More often than not, many people are not interested in getting to know the basics of tax or tax benefits or how it works! This might not be surprising (given the complex stuffs involved in the tax sector). However, the recent rise in the percentage of passive investors call for a need to understand some things (if not much) on topics such as tax benefits. This would make you a distinct and discreet passive investor. It gives an edge in making decisions on investment plans plans presented from time to time. Investment is serious business. It is not wise enough to dabble into such without having adequate knowledge of some basic concepts which would have made a lot of difference in the outcomes of investment. This is why this article was written. This article aims to shed some light on cogent basics of tax benefits.
It must be noted this article does not claim to function as a substitute for a tax advisory system. It is advised that all general tax-related estate questions be referred to accountants as necessary. Also, the projections included in this article do not include any tax advantages such as: debt write off and lass due to depreciation amongst others.
Let’s get started
An attractive feature of the real estate investment lies in the fact that a lot of mouth-watering tax benefits are inherent in the business. These benefits significantly reduce tax bills (sometimes to zero value, as claimed by some investors).
Here are some terms you need to get familiar with:
What is a Capital gain?
Capital gains impact taxable incomes of real estate investors. It is therefore important to gain an understanding of the concept. It is such that the excess realized in terms of gains after a property has been sold for a higher price than it was bought and the gains from the sale distributed to passive investors. This is classified by the IRS as ‘long-term capital gains’. Find below an excerpt of the new tax laws for the year 2019:
|Long-Term Capital Gains Tax Rate
|Single Filers (taxable income)
|Married Filing Jointly
|Heads of Household
|Married Filing Separately
The Use of Depreciation to Lower Taxable Income
The term ‘depreciation’ definitely rings a lot of bells. We are familiar with it. Simply put, depreciation is the amount which is deducted from an income every year as the depreciable items of the multifamily property ages. Depreciable items are classified by the IRS according to the ‘useful life’ of such property. Usually, investors deduct the full cost of the item over the period period of usefulness of the article. Take for instance, in accordance with the IRS, the useful life of real estate is about 27.5 years. Using the straight line depreciation rule, one would deduct equal amounts as depreciation over the course of a year. E.g if an apartment is valued at $5,000,000 is $5,000,000 divided by 27.5 years, or $181,818 per year. Instead of paying tax for, say, $300,000 from the property’s income, investors will pay only $300,000- $181,818 or $118,181.
Usually, when one invests in a syndication, a professional rate and share of the depreciation is accrued. This can be deducted against one’s income from the property as well as other sources of income!
The Concept of Cost Segregation
In casual terms, this concept is referred to by some individuals as ‘depreciation on steroids’. Cost segregation is a strategic tax planning tool which allows investors to increase their cash flow by speeding up depreciation deductions and deferring income taxes.
How it works
Real estate sponsors get engineering reports which enables the classification of property into four major categories:
- Land improvements
- Personal property
- Building component
A very important value of cost segregation is worth of front-loaded depreciation deductions alongside write-offs of certain building components which might need some replacements.
The concept of cost segregation has been proven to increase savings by collapsing the total time of deductions into manageable segments. Usually, cost segregation studies cost within a range of $5,000 to $10,000 depending on the size of the property in question. The concept of cost segregation is applicable to virtually all deals.
Use the 1031 Exchange to Defer Capital Gain Tax
Given the fact that 1031 exchange is yet to enjoy the widespread understanding its counterpart enjoy today, the exchange term is fast spreading like wildfire! This is particularly notable among real estate investors. Basically, 1031 exchange is one which involves a swap of one investment property for another, thereby making room for the deference of tax on capital gains from the sale of a property. It remains unarguable that the profits from property sales are taxable as capital gains in most cases, when the IRS requirement is met in terms of the 1031 exchange, one would be able to defer such a tax. Thus, one can change the type of investment without such move being considered as a ‘cashing out’ move on capital gain. This move is important in the sense that, it allows investments to continue growing tax which has been deferred. This is independent on the number of times one has gone through the 1031 exchange. Rather, the gain is rolled over from one real estate investment to other investments over and over again. Thus, having a profit with each property does not oblige one to pay tax until the property is sold years have the investment was established. In the 1031 exchange term, the only requirement is as follows: the replacement property on the 1031 exchange must be identified within 45 days of sale. Also, the property must have been closed within 180 days of the sale of such a property.
The Concept of Depreciation Recapture
To get a full grasp of this concept, three basic terms must be learnt. The terms are as follows:
- The Original Cost Basis: Refers to the price which must be paid in order to purchase the property
- The Adjusted Cost Basis: Refers to the difference obtained when Depreciation cost is subtracted from Original Cost Basis
- The Realized Gains: Refers to the event of selling properties at a higher price than the original price of purchase.
The concept of depreciation recapture is assessed when the price of purchasing a property exceeds the Adjusted Cost Basis and Original Cost Basis.
Basically, the difference between the costs highlighted above is recaptured when they are reported as income, which in turn is reported as capital gain. The capital gain when the property is sold is further reduced when the adjusted cost basis, improvement costs and the costs of major renovation is added. The above can be illustrated as follows:
An apartment was purchased for $5,000,000 and its annual depreciation is $181,818
After 5 years, the property is sold for $6,000,000
The Adjusted Cost Basis is purchase price minus total depreciation over 5 years, or $5,000,000 – ($181,818 x 5) = $4,090,910.
The Realized Gain on the property’s sale would be sale price minus Adjusted Cost Basis, or $6,000,000 – $4,090,910 = $1,909,090.
Capital gain on the property is Realized Gain minus total depreciation, or $1,909,090 – ($181,818 x 5) = $1,000,000
The depreciation recapture gain is $181,818 x 5 = $909,090
If there is a 20% capital gains tax and that you are in the 28% income tax bracket, the total amount of tax owed on the she sale is 20% capital gain plus 28% on the depreciation recapture, or (0.20 x $1,000,000) + (0.28 x $909,090) = $200,000 + $254,545 = $454,545.
The issues highlighted in this article are of prime importance in passive investing as well as active investing. While a lot of passive investors might despise the need to get a good grounding on these issues, it must be stressed that it is quintessential for successful investing! Having a knowledge of front-loading depreciation helps to further decrease the tax payments accrued during earlier periods of tangible personal property life, thereby making available more cash for investments to meet the operating expenses. Also worthy of note is the fact that the 1031 exchanges make it possible for one to defer tax payments. This points out that, the exchange process involved in the 1031 process must be sought after for understanding, despite its not being popular among most investors (who probably do not know about such benefits accruing from it).
In conclusion, taking time and effort to learn some basics of the tax benefit scheme would go a long way in enhancing one’s ability as an investor to maximize returns on investment. It gives the investor an ability to make informed choices which would result in the best outcomes possible in any investment embarked upon. Rather than spending years of experimenting with hard to find capital and other costs, it is much better to equip oneself with adequate to last a lifetime of successful real estate investment.