Many investors favor multi-family properties because of the consistently robust multi-family market and the resulting significant financial return on investment. Along with providing the opportunity to earn rental income, multi-family projects offer a number of tax benefits to the thoughtful investor. Taking advantage of these benefits allows a property owner to increase cash flow in the short term while maximizing tax savings over time.
Depreciation and Cost Segregation
One of the tax benefits multi-family property can provide is the ability to deduct depreciation of the property from your taxable income. Usually, the amount you are able to deduct is calculated based on the federal depreciation table and MACRS class lives for the property. Multi-family properties classified as residential rental real estate can be depreciated over the course of 27.5 years. Depreciation typically includes the cost of the building and improvements less the amount allocated to the land.
While you are certainly able to depreciate the value of the property over 27.5 years, you will find that cost segregation allows you to maximize your tax benefits and improve your cash flow by accelerating depreciation over a shorter period of time. Instead of looking at the building or property as a whole, a cost segregation study allows for the division the property into distinct assets such as window treatments, carpets, and even landscaping, many of which have a shorter useful life than the building as a whole. This allows you to depreciate different assets of the property over a shorter life, increasing deductions that offset income in the early years of ownership, and taking advantage of the time value of money.
For example, imagine you paid $5 million for a residential multi-family property, and the basis of the building, less land allocation, was $4,000,000. If you were to depreciate the value over the standard 27.5-years, you could deduct $145,450 each year. But, if you were able to accelerate 10% of the basis to land improvements (15-year MACRS life) and 15% of the basis to personal property (5-year MACRS life), the approximate 10 year Net Present Value tax savings by accelerating depreciation would be $190,000.
Another tax benefit of owning a multi-family property is the ability to deduct the cost of interest payments made on the loan during construction. The ability to write off interest from taxable income can improve your cash flow by reducing your tax burden. You can also deduct any credit card interest or interest from a loan if the funds were used for property repair, or for some other function related to property ownership or rental.
Repair vs. Capital
You are able to deduct the cost of expenses related to owning a multi-family property, whether those expenses are related to repairing the property, maintaining it, or finding and retaining tenants. However, you can only deduct expenses related to units you rent out. If you live in one of the units in the property, you can’t use it to claim any deductions. The Tangible Property Regulations were finalized in the fall of 2013 by the IRS and present many potential areas of benefit. They have introduced a greater level of complexity along with a greater potential for benefit, and require more consideration when selecting the appropriate strategies. Ultimately, it is all about proactive tax planning.
It’s important to note that there is a difference between repairing an asset and completely replacing that asset. If the roof was leaking and you hired someone to patch it up, that would be considered a repair and you could deduct the full amount in that calendar year. In contrast, if you completely replaced the roof, that would be considered an improvement requiring capitalization and depreciation over the appropriate schedule. If the roof was completely replaced, the remaining depreciable basis of the old roof may be written off as a Partial Asset Disposition Election under the new Tangible Property Regulations.
The Capstan team is committed to helping clients maximize their tax savings and make the most of their real estate. If you want to learn more about cost segregation or other tax strategies, contact us today.