After sending K’1s, the tax document received for investing in partnerships, some of our new investors were confused as to why it showed a loss in value.
THE TAX INCENTIVE
Multi-Family properties benefit from depreciation, which is an income tax deduction. In short, while real estate values generally appreciate, the physical compartments generally lose value during the hold period as a result of wear and tear. Things like the roof, appliances, and electrical all depreciate and will eventually need to be replaced. The IRS understanding this and accounts for this by offering an income deduction for owning depreciating assets.
HOW IT WORKS
Let’s say we buy a commercial property together for $10M. The tax assesors estimate the land value to be $3M, and the building value estimate is $7M. The land doesn’t benefit from depreciation but the physical property gets depreciated over 39 years, resulting in a tax loss of $179,487. ($7,000,000 / 39 = $179,487) This is what we call a phantom expense, meaning we aren’t writing a physical check for that expense but we get to claim it as a loss for tax purposes regardless.
In most real estate deals, depreciation and other tax write-offs allow all cash flow during the hold period to be received tax-deferred. This means that regarldess of the amount we receive from cash flow during the hold period, that annual taxable gain will usually be net negative, or very close to it.
What does this mean? Positive cash flow each quarter while still claiming a loss at the end of the year. In basic terms, make more and keep more! It’s beautiful!!