The Internal Revenue Code contains several provisions allowing owners of real estate to both defer when their taxes are due and to classify a portion of what might otherwise be treated as income as capital gains, which are taxed at a lower rate. These benefits make real estate investing more tax efficient than investing in other income-generating products such as corporate bonds.
For example, suppose Jane invests $100,000 in the equity of a real estate asset paying 6% in annual distributions, and sells that position after 5 years at the same price. Jane receives $6,000 in distributions each year, but only owes taxes on a portion of those $6,000 payments in the years she receives them.
A portion of the distributions Jane receives is not considered income earned by the asset and is not taxable. This is primarily because the asset is permitted to claim depreciation, and because of a special additional 20% deduction available under Section 199a of the tax code.
If the taxable portion of the distributions Jane receives is 20%, she pays ordinary income taxes on $1,200 in the years she receives the $6,000 payments, and then realizes a capital gain of $24,000 (5 years x $6,000 x 80% not yet taxed) when she sells, which is taxable as a capital gain in the year she sells.
By contrast, if Jane buys a taxable bond at the same price with the same pre-tax yield, she owes ordinary income taxes on the full amount of each distribution in the years they are received.
Jane thus pays taxes on her real estate equity income both later and at a lower rate than on her taxable bond income. This generates a better after-tax return on her real estate investment compared to her taxable bond. If she pays ordinary income taxes of 37% and long-term capital gains taxes of 23.8%, she realizes significantly higher after-tax annual returns over 5 years with her real estate investment than with an investment in a taxable bond with the same pre-tax return.
Note that the precise benefits of real estate investing will vary depending on the investor’s tax profile, the amount of depreciation still available at the time of the initial investment, and other factors. Consult your tax advisor for more information.
Investments in equity are also junior in liquidation preference to investments in bonds, and thus carry more risk.
August 26, 2022
The goal of this article is to offer practical guidance on how to begin building a real estate portfolio, and how the risk and return profiles of different assets fit together.