The Tax Benefits of Value-Add Real Estate Investing

INVESTOR EDUCATION

If your goal is to attain wealth, maximizing your unrealized (non-taxable) income is essential. It’s not about how much money you make; it’s about how much money you keep.

One of  the greatest tax-related benefits of investing in real estate is the ability to shelter income through depreciation. In this article, we’ll give you a run-down of exactly how that works, along with an additional tax shelter strategy that benefits real estate investors: the 1031 exchange.

Investing in real estate - and specifically value-add real estate, for reasons that we’ll delve into soon - is one of the best ways to shelter and defer your tax bill, making it an essential component of any high-performing investor’s portfolio.

First, let’s define forced appreciation.

What is Forced Appreciation?

Forced appreciation is the strategy at the heart of value-add investing: an investor locates a property with some level of deterioration and he addresses those problems through additional investment, aiming to increase revenue and decrease expenses. This is the exact approach we take here at Valiance Capital.

Once the property’s biggest issues are dealt with, the property can command more expensive rents, higher-quality tenants, and longer lease terms. All of these things contribute to a higher net operating income (the building’s revenue minus its expenses). This, in turn, increases the property’s value, “forcing” appreciation.

But what exactly does that have to do with tax savings?

How does this benefit the average investor who’s interested in sheltering his tax bill?

Why is Forced Appreciation Great for Tax Savings?

At its most basic, forced appreciation is great for tax savings because it maximizes depreciation.

Let’s first explain depreciation.  Depreciation is a financial term used to describe the deductible expense of a physical asset over its useful life.  Per the IRS code, Residential Real Estate is depreciated over a useful life of 27.5 years.  However, there’s an opportunity to accelerate this depreciation through a special tax study, called Cost Segregation, which is something Valiance does for all of its investments.

When a property is acquired, not only can the existing building be depreciated, so can all of the additional investments made to improve the property.  Depreciation allows business owners to write off any expense related to buying and improving a property. These tax benefits exist because the government wants to incentivize investors and businesspeople to renew and reconstruct dilapidated buildings and maintain existing ones, because doing so generates economic activity that would promote growth. One person’s spending is another person’s income.

When you purchase real estate, you’re buying the land and everything on top of it, including the HVAC, electrical, and plumbing systems. All of these components have different depreciation schedules because they have different expected lifespans. So, when you replace or improve it, you’re adding to your depreciable basis and maximizing it. Through a cost segregation study,  savvy investors can determine which components will allow for the highest possible tax savings for investors in a given time period.

It can be complicated, so it helps to work with a qualified tax professional when you’re trying to come up with exactly how much you might be able to depreciate, or to work with a partner who’s experienced in real estate investing.

To explain further, here’s an example of how Valiance Capital uses depreciation.

Finally, there are other tax shelter benefits that can be used in conjunction with depreciation that can allow some investors to sidestep their tax bill entirely, essentially letting their gains grow tax-deferred.

How Valiance Capital Uses Depreciation to Offset Taxable Income

Valiance Capital uses a value-add investing strategy that accelerates the benefits of depreciation by using cost segregation analysis. We perform these studies at two separate times: when we acquire the property, and after we make improvements.

This allows for accelerated depreciation, where paper losses are larger in the first few years of ownership, while we fix up the property and restructure the management. For investors who are real estate professionals, they can use this accelerated depreciation to offset their active income. For investors who aren’t, they can still use this to offset passive income.

Additionally, Valiance also stays up to date with legislation that may affect the tax-saving benefits of the investment. For instance, prior to the passage of the Tax Cuts and Jobs Act of 2017, bonus depreciation was just 50% of the eligible asset. After its passage, bonus depreciation increased to 100% of the eligible asset, and the eligibility was extended to used properties.

The 1031 Exchange

The 1031 exchange is by no means integral to the value-add approach, but it does have significant benefits for any real estate investor.

Through the 1031 exchange, capital gains tax can be deferred as long as an investor is purchasing “like-kind” property, which is actually pretty broadly defined. 

This tax break exists to incentivize businesspeople to keep investing in real estate that’s based in the USA.

If you’re interested in downgrading your real estate investments to something that’s more passive, for example, you could sell rental properties that you’ve been managing yourself and use the gains to invest in another real estate project without having to pay capital gains.

If you used this strategy in conjunction with a successful value-add project, there’s enormous potential for gains and tax savings.

Conclusion: The Tax Benefits of Value-Add Investing

Value-add investing optimizes tax-saving benefits by maximizing both the amount that investors claim as depreciation and the amount investors spend on improvements.

This is what allows Valiance Capital to save investors money on their tax bill.

In addition to depreciation, the 1031 exchange allows investors to offset capital gains tax, potentially allowing their investments to grow tax-deferred. By recognizing and utilizing these strategies, investors can maximize the money that they get to keep.

VALIANCE CAPITAL
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Valiance Capital is a privately held real estate development and investment management company with a primary focus on multi-family and student housing properties.

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2425 Channing Way Suite B
PMB #820
Berkeley, CA 94704
investors@valiancecap.com

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GET IN TOUCH

Valiance Capital LLC
2425 Channing Way Suite B
PMB #820
Berkeley, CA 94704

investors@valiancecap.com

Valiance Capital is a privately held real estate development and investment management company with a primary focus on multi-family and student housing properties.

©2021 Valiance Capital. All Rights Reserved.