We often see headlines touting the “Top Ten Tax Benefits of Investing in Real Estate”, and while technically true, these articles tend to be misleading because they include tax benefits available to all businesses. For example, any business is typically able to deduct business expenses from taxable income. While real estate investors can deduct plumbing expenses, so can a dental office. Thus, these broadly available benefits do nothing to help you understand the relative benefits between asset classes.
Other commonly advertised benefits include mortgage interest, Qualified Business Income, general operating expenses, capital gains tax rates, and capital expenditures. The problem is that interest on debt (mortgage or otherwise) is a typical business expense, capital gains tax rates are available to stockholders as well, Qualified Business Income requires active participation, and capital expenditures usually only increase depreciation expense (though there are exceptions mentioned below).
Actual Tax Distinctions
Arlast Capital is a multifamily investment firm, so we will focus on this specific niche within real estate. Multifamily investments do benefit from tax advantages not available to other assets. Some of these advantages exist within other classes of real estate, but often with different rules. With that said, we now move to reviewing the important and distinctive tax advantages of multifamily real estate.
1. Depreciation
Multifamily assets benefit from favorable, and perhaps even generous, depreciation treatment. First, basic straight-line depreciation occurs over 27.5 years for residential property. This means each year roughly 3.6% of the value of the improvements (not land) is deducted. Of course, it is unlikely the value of the property declines by 3.6% each year, so this is a “paper shield” that can be used against rental income to lower taxable income.
Second, the 2017 Tax and Jobs Act modified rules for bonus depreciation, which allows for writing off up to 100% of eligible property in the first year. Performing a cost segmentation allows operators to accelerate depreciation for landscaping, appliances, technology, fixtures, and other items with shorter lifespans.
Third, depreciation is usually ultimately recaptured when the property is sold because as stated previously, the property does not actually decline in value. However, the Depreciation Recapture Tax rate is limited to a maximum of 25%. Thus, it is possible to have deducted the depreciation against a rate of 37%, defer the recapture for years, and eventually pay at a lower rate of 25% or less.
Not all multifamily operators take advantage of depreciation advantages in full because it requires complex accounting that maintains different cost bases and depreciation expenses across the business.
2. Passive Income Offset
While it is possible for passive losses to exist in other businesses, it is much more common in real estate due to the depreciation discussed above. Due to the heavy depreciation, especially in early years, the investment generates “paper losses” that can be used to offset passive gains from other investments. For those invested in multiple properties, this can be useful to offset gains from rental income elsewhere.
Note that this income cannot be used to offset nonpassive income, such as salary, interest, dividends, or capital gains from stock sales unless you qualify as a real estate professional (which generally requires ~15 hours per week of active participation in real property businesses).
3. 1031 Exchanges
While more difficult to execute than most articles mention, it is nevertheless a powerful tax advantage specific to real estate. Section 1031 of the Internal Revenue Code allows capital gains taxes to be deferred as long as the proceeds from a sale are exchanged into a like-kind property. There are no limits on the number of exchanges one can perform, so it is possible to grow an investment tax-deferred forever. When combined with favorable tax treatment for capital gains, which is as low as 0% in 2024, or the tax basis step-up for inherited property, it is in fact possible to legally avoid taxes entirely.
All that said, there are very specific rules that must be followed, making it critical to plan 1031 transactions in advance with a qualified tax professional.
4. Tax Credits
Finally, there are multifamily-specific tax credits such as low-income housing and real estate-specific Opportunity Zones or energy efficiency programs. While too numerous (and state-specific or municipality-specific) to list all possibilities, we will cover the most common.
Affordable housing programs provide incentives to real estate operators for maintaining affordable rents (determined as a percentage of area income) for a portion of units. These incentives can be provided as property tax abatements, below-market loans, participating or non-participating equity, or other financial incentives.
Opportunity Zones were created by the Tax Cuts and Jobs Act of 2017 and allowed investors to defer capital gains and avoid depreciation recapture if invested in an eligible census tract, which were generally low-income. Portions of the program have phased out, but this remains the only way to defer capital gains outside of 1031 exchanges.
Energy efficiency incentives can provide tax credits or subsidized funding for capital improvements to property water and energy systems that allow for the replacement of outdated lighting, HVAC, toilets, and wastewater treatment, among other items.
Summary
Not all multifamily operators take advantage of the full breadth of tax programs available. Arlast Capital employs the most aggressive tax strategies available within the law to increase returns and our asset managers review every possible source of benefit, including federal, state, county, city, and special district funding sources.
Arlast Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisors.
