Tax Advantages of Apartment Investing

It’s tax season. Hopefully, you’re not completely shocked by your tax bill this year. Likely, you’re looking at the dollar amount on your 1040 and thinking about all the things you can do with that money. Did you know that passively investing in apartments can drastically reduce the amount of taxes you pay?

To illustrate how this works, it may be helpful to briefly discuss how your income is categorized and taxed, and then we'll dive in to how passively investing in real estate can help you reduce your tax bill. Of course, if you're interested in taking advantage of these tax savings while still earning a solid return, you can schedule a call with us at any time on our website.

Types of income

The Internal Revenue Service (IRS) lumps income into three categories, and each category has different rules on how income is treated and taxed.

Active income

Active includes all income that you earn from direct involvement. W2 income falls in this category. If you are a freelancer and receive 1099 income, that is also active. If you are self-employed or a small business owner and actively participate in running the business, it’s most likely that you receive active income. Active income is the least tax-friendly of the three and is taxed on a graduate income tax schedule, and those with higher incomes will pay a much higher rate, up to 37% in 2021. Single person earning over $85,500 will fall into the 22% income tax bracket and will contribute over $1 of every $5 earned to Uncle Sam. High income earners are donating $1 of every $2.70.

Portfolio income

Portfolio income includes income received from stocks, bonds, mutual funds, exchange traded funds, and other investments that are not considered passive. Portfolio income from assets held less than one year are considered short-term capital gains and are taxes with active income at a rate up to 37%... Long term capital gains in 2020 are either taxed at 0%, 15% or 20%. If your single with an adjusted gross income of less than $40k, or married with less than $80k, your long term capital gains are NOT taxed. A person or married couple earning more than that and up to roughly a $500k income will pay only 15% on their long-term capital gains. The highest income earners still will only pay 20% of their long-term capital gains as taxes, which is far less than they would for their active income. In its tax treatment, long-term capital gains are preferable to active income.

Passive income

Passive income is income received from rents or royalties in a property or business in which there was no material participation. Income from investing as a limited partner, silent partner, or passive investor in a business or property all fall into this category. Passive income is taxed at the active income tax rate, which by itself is not very beneficial, but there is one HUGE advantage to passive income when real estate is involved – and that’s depreciation.

Depreciation

Depreciation is the reduction in value of an asset due to the passage of time. Conceptually, to illustrate what depreciation is, imagine you buy a new car and pay $20,000. A year from now, even if you don’t drive it, the car will naturally lose value and may only be worth $18,000. In this case, you’ve essentially lost $2,000 due to depreciation. If the purchase of the car was for a business and not personal use, the IRS will allow you to count depreciation as an expense or a LOSS on your taxes.

Depreciation works the same with real estate, but with one huge advantage. It doesn’t matter how old a property is when you buy it, the IRS will consider the property as brand new on the day of purchase, and depending on the property type, will allow you to count the property's depreciated value as an expense on your tax return.

What does this mean? Well, even though the actual value of the property is INCREASING due to inflationary pressures, and even though you actually make money with a passive investment, you can still legally report a LOSS on your tax return every single year. As a passive investor, the depreciation expense and potential losses are passed on to you according to your ownership percentage in the property.

But wait, it gets better. Residential and multifamily real estate can be depreciated over a 27.5 year period, meaning 3.6% of the property's value (minus land) can be used as an expense, but there's much more than bricks and mortar in an apartment complex and different assets are depreciated over different timelines. For example, computers and other office equipment are depreciated over 5 years (or 20% of their value per year), furniture and fixtures over 7 years, and land improvements over 15 years. If a property owner conducts a cost segregation study, they essentially are lumping every single item on the property into either the 5-, 7-, or 15-year bins which will allow for a much higher overall depreciation rate in the first several years of ownership. Additionally, tools like accelerated and bonus depreciation can add significant losses to the first few years of ownership.

That means each year, even if the rental property is producing cash flow, the depreciable losses will...

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If you're interested in taking advantage of these tax savings while still earning a solid return, you can schedule a call with us at any time.