Getting Ahead of Capital Gains Taxes
Successful multifamily investors should have a strategy when it comes to their taxes, so here are some important things to consider when dealing with capital gains taxes.
Capital Gains Tax Basics
Capital gains taxes are collected any time a taxpayer generates a profit from disposing of an asset such as commercial real estate, bonds, or expensive collectibles. Capital gains taxes do not typically apply to ordinary personal and business income or the sale of an individual’s primary residence. That said, multifamily investors who don’t want to see a large portion of their profits consumed by an outsized tax bill should definitely think ahead and strategize for the inevitable capital gains taxes that they will face.
The first consideration of note would be whether or not the asset in question is held over a long term (over 12 months) or a short term (under 12 months). Capital Gains taxes are split into two unique categories; short-term capital gains taxes, and long-term capital gains taxes, with the rates that a taxpayer must face depending primarily on which category their asset falls into. While short-term capital gains taxes follow the federal tax brackets, long-term capital gains taxes have their own unique rates.
In general, at least from a tax perspective, it’s more expensive to “flip” a commercial property and sell it within 12 months vs. holding it for a longer period of time before selling. Similar to income taxes, capital gains tax rates vary depending upon the individual taxpayer’s income during the year in which they sell a property. Since there is a progressive tax system in the United States, taxpayers must only pay the higher tax rates on their income over and above the previous tax rate.
Capital Gains Taxes and 1031 Exchanges
1031 Exchanges, which allow an investor to defer their capital gains tax bill by “exchanging” their current property with a commercial property of similar value, are greatly appreciated by multifamily investors. However, a 1031 exchange is not without a few rules that must be adhered to. The most important of all of these rules is that the new property must cost at least as much as the original one, and personal residences are not eligible. Investors are not required to already have a new property lined up immediately for the exchange to take place; instead, they can utilize something called a reverse 1031 exchange. This allows a delay in purchasing the exchange property for a period of 180 days (additional time may be allowed in some scenarios). The 1031 exchange also generally allows borrowers to delay paying depreciation recapture taxes, though they will still be required to pay them at some point.
Depreciation Deductions and Depreciation Recapture Tax
It must be firmly understood by any multifamily investor that if they own a commercial or multifamily property, that property will naturally age, require repairs, and inherently depreciate in value over time. Fortunately for investors, the federal government allows taxpayers to take property depreciation deductions against federal income taxes to represent a loss in asset value. On average, multifamily properties are generally depreciated over a period of 27.5 years, while properties with solely commercial usage are typically depreciated over 39 years.
When an investor sells a property for a higher amount than the depreciated value, they will be required to pay taxes on any depreciation deductions they have taken. This is what is referred to as the depreciation recapture tax (often referred to as a Section 1250 gain, and taxed at 25%). An easy way to think of it is that if an investor buys a $1 million apartment building and takes $200,000 in depreciation deductions against their federal income taxes, they will be required to pay taxes on that $200,000 upon the sale of the property for any amount greater than or equal to $800,000.
Accelerated depreciation deductions can be arranged via ordering a cost segregation study, which identifies parts of a property (i.e., carpeting, insulation, etc.) that can be depreciated over a shorter period (i.e., 5 or 15 years). On top of this, a temporary provision of the Tax Cuts and Jobs Act of 2017 (extended through 2026) allows investors to take an even larger depreciation deduction in the first year that they own a property (widely referred to as bonus depreciation). It’s important to realize that these accelerated deductions will still be subject to depreciation recapture later on.
The Effects of the Opportunity Zones Program on Capital Gains Taxes
The Opportunity Zones program, which allows multifamily and commercial real estate investors to defer their capital gains taxes until December 31st, 2026 by reinvesting their assets into a Qualified Opportunity Fund (QOF), was authorized as far back as 2017 as a part of the Tax Cuts and Jobs Act. The purpose behind the program was to revitalize the lowest-income census tracts in the U.S. by encouraging additional investments in these areas.
Deferring capital gains taxes for up to 7 years may be quite enough of an incentive for many a multifamily investor, but the program offers some additional incentives to further sweeten the deal. Those investors who keep their money in a QOF for at least 5 years before the end date of December 31, 2026, are permitted to take a 10% reduction in their capital gains tax basis, while those who keep their money in a QOF for at least 7 years before December 31, 2026, are permitted to take 15% reduction in their capital gains tax basis (this only encompasses those who chose to invest prior to December 31, 2019.)
Tax Loss Harvesting
Another consideration worth mentioning to multifamily investors looking to create a tax strategy is that if you have an investment that you can sell at a loss (including art and collectibles), you can utilize that loss to offset your capital gains taxes. This is what is commonly referred to as tax-loss harvesting. So in practice, if you were to sell an apartment building and generate a taxable profit of $200,000, but sell a separate investment at a $100,000 loss, this would reduce the capital gains tax bill to $100,000.