Private real estate continues to be one of the most popular investment strategies for protecting and growing one’s wealth. It offers many benefits to individual investors, such as high returns and portfolio diversification. Plus, being an equity investor in private real estate is highly tax-efficient. In this article, I outline the top private real estate tax benefits that equity investors receive.
Short-Term vs. Long-Term Capital Gains Taxes
Capital gains are the profits from the sale of an asset (stock shares, a business, or a rental, residential, commercial or industrial property). The profits from this sale are generally considered taxable income and how investors are taxed depends on how long they held the asset before selling. If an investor held the asset for one year or less, this is subject to a short-term capital gains tax and the tax rate will be equal to their original income tax rate, or their tax bracket.
If the investor held the asset for over one year, this is subject to a long-term capital gains tax and they will be taxed at a lower rate than short-term gains. The investor would be subject to a tax rate of 0%, 15% or 30%, depending on their tax bracket and filing status. As such, it’s in the individual investor’s favor to hold an asset or stay invested in a private real estate fund for longer than a year because they’ll be able to take advantage of this tax break.
Capital Gains Tax Deferral Through a 1031 Exchange
Another tax benefit of private real estate investing is the 1031 exchange tax provision. This allows investors to defer paying capital gains tax on the sale of a property by reinvesting those gains into a new property. The provision requires the investor to identify a replacement property within 45 days of selling the old one and then must close on the new property within 180 days. In addition, the provision requires that the value of the replacement property must be equal to or greater than the sold asset, the item exchanged must actually be an asset, and the exchange must be held for “productive purposes in business or trade.”
Capital Gains Tax Deferral Through Qualified Opportunity Zones
An additional tax benefit of private real estate investing is the Qualified Opportunity Zone (QOZ) program. As of late 2018, real estate investors are able to defer and even completely eliminate capital gains taxes by investing in a QOZ Fund. This program was created as part of the 2017 Tax Cuts and Jobs Act to drive development and job creation in economically distressed communities.
QOZ Funds are investment vehicles that aim to invest at least 90% of fund capital into qualified opportunity zones. With this investment strategy, investors can defer paying capital gains tax on an appreciated asset sale until 2027 if they invest their gains in a QOZ Fund within 180 days. They may also be able to reduce their original capital gains tax liability by up to 15%, and possibly avoid paying any tax on gains from their investment in a QOZ Fund, if their investment is held for at least 10 years. To learn more about QOZ Funds, please read our other articles on this topic.
Importance of Depreciation
Another tax benefit of investing in private real estate is the ability to shield income generated by investment properties through depreciation. This allows real estate equity investors to take advantage of the long-term benefits of substantial cash flow with a low tax burden.
Depreciation is the decline in value of an asset over time. For example, a new car depreciates in value the minute it’s driven off the lot. Generally speaking, the term depreciation implies a loss, but the opposite is true when it comes to real estate investing. All aspects of a real estate property depreciates except for the land. For example, the appliances and fixtures in a rental unit of a multifamily building will become outdated over time. The land, however, is a fixed cost and will not depreciate. IRS tax law allows real estate owners to take a deduction for the property’s depreciation to smooth out eventual capital expenditures.
The value of a real estate investment could increase in value over time while the value of the building depreciates, which would simultaneously reduce the property’s tax basis. To put this in perspective, if an investor acquires a property for $10 million and then depreciates it by $2 million, the cost basis for tax purposes would be $8 million.
The depreciation tax savings works the same way for investors in an Origin private real estate fund. For example, say we buy a residential rental building for $10 million and four years later we sell it for $12 million. In those intervening four years, we would depreciate the building on our books by approximately $350,000 annually or $1.4 million over the four-year period. In this case, the asset’s cost basis would be reduced from $10 million to $8.6 million. The $1.4 million book gain on the sale — from $8.6 million to $10 million — would be taxed at 25 percent under what’s known as an unrecaptured Section 1250 gain. The $2 million in profit — from $10 million to $12 million — would be subject to the 20 percent long-term capital gains rate. Both rates are typically less than an ordinary income tax our accredited investors pay.
Point being, investing in commercial real estate is intentionally tax-efficient, designed as a reward for equity holders, or the owners of the real estate, who assume more risk than lenders. When evaluating an investment opportunity, investors should keep in mind to compare them after all fees and taxes are accounted for. In some cases, a fund that targets lower pre-tax returns may be a better investment, after taxes are accounted for.