Real estate continues to be considered one of the best wealth-creation strategies. The 2010 foreclosure crisis spooked many investors, but the market has since recovered and we’re in the midst of an 8+ year real estate upswing.
The benefits are hard to overlook – especially when it comes to the tax advantages. But be careful – to truly benefit, investors still need access to quality deals.
The right crowdfunding model can give investors diversity in their real estate portfolios by providing access to a wider net of high quality deals.
The challenge is finding a partner that has institutional-quality deals – which generally means a property with strong real estate fundamentals that would capture the attention of large national or international investors, such as insurance companies, private equity firms or real estate investment trusts. These are the types of properties that were previously exclusive to a small network of players and high net worth individuals with the right connections.
Crowdfunding has not only given a new class of investors access to previously exclusive deals, but has given people a repeatable model that was untenable to the average individual investor. For example, crowdfunding can provide exponential growth in returns if investors participate in several deals and continue to do so in the long term.
The Trump Administration’s New Tax Law
The Tax Cuts and Jobs Act (“The New Law”) reduces tax rates for individuals and corporations and includes provisions that provide certain bonus depreciation deductions, which are discussed below.
Under the New Law that is now in effect, individuals and other non-corporate taxpayers that receive certain business income from a partnership, may be able to deduct up to 20 percent of their income from such partnership (subject to income and other limitations).
However, the New Law requires an individual taxpayer to aggregate all of their income or losses earned through all of their pass-through investments (such as real estate crowdfunding partnerships). If the aggregate amount results in a loss, the taxpayer will not be able to offset this ordinary income (w-2 income for example) by such loss. However, now the loss can get carried forward indefinitely and offset future pass-through investment income.
5 Major Tax Benefits
Whether you’re brand new to commercial real estate or a long-time investor, understanding your tax benefits can be complicated. Here, we break down the five major tax benefits that real estate offers:
Under the existing tax code, real estate investors can offset the gains produced by income-generating property through an annual tax deduction known as depreciation. The IRS defines the depreciation deduction as “an annual allowance for the wear and tear, deterioration or obsolescence of the property.”
Residential rental properties are typically depreciated over 27.5 years, which the IRS considers the “useful life” of a residential or multifamily building. However, it is possible to accelerate depreciation even faster through a cost-segregation study.
A cost segregation study separates personal property from land and building improvements, and then assigns a useful “life” to each asset segregated. For instance, personal property (such as furniture, carpets, fixtures and appliances) can be recovered in as little as 5 years. Land improvements (such as sidewalks, paving, fences and landscaping), can be depreciated over a 15-year recovery period. Cost segregation studies are complex but can save thousands of dollars each year, particularly in the first few years of ownership.
Under the New Law, there is an ability for bonus depreciation, which may allow a business to take an immediate first-year deduction of 100 percent of the purchase of eligible business property, including certain commercial property.
In any event, depreciation is a useful tool for reducing income generated on an investment property without any impact to actual cash flow. This is true whether you own the property outright, or indirectly own it through a limited partnership or limited liability company as is common in some crowdfunding investments. In all cases, the depreciation deduction reduces the income generated by the property, and ultimately, reduces the amount of taxes that an investor would have to pay on such income.
- INTEREST EXPENSE.
Often, interest paid on a real estate loan obtained to acquire an investment property is tax deductible. This is an important deduction for real estate investors and can result in significant tax savings. The interest expense deduction is treated similarly to the depreciation deduction discussed above in that it too reduces income generated on an investment property (but also reduces cash flow), and ultimately, can reduce the amount of taxes that an investor would have to pay on such income.
How much can be saved? It depends on your federal tax bracket, but at the highest federal bracket of over 37 percent, you would save 37 cents for every $1 you paid in interest expense.
- NON-TAXABLE DISTRIBUTIONS.
During the time an investor may hold a real estate investment, you may receive cash distributions in excess of the income that is allocated to you. This may occur because cash flow from the property is in excess of taxable income. The cash distributions are not taxable to you.
- LONG TERM CAPITAL GAIN ON EXIT.
Investments – whether in real estate, stocks or otherwise – are typically subject to two forms of taxes: ordinary income tax and capital gains tax.
You pay ordinary income tax rates when the investment generates operating income and capital gains tax rates upon sale of the asset. Depending on your federal tax bracket, ordinary income tax rates can be as high as 37 percent whereas capital gains tax rates top out at 20 percent. It’s obvious why making real estate part of an investment strategy can be advantageous to the savvy investor.
There’s a provision in the tax code that allows real estate investors to defer paying capital gains taxes upon the sale of an investment asset. It’s known as the 1031-exchange This provision allows a real estate investor to sell a real estate asset and reinvest the proceeds into a like-kind investment, another real estate asset, thereby deferring capital gains tax in the process.
By reinvesting the sales proceeds through a 1031-exchange, the capital gains tax will not be due at the time of the sale which allows the investor to acquire a new real property using more of the sale proceeds. This can enable the investor to purchase a more valuable real property with better cash flows Investors who take advantage of these 1031-exchanges in perpetuity can defer paying taxes while building equity along the way. It is important to note that there are extensive rules set forth by the IRS in order to complete a successful 1031-exchange – so weighing the complicated nature of this benefit should be taken into consideration.
There are many ways to invest depending on an investor’s comfort level, risk tolerance and income. Always remember that investors should speak to their tax professionals to discuss which benefits may apply to them. Nonetheless, by finding institutional-quality deals and taking full advantage of available tax benefits, savvy investors can create an incredible wealth-generating cycle for those who invest wisely.