While financial metrics like internal rate of return, cash-on-cash return, cap rate, equity multiple, and others help to estimate the profitability of multifamily investing, another important component that greatly boosts this profitability potential is the benefit of tax savings that comes with these investments. Paying tax is legally binding, however, there are tricks that investors can use to reduce their tax burden. When multifamily investing meets the correct tax-saving strategies, you can considerably minimize your tax obligations and keep more money in your pocket.

During my investment journey, I have realized how powerful multifamily investing is, not just in terms of the returns it provides, but the incredible tax benefits that come exclusively with this class of asset. In today’s blog, I will discuss the top strategies that I use to reduce tax liability for myself and my investors. I encourage the up-and-coming investors to leverage these strategies so they can make the best out of multifamily investing.

1. Depreciation

Depreciation is the value reduction brought on by the deterioration of tangible assets over time. As real estate is a physical asset that depreciates with time, the IRS allows investors to write off the cost associated with the wear and tear of the property from their taxable income. It is interesting to note that in reality, multifamily appreciates over time, that is its valuation increases. However, with depreciation tax benefits, investors can reduce their tax burden by deducting the hypothetical loss in value, without actually having to spend that much on repairs.

Straight-line depreciation

Per the current US tax code, residential properties depreciate over 27.5 years of useful life and commercial properties depreciate over 39 years of useful life. This means you can deduct the depreciation value on the property’s cost basis uniformly each year for 27.5 years. This method of calculating depreciation is known as straight-line depreciation and takes the following formula:

Straight-Line Depreciation Value: Cost basis/Useful life

The cost basis of the property includes the cost of property without the land’s cost, as land is considered to have an indefinite useful life. However, certain closing fees like legal fees, transfer tax, recording fees, etc can be added to the cost basis. Thus, after deducting land value, and adding the closing costs, the cost basis of the multifamily property is obtained.

2. Cost Segregation

The Cost Segregation technique is used to accelerate depreciation deductions. It acknowledges the fact that not all components of the property depreciate at the same rate. Experts who conduct cost segregation analysis of the property, segregate different components into categories like personal property, land improvement, distributive trade and services, and so on. Kitchen fixtures that fall in personal property depreciate in over 5 years, parking lots that come under land improvement depreciate in over 15 years, and similarly, other components with 5-, 7-, and 15-years of useful life are segregated and accordingly used to calculate the depreciation value.

By reducing the useful life of various components, the depreciation amount is greatly increased using this strategy. As multifamily properties have multiple units, they make an excellent candidate for cost segregation studies.

3. 1031 Exchange

1031 exchange saves the big tax bill upon the sale of the property. With a 1031 exchange, during the sale of a property, the investors reinvest the proceeds into another like-kind property while deferring the payment of capital gains taxes. These transactions can be conducted repeatedly and without a time limit, enabling tax-free capital growth.

4. Mortgage Interest Deduction

This tax benefit allows multifamily property owners to deduct the interest paid on property loans from their taxable income. A deduction is allowed on the first $750,000 of mortgage debt.

5. Cash-out Refinancing

It is common for multifamily investors to invest in value-add properties. After the renovations are complete and the property has been appreciated, the investors can refinance their increased equity in the property. Using cash-out refinancing, investors convert their increased equity to cash. The cash proceeds obtained from cash refinancing are tax-free and used to make a down payment on a new property or update an existing property and force appreciation in multifamily investments without having to pay any tax. Thus, with cash-out refinance tax benefits, investors can keep increasing passive income sources in a tax-free manner.

The Bottom Line

Multifamily investing comes with incredible tax benefits that massively boost the profitability potential by sheltering the cash flow from tax deductions. However, barriers to multifamily investing can be high and not every investor possesses the required expertise, experience, and time to personally own and operate an apartment. This makes Multifamily syndications an attractive option, as they provide regular passive income to its investors along with the massive tax benefits that come with it.

If you want to maximize your passive income while leveraging the tax benefits from multifamily investing, feel free to block my calendar so we can discuss your financial goals and draft an investment strategy that aligns with them.