To quote the great Benjamin Franklin, “In this world nothing can be said to be certain, except death and taxes.”  How true this is.  Those in the highest tax bracket, including most physicians, pay somewhere between 30-50% of their income in taxes – that’s like working up to the first 6 months of every year just to pay the government!  We are talking federal income tax, state taxes, payroll taxes, the additional Medicare tax, net investment income tax, sales tax, property tax, gas tax, and all the other government fees and taxes.  Ouch!
 
I spent years of medical training learning the skill and art of reducing pain.  Unfortunately, that training did very little to provide a solution for alleviating the pain of taxes.  However, real estate does!  Real estate is one of the most tax-advantaged investments available.  Now, you may be thinking, “why would the government make anything tax-advantaged?”  Congress uses the tax code to incentivize behavior that they deem beneficial to society – a form of legal bribery!  It just so happens that providing housing to others is on the top of the list.  When we invest in apartment buildings for example, we are providing a place for people to live.  If the private sector did not offer this, the government would have to do it and we all know what an inefficient job they do.  In fact, they know this as well, which is why they encourage the private sector to invest in real estate - by offering tax breaks.
 
So, let's talk about some of the tax advantages of owning real estate...

1. Depreciation
At the top of the list when it comes to tax advantages is depreciation – generating losses for tax purposes.  Now I am not talking about losing money in an investment just because it’s deductible.  After all, you don’t get rich spending a dollar to save 30 cents!  Depreciation is a non-cash expense and is what creates the paper losses for real estate.  The purpose is to spread the cost of an asset over its useful life.  “Useful life” has been determined by Congress. For residential property it is set at 27.5 years and for commercial property it is 39 years.  Although apartment buildings are considered commercial real estate, for depreciation purposes it is determined residential by its use.  An important point should be made that land is not considered depreciable.  Therefore, in order to calculate depreciation, we need to subtract out the land value from the total purchase price.  As a rule of thumb, for a single-unit building, land is allocated at 20% of the purchase price, and for a multi-unit building it is allocated at 15% of the purchase price.  For an apartment building, the depreciation is calculated as follows:
 
Depreciation deduction per year = Building Value / Useful Life = Purchase price x 85% / 27.5 years
 
Again, this is a deduction that does not cost you anything!  So, it is quite possible to have positive cash flow, while your investment produces “paper losses” from the depreciation deduction on your tax return.  Let’s take a look at an example...
 
-Apartment building purchase price = $4,000,000
-Building value = $3,400,000 (Purchase Price x 85%)
-Depreciable deduction per year = $123,636!
 
You get a $123,636 depreciation deduction each year which can be applied against your positive cash flow – and very likely you pay no taxes on your cash flow for several years due to this paper loss!  This is awesome!... but it gets better...
 
There are also ways to speed up the depreciation, resulting in even more tax savings per year.  Certain aspects of the structure can be depreciated over 5, 7, 12, or 15 years (e.g., furniture, appliances, fixtures, wiring, etc.).  To visualize the amount using the above example, imagine calculating the depreciable deduction per year by dividing by 5 years instead of 27.5 years for certain aspects...as that denominator gets smaller (27.5 to 5), your depreciable deduction per year is getting bigger!
 
On a side note, depreciation is a passive activity loss that gets reported on a K-1.  Those investors who have K-1 activity gains from other business activity are pleasantly surprised to find that our paper losses can offset their actual gains and save them taxes in other areas of their portfolio...pretty neat stuff!

2. Refinance
Competent asset managers are always looking for ways to increase the value of the property.  Unlike with residential real estate, with commercial real estate you have the ability to force appreciation and drive value (Value = NOI / cap rate).  By increasing rents, reducing expenses, and improving retention, your yield and the value of your investment goes up.  Because equity invariably grows faster than income, this equity – from forced appreciation and loan principal paydown by your tenants – starts to become lazy.  This “lazy equity,” can be harvested through a refinance event, and redeployed into another income producing property.  You now have two properties that are spinning off cash flow, increasing your overall yield, and increasing in equity.  So, unlike stocks, you don’t have to sell off your investment to appreciate the appreciation - and also end up paying a capital gains tax!  In fact, the cash taken out during a refinance to purchase another property is a tax-free event!  The result – multiple assets increasing in value and providing yield from one initial investment.

3. Starker 1031 Exchange
When it comes time to sell your property, you will be required to pay back to the government all of the depreciation losses you took (called depreciation recapture tax) as well as a capital gains tax.  Fortunately, the capital gains tax for an asset held for longer than a year is capped and much lower than the highest tax bracket.  Well, it was a fun ride while it lasted, right?  But wait, there is yet another way to get around this capital gains tax!  By taking proceeds from your sale and investing it into another like-minded property, you can defer both the capital gains and depreciation recapture tax!  And when you sell your next property, you can do the same thing – and do it over and over and over!  Essentially, you keep using the government’s money to invest in properties.

4. Legacy Wealth Transfer
As we discussed, when you buy a property and then sell it for a profit, we must pay a capital gains tax on the gain if we are not doing a 1031 exchange.  As an example, let us assume we bought a $4,000,000 apartment building which we later sell for $10,000,000.  For simplicity sake, let us also assume that the mortgage has been completely paid down and omit any fees/costs related to the sale.  If we do not do a 1031 Exchange as described above, our proceeds from the sale would be $10,000,000 and we would be required to pay capital gains on the difference of your selling price ($10,000,000) and your original cost basis ($4,000,000) – a capital gains tax on $6,000,000. As of this writing, for the highest tax bracket, that would be 20% of $6,000,000 - $1,200,000. In addition, if you have completely consumed the entire depreciation amount ($4,000,000 x 85% = $3,400,000), as of this writing, you would also have to pay a depreciation recapture tax of 25% of $3,400,000 - $850,000. Now that's a large check you have to write to the government!
 
However, if the property is inherited by your heirs, the equation completely changes.  Upon death, one’s heirs inherit the real estate on a stepped up basis.  In other words, the original cost basis resets to current market value (from $4,000,000 to $10,000,000).  Imagine if your heir sold the property immediately after your death for the same $10,000,000.  Their sales proceeds would also be $10,000,000, but their tax burden would be the selling price ($10,000,000) minus the stepped up cost basis ($10,000,000) – or a tax on $0!  Oh, and by the way...all depreciation recapture tax goes away as well!
 
Real estate is absolutely the best way to transfer wealth to the next generation.  One can acquire properties over their lifetime, depreciate them annually, sell and defer the taxes using a 1031 exchange, and continue to hold for appreciation and cash-flow.  They when one dies, all of that tax that had been deferred simply gets erased permanently!

Given the progressive nature of our tax system, high income and high net worth individuals (like our investors) typically shoulder a much heavier tax load than the average American.  With that having been said, this weight can be lessened by understanding the fact that the entire U.S. tax system is designed to encourage certain behaviors in society by rewarding or penalizing people for certain actions.  In the case of apartment investing, it is rewarding because we are providing housing for the masses.
 
Did you know that the majority of the U.S. tax code is about how to legally avoid taxes? – avoid, NOT evade!  We should pay every cent of our tax burden. But why give the government a tip?  Apartment investing opens a world of tax-advantaged investing and legacy wealth transfer that just cannot be seen with other investments types. LRG Properties can provide you access to this asset type and help you "Innervate Your Investments!"
 

To learn more about commercial multifamily real estate investing with LRG Properties, download your free report.

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***Note: This is not professional tax advice.  Consult with your tax professional to better understand your individual tax situation. The above was designed to educate and provide general information regarding the subject matter covered.  However, laws and practices often vary from state to state and are subject to change.  For this reason, the user is advised to consult with his or her own adviser regarding that individual’s specific situation.  The author has taken reasonable precautions in the preparation of this material and believes the facts presented are accurate as of the date written.  However, the author assumes no responsibility for errors or omissions, and disclaims any liability resulting from the use or application of the information stated above and is not intended to serve as legal or accounting advice related to individual situations.