Attention Multifamily Investors: Are you STILL Paying Taxes?

“If the American public knew how little we are taxed, we’d have a revolt on our hands!”

This (kind of shocking) statement came from a friend of mine in California — a fellow multifamily investor. This friend was right. It’s yet another reason that, after a multi-faceted career in a variety of entrepreneurial ventures, I have thrown my efforts completely into the multifamily investment ring.

I had only been in the multifamily business for a few years when this friend told me that he could take $20 million of an investor’s money and leverage it to produce $210 million in multifamily assets over 20 years. Throwing off a healthy $131 million in cash flow (to the investor) from years 11 through 20.

This seemed unbelievable, but he had math to prove his point. Then he really amazed me.

“How much do you think the investor might pay in taxes over that 20-year period?” he asked. “There’s no guarantee, since everyone’s situation is different, but I can see how he could pay as little as a few hundred thousand dollars.”

Wait. A few hundred thousand dollars tax on $131 million in free cash flow?

In fact, there are some investors who got into multifamily investing long before the recent demographic shift for the tax benefits alone.

To reiterate the importance of tax-saving strategies, I offer up this vignette from an earlier article I wrote on multifamily tax strategies:

If you take $1.00 and double it daily tax-free for 20 days, it’s worth $1,048,576. Take that same $1.00, taxed every day at 30%, it will be worth only about $40,640 — a loss of over a million dollars! Why is this so? Because with tax-free compounding, earnings accumulate not only on the principal amount of money but also accumulate on the tax-free earnings as well (“Earnings on Earnings”). Thus compounding combines earning power on principal and earning power on interest. Compounding has been called the “8th wonder of the world.” Compounding money at high rates of tax-free return is a definite advantage of real estate, especially with a great tax plan.

Expected Disclaimer

Before I proceed, I need to make a few things crystal clear:

I am not a CPA or tax professional. And I don’t play one on TV. I cannot speak to your specific tax situation, and I cannot tell you if all – or any – of these tax-advantaged strategies will work for you.
Furthermore, I can’t verify the accuracy of the information in this article. I, and many investors across the nation, utilize these tax benefits year in and year out. But that doesn’t mean we all have an intricate knowledge of the mechanics behind them. I don’t have to understand what semi-boneless ham is to enjoy its delicious taste.

Same goes here. You and I don’t have to study the details of these tax strategies to enjoy their benefits. I hired a professional tax strategist several years ago, when my business partner and I were building a Hyatt hotel. He and my CPA know the mechanics, so I can focus on other things.

My goal for this article is not to show you the mechanics behind the curtain, but to continue our conversation of multifamily topics in layman’s terms. (This is why I often say “probably” or “likely” in the rest of this article. I think I’m likely right most of the time.)

Since this article was researched and published at a given point in time, it is obviously possible that the codes, interpretations, and rulings affecting these topics may have changed by the time you read it. This is another reason to check with your own tax strategist or accountant.

So What Are These Amazing Tax-Saving Strategies?

Direct Investment When you invest in stocks or bonds, including a REIT (real estate investment trust), you are investing in a corporation. An entity that owns things and makes profits. If you invest directly, or work with the right syndicator or sponsor, you should be able to invest directly in commercial real estate. You will become a fractional (or full) owner of the property you are investing in, through a limited partnership: a single-use LLC or other entity established just for the ownership of that property. This is important, because it positions you to take advantage of the other tax benefits of this profitable asset class.
Hire a Tax Strategist I discussed this in painful detail in an earlier article. I recommend that you do this first, before implementing the other strategies I’m laying out here.
Return of Capital One of the issues you and/or your syndicator/sponsor will decide is how to treat cash distributions as they are disbursed. It is possible that your cash returns may be treated as a “return of capital” rather than taxable returns on investment.

Return of capital is a payment received from an investment that is not considered a taxable event and is not taxed as income. Instead, return of capital occurs when an investor receives a portion of his original investment. These payments are not considered income or capital gains from the investment. Depending on the structure of the investment, all of your distributions, up to the full amount of your investment, could be treated this way, and perhaps be non-taxable as a result.

This will affect your basis in the asset, and may result in higher taxes later. But as I have stated before, the time value of money received is important, and deferring taxes to a later date is a worthy goal in your investment strategy. Ask your CPA and sponsor for details about what would be best for your situation.

Accelerated Depreciation through Cost Segregation I have written about this in detail in an earlier article, but I wanted to mention it again here. This is one of the most unique and powerful strategies offered to multifamily investors. Whether you’re a syndicator or a direct investor, this is something you need to take advantage of.

Correctly Classify Fully Deductible Repairs It is easy for a uninformed clerk to classify all property rehab expenses as capital expenditures (Cap-Ex). Cap-Ex expenditures are depreciated over many years. Typically five, seven, or 15 — or much more if not classified correctly.

Repairs to the property, however, are generally classified as expenses in the current year. These expenses do not have to be spread out over years. A professional commercial multifamily accountant knows how to use the tax code to be sure every possible repair is deductible in the current period. A competent syndicator/asset manager will know the right questions to ask to be sure this is being maximized on behalf of his investors.

Refinance Tax-Free Ever refinanced your home? Were you able to pull out equity to use for something you wanted? How much tax did you pay? If your apartment complex has grown in value, as it should if operated well in a stable economic environment, you don’t have to wait until you sell the property to safely extract some of the accumulated equity. Refinancing your commercial multifamily investment can be a great way to put cash in your pocket with no tax consequence. This is obviously true for other assets as well (single family rentals, storage units, retail spaces, offices, and more).

If your Sponsor is considering this option, he will have a lender underwriting the deal, so he will likely not extract so much equity that it leaves the property short on operating capital or underwater in the event of a downturn.

Nevertheless, you should calculate how the refinance affects the debt service coverage ratio (DSCR) and how many months of principal and interest will be held in reserve to cover contingencies (we like to hold six months or more).

Here’s an example of how this could work. Note that I am being overly simplistic for the sake of space. In the real world, I’d be calculating closing costs, capital improvements, and many other items.

Imagine you bought a 200-unit multifamily asset for $50,000 per unit – a total of $10 million with a seven-year loan of $7,500,000 (75% loan-to-value ratio (LTV)). The loan was interest-only for the first few years. Equity in the deal of $3,500,000 ($2.5 million down payment plus $1 million in reserves, closing costs, and capital upgrades).

The seventh year is upon you, and the cap rate is stable. Between your upgrades and the strong multifamily demographics nationally, your net operating income (NOI) has gone up by 35%.

The value of your property, which is the NOI divided by the cap rate (assume the same as when it was purchased), has therefore gone up 35% as well, to $13,500,000.

During the past seven years, you have paid down the mortgage balance 12.6%, from $7,500,000 to $6,555,000. The owners’ equity was $2,500,000 at purchase. It has now grown to $6,945,000 ($13,500,000 value less $6,555,000 loan payoff).

Assuming you don’t want to sell the property, you can refinance at 75% LTV again; 75% of $13.5 million is $10,125,000.

How much equity can you extract? Assuming a holdback of $1 million for capital improvements and mortgage payment reserves, the operator can extract about $2,570,000 ($10,125,000 new mortgage less $6,555,000 payoff old mortgage less $1 million holdback). This is a return of over 78% in one day. In addition to the other returns the investor has been receiving along the way.

This cash is returned to all of the investors, or can be invested in a new project. Because it is refinancing of a debt, there is no tax on this distribution (or return of capital, depending on how it is booked)!

Wrapping It Up

So let’s apply several of the concepts in this article to the example we started above:

You’ve invested with a reputable sponsor who has put together a single-use LLC to purchase an apartment complex for $10 million. You confirmed the structure of the deal with your tax strategist, who liked the direct investment opportunity.

You did your own analysis of the asset by reviewing the MSA and the submarket. Your sponsor hired a great property manager and spent three years upgrading the interiors, which drove significant rent increases and improved occupancy.

Costs have been held in check, and the property has thrown off a healthy average 7% annual cash-on-cash return for the past seven years. You’ve already received almost 50% of your original investment as a result (7 years * 7%).

So how much have you paid in taxes? Zip.

The sponsor is depreciating the appropriate percentage of the cost of the building and other improvements each year. Additionally, a cost segregation study allowed accountants to deduct dramatically more from the NOI of the property, which is your NOI since you’re a direct owner of this property. So far, for seven years, you’ve received a passive loss on your tax return each year. Yet you’ve pocketed almost half of what you originally invested.

Now you get word that the sponsor is refinancing the property, and you will receive about 78% of what you originally invested in one day. Also tax-free, since it was generated through refinancing a debt.

You’ve still paid exactly zero in taxes.

Wait, this sounds too good to be true. We’ll have to pay the piper someday, right?

Yep.

Unless you don’t.

What do you think? Is it possible that this direct investor could continue to avoid taxation?

Can return of capital, a 1031 tax-deferred exchange, and a reset basis at the time of death allow this investor (and his kids) to continue in this state of tax deferred bliss? You tell me.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.