Real estate investors generate income through two primary avenues: cash flow and appreciation. With the right playbook, taxes associated with both can be effectively reduced to zero or kept at a minimum.
We call it The Three D’s: Depreciate, Defer, and Die. Yes, you read that right—this tax avoidance strategy reaches completion when you pass away.
Depreciation significantly reduces or eliminates taxes on your real estate portfolio’s cash flow.
Defer refers to the process of continually deferring incurring taxes by using a 1031 Exchange.
Die is the final stage, is where all the deferred depreciation and taxes are wiped out upon the owner’s passing.
Importantly, The Three D's apply to both active and passive real estate investors. Active investors invest on their own, while passive investors, such as those involved with Ridgeview Property Group, invest through a general partner.
Depreciate
The government acknowledges the gradual wear and tear of buildings over time, and depreciation serves as the mechanism for recuperating costs in income-producing properties. This tax write-off is often referred to as a “phantom expense”. The recovery process unfolds over the expected life of the property, allowing investors to reduce or eliminate taxable income at the end of each year.
Another critical element in optimizing depreciation benefits is bonus depreciation, introduced through the Tax Cuts and Jobs Act of 2017. This provision enables investors to depreciate up to 100% of qualifying property expenses (with a life expectancy under 20 years) all in the first year. It’s important to note, this benefit requires the implementation of a cost segregation study.
Caveat- Once you sell your property, all that depreciation will come back to bite you. Upon the sale, a depreciation recapture tax of 25% on all previously expensed depreciation will come due. This is where Defer comes into play.
Defer
A 1031 Exchange allows investors to sell one property and purchase another without triggering immediate taxes. With this strategy, taxes from appreciation gains and depreciation recapture are deferred as long as ownership of the second property is maintained. It’s through the 1031 Exchange that real estate investors can continuously defer their tax liabilities, even as they continue to trade up to larger and larger properties.
Caveat- As investors continue to trade up to larger properties, the accumulation of capital gains and recapture liabilities continue to add up. After a few decades and multiple 1031 Exchanges, selling the final property will result in decades of deferred taxes coming due! Luckily there’s a solution..
Die
Deferring taxes for multiple decades will lead to a large accumulation of capital gain and depreciation recapture tax liability. The kicker is, the entire tax liability is zeroed out when the investor passes away. This principle is known as a stepped-up basis. In this scenario, the investor passes away holding the property/ownership interest and wills it to whomever/wherever they choose. The inheritors receive the property or ownership interest, and they can sell it at any time without incurring any depreciation recapture or capital gains.
Example
Imagine an investor who initially invested $1 million with Ridgeview Property Group. Fast forward three decades, and this investor has experienced continuous long-term cash flow streams along with multiple cash-out refinances. Let’s assume the resulting ownership interests are now valued at $8 million.
If the investor chooses to transfer the property to his children while he is alive, they would be required to pay capital gains and depreciation recapture upon a property sale. If the children sell, $4M would go towards depreciation recapture and capital gains, and $4M would be split by the children.
If the investor keeps the ownership interest in his name until he passes, the children will inherit the property without capital gains or depreciation recapture implications. Now they can sell at any time, and the entire $8M would go to them.
Summary
Unlocking the full potential of real estate investment requires a savvy playbook that we call the Three "D's". It’s important to note that both active investors and passive investors can take advantage of these principles. Despite the complexity and the long-term nature of this strategy, the resulting tax savings are unmatched by just about any other investment vehicle.
Market News
Multifamily Capital Markets Navigate Challenges
According to an article by ALM Globest, the landscape of real estate investment is evolving, with multifamily lending facing challenges and loan originations plummeting. According to the article, multifamily lending witnessed a sharp 55% decline in the year up to the third quarter of 2023. Loan originations hit a seven-year low, dropping 33% from 2Q to 3Q in 2023. Government-sponsored enterprises increased lending, providing stability. However, challenges loom with $682 billion in multifamily loans maturing by 2025.
Source: ALM Globest. Multifamily Capital Markets Continue to Struggle. https://www.globest.com/2023/11/29/multifamily-capital-markets-continue-to-struggle/
Tips & Tricks
Terms:
Active Investor – An active investor is an individual or entity directly involved in making investment decisions and managing their investments. An active investor typically engages in hands-on activities related to property acquisition, management, and improvement. Active investors often dedicate significant time and effort to identify, acquire, and enhance the value of real estate assets. They may use their personal funds for investments, and their involvement can extend to property development, renovations, or active participation in the day-to-day operations of the real estate ventures they are part of.
Passive Investor – A passive investor is an individual or entity that provides capital for investments but takes a more hands-off approach in the decision-making and management processes. A passive investor typically entrusts their funds to professional managers or investment firms, such as real estate partnerships, syndicates, or funds. Unlike active investors, passive investors do not actively engage in the day-to-day operations or decision-making of the real estate projects they invest in. Instead, they rely on the expertise of companies like Ridgeview Property Group to handle property acquisition, management, and strategic decisions.