interest
4. Depreciation
5. Capital Gains Taxes
6. Cost Segregation
7. Owner Expenses
8. FICA Taxes
9. Pass-Through Deduction
10. How is Rental Income Taxed?
11. Why Real Estate Investors Should Work with BAM Capital for Multifamily Syndication
When assessing the potential profitability of a multifamily investment, investors tend to focus on the property’s cash flow or internal rate of return. While this is not a bad idea, it also doesn’t paint the entire picture.
Beyond generating income and increasing equity over the long term, there are other ways for real estate properties to create profit for its investors. To fully appreciate a multifamily property, investors need to consider its potential tax benefits. The US tax code is actually very friendly to real estate investors. [1]
A multifamily real estate investment can offer several tax advantages that you can’t get from commercial real estate. It is important to know all about these tax benefits so you can save money and avoid paying taxes on the investment entirely.
Here we will discuss the tax advantages of investing in multifamily real estate, which will help you earn higher returns.
What are the Potential Tax Benefits of Owning Multifamily Real Estate?
Every real estate investor should be familiar with some of the tax benefits of multifamily properties. Multifamily investors who own rental properties can benefit from tax deductions such as capital gains tax deferral, depreciation expense write offs, operating and owner expense deductions, and avoiding FICA tax. [1]
To claim these benefits, the US Internal Revenue Service (IRS) requires rental property investors to keep good records as well as a paper trail.
Operating Expenses
For real estate investors, operating expenses are deductible. You can deduct state and local property taxes as an itemized deduction on your federal tax return. Additionally, if you use your property for business or rental purposes, you may be eligible for cost recovery deductions, including depreciation and repairs.
According to the IRS, ordinary and necessary expenses may include: interest, taxes, advertising, maintenance, utilities, supplies, repairs and insurance. [5]
Mortgage Interest
Similarly, mortgage interest is also deductible. According to the IRS, mortgage interest may be deducted on a tax return if you receive rental income from the rental of a dwelling. [5]. This can result in a significant reduction in your taxable income.
For investors who purchase major items using a credit card, it may be a good idea to get a business credit card to keep business expenses separate from personal expenses. [1]
Depreciation
Investors can also claim depreciation on the property, which is a non-cash expense that reduces taxable income. [5]. While a multi family property can last for a very long time, the systems within its physical structure continue to deteriorate over time. With time and exposure to the elements, the property begins to depreciate in value.
In accounting, depreciation is a concept that lets property owners “expense” a portion of the property’s value each year to account for its deterioration. This expense shows up on the income statement and reduces the multifamily property’s net operating income (NOI). In turn, it reduces the investor’s tax liability. [2]
Capital Gains Taxes
Investors are able to defer capital gains taxes. If you exchange one property for another of equal or greater value, you can defer paying taxes on the capital gains from the sale. You can do this by conducting a Section 1031 tax deferred exchange.
With a 1031 exchange, an investor can put their money to work by investing in another rental property instead of paying taxes on the sale of a rental. However, there are complex rules and restrictions when it comes to the Section 1031 exchange, so investors are advised to work with a licensed real estate professional. [1]
Cost Segregation
Cost segregation is a tax planning strategy used in real estate to reallocate the costs of building improvements and personal property within a building into separate cost categories, each with its own depreciation schedule. The goal of cost segregation is to identify and reclassify assets in a way that allows the owner of the property to accelerate the depreciation and take advantage of the tax benefits that come with it.
A cost segregation analysis is a study conducted by an expert consultant or engineer that inspects the real estate investment property and separates its physical aspects into four categories: personal property, land, buildings/structures, and land improvements. [2]
The result is that the allowable depreciation in a given year can be greatly increased, resulting in additional tax savings for investors.
For example, personal property can be depreciated over a much shorter period of time (5 to 7 years) compared to improvements like sidewalks or paving (15 years). By identifying these assets and reclassifying them as personal property, a property owner can increase their current tax deductions and reduce their overall tax liability.
Just like capital gains tax, cost segregation is a complex area of tax law and it’s best to consult a professional, such as a tax attorney or a cost segregation specialist, to determine if cost segregation is right for you and to ensure that you comply with all applicable tax laws.[2]
Owner Expenses
Certain expenses can still be deducted to reduce taxable income even if you have a property management company taking care of the apartment complex. For example, a rental property owner may deduct travel expenses like airfare and lodging as long as it meets certain criteria. Travel expenses can be deducted if it has a clear business purpose and the majority of the time is spent on business activities instead of leisure. [1]
Real estate owners are also able to deduct expenses for their continuing education and their home office [1].
FICA Taxes
With multifamily investing, you can even avoid FICA taxes. Normally, taxpayers who are self-employed have to pay the employer and employee portion of the Social Security and Medicare taxes, also known as FICA or payroll tax. But because rental property income is not classified as earned income, it is not subject to FICA tax. [1]
Pass-Through Deduction
A pass-through deduction is a tax provision in the United States tax code that allows business owners who operate as a pass-through entity (such as a sole proprietorship, partnership, or LLC) to deduct a portion of their business income from their taxable income.
This deduction, known as the Qualified Business Income Deduction, was introduced as part of the Tax Cuts and Jobs Act of 2017 and is aimed at reducing the tax burden on small business owners. The pass-through deduction allows eligible taxpayers to deduct up to 20% of their qualified business income, subject to certain limitations.
How is Rental Income Taxed?
Rental income is taxed as regular income, and the amount of tax you pay depends on your tax bracket. The rental income is reported on Schedule E of your tax return and any related expenses, such as property maintenance and repairs, can be used to offset the rental income and reduce your tax liability.
Additionally, if you have a mortgage on the rental property, you may also be able to deduct mortgage interest and property taxes.
To make sure you can get the full benefit of all these tax deductions, the IRS recommends good record keeping. Investors are required to monitor the performance of their rental properties and prepare financial statements. You will have to identify the source of income and expenses, prepare tax returns, and track all deductible expenses. [1]
If a particular tax return is selected for an audit, investors need to provide receipts, proof of payment, canceled bills, and other documentary evidence. If you are unable to provide these documentations to support your tax deductions, you may be subject to additional taxes, penalties, and interest.[1]
It is important to consult with a tax professional to ensure that you are properly reporting your rental income and claiming all eligible deductions.
Why Real Estate Investors Should Work with BAM Capital for Multifamily Syndication
Tax benefits are great, especially considering that it is only one of the reasons why you should consider investing in multifamily real estate. Apartment complexes and condominiums generate a strong and consistent cash flow that help investors build their wealth.
However, multifamily investing is no walk in the park. It also comes with challenges. For starters, there is a much bigger barrier to entry because multifamily properties are generally larger and more expensive. The average investor could not purchase it on their own. Even accredited investors who have the income and net worth for it may think twice about such a huge investment.
Managing a multifamily property is also a major challenge because you have to deal with tenants, collect rent, handle repairs, and manage the day to day operations of an entire building. This is not an easy task especially for first time landlords. You can hire a property management company to help you with this, but you’ll be pleased to know there’s an even better alternative.
Accredited investors can participate in multifamily syndication, an investing strategy that solves most of the challenges associated with multifamily real estate investing. It gives you all the benefits of owning a multifamily property but without the headaches associated with being a landlord.
You can avoid the high upfront costs by participating in a syndication deal. A syndication deal involves multiple investors pooling their funds together to purchase a single property. It is set up by a syndicator who locates the investment property, coordinates the funding, and finds investors who can provide most of the capital needed for the deal. [3]
A real estate syndication deal can be done with any type of real estate property, but multifamily syndication is the most popular one. With a syndication deal, you no longer have to worry about purchasing an entire apartment building all by yourself.
The syndicator even handles property management, so investors do not have to worry about becoming a landlord. In the syndication deal, the syndicator acts as the general partner (GP) while the investors are limited partners (LP). The investors receive a share of the cash flow as well as the equity upon resale, depending on the deal structure. [3]
Most syndication deals are exclusive to accredited investors. This is a truly passive investment that generates a strong and consistent monthly cash flow through rental income. This is the perfect investment vehicle for real estate investors looking to diversify their portfolio and generate passive income.
Accredited investors who want to try participating in a syndication deal should work with the Indianapolis-based syndicator BAM Capital.
BAM Capital is a reliable syndicator that prioritizes Class A, A-, and B++ multifamily properties in the Midwest with proven upside potential and in-place cash flow. [4]
>BAM Capital’s mission is to help accredited investors grow their wealth using an award-winning investment strategy that mitigates investor risk and creates forced appreciation. In fact, BAM Capital now has over $700 million AUM and 5,000+ units, making it one of the most reliable syndicators for accredited investors.
This syndicator can handle every step of the syndication deal from negotiating the purchasing and financing to managing the property. BAM Capital will handle everything from start to finish, on your behalf. [4]
No investment is without risk. Make sure to consult your investment advisor or speak to a BAM Capital investment team member before making any financial decisions.
Accredited investors can schedule a call with BAM Capital and invest today.
