Real estate has some highly attractive tax advantages.
Tax advantages such as:
Almost any W-2 employee can tell you that they are taxed based on their gross income and that those taxes are taken out prior to receiving their check. Consequently, they pay their expenses with their after-tax net income.
Real estate, similar to business, gets preferred tax treatment.
With real estate, the owners get their gross income and can deduct their expenses including mortgage interest before having to pay taxes on the net income that is left over.
In addition to a better tax framework (business vs. personal), real estate investors are given phantom or paper losses called depreciation that also gets subtracted against the actual income of the property. The theory behind depreciation goes something like this. If you buy a physical asset whether it is a computer for a business or a property as an investment, it only has so much useful life before it will need to be replaced. Therefore the IRS allows you to write off or depreciate that asset over a given period of time.
Currently, for resident occupied real estate (cash flow homes and apartments) that time is 27.5 years and for other commercial real estate (office, retail, etc.) it is 39 years. They will not allow you to depreciate the value of the land, so that must be taken out of the equation before calculating depreciation.
To better understand depreciation, let’s take a look at two examples. The first is a $300,000 residential rental triplex and the second is a $5,000,000 apartment complex. For the purposes of this example, we will assume the value of the land to be worth 20%.
Depreciation = $300,000 – ($300,000 x 0.20) = $240,000 / 27.5 years = $8,727.27
Depreciation = $5,000,000 – ($5,000,000 x 0.20) = $4,000,000 / 27.5 years = $145,454.54
What this means is that for each year of ownership, the real estate investor is allowed to deduct the above amount ($8,727 or $145,454) against his or her respective properties income in addition to the operating expenses. Depreciation is often called a phantom or paper loss, because this tax break is allowed to take place even when the property is making money and experiencing appreciation in value. And, unlike the computer, which does have a short useful time frame, real estate lasts much longer and tends to go up in value over time.
Think about it, if the above depreciation schedules were actually true for the useful life of real estate, then we would not see any single family homes or other residential properties older than 1990. Also, older homes would have gone down significantly in value from when they were first built. Perhaps now you are seeing why they call this a phantom loss.
Now, let’s say that even after subtracting out the operating expenses and the depreciation, you are still seeing a profit that could be taxed as ordinary income by the IRS. Fortunately, the IRS gives you another tax reducing gift called accelerated depreciation. Accelerated depreciation is also known as cost-segregation. In this scenario, you can segregate all of the non-structural elements of the building from the building itself.
While the building still gets depreciated over the usual time frame, its contents get depreciated using an accelerated schedule of either 5, 7, or 15 years. This can create a much larger paper loss that is front-loaded in the earlier years of ownership as opposed to being spread out equally over a longer period of time. The time value of money for this benefit is significant.
Be aware that when you sell the property, you will be required to recapture all of the depreciation and accelerated depreciation that you took over the years and pay taxes on it. To defer these taxes, many investors use what is called a 1031 Exchange. A 1031 Exchange allows the real estate investor to sell one property and exchange it for a like-kind property while deferring the capital gains tax. The tax is not erased, but it is deferred until the time that the investor either sells without doing a 1031 Exchange or dies.
(Note, there are few other wealth transfer and estate planning options to manage the 1031 tax burden in your lifetime, but they are advanced and beyond the scope of this report).
Upon the death of a real estate owner, his or her heirs are allowed to inherit the property on a stepped-up basis. This erases the depreciation that was taken and resets the basis of the property to current market value at the time of inheritance. In other words, it has eliminated depreciation recapture. This is a huge wealth transfer benefit of owning real estate and one that many families use to transfer legacy wealth from one generation to the next.
One last point about real estate, taxes, and refinances. Over time, equity can grow in a property due to the effects of appreciation and principal pay down. Smart real estate investors do not like to let that equity sit and do nothing. These investors will look to accelerate their financial growth and increase the velocity of their money. To do this, they refinance their property and harvest the equity that they have built so that they can go out and buy another property.
Over time, equity can grow in your property due to the effects of appreciation and principal paydown.
Fortunately for these investors, refinances are tax-free. Keep in mind that refinances are not free of fees and that re-leveraging a property back to a higher loan-to-value is not without its downsides. Having said that, professional real estate investors are quite adept at harvesting their equity to turn one property into two and then two properties into four – which may help grow their income and equity over time.
Another often misunderstood and significant benefit of commercial multifamily real estate is inflation resistance. Inflation is a silent tax that erodes the value of your money over time. Given recent fiscal policy that saw the Federal Reserve produce round after round of quantitative easing, it is no surprise that many fear that inflationary times are coming.
In fact, consider the graph below which shows the performance of real estate during the last significant period of inflation. Another stability benefit of commercial multifamily investing is that it is 100% evergreen. Shelter is a basic human need that will never go away. In contrast, history is filled with products and industries whose time has come and gone. Whether it’s the horse and buggy, the steam engine, Kodak film, or the rapidly declining print newspaper industry, most businesses have a useful shelf-life. The need for shelter on the other hand has stood the test of time.
As a commercial multifamily investor I know that my preferred investment approach will be around well beyond the foreseeable future. It’s also nice to not have to worry about what the talking heads on CNBC or Bloomberg have to say about the markets or being a sex-scandal away from a 50% stock drop.
Commercial real estate has a proven track record as a stable hedge against inflation.
For legal protection, business ownership structures like limited liability company’s (LLC) can be used to hold real estate and therefore shelter the owner’s other possessions and assets from legal claims. This provides significant asset protection. Additionally, many investors will seek bank financing to purchase a property.
With bank financing, investors are allowed to put a small fraction of the purchase price down while the bank provides the rest. What other investment can you put 10% to 30% down and control the entire investment? This use of bank financing is called leverage. Leverage can be a double edged sword. It magnifies profits on the upside, but can also compound losses on the downside. To minimize this risk, many larger commercial properties will qualify for non-recourse lending. With this type of financing, banks secure the loan with the physical property and do not require any further guarantee from the owner. In other words, the owner’s risk of loss is limited to his or her initial capital contribution.
On first blush, this may not sound that significant. However, let me illustrate how significant the asset protection can be when leverage is combined with non-recourse lending. Consider two investments valued at $1 million each. The conventional way to cover that $1 million in stock would be for the investor to pay $1 million. However, the $1 million real estate asset can be purchased with 25% down or $250,000. Now worst case scenario both investments and assume that they each go belly up, losing their entire value. In this scenario, the stock investor lost $1 million dollars. The real estate also lost $1 million, but the bank lost $750,000 while the investor only lost $250,000. This represents a 75% reduction in exposure.
Finally, in addition to being an evergreen asset class, commercial multifamily apartments have a high degree of economic cycle protection. Since apartment leases are only 1 year in length, you have the ability to adjust to the demographics and economics of your local market much more readily than you can with 5, 7, 10, or even 25-year retail, commercial and industrial leases. It’s also important to note that apartments, more so than any other real estate asset class, are population cycle dependent.
Figure 9 shows just how economic cycle resistant (uncorrelated to the stock market) real estate is. It looks at the 20 worst quarters over a 34 year period for stocks and bonds. It then compares that with what real estate did. 17 of the 20 quarters that the economic cycles were down, real estate was up. Consequently, real estate offers the investor true diversification to strengthen their portfolio.
Lastly, for those who are new to the idea of real estate, it is a multi-trillion dollar industry that represents a large investable universe. In fact, real estate represents the third largest asset class in the United States. Of the $6.5 trillion real estate market, multifamily represents $1.6 trillion.
What follows next includes two charts from the Fuller Report that was published in February 2013 and authored by Stephen S. Fuller, Ph.D. of George Mason University. They illustrate the economic impact and sheer size of the multifamily real estate market.
Next Steps
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References & Sources
- WikiBooks. Real Estate Financing and Investing/Sources of Funds.
https://en.wikibooks.org/wiki/Real_Estate_Financing_and_Investing/Sources_of_Funds - J.P. Morgan Asset Management. Real Estate: Alternative No More. July 2012.
https://am.jpmorgan.com/blobcontent/131/169/1383169203231_11_559.pdf - The Street. Real Estate: Best-Performing Asset Class During the Past 20 Years. October 2016.
https://www.thestreet.com/story/13861401/1/real-estate-best-performing-asset-class-during-the-past-20-years.html - MetLife Investment Management. US Core Real Estate: A Past, Present, and Future View. 2017.
https://www.metlife.com/assets/cao/investments/US-Core-Real-Estate-Par-Present-Future-View.pdf - Mortgage Bankers Association. Commercial/Multifamily Mortgage Delinquency Rates for Major Investor Groups. Q2 2016.
https://www.mba.org/Documents/Research/2Q16CMFDelinquency.pdf - Forbes. Five Reasons 8 Out Of 10 Businesses Fail. September 2013.
http://www.forbes.com/sites/ericwagner/2013/09/12/five-reasons-8-out-of-10-businesses-fail/#605955d55e3c - Inc. Why 96 Percent of Businesses Fail Within 10 Years. August 2015.
http://www.inc.com/bill-carmody/why-96-of-businesses-fail-within-10-years.html - Business Insider. Millennials Are Getting Stuck Renting For Way Longer Than Previous Generations. August 2015.
http://www.businessinsider.com/millennials-renting-for-very-long-time-2015-8 - CNBC. Millennials will be renting for a lot longer. September 2016.
http://www.cnbc.com/2016/09/09/millennials-will-be-renting-for-a-lot-longer.html - National Multifamily Housing Council. Apartment Supply Shortage Fact Sheet.
https://www.nmhc.org/Advocacy/Apartment-Supply-Shortage-Fact-Sheet/ - Bloomberg. Student Debt Is Stifling Home Sales. February 2012.
https://www.bloomberg.com/news/articles/2012-02-23/student-debt-is-stifling-home-sales - Freddie Mac. Multifamily Research Perspectives. 2015 Multifamily Outlook Executive Summary.
http://www.freddiemac.com/multifamily/pdf/2015_outlook.pdf