Investing in multifamily real estate can be lucrative, offering steady income streams and long-term capital appreciation. However, it also comes with a unique set of tax implications, and navigating the ever-changing taxation landscape for multifamily properties is crucial for investors aiming to maximize their returns and stay compliant with the law. This article explores several key aspects of multifamily real estate taxation.
Depreciation: A Major Tax Benefit
One of the most significant tax advantages of investing in multifamily real estate is depreciation. Under the Internal Revenue Code (IRC) Section 167, the value of a building (but not the land) can be depreciated over 27.5 years for residential properties.
Additionally, some components of the property may qualify for a depreciable life of less than 27.5 years, such as five, seven or 15 years, accelerating depreciation expense. This allows investors to deduct a portion of the property’s cost each year, reducing their taxable income.
Interest Deduction
Mortgage interest is another major deduction available to multifamily property investors. Under IRC Section 163, the interest paid on loans used to acquire or improve the property can be deducted from rental income, reducing the overall tax burden.
However, real estate investors should be aware that under IRC Section 163(j), interest expense can be limited, reducing the allowable deduction in the year the interest was incurred. The good news is that there are several planning opportunities that can help mitigate the impact of 163(j) interest limitation on the real estate industry.
Operating Expenses
Investors can deduct various operating expenses associated with managing and maintaining a multifamily property. These may include property management fees, repairs and maintenance, utilities, insurance, legal and tax preparation fees and property taxes. Careful consideration must be given when deducting repairs and maintenance expenses; some may need to be capitalized rather than expensed. Investors can reduce their taxable income by diligently tracking and claiming these expenses.
1031 Exchange: Deferring Capital Gains
A powerful strategy for multifamily real estate investors is the 1031 exchange. This allows investors to defer paying capital gains tax on the sale of a property if they reinvest the proceeds into a similar, like-kind property within a specified timeframe.
To qualify for a 1031 exchange, the replacement property must be identified within 45 days of the sale, and the purchase must be completed within 180 days. Sellers must utilize a qualified intermediary to facilitate the collection and distribution of funds throughout the exchange process. Even in a properly executed 1031 exchange some states may still require taxes to be withheld from the sale of property. The 1031 exchange strategy enables investors to leverage their gains to acquire larger or more lucrative properties without immediately incurring a hefty tax bill.
Passive Activity Loss Rules
The IRS classifies rental real estate as a passive activity, meaning losses from these activities can typically only offset income from other passive activities. However, there are two exceptions under IRC Section 469.
First, if you actively participate in managing the property and your adjusted gross income (AGI) is below $100,000, you may be able to deduct up to $25,000 of passive losses against your non-passive income. This allowance phases out for AGIs between $100,000 and $150,000.
Second, real estate professionals who spend more than 750 hours per year and over 50% of their working time materially participating in real estate activities can off set passive losses against other income without limitation. The complexities surrounding real estate professional status are not discussed here in detail; special consideration should be used in determining real estate professional qualifications.
State and Local Taxes
In addition to federal taxes, multifamily real estate investors must navigate state and local tax obligations. Property taxes, which are levied by local governments, can vary widely by location and significantly impact the profitability of an investment.
State income taxes also impact an investor’s profitability. The $10,000 limit often impacts the deduction of state income taxes from a taxpayer’s federal income on state and local taxes claimed as itemized deductions. If real estate is owned by a pass-through entity such as a partnership or S corporation, in some cases, state income taxes may be paid at the entity level to allow for a deduction from federal income over the $10,000 cap. These are known as pass-through entity taxes and vary by state.
Conclusion: Strategic Tax Planning is Key
The taxation of multifamily real estate is complex, but with careful planning and the right strategies, investors can optimize their tax positions and maximize their investment returns.
Investors should work closely with an experienced tax advisor specializing in the complexities of the tax code and regulations pertaining to rental real estate.
Peter Dixon
Tax Manager
CBIZ
One Citizen’s Plaza, 9th Floor
Providence, RI 02903
(409) 626-3200
