Investing in multifamily properties can provide attractive returns, but also comes with tax implications. However, there are ways for investors to maximize after-tax returns through tax benefits. Depreciation allowances mean investors can deduct a portion of property value from taxable income each year. Cost segregation can accelerate depreciation in the early years. 1031 exchanges allow deferring capital gains taxes when selling a property and reinvesting proceeds. Understanding how to fully utilize these tax benefits is crucial for optimizing returns.
Depreciation results in paper losses that lower taxable income
One of the biggest tax benefits of multifamily investing is depreciation. As buildings age, their value decays or depreciates over time. The IRS allows investors to deduct a portion of the property’s value from taxable income each year to account for this depreciation. For residential buildings, this depreciation allowance is 27.5 years. Even though the property may be gaining value in the real world, on paper it is losing value, resulting in tax deductions. This can generate substantial ‘paper losses’ for tax purposes that lower an investor’s tax bill. For example, a $10 million apartment building would generate roughly $360,000 in depreciation deductions each year, assuming a 27.5 year depreciation schedule.
Cost segregation can accelerate depreciation deductions
Depreciation deductions can be accelerated using cost segregation, which is dividing the property into components with varying useful lives. Components like appliances, fixtures and common areas are given shorter depreciation schedules by the IRS, such as 5 or 15 years. By allocating purchase price into these components, investors can maximize depreciation in the early years of ownership. Accelerated depreciation results in larger deductions, increasing ‘paper losses’, and deferring taxes. A cost segregation study is required, but often provides a positive ROI through increased depreciation and tax savings.
1031 exchanges allow deferring capital gains taxes
Capital gains taxes can be deferred by utilizing a 1031 exchange when selling a multifamily investment property. Section 1031 of the IRS code allows proceeds from selling a property to be reinvested in a similar ‘like-kind’ property while deferring capital gains taxes. Taxes are deferred rather than avoided, as the cost basis is transferred to the new property. When that property is eventually sold without a 1031 exchange, accumulated deferred capital gains become taxable. Still, 1031 exchanges are popular as they allow gains to compound tax-free for years. This generates higher after-tax returns. Rules require identifying a new property within 45 days and closing within 180 days of selling the old property.
Utilizing depreciation allowances, cost segregation, and 1031 exchanges can provide substantial tax benefits for multifamily investors. Understanding these strategies allows maximizing after-tax returns.