For real estate investors, tax season is the time of year when they benefit from a variety of deductions and losses against their income. By being strategic about taxes, investors can potentially pay little to no tax, or even receive a refund.
Investors who are informed and knowledgeable about real estate investing and the tax laws can save themselves a significant amount of money by garnering these deductions. However, it’s important to consult with a tax professional to ensure that you are obtaining the appropriate deductions.
Amongst real estate investors, it is well known that real estate offers I.D.E.A.L. investments (income, depreciation, equity build up, appreciation, and leverage). When it comes to depreciation, many people think of it as a way to lower their taxes. And while that is one benefit, there are other factors to also consider, including cost segregation study.
What is Cost Segregation?
Cost segregation is the process of identifying and classifying components.
When it comes to depreciation, residential and commercial real estate follow different rules. Residential property can be depreciated over 27.5 years, while commercial real estate must be depreciated over 39 years. Apartments are considered both commercial and residential, so the depreciation period will depend. For the purpose of this article, we will consider apartments to be commercial properties. While real estate typically appreciates in value, we can depreciate the asset as a paper loss due to the wear and tear on the property over time.
By default, approximately 80% of the property value is depreciable. This is because land is not depreciable and is typically considered 20% of the property value. However, with a cost segregation study, an expert team of engineers and tax professionals can change the property into various components, modifying their classification from real property to personal property. Depending on how the personal property is classified, the depreciation schedule becomes accelerated into 5-, 7-, 10-, 15-, or 20-year allocations. And with bonus depreciation, we can obtain 100% of the personal property depreciation in year 1 The bonus depreciation opportunity is phasing out after 2022. So it’s definitely worth considering if you want to maximize your deductions. Legislation passed in 2017 has improved tax benefits for passive investors in recent years. Now, the IRS rewards real estate investors by significantly lowering one’s tax bill via bonus depreciation.
Many people only contemplate their taxes at one period within a year…Generally, that may be when they compile their receipts, invoices, paperwork, etc. for their accountant…Or it might be when one purchases the latest version of TurboTax, with anticipation of obtaining some kind of a refund from the IRS. Then, there’s a few people who truly plan for taxes throughout the year so to expand and safeguard their wealth.
Many investors find real estate to be an attractive investment option because of the potential tax deductions. If you’re thinking about investing in real estate, consult with a qualified tax advisor to learn more about the potential tax benefits that may be available to you. With the right planning, investing in real estate can be a great way to boost your financial returns on your investments.
Limited partners (LP), also known as passive investors, in an apartment syndication can expect to receive a share of the profit based on how much you invest. Additionally, investors receive a share of the tax benefits, via a Schedule K-1 document each year, based on the amount you invest. This IRS document, the Schedule K-1, will show one’s income and losses for that particular asset, primarily in the first year of owning the asset. It is important to note that the K-1 may include accelerated and Bonus Depreciation, which can offset any negative numbers. Ultimately, the K-1 provides valuable information for tax purposes and should be reviewed carefully.
While you’re receiving cash flow distributions periodically, the K-1 form can show a significant paper loss. The advantage of this means you can defer or reduce taxes owed on the cash flow you received and the proceeds from the sale.
For example, lets say you invested $50K on a particular deal, and the K-1 paper loss you receive back is $41.5K, which means, the government is investing right alongside you and I, and we are essentially investing in the deal for $8.5K, and the government contributed the $41.5K, yet we’re benefiting seemingly like we invested all the $50K initially.
Legislation was passed in 2017 to reward passive investors with bonus depreciation.
Prior to the new legislation, the bonus depreciation amount was allowed for qualified properties (acquired during a particular tax year) and the bonus depreciation / savings was much lower (i.e. 30-50% of the asset). After the legislation passed, it permitted investors to garner 100% Bonus Depreciation on certain types of fixed assets, including the commercial real estate assets we invest in. The actual dates to benefit from the 100% Bonus Depreciation are for properties acquired and operations starting between September 27, 2017, and before January 1, 2023. After that date, bonus depreciation will phase out. (i.e. year 2023 – 80%, year 2024 – 70%, year 2023 – 60%, etc.)
Tax Benefits 101
Let’s start with an overview of the tax advantages of investing passively into an apartment syndication, as they currently stand. If you’re already a seasoned passive investor and could recite all the advantages by heart with us, feel free to skip ahead.
The first thing you should know is that, as a passive investor, even though you’re not doing the work of fixing toilets, finding tenants, or dealing with trash, you still get the same tax benefits, which flow through the syndication entity (usually an LLC), straight to you as the investor.
Commercial Break: 50% vs. 100% Bonus Depreciation
Alright alright, we’re talking a lot about BDE– Bonus Depreciation energy– but it’s easier to explain through an example. So let’s walk through a quick scenario so you can better understand the full impact of increased Bonus Depreciation.
Let’s say we buy a commercial multifamily property before the end of 2022, for $33,000,000.
I like it– let’s manifest that! If we take the straight-line approach to depreciation, that means we can depreciate the cost of the building in equal portions, like a straight line, over 27.5 years, which is the depreciation schedule for commercial properties.
However, through the power of cost segregation, we can show that certain elements within the property such as the flooring, light fixtures, etc., can be depreciated over a shorter lifespan. Let’s say those additional elements qualify for accelerated depreciation come out to 25% of the cost of the asset, or $17,750,000.
This is where 100% Bonus Depreciation comes in. This means that 100% of the full $17,750,000 amount in this example can be deducted in that same tax year when the property is acquired and placed in service. The remaining $53.25 million would then be deducted in smaller increments over the life of the asset.
Now, all our cost segregation has been conducted by the 3rd party engineer firm, and for this particular example, the estimated bonus depreciation came back at 80%, meaning, that if you were to invest $100,000 into this apartment syndication, then you would receive a K-1 showing a paper loss of roughly $80,000, given the current allowance of 100% bonus depreciation.
Okay so let’s compare this same example at 50% Bonus Depreciation. Your investment is still $100,000. If that bonus depreciation were to drop to 50%, then the paper loss you’d see would only be around $50,000.
This is particularly relevant if you have significant passive active income (from real estate investments, businesses, or otherwise), and/or you qualify for REPS (real estate professional status), in which case your passive losses could apply to other types of income as well.
Again, everyone’s tax situation is different as well as their assets. So check with your CPA to see if this could work for you too!
But regardless of the exact implications for your tax bracket or tax situation, the point stands that greater depreciation now or in the near term is generally better and more desirable.
Why? Because of the time advantage and opportunity cost. If you can pay less in taxes now– even if that depreciation is recaptured later, upon the sale of the asset– that gives you additional time to invest and grow the money you would have otherwise paid toward your tax bill.
Are you getting this whole hype around bonus depreciation? This is why it’s imperative that you take advantage of the 100% bonus depreciation while it’s still available. This brings us to our next topic – the phasing out of TCJA in the coming years and what that means for you.
The Phasing Out of 100% Bonus Depreciation
Much like the Chaco Taco, as we know all good things must come to an end. So it must be true with Bonus Depreciation.
Sigh. I am not looking forward to this so we’ll give it to you straight. As of the time this recording is being written, we are in the last calendar year, 2022, in which you will be able to take advantage of the 100% Bonus Depreciation benefit as laid out by the Tax Cuts and Jobs Act.
Here’s a breakdown of the schedule
- 2018 to 2022 – 100% bonus depreciation
- 2023 – 80% bonus depreciation
- 2024 – 60% bonus depreciation
- 2025 – 40% bonus depreciation
- 2026 – 20% bonus depreciation
In other words, for apartment syndication investments you make by December 31, 2022, those investments are still eligible for that 100% bonus depreciation.
Keep in mind though, that if you make an investment on December 31, 2022, but the deal doesn’t actually close until January 2023, then that investment would fall under the 80% bonus depreciation guidelines for 2023.
Thus, it’s risky to continue to wait for investment opportunities that may or may not come later this year, particularly if they don’t close by the end of this calendar year.
What this gradual phasing out means for you as an investor is that with each passing year, as the bonus depreciation continues to decline, your tax bill may climb with it which means you need to take advantage of this time sooner than later.
On top of that, President Biden’s proposed Tax Act, had it passed, could eliminate some benefits of the depreciation altogether, and potentially much sooner than 2026. All the more reason to invest now.
Let’s play this out further and see what the implications would be in each subsequent year, assuming we’re talking about the same asset with the same cost segregation slash depreciation potential.
- 2022 – 100% bonus depreciation = $80,000 paper loss (in this example)
- 2023 – 80% bonus depreciation = $64,000 paper loss
- 2024 – 60% bonus depreciation = $48,000 paper loss
- 2025 – 40% bonus depreciation = $32,000 paper loss
- 2026 – 20% bonus depreciation = $16,000 paper loss
A huuuge jump from the original 100% you had a mere 4 years ago.
So, where does this leave you, passive investor? It means you need to act now. This is a matter of urgency because we can hear the time clock behind us and it’s catching up fast. If you act now you can benefit from the 100% depreciation as it still stands when you close this year versus waiting another 2-3 years.
If your tax situation is structured in a way that you could apply those passive losses to other streams of passive (or even active) income, that decline in bonus depreciation would mean a substantial shift to your overall tax picture.
And even if you are only able to apply those passive losses to your passive income in that asset directly, that lower bonus depreciation means you’ll have less depreciation to carry forward into subsequent years, meaning your overall tax liability could be higher.
If you’re interested in learning more about this topic, click here.
If you are interested in potential tax savings and future investment opportunities, click here.
By Kelsie Mans-Ray
KMR Multifamily Acquisitions / Syndicator
NOTE: This information is of a general, educational nature and may not be construed as tax, financial, or legal advice pertaining to a specific offering, exemption or situation.
