Tax Benefits of Private Real Estate Equity Investing

Private real estate equity investing can offer potentially attractive tax benefits to U.S. taxable investors, which may lead to higher after-tax returns than investments in other asset classes. These benefits may include depreciation deductions, long-term capital gains tax treatment, and deferred taxes via incentive programs.

In the landscape of real estate investments, it is common practice for stated return targets to be presented before factoring in taxes. However, it is critical for investors to recognize that the tax treatment of different investment types - stocks, fixed income, and alternative investments - may vary.  To make well-informed investment decisions, investors should learn about and thoroughly evaluate the tax implications associated with different investment opportunities.

Depreciation

One tax benefit of private real estate equity investments, which is not typically available in other investments, is that property income can be offset by depreciation, thereby potentially delaying and ultimately decreasing an investor’s tax payments.

Depreciation deductions reduce a real estate investor’s taxable income, and therefore result in lower tax payments during an investor’s hold period. Upon the sale of the asset, the investor must pay a “depreciation recapture” tax, but that tax rate, 25%, is lower than many marginal tax rates.^[2]

What is Depreciation?

Real estate assets experience wear and tear over time. The United States tax code allows private real estate equity investors to deduct a portion of the property’s value over time to account for this “depreciation,” even if the market value of the property has gone up or if the property is generating income.

Calculation and Contribution to Tax Liability

There are multiple methods of calculating depreciation, but the simplest one is straight-line depreciation, which depreciates property value evenly over its useful life. The IRS defines useful life as 27.5 years for residential properties, and 39 years for commercial properties. Land value is excluded from depreciation calculations. It's important to note that the value eligible for depreciation is not static and it can evolve over the property's hold period. The depreciable basis can potentially be increased to reflect the evolving asset value, including renovation costs and other expenditures, leading to potentially higher depreciation. Depreciation deductions apply solely to existing real estate assets and do not extend to those under development. According to IRS guidelines^[3], real property becomes depreciable upon being "placed in service," indicating its availability for its specific use,  irrespective of whether it is actually being used.

The decrease in taxable income resulting from annual depreciation expenses may result in lower tax payments during an investor’s hold period.

Example:^[a][4]

An investor buys a multifamily property for $100mm with $60mm of debt ($40mm of equity) and $2.4mm of cash flow after debt service (6% initial cash yield on equity). $20mm of the purchase price is associated with the price of the land for depreciation calculation purposes. The multifamily property’s useful life is 27.5 years, as defined by the tax code.

Depreciation expense would be calculated as:

$100mm (Total property value) - $20mm (land value) = $80mm (depreciable basis)

$80mm / 27.5 years (useful life of residential property) = $2.9mm (annual depreciation expense)

In the first year, the $2.9mm depreciation expense would be deducted from your total taxable income ($2.4mm) each year, resulting in no tax liability for that year since the depreciation more than offsets the asset’s income and delivers a net taxable loss.

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Year 1 Cash Yield Comparison

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As such, an investor is saving up to $880k of potential tax payments in Year 1. Importantly, the payment of depreciation recapture at sale allows an investor the opportunity to invest the excess cash saved during the hold period ($880k in the example above) in other investments, potentially allowing for further compounding of returns.

These benefits can continue for multiple years, though it's important to note that depreciation deductions will be recaptured and taxed when the property is sold. Upon the sale of a real estate asset, a recapture tax rate of 25% may be applicable on any depreciation deductions taken. Compared to other possible investments, this 25% recapture tax rate may still be lower than the marginal ordinary income tax rate (up to 37%) that an investor may have otherwise paid during the holding period on investment income from stock ordinary dividends or bond interest, for example.

Below is a detailed analysis of potential tax treatment over an investor’s hold period for a hypothetical investment^[5].

Average Tax Rate on Total Profits for a Hypothetical Investment (7 year Hold)

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Long-Term Vs. Short-Term Capital Gains Tax Treatment

A second benefit of private real estate investing is that taxes on any investment must be paid on (1) income generated during an investment’s hold period, which is typically taxed as ordinary income, and (2) profit generated upon the sale of an investment, which may be taxed as short-term or long-term capital gains.

When an investment is sold for a profit, the difference between the sale price and the tax basis is considered a capital gain and is subject to tax. The tax obligation varies based on how long you hold the asset before selling it. The IRS categorizes capital gains into two main groups: short-term and long-term capital gains.

Federal long-term capital gains are gains realized from the sale of investments that were held for more than one year, and are taxed at rates between 0% and 20% (plus net investment income rate of 3.8%, if applicable), depending on an investor’s income level.^[6] Because many marginal tax rates on ordinary or interest income are higher than these capital gains tax rates, long-term capital gains can lead to reduced tax liabilities relative to other investments.

Profits from the sale of real estate investments typically receive long-term capital gains treatment because properties are typically held for more than a year to allow time to execute the business plan. A business plan could involve completing a renovation, implementing new management practices, or leasing up the asset.

Federal short-term capital gains are gains realized from sale of investments that were held for less than a year, such as buying and selling a stock in less than a year. Short-term capital gains may be taxed at ordinary income rates ranging from 10% to 37%, depending on your income level,^[7] which may be higher than the applicable long-term capital gains tax rate in most cases.

100% Pass-Through of Income and Losses to Investors

Real estate investments may be held in limited liability company (LLC) structures, which are not typically subject to income tax at the entity level. Instead, all profits and losses flow directly to the investors, and  investors include their share of the LLC’s income or loss on their tax return,  so they are not subject to potential double taxation. To the extent the asset is held in an LLC, the investor will receive a K-1 tax document at the end of each year. The K-1 tax document provides a comprehensive breakdown of income, losses, and deductions, facilitating accurate reporting and enhancing the overall tax efficiency of real estate investments held within an LLC structure.

Real Estate Tax Incentive Programs

Qualified Opportunity Zones (QOZs): Opportunity Zones serve as a mechanism for individuals to invest in economically underserved areas within the United States. The primary objective is to stimulate economic growth and job opportunities in low-income communities through development and revitalization, while providing tax advantages to the investors involved. Some of these tax advantages are explained below:

• Deferred Capital Gains Taxes from the Sale of an Investment: By investing capital gains from the sale of any investment (e.g., stocks, bonds, a business, or real estate) into a Qualified Opportunity Fund (QOF) within 180 days of the date that the gain would be recognized for federal income tax purposes, investors can defer the payment of capital gains taxes on that original gain until the Qualified Opportunity Fund investment is sold or until December 31, 2026, whichever comes earlier. In addition to deferring the payment of capital gains tax, this also allows investors to reinvest their pre-tax capital gains and potentially earn additional returns over the deferral period.^[8]

• Tax Exemption on Gains from Qualified Opportunity Fund Investment: If the QOF investment is held for at least ten years, any capital gains generated from the appreciation of the investment within the QOZ can be completely tax-exempt. This means that the investor pays no capital gains tax on the appreciation of the QOF investment.
• Depreciation Recapture Tax Elimination: Once the asset in the Qualified Opportunity Fund is developed and operating, taxable income from the cash-flowing property may be offset by depreciation, and if the investment is held for ten years or more, the depreciation recapture tax on the QOF investment is also eliminated.

You can explore the list of designated Opportunity Zones here.

1031 Exchanges: A 1031 exchange, also known as a like-kind exchange, allows investors to defer paying capital gains taxes on the sale of real estate by reinvesting the proceeds in a “like-kind” property. Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.^[9] To receive the full benefit of a 1031 exchange, the investor’s replacement property should be of equal or greater value. The investor must identify a replacement property for the assets sold within 45 days and then conclude the exchange within 180 days.

Rather than recognizing and paying taxes on the capital gains, the investor can reinvest the proceeds into a replacement property and defer the tax liability until a future sale. Investors can repeat this process as many times as they like. Capital gains tax will be due on the final transaction that does not include a 1031 exchange.

Conclusion

Private real estate equity investing offers potentially attractive tax benefits such as depreciation deductions, long-term capital gains tax treatment, and deferred taxes via incentive programs. These benefits may lead to higher after-tax returns than investments in other asset classes, which is one reason sophisticated investors often seek to allocate capital to the sector.

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