The short answer is YES!
There are numerous tax concepts that affect the real estate investor. The most common are as follows:
- Depreciation
- Preferential capital gains tax treatment
- Like-kind exchanges
In this article, I will give you a general description of each of these, and then I will lay out the potential impact that some of the proposed tax law changes may have on your real estate investment strategy and the private equity real estate industry.
Current Private Equity Real Estate Tax Benefits
Depreciation
One of the most commonly used real estate tax benefits is depreciation. Although over the last 40 years, many of the depreciation rules have become less investor-friendly, depreciation remains one of the biggest tax advantages real estate investors enjoy.
By definition, depreciation allows a company to allocate the cost of a long-term asset to the periods in which that asset benefits. The concept originated from the accounting concept of matching expenses and income to the same periods. For example, if you buy an asset that you use in your business for five years, that asset should be expensed over that five-year period. Through this accounting concept, known as matching, the company is able to match the cost of that asset over the period in which it is used to generate income.
Interestingly, the tax rules allow the owners of real estate to also depreciate the cost of the real estate over the period in which it benefits. The tax rules allow this despite the fact that generally, real estate is appreciating over time instead of depreciating. As a result, investors are able to take depreciation deductions on their tax return even though the asset is going up in value!
Preferred Capital Gains Treatment
Another very important tax benefit currently afforded to real estate investors is the concept that if you hold an asset for more than one year, and sell it, presumably for more than what you paid for it, the tax code allows you to pay a lower tax rate on the difference. This difference is known as capital gains. Alternatively, if the asset is held for less than one year this capital gains benefit is not available.
Currently, the tax rate difference is significant and is dependent upon your personal income tax situation. What is important to know is that currently, capital gains are definitely taxed at a lower rate than other types of income. A huge benefit when you sell!
Like-Kind Exchanges
The last tax benefit that I will talk about in this article is known in the real estate world as a 1031 Like-Kind Exchange. Generally, these tax rules allow you to defer the gain on the sale of an asset like real estate as long as you roll those gains into another real estate asset. The specific rules that must be followed in order to defer the tax are well beyond the scope of this article, however, it is important for you to know that it is possible to defer the tax on these gains for a very long time – even for the rest of your life!
Should the Proposed Tax Rules Change Your Real Estate Investment Strategy?
As I write this article, the current Administration is talking about making sweeping changes to each one of these significant tax benefits. Whether any or all of the changes that are being discussed will actually make it into law is anyone’s guess. There is no way for me to give you any significant guidance on this. The only thing I will say is that these tax benefits impact an enormous number of taxpayers and promotes an industry that is important in the day-to-day lives of every U.S. taxpayer. Because of that, it seems like some of these changes may be difficult to get through the legislative process. Only time will tell.
Should you change your real estate investment strategy to accommodate one or all of these potential changes in the tax law?
When I talk to clients and investors, I am always careful to remind everyone that real estate is profitable first because of the economics of the deal. If the deal does not make sense because of the economics and cash flow of the deal, then you shouldn’t do it. However, if the transaction is profitable and makes sense without considering the tax benefits, then you should do it. The tax benefits we enjoy from the ownership and investment in real estate is really icing on the cake, so to speak.
So, my answer to the question I posed at the beginning of this article is simple. We invest in real estate because of the economics of the business. Said another way, it makes money. As long as we’re able to make money in this business, then we will continue to do it regardless of the tax consequences. Of course, it is my hope that we continue to enjoy all the tax benefits that we have currently, but if they are scaled back in some way, I still think real estate should play a very important role in every investor’s portfolio.
If you want to talk with us about learning more about real estate investing or participating in our real estate investments please don’t hesitate to reach out to us.