✍🏾The Top 3 Major Keys 🔑 to Know About Apartment Syndication Taxes
We’re just going to say it: Nobody likes thinking about taxes, let alone talking about taxes!
The more money you make, the more taxes you pay, and that’s not fun even for the most die-hard CPA. Taxes will never be the cool thing when it’s coming out of your bank account. They’ll never be “in style”. They’re always going to be just…taxes. Thinking about taxes can make your brain go from green light to red light faster than you can blink when all you want to do is imagine new money flowing into your account thanks to another great investment.
The good news is that unlike many types of asset classes, investing real estate can help you decrease the amount you owe in taxes. This is why real estate investing tends to be a favorite among the masses. The IRS views profits gained from real estate-related transactions differently than they view profits gained through, let’s say, stocks. The tax law favors real estate investors both passive investors and active investors. You can get perks from tax benefits due to debt write off and losses due to depreciation, amongst other things.
By investing in real estate, a taxpayer can take advantage of the write-offs, and apply those write-offs to other taxes they may owe, which decreases their overall tax bill, proving to be a great wealth-building strategy.
Of Course We Have A Disclaimer
We are not tax professionals or tax attorneys at Dwellynn. We created this informational blog about taxes in relation to syndication deals based on our experiences. We will always refer you to speak to your personal tax professional and/or accountant to guide you about all tax-related questions.
In this blog, we’re just going to scrape the surface of the numerous tax incentives that real estate investors can benefit from, but we’re going to focus on 3 major tax benefits that will have you 100% convinced that real estate investing is a smart financial move.
Depreciation
Cost Segregation
Depreciation Recapture & Capital Gains
Depreciation Is Your Very Powerful Friend
The basic concept behind real estate depreciation is that everything has a life span, and as time goes by everything will age and come to the end of its life span. This principle is then applied to the world of business and real estate. Everything that is used in real estate has an “expiration date”, whether it’s obvious or not. When something is nearing “expiration”, or coming close to the end of its life span, the government wants to encourage you to replace it with a new version. When you replace an item, you are contributing to the economy as a consumer, which contributes to multiple industries, and the overall economy.
The government encourages real estate investors to replace items and renovate their property by offering to deduct the cost of the expenses to replace items and renovate against the income generated by the property. Depreciation is a non-cash deduction that reduces the investor’s taxable income. Real estate depreciation assumes that the property is declining over time due to wear and tear, but often this is not the case. Thanks to real estate depreciation, an investor may see cash flow from their property but can show a tax loss on paper. Instead of taking one large deduction in the year that the investor purchases or improves the property, depreciation is split up over several years based on the useful life of the property.
The most popular form of depreciation is straight-line depreciation, which means that the deduction will be in equal amounts each year. The IRS currently determines the useful life of residential real estate at 27.5 years, and this applies to apartment buildings as well.
Example
If you bought a property for $1,000,000 with the land being valued at $100,000 and the building being valued at $900,000, then your depreciation would be $900,000/27.5 = $32,727/year. This is what your accountant will show as a deduction each year for this property. With this great tax advantage, passive investors typically won’t pay on their monthly, quarterly, or yearly cash flow from the syndication, but they will pay on the sale proceeds of the property at the end of the syndication.
The Tax Cuts and Jobs Acts of 2017 allow for 100% bonus depreciation on qualified properties that are purchased after September 27, 2017, creating an even greater tax advantage in the first year.
If You Like The Sound of Depreciation, You’ll Love Cost Segregation
Straight-line depreciation allows you to spread depreciation over the lifespan of a property, which is 27.5 years according to the IRS. However, in apartment syndication deals, the partnership typically holds an apartment community for 5-7 years. Consequently, this leaves a lot of unrealized tax benefits on the table, as the partnership would only get 5-7 years of the tax deduction benefits, leaving 20.5-22.5 years of tax deductions unutilized. Cost segregation enables property owners to accelerate depreciation to help them take advantage of these depreciations over a shorter property hold-time.
Cost segregations is a tax benefit that allows real estate investors who have developed, purchased, expanded, or renovated real estate to increase cash flow by accelerating their depreciation deductions and deferring their income taxes. The idea behind cost segregation is that different assets have different lifespans. The carpeting in apartment units will have a far shorter lifespan than the bricks that the apartment building is made of. Items that have shorter lifespans like fixtures, carpeting, windows, and wiring, can be depreciated over shorter timelines of 5, 7, or 15 years. A cost segregation specialist is hired to identify and reclassify the components of an apartment community that can be depreciated on an accelerated time frame.
The paper losses that are created through depreciation deductions can apply to the other taxes you pay on your salary and other income sources, not just the taxes on the income from the investment property from which the tax deductions came from. This can be different on a case-by-case basis, so verify this with a tax professional
The IRS Has To Get Paid: Depreciation Recapture & Capital Gains
There will be a time where you have to “pay up” to the IRS, no matter how much you want to live a tax-free life. As we all know, the IRS will get their money one way or another. In this case, it’s through depreciation recapture and capital gains once the property is sold at the end of the syndication cycle.
When the apartment community is sold at the end of the apartment syndication deal, the apartment community is considered a depreciable capital project. The gain from the sale of this depreciable capital property must be reported as income. When the assessed sales price of a property exceeds the adjusted cost basis, the difference between these two figures is reported as income to enable the IRS to “recapture” previous depreciation benefits. When the asset is sold at the end of the partnership, the initial equity and the profit distribution that the passive investors receive at the sale of the property is classified as a long-term capital gain by the IRS.
Example
In the previous example, you bought a property for $1,000,000, and the annual depreciation of your property, excluding the land, was $32,727/year. You decide to hold your property for 10 years and then sell it for $1,200,000. The adjusted cost basis will be $1,000,000 - ($32,727 x 10) = $672,730. The realized gain when you sale this property will be $1,200,000 - $672,730 = $527,270, the capital gain will be $527,270 - ($32,727 x 10) = $200,000, and the depreciation recapture gain will be $32,727 x 10 = $327,270.
In this example, the capital gains tax will be 15% and you’ll fall under the 28% income tax bracket. The capital gains you owe will be 0.15 x $200,000 = $30,000 and the depreciation recapture you owe will be 0.28 x $327,270 = $91,635. The total amount of tax you owe at the sale of this property will be $30,000 + $91,635 = $121,635.
Below are the tax brackets and percentages based on the new 2018 tax law:
$0 to $77,220: 0% capital gains tax
$77,221 to $479,000: 15% capital gains tax
More than $479,000: 20% capital gains tax
The Best Part? You Don’t Have To Do Anything
As a passive investor, the depreciation and cost segregation tax advantages are already done for you by the professionals that the syndicator of the apartment communities hire. In this sense, being a passive investor has its perks. The only thing you have to do is get your K-1 from your apartment syndicator and hand it over to your accountant to take it from there. It doesn’t get any more simple than that.