By Darren Fisk
Today’s investor faces a three-pronged problem: low yields, high correlations and – likely – an increasing tax bite. As an asset class, multifamily real estate often gets credit for solving the first two issues, but its ability to alleviate the tax burden associated with investing is often overlooked.
This blog is the first in a series explaining the tax benefits of multifamily real estate investing. Through simple math, we illustrate the tax benefits, and what it means for the end investor. But first, the other benefits of real estate investing are worth a quick review, particularly in the context of the current market climate.
Reliable Income is Hard to Find
As we have mentioned in previous blogs, razor-thin yields have sent investors into riskier credit markets in search of income. More recently, an unprecedented economic downturn threatens dividend growth for most companies including specialized vehicles such as MLPs, further complicating the income search. Multifamily real estate is a potential solution. Yields are attractive relative to the less risky areas of the fixed income market, and income streams from multifamily properties are more reliable than other real estate sectors due to the basic necessity of housing: Rent is simply the last item consumers can cut from their budget.
Download this 1031 exchange calculator tool to help determine your potential capital gains exposure
The Search for Uncorrelated Assets is Even Harder
March served as yet another painful reminder that volatility is a reality of equity investing. While markets have recovered much of their losses, economic uncertainty means more volatility is likely to follow. Investors will be hard-pressed to find uncorrelated assets to withstand it. Hedge funds tend to experience rising correlations to stocks in market crises – precisely when investors need diversification most. Meanwhile, specialized areas of income investing such as MLPs have also proven to be more volatile than investors expected.
Multifamily real estate is less volatile. As the last few downturns have shown, the universal need for a roof over one’s head has made the multifamily space a highly resilient property sector. Properties are also infrequently traded, and valued only quarterly or annually, which insulates real estate from general market volatility.
“This blog, and future pieces in our series, explain the tax benefits of real estate investing. We start with the 1031 exchange, a mechanism that allows investors to defer capital gains taxes when they sell a property and reinvest those proceeds into a new investment. As the math below shows, deferring this tax hit can enhance the investor’s yield on their next investment.”
The Tax Benefits of Real Estate Investing Are Significant, but Overlooked
Getting back to the three-prong problem facing investors, an investor’s tax burden is the one that is frequently overlooked, and likely to become a growing burden. Given rising debt levels in the U.S., it’s not hard to fathom capital gains and income related taxes both increasing in the future. Advisers can add value for clients by shielding their investments from that growing tax bite as much as possible.
The Math Behind the 1031 Advantage
Let’s assume an investor – we’ll call her Julie – uses $250,000 to buy into a portion of a multifamily real estate property, and that multifamily properties are yielding 6%, which translates into $15,000 in annual cash flow from her investment. The real estate company organizing the purchase raises $25 million in cash and $45 million in debt to purchase a $70 million workforce housing complex. Julie’s initial $250,000 means she owns 1% of the equity value in the property.
In five years, the complex has appreciated by 10% and is sold for $77 million. After paying off the $45 million in debt, there is now $32 million in equity value for the property. Julie receives $320,000 (her 1% of the new equity value).
This is where the benefits of a 1031 Exchange come in. Assuming Julie is still seeking income, she needs to reinvest in a new property. Without a 1031 exchange, she would have to pay an estimated 30% in taxes, derived from a combination of long-term capital gains and depreciation recapture, on the $70,000 in gains she received from the initial property sale. This means writing a check for $21,000. That leaves her with a total of $299,000 to invest in a new property ($250,000 from the initial investment + a $49,000 after-tax gain on the sale).
Assuming the average multifamily property still yields 6% annually, when Julie invests her $299,000 into a new property deal, her cashflow will be $17,940. By reinvesting her sale proceeds, Julie has improved the cash flow of her initial investment by $2,940, or just under 20%. That’s good, but by using a 1031 exchange, she can likely improve that annual cash flow even more and defer the tax payment because of the sale. Let’s take a look at the 1031 scenario:
By using a 1031 exchange to sell the original property and purchase a new one, Julie doesn’t pay any taxes associated with the gain from the sale. Going back to the original example, she now has the full $70,000 from the property sale to add to her initial $250,000, leaving her with $320,000 to reinvest. Assuming the standard 6% yield, her cash flow from this new investment is $19,200, an increase of $4,200, or about 28%. Had Julie not used the exchange, she’d have lost about $1,300 in future annual income because of the taxes on real estate investment gains and would have had to pay the government $21,000 of her sales proceeds.
This example illustrates just one transaction, however. If Julie continues to sell and repurchase properties through a 1031 exchange and avoids capital gains on those sales, the yield and cash flow based on her original investment continues to improve.
If capital gains rates go higher in the coming years, the yield and cash flow advantage from using 1031s will likely continue to widen. The ability of real estate to potentially solve this third prong of the investor problem set – the tax bite – may be the asset class’ most unheralded benefit.
Forum Investment Group is a private real estate investment firm with expertise and emphasis on generating current income and long-term value creation by accessing unique real estate acquisition, development and debt investment opportunities across the capital stack and real estate cycles. Since 2007 we’ve invested more than $2 billion in real estate and built a successful track record of high-performance investments, earning the trust of our investors and partners.
Darren Fisk – Founder and CEO
Forum Real Estate Group, a Glendale, Colorado-based real estate investment firm and affiliate of Forum Investment Group, has a focus on multifamily living and develops, owns, operates and manages properties across the United States.