Before I get started, a bit of a bio, first…
I’m Tim Wallen, CEO of MLG Capital, a private equity firm specializing in investing in small- and mid-cap private real estate investments. We find attractive real estate investments for clients, while also structuring our deals in a tax advantageous way. Prior to joining MLG about 25 years ago, I was a CPA and Tax Manager with PricewaterhouseCoopers working in the Milwaukee and San Francisco offices.
Over these past twenty-five years, I’ve gained a wealth of experience acquiring and structuring real estate investments. My goal here is to impart some of that knowledge in the hope that you can apply it to making the most of your own investments.
Find good deals first, avoid poor investment structures, and don’t worry about paying taxes
Before I discuss tax strategies, I want to emphasize the importance of, first and foremost, focusing on finding smart real estate investments. Then focus on avoiding paying income taxes to Uncle Sam.
Many investors make the mistake of trying to avoid income taxes by trading the proceeds tax free under a 1031 exchange into a property that they really do not like very much or into a Tenant-in-Common structure with multiple people that lacks the appropriate level of control for an investor. The tenant-in-common structure (commonly referred to as “TICS”) is a great income tax structureonly if you have the proper legal controls and you trust your fellow TIC investors.
Remember that you are almost always better off paying the taxes on a sale versus investing into a poor real estate asset or a poor investment structure.
Consider the tax advantages of your investments
Many investors are already aware of the positives that an investment in a private real estate fund, like our MLG Private Fund may provide. For example, ownership in a diversified group of tangible real estate assets, not having to take the time nor additional funds to operate those assets, being able to invest in an asset class that doesn’t necessary mirror the fluctuations of stock market, and experiencing returns that meet or exceed those paid by many other fixed income investments.
However, many investors fail to consider the tax advantages that also come from an investment in real estate…
The key advantages of private real estate investments are tax deferral and the creation of capital gains versus ordinary income
If analyzed and structured properly, a portion of the current cash flow from an investment in private real estate may be partially tax sheltered and deferred. At MLG Capital, our current fund is primarily focused on investing in income producing properties from the four major real estate asset classes: multi-family, industrial, retail, and office. This group of assets currently produces monthly cash flow.
However, each of these asset classes are allowed to expense a portion of the purchase price and capital improvements made to the property over a defined life of the asset (typically 5 to 37.5 yrs.) through depreciation expense. Apartments allow the most sheltering of income in comparison to the commercial assets.
This depreciation expense adjustment allows investors to reduce the taxable income otherwise allocated to them, typically to an amount below that of cash flow paid to them during the year. Compare this to dividends and interest paid by most other investments (i.e. stocks and bonds), which are taxable to the extent of the cash received by the investor.
The extent of the sheltering of income depends on the real estate sponsor spending time doing cost segregation studies upon acquiring real estate assets. For example, when purchasing an apartment building, the purchase price can be broken into parts including appliances, furniture and fixtures, equipment, boilers, parking lot improvements, buildings and land.
A sponsor should always attempt to maximize the allocation to depreciable assets with shorter depreciation lives and limit the allocation to land which cannot be depreciated. At MLG Capital, we spend a significant amount of time to understand the assets that we are purchasing in an attempt to segregate these costs of the purchase in a way that allow us to maximize the depreciation allowed.
Capital Gains on Sale and 1031 Exchanges
In addition to the benefit that deprecation provides, there are additional tax advantages that a private real estate investment provides to investors. When an investment property ultimately is sold, investors are generally taxed at a capital gains tax rate for the portion of the gain that exceeded their original cost. Additionally, the depreciation which was taken during the life of an asset is generally taxed on sale at a tax rate between ordinary tax rates and the capital gain tax rates.
Furthermore, real estate investors are allowed the unique opportunity to sell a real estate property and trade the proceeds from that sale into one or more real estate assets (commonly referred to as “1031 Exchanges” under very distinct rules) and not pay any current income taxes. These rules are complex and require professional advice.
In general, this strategy is limited to Fund structures where the Fund itself does the 1031 Exchange or TIC structures where the investor has direct title in the asset. A limited partner or LLC member cannot trade the proceeds from a sales distribution from a real estate partnership or LLC under these rules.
Gifting and Estate Tax Planning in Private Real Estate investments
Finally, investing in private real estate ventures through LLCs and Limited Partnerships has some unique gifting and estate tax benefits. Unlike gifting stocks, when an investor gifts an LLC interest of a real estate investment to a family member, an investor will likely be able to reduce the value of the gift by about 30% for gift and estate tax rules. For example, a 10% interest in a LLC that holds a real estate investment valued at $1,000,000, would likely only be valued at $70,000 and not $100,000 for gift and estate tax purposes. The value is discounted under the theory that the investor has limited control over the LLC interest and that a discount from the underlying real estate asset is warranted under the IRS rules.
I hope this gives you a sense of the power of investing in private real estate investments and the tax benefits to be gained through good tax planning and analysis. You should ask your real estate sponsors about their income tax planning for your real estate investment, as good tax planning enhances your after-tax returns. However, always remember that the primary focus should be on making good real estate investments first and foremost.