Investing in multifamily property offers a wide variety of advantages for sophisticated investors. Leverage, cash flow, appreciation, equity growth, and, often overlooked, tax savings are all financial features of a sound multifamily real estate investment.
Benefits of Investing in Multifamily Property
Most investors are quick to get their heads around the benefits of cash flow as a multifamily investment strategy. Rents less expenses, debt service, and capital improvements typically leave an investor with a healthy return on investment simply looking at it from a cash flow perspective. Add the appreciation of the asset over time, the equity growth that will likely occur on the sale of the investment, and multifamily real estate investing can produce returns that outpaces comparable asset classes.
But when you begin to consider the tax benefits of investing in multifamily properties, you can get really excited about this category.
What are the Tax Benefits of Investing in Multifamily Property?
The IRS allows investors to deduct interest on a mortgage against the property along with the deprecation of the improvements (the value of the buildings, but not the land). It is quite possible for an investor to realize significant cash flow from their investment but achieve a tax “loss” as a result of the deduction of these two expenses. What makes multifamily properties unique is that the IRS allows the improvement for residential properties to be depreciated over 27.5 years, whereas, most other types of income producing real estate (office, industrial, etc.) are depreciated over 35 years. This acceleration of depreciation creates more losses for investors that can offset real cash flow income.
But there are even more benefits! The IRS code actually goes further and allows investors to depreciate different components of the building under even shorter timelines. For example, roofs, windows, parking lots, etc. all have shorter depreciation timelines than the standard 27.5 years. A qualified third party can produce a “cost segregation” report that will identify each of the building components and apply the appropriate depreciation schedule that shortens the depreciation timeline. In some cases, components of the building can be appreciated over as short as a ten-year timeframe.
How Can Multifamily Tax Benefits be Leveraged?
For investors with other passive investments, it is not uncommon to be able to use the losses from a multifamily investment to offset other gains.
As compelling as the deduction of mortgage interest and depreciation are to an investor, perhaps the greatest tax advantage of direct investments in multifamily real estate is the 1031 exchange. Under section 1031 of the IRS Code, investors can defer most, or all, of their capital gain tax on a commercial real estate investment if they “exchange” the property for another one that meets the following criteria:
- The acquired property must be equal to or greater in value than the property sold.
- The acquired property must be used for productive business purposes.
- Both properties have to be “like kind”.
Most investors will use a qualified “exchange facilitator” to ensure that a 1031 exchange meets all the necessary requirements, but if you are successful in completing a qualified exchange, you can protect significant equity that has the opportunity to gain a return on the series of investments before, ultimately, being subject to taxes.
We strongly encourage you to speak with your tax and legal advisors when considering real estate investments, but whether you want to ‘go it alone’ and create your own real estate portfolio, or partner with other investors and managers, you have a great opportunity to grow your wealth through cash flow and asset appreciation in a highly tax-advantaged manner through real estate investments.