As multifamily owner/operators, we have a fiduciary responsibility to our investors and stakeholders to manage our properties in a way that will maximize their return on investment.  There are things we can do operationally to accomplish this – like renovate units, raise rents, or reduce expenses – to boost our operating profit.  But, this isn’t the only source of return.  There are also things that we can do financially to minimize the tax liability – for ourselves and our investors – that are often overlooked.  In fact, the favorable tax benefits offered by a multifamily investment are a core component of investment returns and a major benefit of ownership.

Net Operating Income

The driving force behind a property’s tax liability is a metric called Net Operating Income, which is defined as income less expenses.  For example, if a property has $100,000 in Gross Rental Income and $50,000 in Operating Expenses, the Net Operating Income would be $50,000.

Within the expense category, there are a variety of traditional expenses that we don’t have direct control over.   These are things like Property Taxes, Insurance, Utilities, Property Management.  But, there is one expense that we can do something about, and it plays an active role in reducing a property’s tax liability.  It is called “Depreciation.”

What is Depreciation?

The physical structure of a multifamily property has a series of hard assets like appliances, furniture, fixtures, plumbing, and air handling systems.  When purchased, these are things that can be very expensive, but they tend to degrade over time.  The combined value of these assets can be significant, and “Depreciation” is an accounting concept that allows a property owner to “expense” a portion of the value each year to account for the deterioration in the value of the assets.

In most cases, the depreciation is taken in a “straight line” over 27.5 years.  For example, if the assets have a combined value of $1,000,000, then the allowable depreciation is $1,000,000/27.5 = $36,363 per year.  Using the same example above, the following table shows the difference in Net Operating Income between a property where no depreciation is taken and one where it is:

The example above demonstrates that Net Operating Income is significantly lower when factoring in depreciation, which means that the tax liability is also lower.  Depreciation is a great benefit, but the critical point is that depreciation is a “non-cash” expense, meaning that it doesn’t represent any money coming out of the property’s bank account.  It reduces the tax liability, but not the cash available for distribution.

Cost Segregation & Accelerated Depreciation

Depreciation is a valuable tool, and we seek to use it to the maximum allowable limits.  To that end, we also like to employ an advanced strategy known as “Cost Segregation” to accelerate depreciation in our properties.

Cost Segregation starts with an extraordinarily detailed examination of a property’s assets, and it seeks to divide them into four categories:  personal property, land improvements, buildings/structures, or land.  The logic behind “segregating” the assets is that the allowable depreciation varies for each group and can usually be accelerated.  For example, the current tax laws allow depreciation of the physical structure of multifamily properties, not the land, over 27.5 years. However, depreciation for personal property can be over five or seven years, and improvements such as sidewalks or paving can be depreciated over 15 years.  The result is that we are allowed to take more depreciation in a given year than would have been allowed under the “straight line” method.

To illustrate this point, let’s continue with the example above under the assumption that we are now allowed to take $145,000 in depreciation once the Cost Segregation analysis is complete:

By taking the accelerated depreciation allowed as a result of the Cost Segregation analysis, the same property now shows an operating loss of $95,000.  The good thing about this is it will enable us to pass this paper “loss” on to our investors to offset their individual tax liability.  Again, remember that depreciation is a non-cash expense.  So, while the property shows an operating loss, the Cash Available for Distribution may be positive.

To be completely transparent, these examples are overly simplified to demonstrate the broader point, returns from a multifamily investment don’t come from a property’s cash flows alone.  They also come from the tax benefits associated with the accounting treatment of depreciation, and this doesn’t always show up in the return metrics.  But that’s not all.  After selling a property, there is a third strategy that can be used to defer taxes on the gain, and it is called a “1031 Exchange.”

What is a 1031 Exchange?

A 1031 Exchange is named for a section of the tax code that allows an investor to defer taxes capital gains as long as they “exchange” the property’s sales proceeds into another property of “like-kind.”  The rules that govern a 1031 Exchange can be complicated, and they must be followed precisely to take full advantage of the program, but the major points are:

• The “replacement” property must be “of the same nature or character” as the “surrendered” property.
• The “replacement” property must be “identified” within 45 days of the sale, and the purchase completed within 180 days of the sale.
• The amount of the money invested into the “replacement” property must be the same as the sale proceeds from the old property.  If there is a difference, it is known as “boot,” and it can be taxable.
• The “replacement” property must be similarly titled as the old one.

Further, the 1031 Exchange isn’t just a one-time thing.  In theory, it could be done over and over again as a way to defer taxes indefinitely and allow the sale proceeds to grow tax-free over time.  Additionally, a 1031 Exchange can be a useful estate planning tool since heirs inherit the asset(s) at a stepped-up cost basis, which can reduce or eliminate taxes in the inheritance.

Summary & Conclusions

The investment returns produced by a multifamily property come from:  (1) Regular cash flows; (2) asset appreciation; (3) rising rents; and (4) favorable tax treatment.  If managed proactively, the tax liability can be a significant contributor to the overall return and allow an investment to grow tax-free over a long period.  Often overlooked, tax benefits are one of the many ways we seek to maximize each one of our investments.  We use a vetted CPA on our team who specializes in real estate assets to maximize this strategy.

1 The principals of Rize Equity are not lawyers or CPAs.  The contents of this article are for educational purposes only and are not to be construed as financial advice and/or an offer to buy or sell securitized investments.  Individuals should seek advice from their lawyer and/or CPA before making a significant investment decision.