By Michael Moran

Death and taxes – you know the old saw. And while we can’t do much about the former, the US tax code provides some pretty amazing relief when it comes to taxes, at least if you’re an investor in a multifamily real estate property.

Passive income, defined by the Internal Revenue Service, is treated very differently than the money you earn from a job (a W2 salary) or even from the sale of stocks and bonds. And while the federal government in 2017 drastically curtailed the amount of mortgage interest you can write off from your primary residence, it actually improved the tax breaks available to those earning “passive income” from multifamily property investments.

First, it’s worth defining the term. Passive income is classified as income that comes from a business that you do not directly manage, or from a rental property. In effect, unlike W2 income, you do not trade your time and labor for money with passive income. It accrues, instead, from an owned asset. (For the masochists out there, here’s the IRS’s definition (PDF). Don’t worry, it’s only 17 pages long).

For multifamily investors – “passive investors” who take part in a multifamily project as Limited Partners (LPs) – concerns like maintenance, insurance, filling apartments, dealing with tenant complaints or local tax issues, are not your problem. Those tasks fall to the General Partners (GPs), or in other words, PCRP Group and its team.  In a typical deal, the LPs collect a quarterly distribution of 7-to-8 percent annually while we handle the operational details.

But the passive investor, the LP, gets some very active help from the tax code. Here are some of the tax breaks that passive investors accrue from multifamily investments.

 

  • Debt Servicing Deduction: Passive income investors are allowed to deduct their proportion of the interest paid on debt assumed to purchase the multifamily property. Since the purchase price generally ranges from $10 to $50 million, that deduction can be very significant. For W2 wage earners, finding ways to lower your tax bill can be difficult or even impossible, depending on where the income is earned. This is your ticket to tax breaks that historically had been reserved for the 1%.

 

  • Repair Deductions:Repairs that qualify for the IRS definition as “reasonable” can also be deducted by passive investors in proportion to their participation in the deal.

 

  • Depreciation:Passive investors can claim depreciation as losses on their tax returns – again, in proportion to their share of a project’s ownership. The original idea was to account for the gradual deterioration of value that any building suffers over time, amazingly, even though decades of research shows that well-maintained multifamily properties and the land they sit on only get more valuable over time. (That appreciation in value will be distributed to investors when the property is eventually sold, and it is subject to capital gains).  But the monthly income derived from the rental property is passive, and depreciation allows often large write offs to be taken by passive investors and is set against their income. In some cases, even high-income W2 earners have found that the tax breaks that flow from participation in a small number of multifamily properties have reduced their overall tax bill to zero!

 

  • Cost Segregation: Multifamily investors, both LPs and GPs, also benefit from an additional tax strategy known as cost segregation. Also known as “accelerated depreciation,” this strategy allows property ownersto depreciate particular components within the property, from parking lots to pool decks, boilers to balconies, doors to kitchen cabinets. The depreciation life span of an apartment building is set by the US tax code at 27.5 years, with each year allowing an equal share to be depreciated as a loss. But the tax code assigns a separate, much shorter “useful life” to each of the physical elements of the property and breaking them out separately greatly increases the tax breaks that flow from depreciation.

 

  • Bonus Depreciation: Yes, I know what you’re thinking: More depreciation? Tax changes that took effect in 2018 added a further benefit known as bonus depreciation that can only be taken in the first year of ownership. This makes sense for some properties, especially if a quick sale is anticipated (thus allowing a 100% depreciation in the first year rather than over the course of the hold). PCRP Group’s “value-add” strategy generally means we prefer to improve the property in ways that bolsters sustainability, tenant satisfaction and ultimately its value at sale, and thus we depreciate over time. But bonus depreciation is an excellent example of the hidden gifts that Washington bestows on the multifamily investment community.

What not join them?

For more on PCRP Group and our strategy, visit us at www.pcrpgroup.com. Stay tuned for our next post, focused on our commitment to sustainable principles. PCRP Group’s strategy positions you to do well even when you do good. And by choosing markets wisely, as we do, mitigates your investment from the growing risk of climactic and other natural disasters.