Investing in Private Real Estate provides unique tax advantages. While tax efficiency is important, particularly for highly compensated individuals, it shouldn’t be the sole driver of your investment decision.

PCRE Advanced, Video

Cash Flow vs. Taxable Income in Private Real Estate Funds

Investing in Private Real Estate provides unique tax advantages. While tax efficiency is important, particularly for highly compensated individuals, it shouldn’t be the sole driver of your investment decision.

We always emphasize focusing on “smart” investments and considering opportunities that make sense for your overall financial picture. This means identifying investments that will not only provide tax advantages but also yield a reasonable return while diversifying your portfolio.

Watch this 16 minute video as we explain cash flow vs. taxable income within the funds offered by MLG Capital.

Tax benefits for private real estate fund investors

1. Tax Deferral
Essentially, the ability to “kick taxes down the road” while still receiving distributions from the investment. From the Time Value of Money perspective (a dollar today is worth more than a dollar tomorrow), this is a powerful tool.

2. Reduced Tax Rate
If most of the ordinary income generated by a series of funds is eliminated, most of the taxable income is taxed at the capital gains tax rates, instead of high ordinary tax rates. Alongside the tax rate benefit is the potential to offset other passive income.

MLG Funds have historically created cumulative capital gain combined with cumulative ordinary loss. As a result, investors can pay taxes at the lower capital gains rate, which is 20% at the federal level. There is an unrecaptured 1250 gain of 25% with depreciable assets in these Funds but compared to ordinary income rates of 37% (at the highest federal bracket), cap gain rates will still be lower.

Ways to optimize tax planning in fund distributions

Cost Segregation Studies
In this strategy, property assets are segregated into groups based on their depreciation recovery periods. This is done to identify which components are eligible for accelerated depreciation. The goal of the study is to maximize depreciation deductions and shorten depreciation lives—resulting in less income taxes paid for that year, and therefore increased cash flow.

Example: Take for example a multifamily property. Asset types that can be segregated include roofing, appliances, furniture, and plumbing, to name a few. At MLG, we hire a third-party expert to break up a building’s purchase price into different asset types with different recovery periods.

Utilizing Bonus Depreciation
As part of the 2018 Tax Cuts and Jobs Act (TCJA), bonus depreciation was substantially modified to provide 100% deduction for asset classes that have a recovery period of 20 years or less. Combined with cost segregation, this can create very material benefits.

Example: Let’s say you’ve invested $100M in the multifamily unit: cost segregation could allocate a percentage of the purchase basis to asset classes within that recovery period threshold. Historically in MLG deals, the percentage has been 25%, so an investor could essentially bonus depreciate $25M in the year of acquisition, creating beneficial ordinary loss in early years.

Willingness to Sell Investments vs. Holding Indefinitely
A component of doing “smart” deals is about selling at the right time which, in turn, will trigger long-term capital gains rates. Additionally, if you have suspended losses from the sale, you have the potential to release those suspended losses to offset other classes of income, once the asset is sold and disposed.

MLG Fund Examples: Cash flow vs. taxable income sent to investors

MLG Private Fund II, LLC, incepted in 2014

Fund II Overview: $54M equity
As of 12/31/19, 8% preferred return payment to investors is current and >60% of capital returned. The fund is no longer raising money or acquiring properties.

Tax deferral and shift from ordinary to capital gain tax rates:

  • 5 years into life, still has $19.2M in ordinary loss
  • Profitable sales = ~$41M in cum. cap gains (which is taxed at lower rates)
    • Summary: $21.7 net taxable gain

Fund IV: ~$152M raised of $200M ($250M max)
In 2018 (one quarter of operations), the fund brought in $16M in investor capital, and generated $9.8M in beneficial ordinary loss, mostly due to the cost segregation study and bonus depreciation.

Tax benefit: Investors received loss allocation of 60% in 2018. For example, if an investor contributed $1M, they received a loss allocation of $600K.

In 2019, the fund brought in additional $94M of investor capital and created $53.8M ordinary loss (roughly 57% of capital contributed).

So how are losses shared when there’s capital contributions across multiple years?

  • Majority of 2019 loss allocation has to go to new investor capital to catch-up
  • Investors are able to re-invest year-over-year to receive new loss allocations

Learn more about how MLG Capital Funds are tax efficient.

For MLG Private Funds, we’ve developed strategies that cover those two main tax benefits, alongside many others. Our series of funds target cash on cash yields, quarterly distributions, and appreciation over time for investors in a tax efficient manner.