Limited Partnership Tax Benefits
Happy New Year, and thank you to each and everyone for being a part of our community and helping us build a stronger team. Team Saorsa partners with everyday professionals to achieve financial freedom through passive apartment investing. As we kick off the new year, we thought it was beneficial to discuss tax strategies that help busy professionals preserve, protect, and grow their capital. Charitable donations and tax deferred plans are always a good start, but as a Limited Partner on commercial real estate investments there are several tax advantages that any investment strategy in real property should utilize. This month we’ll cover a few options that should benefit this situation;
Bonus Depreciation
Interest Write-Off
IRA Checkbook
Government Funded Tax Incentives
1031 Exchange Programs
Capital Gains impact on Short Term or Long Term Investments
Depreciation
Depreciation is the incremental loss of an asset’s value, generally due to assumed wear and tear. As a real estate investor that holds income-producing rental property, you can deduct depreciation as an expense on your taxes. That means you’ll lower your taxable income and possibly reduce your tax liability. Because commercial real estate is a non-cash expense, depreciation does not reduce an apartment building’s cash available for distribution (i.e. paper loss but cash flow positive!).
You’re allowed to take the depreciation deduction for the entire expected life of a parcel (currently set by the IRS as 27.5 years for residential properties and 39 years for commercial properties). Let’s say you purchase a home you intend to rent out. The value of the building itself (excluding the land it sits on) is $300,000. If you divide that value by the 27.5 year expected life of the dwelling, you can deduct $10,909 in depreciation each year.
Given the role that depreciation deductions play in reducing a property’s tax liability, property owners have a strong incentive to maximize the amount taken each year. Experienced property owners can do this by utilizing an advanced depreciation strategy known as “Cost Segregation,” which segments the property’s assets into buckets and depreciates them over accelerated time periods. For example, the IRS tax code allows a multifamily property to be depreciated over 27.5 or 39 years. But a Cost Segregation Study can divide the components of the asset into buckets like Personal Property, which can be depreciated over 5 or 7 years, or Land Improvements, which can be depreciated over 15 years. These accelerated timelines can maximize both the depreciation deductions and the tax savings that goes with it. However, it’s worth noting that once the property is sold standard income tax is owed on the claimed depreciation. This is known as depreciation recapture, which you can avoid if you pursue other tax strategies, like a 1031 exchange (more on that below).
IRA Checkbook
Some investors prefer to make investments through their Individual Retirement Account (IRA), which allows investment funds to grow tax deferred until retirement age. After this point, money pulled from the account is taxed as ordinary income at income tax rates as high as 37%, depending on the account owner’s tax bracket. Profitable real estate investments are taxed as a “Capital Gain,” carrying a lower tax rate than ordinary income; for example, in 2020 the highest long term capital gains tax rate is 20%. For those actively planning for retirement, this is an advantage.
Interest Tax Deduction
Commercial real estate investors and homeowners share a similar advantage in that they can both deduct the interest expense on the property’s mortgage. In some cases, this deduction may be larger than actual profits earned by the property, which helps to offset the tax bill. If the interest rate on the mortgage is particularly high, this is a benefit that can pay off every year.
A pass-through deduction allows you to deduct up to 20% of your qualified business income (QBI) on your personal taxes. When you own rental property as a sole proprietor, via a partnership, or through an LLC or S Corp (known as pass-through entities), the money you collect in rent is considered QBI.
Let’s say you have an LLC that owns an apartment complex. Each year, you receive $30,000 in rental income. By using a pass-through deduction, you can write off up to $6,000 on your personal return. Of course, some rules and regulations must be followed, so please consult with your accountant.
Tax Credits for Real Estate Investors
One of the major tools that governments and regulators use to incentivize investment in affordable housing and overlooked parts of town is something called a “tax credit,” which is an amount of money that can be subtracted from an investor’s income taxes, thereby reducing their overall tax liability. The specifics of the tax credit deductibility can vary based on the program that administers them, but one example that exemplifies this benefit is the Low-Income Housing Tax Credit or Opportunity Zone Tax Credits.
The Low-Income Housing Tax Credit program (LIHTC) subsidizes the acquisition, construction, and rehabilitation of affordable housing for low- and moderate-income tenants. Each year, the federal government issues tax credits to state governments, who in turn award them to private developers through a competitive process. For those who receive them, they can be used to offset taxable income for a period of up to 10-years.
1031 Exchange
An investor’s enthusiasm over the profitable sale of an investment property can be quickly diminished by the realization that a big tax bill is likely to follow. Fortunately, a provision in the US tax law, Section 1031, allows for the deferral of taxes when an investor “exchanges” sale proceeds into another property of equal or greater value that is considered to be “like kind” to the property sold. Further, there is no limit to the number of 1031 or “like kind exchanges” that an investor can complete. So, in theory, an investor could complete a series of successive 1031 Exchanges that would allow their profits to grow tax deferred over a long period of time.
1031 exchanges exist because the government wants to reward people who reinvest their real estate profits into new deals. If the new property you buy is of equal or greater value than the one you sell, the program lets you swap them for tax purposes. That means you can defer paying the capital gains tax on the sale of the first property.
You can use 1031 exchanges indefinitely. But, when you want to cash out your profits, you’ll have to pay any tax owed. There are a few different forms of the program available based on the timing of your purchase and sale transactions. Since the program can be complicated to navigate and take full advantage of, it’s wise to consult with a qualified financial professional.
Capital Gains Scenarios
A capital gains tax may be assessed when you sell an asset, like a piece of property, for a profit. There are two types to be aware of: short-term and long-term. They each impact your tax situation differently.
Short-Term Capital Gains
When you profit from selling an asset within a year of owning it, you realize a short-term capital gain. While you may not have a choice but to sell, be aware that doing so can have a negative effect on your taxes. That’s because the gain gets counted as regular income.
So, if you earn $100,000 from your day job and sell an investment property for a $100,000 profit, your income essentially doubles for tax purposes. If you file single, that extra income puts you in the next tax bracket (as of 2020), which potentially means a larger tax bill than you expected.
Long-Term Capital Gains
On the other hand, you see a long-term capital gain if you profit from the sale of an asset that you’ve held for a year or longer. If you can wait until the anniversary of your purchase to sell, you’ll get to keep more money in your pocket. That’s because the long-term capital gains tax rate is significantly lower than the tax rate on income.
And, if your income is low enough, you may not have to pay the tax at all. Suppose you and your spouse make a combined $75,000 per year and file a joint tax return. The long-term capital gains tax rate for your income level is 0%. That means you can keep every cent of the profit you get when selling a property.
Losses
On occasion, a commercial real estate investment does not work out as planned. In such cases, it is possible that investors could experience a loss on some or all of their investment principal. If this happens, the amount of the loss can be used to offset taxable income, thereby reducing the investor’s income tax liability. If the amount of the loss is large, or if it exceeds the entirety of an investor’s taxable income, it can potentially be taken over multiple years. So, while a loss is never the desired outcome, it can provide ancillary income tax benefits that help to mitigate the impact.
