Rod Khleif Real Estate Investor, Mentor, Coach, Host, Lifetime Cash Flow Through Real Estate Podcast. www.RodKhleif.com
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When modeling the potential profitability of a multifamily investment, there is a common tendency to focus only on the return generated by a property’s cash flow as measured by metrics such as internal rate of return or cash-on-cash return. This isn’t necessarily wrong, but it doesn’t tell the whole story. It ignores the tax benefits associated with a multifamily investment, which can be a major component of total returns.
Multifamily owner/operators who proactively manage their potential tax liability may be more likely to realize higher returns than those who don’t. I encourage up-and-coming investors to utilize three specific strategies.
Depreciation
The physical structure of a multifamily property consists of a complex network of mechanical systems including electrical, plumbing, air handling and roofing. These systems are expensive and have a long useful life. But their physical condition deteriorates over time with exposure to the elements.
Depreciation is an accounting concept that allows the property owner to “expense” a portion of the physical structure’s value each year to account for its deterioration. This expense appears on the income statement and serves to reduce the property’s net operating income, which reduces the tax liability in turn.
Depreciation is what is called a noncash expense, meaning that it reduces income but does not reduce the amount of cash available for distribution. The more depreciation that can be taken in a given year, the larger the potential tax benefit.
Cost Segregation
IRS accounting rules govern how much depreciation can be taken in a given year and dictate that a multifamily property can be depreciated in a “straight line” over 27.5 years. For example, a property worth $1 million could take $36,363 ($1,000,000/27.5) in depreciation per year. However, an advanced technique known as cost segregation can potentially accelerate this amount.
A cost segregation analysis is a study conducted by an expert consultant or engineer that seeks to perform a top-to-bottom inspection of the property and separate the physical assets into four categories: personal property, land improvements, buildings/structures and land. Based on the classification, the depreciation can be accelerated by taking it over a shorter period of time. For example, personal property can be depreciated over five or seven years, while improvements such as sidewalks or paving could be depreciated over 15 years. The net result is that the allowable depreciation in a given year can be greatly increased, resulting in additional tax savings.
The exact math can be complicated and should be left to the qualified experts, but the larger point is this: Performing a cost segregation analysis and accelerating the allowable depreciation on the appropriate assets can lead to major tax savings, particularly because the typical multifamily investment holding period is five to 10 years. I encourage investors to perform a cost segregation analysis when appropriate because it can be a significant contributor to their investment returns.
Depreciation and cost segregation are tax mitigation techniques that can be used during the ownership period, but there is another technique that can be used upon sale that can potentially defer capital gains taxes indefinitely. It is called a 1031 exchange.
1031 Exchange
Successful property owners face a common challenge: a big tax bill upon sale. The difference between a property’s cost basis and the sale price is known as a capital gain, and it can be taxed at a rate between 15% and 28%.
Section 1031 of the Internal Revenue Code allows a property owner to defer capital gains taxes on a profitable sale by reinvesting the proceeds into another property of “like kind,” and there is no limit to how many times it can be done. In theory, there could be a successive series of exchanges that defer capital gains taxes indefinitely, which allows an investor’s income to grow tax-free over a long period of time.
Like the cost segregation study, the rules of a 1031 exchange can be complicated, but there are several key points to remember:
• The new property must be “of the same nature or character” as the old one.
• The new property must be “identified” within 45 days of the close of the sale, and the purchase transaction must be completed within 180 days of the sale.
• The amount of money invested into the new property must be the same as the sale proceeds from the old property. If there is a difference, it is known as “boot,” and it becomes taxable.
• The new property and the old property must be titled similarly.
Any errors in the transaction or violations of the rules can cause the transaction to become taxable. So, it is important to work with an experienced professional, known as a qualified intermediary, to ensure that everything runs smoothly.
Summary And Conclusions
Smart investors think beyond just the traditional, cash flow-driven metrics such as internal rate of return or cash-on-cash return. While these are important measures of an investment’s return, they don’t always tell the whole story. Proactively managing an investment’s tax liability by maximizing depreciation through cost segregation and deferring capital gains taxes through 1031 exchanges can magnify returns and allow profits to grow tax-free over time.
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