The Top 5 Tax Strategies Every Multifamily Investor Must Know

Welcome to the guide on the powerful tax benefits of multifamily investing and commercial real estate.

Rental real estate stands out as one of the premier asset classes for building tax-advantaged wealth.

To optimize these advantages, various tax strategies and tactics exist. There are a select few that prove especially valuable in minimizing taxes and fostering enduring, sustainable wealth.

Within this guide, you will discover the “top five” strategies for multifamily and commercial real estate investors. By understanding and implementing these strategies, you can minimize taxes, maximize your returns, and pave the way for long-term financial prosperity.

Real Estate Professional Status (REPS)

The real estate professional status (REPS) is a classification under the U.S. tax code that allows individuals who own real property trades or businesses to treat rental real estate activities as a non-passive trade or business.

This can provide certain tax advantages and allows individuals to offset rental losses against their other income.

Under normal tax rules, rental real estate activities are typically considered passive activities, and any losses incurred from these activities can only be used to offset passive income. Passive losses cannot be used to offset other types of income, such as wages, salaries, or active business income. This limitation can restrict the ability to deduct rental losses and reduce overall tax liability.

However, if you qualify as a real estate professional, you can be exempt from the passive loss limitations.

REPS Criteria

To meet the criteria for real estate professional status, two conditions must be satisfied:

• More than 50% of your personal services must be performed in real property trades or businesses in which you materially participate.
• You must perform more than 750 hours of services in real property trades or businesses in which you materially participate.

Material participation generally means being involved in the operations of the rental activities and meeting one of seven material participation tests. The most preferable often is spending more than 500 hours on your rental properties.

Meeting these requirements allows the taxpayer to treat rental real estate activities as non-passive, and they can offset rental losses against their other income without limitation.

When combined with cost segregation studies and accelerated depreciation, discussed later in this guide, the real estate professional status can help you significantly reduce your tax liability.

It’s important to note that qualifying as a real estate professional has specific criteria. And, it must be supported by accurate records and documentation of time and activities.

Consulting with a tax professional knowledgeable in real estate taxation is recommended to ensure compliance with the tax code and maximize the benefits of real estate professional status.

Cost Segregation Studies

A cost segregation study is a detailed analysis of the components of a property or building for tax purposes. The goal of a cost segregation study is to identify and reclassify certain assets within a property in order to accelerate their depreciation and maximize tax benefits.

In the United States, buildings are depreciated over a long period of time, typically 27.5 years for residential rental properties (including multifamily, even those with 5+ units) and 39 years for commercial properties.

For example, a multifamily property with a building value of $2,750,000 would have a “non-cash” depreciation expense of roughly $100,000/year over the life of the property.

However, certain components within a building, such as electrical systems, plumbing, lighting, flooring, specialized equipment, and land improvements, may have shorter depreciation periods (typically 5, 7, or 15 years).

A cost segregation study aims to identify these shorter-lived assets and assign them to appropriate asset classes for accelerated depreciation.

By accelerating depreciation, property owners can deduct larger depreciation expenses in the earlier years of ownership, which can significantly reduce taxable income and increase cash flow.

This allows property owners to recoup their investments faster and have more funds available for reinvestment or other purposes.

How Cost Segregation Applies in Multifamily Investing

Thanks to bonus depreciation, a significant amount of the value of 5, 7, and 15-year property identified in a cost segregation study can be depreciated in the year a property is acquired and placed into service.

A cost segregation study is often conducted by a qualified professional, such as a qualified engineer or a specialist in cost segregation.

They evaluate the property, review construction plans and cost records, and perform a detailed analysis of each component to determine its proper classification and depreciation schedule. The study results in a report that outlines the reclassified assets and their respective depreciation periods, which can then be used for tax purposes.

As an individual investor, you can benefit significantly from cost segregation if you and/or your spouse are high-income earners and can qualify for the real estate professional status (REPS). This is because of the increased depreciation expense generated by a cost segregation study often creates a non-cash loss that can be used to offset your other income, reducing your tax liability.

Even if you can’t claim REPS, as an individual investor, the losses generated by a study can help you offset other passive income, such as income from other rental properties or gains on the sale of other properties.

Sponsors of syndicated rental properties, including multifamily, often choose to use cost segregation studies and pass through the losses to their limited partner investors, allowing them to use the losses in the same manner as individual investors without REPS.

This is a strong tax benefit in multifamily investing. Depending on how the deal is structured, sponsors (i.e., general partners) may also receive an allocation of these losses.

If you’re not sure if a cost segregation study is right for your situation, speak to a qualified tax professional.

Partial Asset Dispositions

Partial asset dispositions are a powerful but often overlooked tax savings tool for real estate investors.

When you acquire a property, you start to depreciate the property’s components. However, at some point, you may replace these components, such as roofs, HVAC systems, plumbing, electrical systems, and others.

A partial asset disposition allows you to fully deduct the remaining value of these components of a property as an expense in the year you replace it rather than letting it sit on your depreciation schedule, continuing to be depreciated over several years.

For example, if you buy a building in 2023 and $75,000 is allocated to the roof, and in 2025, you replace the roof for $100,500, the $100,500 restoration cost must be capitalized. However, you can immediately deduct the remaining value (what has not been depreciated) of the old roof using a partial asset disposition.

There are several ways to determine the remaining value of the components you’re disposing of.

However, a cost segregation study is a common tax benefit used by owners of multifamily and commercial properties

1031 Exchanges

A 1031 exchange, also known as a like-kind exchange, allows you to defer capital gains taxes that would typically be due upon the sale when you sell a rental property and reinvest the proceeds into another rental property.

Reinvesting the proceeds from the sale into another property and deferring capital gains allows you to take the taxes you would have paid and use them to expand your portfolio.

It’s important to note that while a 1031 exchange allows for the deferral of capital gains taxes, it does not eliminate them entirely. Selling the replacement property (i.e., the property acquired in the 1031 exchange) without completing another 1031 exchange will generally cause you to pay capital gains taxes, effectively paying the taxes you previously deferred.

Factors for 1031 Exchanges

There are a few factors to be aware of when considering a 1031 exchange:

• Timing Requirements: There are specific timeframes that must be followed in a 1031 exchange. The taxpayer must identify a potential replacement property within 45 days of selling the original property. The acquisition of the replacement property must be completed within 180 days.
• Qualified Intermediary: To facilitate a 1031 exchange, a qualified intermediary (QI) is often used. The QI is a third-party intermediary that holds the funds from the sale of the original property and facilitates the purchase of the replacement property. The involvement of a QI is crucial to ensure compliance with the exchange rules; if you accept the sales proceeds from the sale of the property, a 1031 exchange is typically no longer possible.

Given the complexity of such a transaction, you should consult with tax professionals and qualified intermediaries to understand the rules and requirements of a 1031 exchange and how it applies to your specific circumstances.

Swap Till You Drop

While 1031 exchanges will generally only defer capital gains taxes, there is one strategy that can eliminate them, often referred to as “Swap Till You Drop”.

As mentioned above, if you sell a property that was previously exchanged, you’ll owe capital gains taxes. However, when you pass away, there is something called a “step-up in basis”,  which allows your heirs to receive the property at its fair market value at the date of your death, eliminating all the capital gains you would have paid had you sold the property during your lifetime.

Thus, “Swap Till You Drop” allows you to continually use 1031 exchanges throughout your life to build a massive portfolio, and then pass it to your heirs, eliminating the capital gains taxes.

While easier said than done, this is a viable strategy that we’ve seen several clients employ. If you would like to use this strategy, it’s recommended that you work with tax and estate planning professionals to make this a reality for you.

Buy, Borrow, Die

If you’ve ever heard of the strategy buy, rehab, rent, refinance, and repeat (BRRRR), you’re already familiar with some of the elements of buy, borrow, die.

As we’re all aware, real estate tends to appreciate in value over time due to market forces or by forcing appreciation value through renovations (i.e., “value-add”). When this happens, your equity increases in the property.

Buy, borrow, die allows you to tap into this idle equity tax-free without selling your property, using cash-out refinances or HELOCs. These loan proceeds can then be used as down payments to acquire additional properties, expanding your portfolio.

The die part uses the same “step-up in basis” concept in “Swap Till You Drop” to eliminate capital gains tax on death. Many investors use these two strategies in tandem to build massive portfolios.

Conclusion

Investing in multifamily and commercial real estate offers a plethora of strategies, tactics, and tax incentives. This makes it an exceptionally enticing asset class for building tax-advantaged wealth.

While numerous others exist, such as the carried interest rules, qualified improvement property, and section 179 for commercial properties, the significance of these five strategies cannot be overstated.

Their impact on maximizing returns, minimizing taxes, and fostering long-term financial prosperity makes them indispensable for multifamily and commercial real estate investors.

Ready to explore which of these strategies, along with other valuable approaches, align best with your specific circumstances?