Intro to paper losses like depreciation
Intro to cost segregation
Intro to 100% bonus depreciation
Typical tax benefits from a syndication
It’s the final lesson in our series and it’s possibly the most exciting one! We're kidding obviously, we're just talking about tax benefits. But even though it’s kind of dry, it’s something all of us should know and in the end, it’s one of the biggest reasons to invest in multifamily.
To start, let’s just reiterate something we covered in a past lesson. As a passive investor, you share in all the gains and paper losses of a property. If you own 5% of deal and the deal as a whole has paper losses for the year of $1,000,000, you’ll receive $50,000 of those “losses”. So let’s cover what these losses are and how you might benefit from them.
Before we start, we need to put out a disclaimer. Don’t rely on anything here as tax advice. We're simply introducing some ideas and concepts – not to give you advice or even the full picture. Consult your tax professional to gain a clear understanding of how these concepts might apply to your own situation.
Now that’s out of the way, let’s talk about depreciation. When it comes to residential rental property, no matter what the size, the asset is depreciated over 27 1/2 years. It’s a pretty odd number, but this just means that every year, in the eyes of the government, the value of an asset decreases by 1/27.5th every single year. We’re not actually realizing this decrease from a property value standpoint, but the IRS requires you to take depreciation as a loss when reporting taxes. Because this is loss isn’t actually affecting our income for the year that it’s realized, this is called a paper loss. The only place you see the loss is on paper.
Now, the great thing about investing in multifamily is that we can take this a step further. We can do what’s called a cost segregation study. Before we jump in, I want to point out that retirement accounts can’t make use of this concept, and can only use the straight line method, where an equal share is taken out over the course of 27 1/2 years.
A cost segregation study is fairly simple. Look around the room you’re sitting in. There are outlets and lights, paint and flooring. All kinds of odds and ends that are part of the property. Well, an outlet isn’t a residential rental property, right? It’s just an outlet! So what is it considered? Well it’s considered personal property and personal property depreciates at a different rate. In fact, this category depreciates over three different rates - 5, 7 and 15 years.
What a cost segregation study does is identify every single item in a building. Each item goes into one of those three buckets. The 5 year bucket, the 7 year bucket, and the 15 year bucket. Then we take the value of each of those buckets and depreciate the total over the course of its corresponding number of years. This means that more depreciation is taken at a much faster rate. If we have $1,000,000 worth of 5 year personal property at our property, we would see $200,000 of paper loses each year just from this bucket alone.
Overall, taking a step back to the whole building, outlets and all…the total depreciation remains the same. We’re just able to front-load a lot of that depreciation into the first few years because of the cost segregation study.
Another incredible feature that multifamily can bring is 100% Bonus Depreciation. Introduced in 2017 as part of the Tax Cut and Jobs Act, Bonus Depreciation allows us to take 100% of the value of eligible assets - things like new air conditioning units or ovens while remodeling kitchens - and receive 100% of the total depreciation in Year 1. So if we buy a $500 washing machine, we can immediately take a $500 deduction.
But we’re not just buying one washing machine…we’re likely buying 100 for all the units at the property. That’s a $50,000 paper loss as soon as we buy the new equipment.
This concept was introduced to help stimulate the economy. It’s slated to begin phasing out at the end of 2022, at which point the bonus begins to drop by 20% every year. 80% bonus depreciation in 2023, 60% in 2024 and so on. Hopefully Congress decides to renew this policy, because we’re big fans!
What does this mean for you as a passive investor? Well the theme here has been high paper losses early on in the life of an investment. This often results in losses of more than 50 cents on the dollar. These losses can be used to offset any income or gains from the property. If you don’t end up using all of your losses or aren't eligible, you can roll them forward to the next year, and the next, often offsetting meaningful portions of your investment returns. And if you’re really strategic, you can pursue real estate professional status. Fair warning, this isn’t really for most. But for those who can achieve this “classification”, whether it’s themselves or a spouse, they can use 100% of these passive paper losses that we just discussed to offset active income, like a W-2 wage! People like real estate agents very often qualify for this classification and it’s the key way that many people in the multifamily industry are able to fully offset their federal income obligations. If you happen to spend nearly all of your time within the real estate world and are curious if you qualify, I’d highly suggest researching it a bit more or asking your CPA.
Want to take advantage of all the incredible tax benefits that multifamily offers?