Tax season 2016 is gaining steam, marking an ideal time to hunt for tax policy that affords compelling after-tax returns for most real estate investments. Fortunately, Congress has over the years carved out a number of tax code benefits for the real estate industry, a few of which are worth mentioning for anyone looking to seize new opportunities in this space.
The most significant benefit is the opportunity to depreciate the value of a building over time, regardless of whether its true value has deteriorated. This allows investors to utilize depreciation — a noncash expense — as a deduction against cash income to reduce or even eliminate the tax burden associated with that income. For example, let’s look at a case of someone who purchased an apartment building for $10 million, with the appraised value of the building at $7 million and the land value accounting for the remaining $3 million. The value of the building can be depreciated evenly over 27.5 years, meaning that the owner can take about $255,000 as a tax expense per year.
Let’s assume further that the net income of the property is $650,000 per year, meaning that if the owner bought the property for all equity, the annual pretax return would equal 6.5% ($650,000/$10,000,000). Without the depreciation benefit, living in a state like New York where the tax rate on income is about 50%, the after-tax cash flow would be $325,000 and the after-tax return would fall by half to 3.25%.
By applying the noncash depreciation expense, the owner would only have taxable income of $395,000 ($650,000 minus $255,000), and would owe taxes of $197,500, making the effective tax rate only 30.3%. With an after-tax cash flow of $452,500, the after-tax yield becomes 4.52%.
This effect is significantly amplified by borrowing a portion of the purchase price, which is standard practice in real estate. For this example, let’s assume the owner borrowed $6 million from a bank at a rate of 4%, and only invested $4 million of equity to close an apartment building purchase. To calculate the after-tax return, the owner would first reduce the $650,000 of income by the $240,000 of interest that must be paid annually to the bank, which leaves the pretax net income of $410,000, or a pre-tax return on the $4 million of equity equal to 10.25%. Now, the owner would deduct the full amount of the annual depreciation, or $255,000, making the taxable income $155,000, and taxes $77,500, for an effective tax rate of 18.9% . The after-tax return here is now $332,500, which translates into an after-tax return of 8.31%.