Why You Should Be Investing in Pass-Through Commercial Real Estate
It was very apparent that the 2017 Tax Reform (formally, the Tax Cuts and Jobs Act) (the “Act”) was passed to spur economic growth, but how economic growth would be accomplished was less apparent.
The more you dig into the Act, the more it will be apparent to you that the Act wants to encourage pooled investments.
It’s clear that President Trump and the architects of the Act believe in the economic power of private equity and private real estate investments.
The two major provisions of the Act designed to encourage pooled investments – especially real estate investments – were:
- the Qualified Opportunity Zones (“QOZ”) program; and
- the Qualified Business Income (“QBI”) deduction.
The QOZ program encourages investment in distressed communities across the country through the use of investment funds.
We’ll save the discussion on QOZ’s for another day. The focus of this discussion will be the benefits of the QBI deduction for investors in a private real estate investment fund.
Investors have been taking advantage of the tax benefits of passive commercial real estate investments for years.
Some of the more significant benefits include the following:
- Long-Term Capital Gains. Real estate investments held for more than a year and sold for a profit qualify for long-term capital gains treatment. Compare the top long-term capital gains rate of 20% vs. the top ordinary-income rate of 37%.
- Avoidance of FICA and Medicare Taxes. Passive commercial real estate income is not subject to FICA (Social Security) and Medicare taxes. That’s a savings of 7.65% to 15.3% on that income.
- Regular Depreciation. Regular depreciation deductions allow investors a business deduction for the cost of items that have a “shelf life” like a building. The typical depreciable period is 27.5 years. For example, if the cost basis of a multi-family property (the building only and not including the land or improvements) is valued at $1,000,000, the annual depreciation deduction allowed over 27.5 years would be approximately $36,400. In a passive investment, this depreciation would be distributed pro-rata to all the partners.
- Bonus Depreciation. Besides, regular depreciation, the bonus depreciation allows for a deduction of 100% (increased from 50% to 100% with the Tax Reform) of items with a shelf life of 20 years or less. This bonus depreciation is geared towards commercial building improvements.
With the common tax benefits of passive commercial real estate investing out of the way, let’s talk about the Qualified Business Income (QBI) deduction.
The QBI deduction allows you to deduct up to 20% of your taxable income from a qualified business. A passive commercial real estate investment through a private fund organized as a partnership, LLC or S Corp (C Corps are excluded) qualify as a qualified business.
Certain limits apply if your income level is greater than $207,500 (individually) or $415,000 (jointly with a spouse) – which we won’t get into – but for purposes of this exercise, we’ll stick to the 20% deduction.
Let’s compare a $1 M investment in a real estate fund vs. a $1 M investment in a dividend stock. Let’s assume both pay an annual return of 10% (I know. Not likely with a dividend stock, but humor me for this exercise). Let’s also assume both investors are in the highest tax bracket.
Compare the annual net returns for both investments when taking into consideration the tax savings **
The tax benefits of private commercial real estate investing have been known for years, but with the recent Tax Reform, the QBI deduction just made it that much sweeter for passive real estate investors.
** Annual tax benefit calculated based on 20% of taxable income of $100,000 * 37% tax rate.
Michael Foley, president and CEO of Humabilt Capital, oversees the entitlement process, funding, and operations for Humabuilt Capital. Mr. Foley has been a full-time real estate investor since 1995 during which time he has developed hundreds of single-family homes, townhomes, condominiums, and apartments. Mr. Foley started his investment ventures in Long Beach, California, and has expanded to Apex and Durham North Carolina. Mr. Foley is a graduate of the University of California at San Diego.