Introduction:
What are the tax advantages of Private Real Estate Investing? Find out here!
What are the Tax Advantages of Private Real Estate Investing?
Private equity real estate funds enable high-net-worth individuals and institutions such as endowments and pension funds to participate in property equity and debt. Private equity real estate uses an active management technique to diversify property ownership.
General partners invest in a wide range of property kinds in various regions. Ownership options might include everything from new construction and raw land holdings to the total rehabilitation of existing properties and cash-flow injections into struggling enterprises.
Individuals or couples interested in investing in private equity real estate should seek a firm specializing in the field. When analyzing a private equity firm’s fund alternatives, they should be aware of the form of each private equity fund, which is often a limited partnership.
Outside investors that join a fund become limited partners, which means they assume accountability for the money they invest in the fund. The funds of a limited partner will be pooled with those of other participating investors, and fund managers will construct a portfolio of properties to maximize profits while minimizing financial risk.
Understanding the Costs and Investment Structure of the Fund
Investors must pay management and performance fees to private equity real estate funds. Private equity funds typically charge 2% of the money invested to cover company wages, deal sourcing and legal services, data and research expenditures, marketing, and other fixed and variable costs. These investor fees, however, have no upper limit.
Here’s how investors can get involved in private equity real estate, as well as an overview of the industry’s prospects, risks, and constraints.
Individual investors can profit from several aspects of private real estate, including high returns, portfolio diversification, and tax efficiency. Institutional investors have long recognized the value of this asset class and relied on it to provide stability in the face of market volatility.
Consider Yale’s endowment, which is regarded as the gold standard for its extraordinary performance; real estate accounts for 10% of its investment portfolio. Unsurprisingly, most endowments and pension funds adhere to a similar investment strategy. On the other hand, individual investors have recently begun to recognize this technique and add private real estate to their portfolios.
Even determining what constitutes private real estate can be difficult. In layman’s words, it involves owning a piece of tangible real estate to profit from. Individuals can invest in private real estate as a direct buyer or passively.
But three things are clear: the primary advantages of investing in private real estate. All three are thoroughly detailed here to assist investors in making well-informed selections about private real estate.
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The first advantage is that private real estate generates high absolute returns.
Private real estate allows investors to produce significant absolute returns. An absolute return measures the amount of money an investment makes over time by accounting for appreciation, depreciation, and cash flows and is stated as a percentage gain or loss on the initial investment.
According to Bloomberg data, a $100,000 investment in private real estate beginning on December 31, 2000, would be worth around $420,000 on December 31, 2019. The chart below shows that a $100,000 investment in the S&P 500 would be worth approximately $356,000 on December 31, 2019.
**As of 6/24/20, total return figures for the NFI-ODCE and S&P 500 were obtained from Bloomberg.
***The NFI-ODCE is an index of investment returns of the largest private real estate funds pursuing a core investment strategy typically characterized by low leverage (less than 40%), low risk, and stable properties diversified across the US.
The second advantage is that private real estate has a low correlation to other asset classes.
Every portfolio’s goal is to generate the maximum total return with the least volatility. Most investors are OK with combining stocks and bonds in their investment portfolios—until the market’s ups and downs worry them. Because it is immune to trade shocks, private real estate helps investors manage the volatility in their portfolios.
A private real estate fund’s worth is determined by the actual value of the property held by the fund. In contrast, the share price value of a public REIT is set by daily market forces, which means that the share price of a public REIT may not reflect the true worth of the underlying real estate. In some circumstances, the share price of a REIT can be 30% higher or lower than the underlying real estate value.
Private real estate values do not fluctuate daily but gradually increase over time, making private assets less volatile than their public counterparts. Both vehicles have advantages and disadvantages, and the best portfolio includes a mix. Public markets provide liquidity at the expense of volatility, whereas private assets provide investors with low volatility at the penalty of illiquidity.
As studied by the National Council of Real Estate Investment Fiduciaries (NCREIF) property index (NPI), private real estate does not correlate with stocks, bonds, and even public REITs.
A correlation coefficient of 0 indicates that price movements are not at all associated. A correlation coefficient of one indicates that assets move in tandem, whereas a negative correlation indicates that they move in opposite directions. When an investing portfolio includes asset classes that are not correlated to each other, it benefits substantially.
Third, private real estate is tax efficient.
Investors who only consider an investment’s underlying returns and neglect its after-tax yields miss out on a significant benefit of real estate investing. Property income is often sheltered by depreciation, giving investors the long-term benefits of significant cash flow and minimizing the tax burden.
According to IRS guidelines, owners can absorb annual losses in the form of depreciation to smooth out inevitable capital costs as buildings age. However, only the physical aspects of a property are subject to depreciation. Land cannot be depreciated and must be valued separately from physical property. A multi-family property, for example, can be depreciated straight line over 27.5 years. If the home was purchased for $6 million and sits on $1 million in the land, the annual non-cash depreciation will be $181,818 as computed by $5 million divided by 27.5.
Individuals will pay between 20% and 25% in taxes on real estate investments, compared to 37%, the highest tax level on a regular income, for hedge funds and other alternative vehicles. So, if a property generates $100,000 in cash flow and $50,000 in depreciation, the individual’s taxable income will be $50,000.
An investor’s tax burden is calculated as.37 x $50,000, or $18,500, which is equal to an 18.5% tax rate on the total cash flow of $100,000 if they are in the “highest federal tax bracket.”
On the other hand, the depreciated component of the property is subject to a recapture rate of 25% upon sale. Here’s how it works: if a property costs $10 million and is depreciated by $2 million, the cost basis for tax purposes is only $8 million. At the time of sale, the difference between the cost basis and the original purchase price is taxed at the recapture rate.
Furthermore, presuming the property has been owned for more than a year, any investment appreciation above the original purchase price will be subject to the long-term capital gains rate of only 20%.
If the property were sold for $13 million, the difference of $2 million between the IRS tax basis of $8 million and the purchase basis of $10 million would be subject to a 25% recapture rate. The increase in value from $10 million to $13 million would be taxed at the capital gains rate of 20%. At the time of sale, the adequate total tax liability would be $500,000 + $600,000, or $1.1 million.
Another tax advantage of real estate is the possibility to postpone taxes indefinitely via a 1031 exchange. The 1031 exchange tax rule permits real estate owners to sell one property and buy another without paying capital gains taxes on the difference. In theory, an investor may buy and sell real estate without ever paying capital gains taxes. One of the most significant benefits of directly owning real estate is the potential to defer taxes into the future.
Finally, because private equity real estate is often owned in an LLC, which the IRS considers a pass-through entity, all profits, losses, and expenses are passed through to the owners. Unlike corporations, where owners may face double taxation (the corporation pays taxes on corporate net revenue and the owner pays taxes on any dividend income received), the LLC is not taxed.
On the other hand, individual members are taxed on their part of the income, expenses, and losses recorded on their year-end tax form, the K-1. They are taxed at their tax rate, which is frequently lower than that of the corporation.
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