From the potential for passive income to the profit after a sale, there are so many benefits to investing in multifamily real estate that it can be hard to pick a favorite.
The potential tax benefits may be just that.
Multifamily real estate can help investors reduce their taxable income through the power of depreciation. Depreciation is nuanced, so read this comprehensive guide to understand better what it is and how multifamily real estate can benefit you.
What does depreciation in multifamily real estate mean?
In the context of multifamily real estate, depreciation refers to the allocation of the cost of a property over its estimated useful life. In other words, it’s a way to account for the wear and tear a property undergoes over time.
From a tax perspective, depreciation is a significant advantage for real estate investors. Each year, a portion of the property’s value can be written off as an expense against rental income, thereby reducing the amount of taxable income an investor reports.
This doesn’t mean the property is losing market value. It’s an accounting method allowed by the IRS and allows a property to be depreciated over a 27.5-year lifespan using a straight-line method. The value (excluding land) is divided evenly over 27.5 years, providing an annual deduction amount, allowing investors to mitigate taxes as the property value increases.
What are the types of depreciation in real estate?
We mentioned straight-line depreciation above, but that is not the only form of depreciation. Here are a few standard terms that you can expect to hear when evaluating multifamily investment opportunities:
- Straight-Line Depreciation: This is the most common method used in real estate, especially for residential properties. The total depreciable cost (property value minus land value) is divided evenly over the asset’s useful life. For multifamily properties, this lifespan is typically 27.5 years.
- Accelerated Depreciation: As the name suggests, accelerated depreciation allows for larger deductions in the earlier years of an asset’s life. The Modified Accelerated Cost Recovery System (MACRS) is a form of this, offering a declining balance method that front-loads the deductions.
- Cost Segregation: Though not a depreciation method, cost segregation is a strategic tax planning tool that allows real estate owners to accelerate depreciation on certain property components. By segregating a property into its parts (like electrical systems, carpets, or landscaping), investors can depreciate these elements over shorter lives, leading to more significant deductions in the earlier years.
This is good in theory, but what does it mean in practice? Next, we will explore the tax benefits that come with depreciation.
Why depreciation matters for taxable income
As mentioned above, depreciation affords investors many potential tax advantages that can help offset or reduce their tax burden.
Here is a rundown of the top tax benefits that come with multifamily depreciation:
- Tax Sheltering: At its core, depreciation serves as a non-cash expense. So, while the property may produce positive cash flow on paper, the investor might report a loss or reduced profit due to depreciation. This phenomenon effectively shelters rental income from taxes, allowing investors to retain more earnings.
- Offsetting Rental Income: Multifamily properties can generate rental income for investors. Depreciation allows offsetting a portion of this income, reducing the overall tax burden. For instance, if an investor receives $50,000 in rental income but has a depreciation expense of $20,000, they’ll only be taxed on the net amount of $30,000.
- Flexibility in Investment Strategy: Understanding and leveraging depreciation can aid investors in crafting a tax strategy that aligns with their overall investment goals. Whether aiming for immediate tax savings through accelerated methods or preferring consistent annual deductions with the straight-line approach, investors can tailor their tax strategy based on their financial outlook and needs.
- Capital Gains Consideration: When a property is sold, depreciation plays a role in determining the taxable amount on the capital gains. The total amount of depreciation taken during the ownership period reduces the property’s cost basis. While this can increase the capital gains tax when selling, the immediate benefits of annual tax reductions can outweigh the eventual tax on the gain, especially when considering the time value of money.
These benefits are fantastic in their own right. However, with cost segregation, you can reap even more tax benefits from a multifamily investment. We will go in-depth on that next.
What is cost segregation in multifamily depreciation?
Cost segregation is an advantageous tax strategy available to real estate investors.
Cost segregation involves categorizing a property into its components and classifying them based on their respective depreciable lifespans. This reclassification primarily distinguishes between personal property assets, land improvements, and real property.
When conducting a cost segregation study, specific components of a property, like carpeting, specialized kitchen equipment, or specific electrical installations, can be identified as tangible personal property. These components usually have shorter depreciable life spans of 5 or 7 years, as opposed to the standard 27.5 or 39 years for real property. Similarly, landscaping, parking lots, or fencing are considered land improvements and depreciated over 15 years.
The main advantage of this strategy is the acceleration of depreciation deductions. By front-loading these deductions into the earlier years of property ownership, investors can significantly reduce current income tax liabilities, thereby improving cash flow and potential return on investment.
Ready to reap the tax benefits of investing in multifamily real estate?
Ready to leverage the tax benefits that depreciation offers? Take the first step to discuss your options with our team. At Colony Hills Capital, we specialize in purchasing value-add multifamily real estate properties, allowing our investors to benefit from passive income and the appreciation of each property when sold. Past performance is no guarantee of future results. Contact us today to learn more.
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