How Death Gives You A Huge Tax Benefit In Multifamily Real Estate

As a multifamily real estate investor, I knew it was a tax-advantaged investment. But I wanted to make sure I completely understood all of its tax benefits. So I interviewed my CPA, Chris O’Neal of Moody & O’Neal CPAs LLC of Mt. Pleasant, South Carolina, to get the facts.

I learned that Death (Death!) is a great tax benefit of real estate!

But more on Death later. I also learned a lot of other great tax information about multifamily real estate.

Before we get into it, I need to tell you that I’m only conveying what I learned from Chris, and in the re-telling errors may have been made. I am not a CPA, tax attorney, or tax expert. Before you make any investment decision, be sure to consult with someone who is a professional multifamily real estate tax expert, like Chris. His website is below.

With that caveat in mind, I learned from Chris that there are a number of enormous tax advantages to investing in multifamily real estate – Depreciation, Cost Segregation, Passive Income Tax Treatment, Section 1031 Exchanges, and, yes, Death.

Depreciation Can Eliminate Most of Your Taxable Income

Depreciation is the first great tax benefit of multifamily real estate investment, because it can eliminate most or all of the taxable income from your investment.

The government wants investors to make the necessary capital improvements to keep their multifamily properties in good, habitable condition. But capital improvements come out of post-tax dollars and cannot be deducted from operating income – meaning you could spend the money and still owe tax on it.

To encourage capital spending, the government lets multifamily owners deduct depreciation from taxable income. Though properly maintained buildings can last indefinitely, for tax purposes the government permits multifamily real estate investors to act as if their building will be completely useless in 27.5 years. So, each year, it lets owners deduct 1/27.5th of the purchase price of the property from the property’s taxable income.

This is huge! If you buy a building (you cannot depreciate the land) worth $1,000,000, you can deduct $36,363 each year for depreciation expense. Particularly in the early years of the investment, this may exceed the property’s taxable income. You could put cash in your pocket and show a loss on your tax return!

But depreciation comes with a big trap for the unwary. I’ll discuss that below.

Cost-Segregation Accelerates Your Depreciation Deductions

Something called “cost segregation” allows you to accelerate your depreciation even more.

While buildings depreciate on a 27.5 year schedule, items like cabinets, fixtures, appliances, etc. depreciate even faster – in as little as seven years or less.

If you hire a cost segregation firm to segregate out these items, you can depreciate them on the faster schedule.

So, if $200,000 of your $1,000,000 is actually composed of cabinets, fixtures, appliances, etc., your annual depreciation deduction would actually be $57,661 per year! ($29,090 for the building and $28,571 for everything else.)

But remember: you can’t segregate costs yourself. You must hire a certified firm to perform a study for you, or you cannot get the tax benefit.

And that depreciation “trap” I mentioned? Cost-segregation can multiply them if you are not careful. I’ll explain why below.

If You Do Owe Tax, It’s At Lower Passive Income Tax Rates

What happens if the net income from your property exceeds the depreciation deduction?

Something wonderful, that’s what!

Assuming you are not a “real estate professional” (i.e., someone who spends more than 500 hours a year working on real estate investments), income from your multifamily real estate investment is not taxed at current income tax rates, which are subject to employment taxes.

Instead, the net income from your property is taxed at lower passive income rates, which are not subject to employment taxes.

Thus, even if the depreciation deduction does not fully eliminate the taxable income from your property, you still receive a tax advantage on this income versus income from your job.

(Just remember, though, if you make real estate your job, then you become a “real estate professional,” and the income is taxed at normal income tax rates.)

Section 1031 Exchanges Allow You To Defer Capital Gains Taxes Indefinitely

Depreciation has a dark side: “recapture.” That’s the “trap” I referred to above.

Multifamily real estate investors usually owe capital gains tax when they sell the property. Capital gains are calculated by deducting the “tax basis” from the sale price. The tax basis is the original purchase price minus accumulated depreciation.

In other words, depreciation is not free. Each depreciation deduction decreases the tax basis, which increases the taxable gain on the property. Thus, depreciation is said to be “recaptured.”

So, in the example, if you sell the property for $1,250,000 three years later, you will not owe capital gains tax on just $250,000 of profit. You will owe tax on $250,000 plus $109,089 of recaptured depreciation if you did not perform a cost-segregation study and $250,000 plus $172,983 of recaptured depreciation if you did.

(Because of recapture, cost-segregation may not be right for every multifamily investment.  The tax basis may be reduced so much that your capital gains tax liability exceeds the cash proceeds from the sale of the property. So please consult your accountant before doing a cost-segregation study.)

However, the U.S. Tax Code provides a way to avoid a big tax bill, at least temporarily.  Named after Section 1031 of the Tax Code, this benefit is commonly known as a “1031 exchange.” Doing one allows you to defer capital gains tax indefinitely if you reinvest the proceeds of the sale in a more expensive property within a defined period of time.

In other words, the government is encouraging you to do a bigger multifamily real estate deal with your profits. And it permits you to repeat this process indefinitely, rolling the sale profits from each property into a bigger property, and expanding the size of your real estate empire!

But, again, there is a downside to 1031 exchanges. With each exchange your deferred capital gain increases. Over time, especially with mortgages on the property, your deferred tax liability could overwhelm the cash proceeds you would receive from a sale of the property.

And that’s when you benefit from the cold, dark hand . . .

Death Makes Your Deferred Capital Gains Vanish Into Thin Air!

. . . of DEATH!

Yes, in multifamily real estate investing, Death is your friend.  Well, at least it’s your heirs’ friend. Here’s why.

Whether or not your estate is large enough to exceed the estate tax exemption ($5,000,000 at the current time), your estate is subject to estate tax and you are deemed to have “paid” it even if your taxable estate was not large enough to actually owe the government any tax.

To avoid “double taxation,” assets inherited by your heirs have a “stepped-up” tax basis. If that multifamily real estate property is worth $1,250,000 at your death, then they do not inherit it with a basis of $1,000,000 minus the accumulated depreciation and a built-in capital gains liability.  

Instead, your heirs’ tax basis in the property is “stepped up” to the fair market value at the time of your death – $1,250,000. All the accumulated deferred capital gains are eliminated, and the clock starts ticking at $1,250,000 as if they had purchased the property themselves.

(Just to be clear, the Death “benefit” works even if you do not do a 1031 exchange. It also eliminates all accumulated capital gains liability if you buy a property and hold it until you die.)

In sum, this is how Death works in your favor as a multifamily real estate investor. You can take substantial current tax deductions for depreciation, which roll into capital gains, which can be deferred through a 1031 exchange, and ultimately eliminated by your death.

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A True Multifamily Real Estate Tax Expert

I’m not a tax expert, but my CPA Chris O’Neal of Moody & O’Neal CPAs LLC is.  If you’d like to speak to Chris about the tax implications of investing in multifamily real estate, please follow this link to their website.

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1 Comment

  1. Jonathan – this is a great article. I liked how clearly it explains the flow and the benefits/consequences.

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