Potential Tax Benefits of Private Real Estate Investing
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The following is a guest post by Nathan Clayberg, Assistant Vice President at MLG Capital, a private commercial real estate company.
As anyone who reads this blog knows, my two favorite aspects of real estate investing are cash flow & tax savings.
I asked Nathan to write up a blog post addressing how a private real estate company thinks about those those two aspects for their investors.
MLG Capital is a long-time partner of Passive Income MD. This is not a sponsored post.
Many of us have likely heard of the old adages saying, “Don’t count your chickens before they hatch.” Or, “You can’t put the cart before the horse.” Without any real experience in chicken raising or cart driving, the general message is clear – it’s often crucial to take things one step at a time and jumbling the order of priority can negatively affect a desired outcome.
To maximize wealth through real estate, it’s important for investors to carefully consider a two-step process: first, engaging in smart real estate deals, and second, doing great tax planning around it.
The chronology of this process is important, as failure to carefully consider step one can make step two completely irrelevant – you must make money on the deal before you can figure out how to manage the taxes!
At MLG Capital, we have a long track record of doing the types of smart deals that end up making our investors' money, but how we go about that is a topic for a different day. This article is about step two of the process – how real estate can be used to maximize the after-tax return realized by investors.
After all, at the end of the day what matters most is how much of the return is going into your pocket as an investor. This article summarizes some of the tax benefits we have been able to achieve for our investors.
Tax Deferred Income
When purchasing an apartment building, we will generally use a cost segregation study to break up the purchase into various assets. Each asset can then be treated separately for depreciation purposes; further, allocations to assets with shorter class lives and assets that are eligible for bonus depreciation can materially accelerate beneficial depreciation deductions.
These depreciation deductions can then be used to reduce the rental income and even create beneficial taxable losses for investors.
We often find that a first-year loss allocation can amount to around 50-60% of capital contributed and these beneficial losses are all passed back to investors! Of course, these are just paper losses, as the assets are still producing positive cash flow, but these losses can be very powerful, as they can commonly be used to offset and defer other passive income that investors may have within their portfolio.
If these losses cannot be used each year, they can often be carried forward to offset future passive income.
This benefit typically results in significant tax deferred income for investors. This can be a very powerful tool. Especially, for folks who are highly compensated and highly taxed. This deferred income is typically classified as ordinary income and can often be subject to tax rates at or near 40% (plus state taxes on top)!
The ability to defer this income is meaningful as it allows investors to capture the benefit of the time value of money – a dollar in your pocket today is worth more than a dollar in your pocket five years from now.
Fact: As of 12/31/2020, our series of private funds each have produced cumulative beneficial ordinary loss throughout the life cycle of the fund, all the while producing desirable returns for investors.
Permanent Tax Savings
While the benefit of deferred income is nice, the goal is ultimately to produce permanent tax efficient income for investors. Our tax strategy centers around capturing the delta between ordinary income tax rates and capital gain rates, often producing an all-in tax rate in the mid 20% range.
This difference in tax rates can be dramatic for highly compensated individuals, who are taxed at the highest federal ordinary rates. When the ordinary passive losses (generated from past accelerated depreciation) can be utilized due to triggering passive capital gains (selling the asset), a highly compensated individual may very well benefit from tax savings due to the income tax rate differential between capital gain rates (20-25%) and ordinary rates (37%+).
If you’d like to learn more about this and other tax strategies, our CEO, Tim Wallen, penned an article you may find interesting.
Don't Forget the Key Principles
So as you're looking to build wealth through real estate investing, remember the two key principles again: 1) Find smart real estate deals, and 2) Make sure to do great tax planning around it.
Our series of funds target cash on cash yields, quarterly distributions, and appreciation over time for investors in a tax efficient manner. You can learn more here. Take the first, or next step in your real estate investment journey with us.
This release is for informational purposes only and is qualified in its entirety by reference to the Confidential Private Placement Memorandum (as modified or supplemented from time to time, the “Memorandum”) of MLG Private Fund V LLC (the “Main Fund”) and MLG Dividend Fund V LLC (the “Parallel Fund,” and together with the Main Fund, the “Fund”), the limited liability company agreements (the “LLCAs”) of the Main Fund and the Parallel Fund, each as may be amended and/or modified form time to time, and a subscription agreement related thereto, copies of which will be made available upon request and should be reviewed before purchasing a Units in the Fund. This release is not intended to be relied upon as the basis for an investment decision, and is not, and should not be assumed to be, complete. The contents of this release are not to be considered as legal, business or tax advice, and each prospective investor should consult its own attorney, business advisor and tax advisor as to legal, business, and tax advice. This release does not constitute an offer or solicitation in any state or other jurisdiction to subscribe for or purchase limited partnership interests in an offering. Recipients of this release agree that the manager and offerings, its affiliates and their respective partners, members, employees, officers, directors, agents, and representatives shall have no liability for any misstatement or omission of fact or for any opinion expressed herein. An investment into a private offering is subject to various risks, none of which are described herein
Disclaimer: The topic presented in this article is provided as general information and for educational purposes. It is not a substitute for professional advice. Accordingly, before taking action, consult with your team of professionals.