One of the main reasons that investors seek real estate investment opportunities is the tax advantage. Taxes can be people’s largest annual expense, so it is natural to want to seek ways to reduce that expense. Unlike passively investing in stocks, investing passively in real estate can enhance your return by adding large tax savings. As you know, profit from any investment is taxable but here is where the real estate tax advantage and strategies come into play. Please note that this is not professional tax advice and it is for your information only. Always consult with your tax professional to better understand your individual tax situation.

Depreciation

Property that is used for business or income-producing purposes can be depreciated over time. Depreciation accounts for a decrease in value from average use and wear and tear but real estate doesn’t deteriorate at such expedited time. In fact, with reasonable maintenance, properties typically will not only last much longer than their depreciation schedule would suggest, but they will likely experience appreciation over that time period. The decrease in value becomes only a paper loss. The depreciated amount per year (or paper loss) can be deducted from the income the property generates, and can make the income you receive as a passive investor tax-free. This paper loss can also be used against other passive income.

Cost Segregation

Cost segregation is a tax strategy that allows real estate investors who have acquired, built, expanded or remodeled any kind of real estate to accelerate depreciation deductions. A cost segregation study is performed by a cost segregation engineering firm with the primary goal to identify all interior and exterior components of the property that can be depreciated over 5, 7, and 15 years instead of the standard 27.5 years for multifamily or 39 years for hotel/self-storage/other commercial asset. As a result, the investor receives a greater depreciation benefit in the early years of ownership, further helping to reduce or eliminate their tax bill on the cash flow distributions.

Bonus Depreciation

Bonus depreciation is a form of accelerated depreciation but on steroids based on the Tax Cuts and Jobs Act of 2017. Before 2023, items that depreciate in less than 20 years could be accelerated to the first year of ownership. In 2023, 80% of the depreciation amount based on items that depreciate in less than 20 years can be used in the first year of ownership. This benefit will decrease to 60% in 2024 and will decline 20% per year until it phases out by 2027. This benefit helps to further reduce or eliminate the investor’s tax bill.

Cash-Out Refinance

The property can be refinanced, and any capital above and beyond the remaining balance on the original loan can be returned to investors. This capital is tax-free and can be put to work immediately, maximizing the benefit of this strategy and amplifying your returns.

1031 Exchange

A 1031 exchange is a strategy that allows real estate investors to sell a property and avoid capital gains or depreciation recapture on the sale of the property as long as you buy a “like-kind” property that is of equal or greater value within a certain timeframe. If you own property yourself and want to truly be a passive real estate investor, you can 1031 exchange into a passive real estate investment. However, this is something that must be executed correctly and can be very involved.

Additionally, if you exchange assets over and over again until you pass away holding the assets, you will avoid any taxation and your heirs could inherit the assets tax-free. The basis of the property is adjusted to the fair market value at the time of your passing. Most investors will gift their assets to their heirs before passing instead and trigger taxation.

Lazy 1031

The much larger tax paper depreciation loss in year one due to bonus depreciation and cost segregation is a significant tax benefit. This passive loss can be used to offset passive gains from real estate which can come from cash flow or capital gains. However, when the asset is sold, the depreciation is recaptured, which means that the depreciated amount is regained and taxed. This is because the IRS wants to be “repaid.” Therefore, a way to offset taxation on depreciation recapture and capital gains when you liquidate an asset is to immediately invest all your capital within the same calendar year into another asset that has comparable tax benefits (depreciation and bonus depreciation) to the asset sold. This strategy is called the “lazy 1031” because you are avoiding the stringent process and timing required by a 1031-exchange but still reducing or eliminating your tax exposure.

If you don’t want to meet the demands of an actual 1031 Exchange because you can’t meet the timing or you don’t want to continue investing actively, then the “Lazy 1031” might be an effective strategy for you.

If you are not already taking advantage of the tax benefits and strategies that this asset class provides, you could be leaving thousands of dollars on the table that goes to the IRS. If taxes are your largest expense, it is always a good idea to consult with a tax strategist so they can look at your specific tax situation and give you advice on how to best lower your tax bill.

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