Understanding the Tax Implications of Investment in Multifamily Properties
Last December's passage of the Tax Cuts and Jobs Act (TCJA) has made headlines with its sweeping changes to the way individuals and corporations pay income taxes. From capping state and local tax deductions to reducing the corporate tax rate by nearly 50 percent, the TCJA has the potential to reshape the way U.S. income taxes are allocated for decades to come.
But for multifamily and commercial real estate investors, the benefit of certain changes has been less clear. Knowing more about the way depreciation deductions pass through to real estate investors and how operating expenses are deducted can ensure you structure your deal to take full advantage of all the benefits the U.S. Tax Code has to offer.
The depreciation deduction applies to buildings, improvements, and some types of personal property—but not land. This makes depreciation an especially attractive deduction for owners and investors in multifamily commercial properties, which don't usually boast much acreage in high-value districts. The more of a property's value that's tied up in the building itself, the more effective an owner can be in capturing depreciation.
The Tax Cuts and Jobs Act didn't alter the depreciation period for multifamily properties, which remains 27.5 years. What it did accomplish is a temporary doubling of the "bonus" depreciation allowance—improvements and personal property—from 50 to 100 percent. This makes it far more advantageous for multifamily investors to spring for new appliances, carpet, roofing, landscaping, and other "curb appeal" items before this allowance reverts; you'll be able to capture this depreciation almost immediately, rather than having to hang onto a property for two years or more to take full advantage of these tax benefits.
Who Benefits from the Depreciation Deduction?
Because of the significant value this deduction can provide to sponsors and equity investors, it's important to understand how the depreciation deduction is allocated among property stakeholders.
In a limited partnership or LLC, each limited partner's deduction is equal to their equity stake in the project. For example, if you have eight investors in a property with a building valued at $27.5 million and land valued at $2.5 million, the total depreciation deduction (over 27.5 years) will be exactly one million per year. Assuming each limited partner has a 10 percent stake in the property (with the general partner maintaining a 20 percent stake), they'll receive a depreciation deduction of $100,000 apiece.
And since January 1, 2018, these pass-through entities enjoy a new 20 percent deduction in the net income that flows through to partners. This means holding multifamily real estate in an LLC or LP is far more advantageous than in an S corp or as an individual, as both latter approaches treat investors as individual taxpayers, eliminating access to valuable business deductions.
Other Changes Enacted by the Tax Cuts and Jobs Act
Operating expenses—like mortgage interest, repairs, maintenance, property insurance, and property taxes—continue to be deductible against a rental property's income. This is yet another way in which holding property within a corporate structure provides additional benefit; one of the TCJA's biggest changes was a cap in the amount of mortgage interest and home equity loan interest that can be deducted by individual taxpayers.
These changes may encourage more would-be buyers to rent instead, especially in hot or pricey real estate markets where paying non-deductible mortgage interest just isn't worth it. The more rental competition you have for your multifamily units, the lower your risk of cash-flow problems or high tenant turnover.