Real estate investment has long been a component of wealth-building for many high-net-worth individuals (HNWIs). Beyond generating cash flow and building equity, one of its most compelling advantages lies in its tax efficiency. The tax benefits of real estate investment provide investors with powerful tools that have the potential to help them preserve wealth.
The following sections will focus on strategies for optimizing these benefits. When considering options, it’s worthwhile to review private real estate partnerships. These can be a vehicle which offers tax advantages that aren’t always found in other structures, such as tax-efficient real estate investment trusts (REITs).
Understanding the Tax Benefits of Real Estate Investment
When added to a portfolio, real estate can provide the opportunity for possible growth and long-term protection. There are numerous advantages related to taxes to consider. These include depreciation, tax deferral, or capital gains tax reduction.
Let’s look at each one:
- Depreciation Deduction
Depreciation is a non-cash expense that allows property owners to reduce taxable income by accounting for the wear and tear on their investment properties. The depreciation timeline can vary based on factors such as property type.
- Tax Deferral on Rental Property Sales
Another tax benefit can be the ability to defer taxes on the sale of investment properties through tools like 1031 exchanges. This allows investors to reinvest proceeds from a sale into a similar property without triggering a taxable event.
- Capital Gains Tax Reduction for Real Estate Investors
When properties are sold, the profits are taxed as capital gains, which typically have lower rates than ordinary income. Long-term capital gains (for properties held more than a year) offer even more favorable tax treatment, which can reduce an investor’s tax liability.
The Difference Between REITs and Private Real Estate Partnerships
A REIT is a company that owns, operates, or finances income-generating real estate. REITs allow individuals to invest in portfolios of real estate assets the same way they invest in other industries—through purchasing shares. REITs often generate income through rent from properties, interest from loans, or profits from selling properties. Publicly traded REITs are bought and sold on major stock exchanges, making them relatively liquid investments. REITs are required by law to distribute at least 90% of their taxable income to shareholders as dividends.
A private partnership in real estate is a business arrangement where multiple investors pool their resources to invest in real estate assets. Unlike public investments such as REITs, private partnerships operate privately and are typically accessible only to accredited or high-net-worth investors. They are often organized as a Limited Partnership (LP) or a Limited Liability Company (LLC). The General Partner (GP) or managing member oversees the partnership, including property acquisition, management, and eventual sale. Limited Partners (LPs) provide capital but have limited liability and minimal involvement in day-to-day operations.
Private partnerships invest in various real estate types, including residential, commercial, industrial, or mixed-use properties. They may focus on specific strategies, such as development, value-add (renovation), or long-term income through rental properties. Private partnerships typically have high minimum investment thresholds, and investors can participate in significant real estate projects that might be out of reach individually. GPs or professional management teams handle operations, leveraging their expertise to maximize returns.
While REITs may seem attractive due to their liquidity and income potential, they don’t offer the same level of tax benefits as private real estate partnerships. High net worth individuals often prefer private partnerships. Some of the reasons for this are listed below:
- Pass-Through of Tax Deductions and Credits
Private real estate partnerships allow for the pass-through of tax deductions and credits directly to investors. Unlike REITs, which are required to distribute 90% of their taxable income as dividends (often taxed at ordinary income rates), private partnerships can pass along deductions for depreciation and interest expenses.
This structure enables investors to offset their income with these deductions, potentially reducing their overall tax burden. For example, if a partnership generates $1 million in income but has $500,000 in depreciation expenses, only $500,000 is subject to tax.
- Depreciation Allocation
Private partnerships may employ cost segregation studies to accelerate depreciation. This technique separates property components (e.g., appliances, flooring, or lighting) and allows them to be depreciated over shorter time frames. As a result, investors can front-load their depreciation deductions, thus reducing taxable income in the early years of ownership.
- Capital Gains Deferral Through 1031 Exchanges
Private real estate partnerships also provide access to tax deferral on rental property sales through 1031 exchanges. By rolling over the proceeds from a property sale into a new investment, investors defer capital gains taxes, allowing their capital to compound over time.
Unlike REITs, which rarely use 1031 exchanges due to their structural constraints, private partnerships can seamlessly facilitate these transactions.
- Qualified Business Income (QBI) Deduction
Thanks to the Tax Cuts and Jobs Act (TCJA), investors in private partnerships may also qualify for the QBI deduction, which allows up to 20% of qualified business income to be deducted from taxable income. This deduction is particularly valuable for investors whose partnership income qualifies under the act’s guidelines.
- Opportunity Zones
Private partnerships often invest in Opportunity Zones, which offer substantial tax benefits. These zones, designated in economically distressed areas, provide tax incentives for long-term investments, including deferral and reduction of capital gains taxes.
While REITs offer diversification and liquidity, they lack the customizable tax benefits available through private partnerships. REIT dividends are typically taxed as ordinary income unless they qualify for the QBI deduction, and the absence of direct pass-through benefits means investors miss out on significant tax savings. Private partnerships, on the other hand, provide direct control over asset disposition and timing, flexibility for 1031 exchanges, and full access to depreciation deductions.
Case Study: Maximizing Tax Efficiency Through a Private Partnership
Consider a high-net-worth investor, Sarah, who invests $1 million into a private real estate partnership that acquires a commercial property. Here’s how she leverages the tax benefits:
- Depreciation Deduction
In the first year, the partnership conducts a cost segregation study, which accelerates $300,000 in depreciation. This depreciation offsets Sarah’s share of the partnership’s rental income, reducing her taxable income significantly.
- 1031 Exchange
After five years, the partnership sells the property for a $5 million gain. Instead of paying capital gains taxes, the partnership executes a 1031 exchange, rolling the proceeds into a new, higher-value property. Sarah defers her share of the capital gains tax, allowing her investment to grow tax-free.
- Capital Gains Tax Reduction
When Sarah eventually exits the partnership after 15 years, she benefits from long-term capital gains tax rates, further reducing her tax liability. If the partnership invested in Opportunity Zones, Sarah could also receive additional reductions on her deferred gains.
For high-net-worth individuals, real estate offers opportunities to protect wealth. From depreciation allocation to capital gains tax reduction for real estate investors, private real estate partnerships provide a powerful framework for optimizing after-tax returns. When coupled with strategic tools like 1031 exchanges and Opportunity Zone investments, these partnerships enable investors to build wealth while minimizing tax liabilities.