One Big Thing
The following is not tax advice.
There are several things that we can say definitively about disgraced WeWork co-founder Adam Neuman. Here are a few:
- He is a massive self promoter
- He is generally full of shit.
- Like it or not, he is one of the great salesmen of all time
- He is human catnip for media clicks and eyeballs.
Taking the above into account, I wasn’t exactly shocked to see a headline in the Wall Street Journal last week loudly proclaiming that Neumann is “Becoming an Apartment Mogul.” For those of you not well-versed in hyperbolic newspeak, he’s been aggressively buying apartments in the Sunbelt (but honestly, who hasn’t been lately). But its Neumann and its clearly a clickbait headline, so whatever.
Of course, the article contains an obligatory statement from a friend or employee about Neumann’s grand ambitions that resulted in his buying spree because, as stated above, this is clickbait:
Mr. Neumann has told friends and associates of his ambitions to build a company that would shake up the rental-housing industry, say people familiar with the matter.
That makes for a great headline, I guess. However, the reason Neumann is buying all of those units is likely a lot less exciting – tax mitigation. As the WSJ article referenced, Neumann was paid several hundred million in consulting fees and sold nearly $600MM in stock recently. We can probably assume that the consulting fees were classified as earned income and the stock sale was capital gains – both of which would result in a massive tax bill.
However, the US tax code offers a loophole for real estate professionals. You can find a lot more by doing a Google search but the IRS defines a Real Estate Professional (REP) as someone meeting both qualifications below:
- More than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated
- The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which he or she materially participated
The qualifications for “material participation” are longer and I’m not going to list all here but the American Institute of Certified Public Accountants has a very concise write up if you are interested in learning more:
A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis that is regular, continuous, and substantial. Generally, no interest in a limited partnership as a limited partner is treated as an interest with respect to which a taxpayer materially participates.
Given the above, Neumann will very clearly meet the IRS standard for a Real Estate Professional. In a twist of irony, he notoriously argued for years that WeWork was a tech – not real estate – business. Now that there are millions of tax dollars on the line he has likely changed his tune.
H/t to Matthey Gottesdiener, CEO of Northland who was the first person I saw pointing Neumann’s true motivation out on Twitter, while also pointing out that Neumann is frequently offering well above the level of other sophisticated bidders.
So, how does Neumann’s tax mitigation strategy work?
- When a real estate investor purchases a property, they can order a report called a Cost Segregation Study. These studies will identify real property and assets – that is, assets that aren’t the building themselves and personal property – and assign depreciation values to those items.
- The new tax laws passed in 2017 allow owners to deduct 100% of asset costs from their taxable income during the first year of ownership. This deduction, known as “bonus depreciation,” can create a substantial paper loss in the first year of ownership. (side note: this first-year bonus depreciation is only valid until 2022, and will phase out completely by 2027)
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Once the cost segregation study is complete, the investor can use the accelerated depreciation from these assets to offset their taxable income.
- The property needs to have been put in service in the same year in which the taxable event occurs in order to work. For example, if you had a large taxable event in 2021 and buy a property in 2022, it can not be used to shelter the 2021 income.
This is where the IRS’s definition of Real Estate Professional comes in. An investor who is not a REP is subject to restrictive passive loss limits which only allow the bonus depreciation to be used to offset other passive activities like rental income or capital gains. However, an investor who is a REP in the eyes of the IRS can use the net operating loss (NOL) from accelerated depreciation against ordinary income. This NOL can potentially completely offset the tax owed depending on the deal structure and how much leverage is used.
There is a good chance that Neumann was able to eliminate nearly all of his tax liability by overpaying for his sunbelt apartments by taking advantage of accelerated depreciation afforded to REPs. However, it apparently isn’t as good for clicks as some story about another crank plan by Neumann to “shake up” the apartment industry.
We are very familiar with the tax benefits of accelerated depreciation because several of our partners who are real estate professionals have sheltered their income in this way by investing in RanchHarbor deals. Want to learn more? Please reach out but make sure to consult your tax professional first.
What I’m Reading
Flexing: Co-working companies are benefitting from turbulence in the office market as tenants seek shorter term leasing arrangements. Bisnow
Upwardly Mobile: A shortage of workers versus available openings is allowing people to upgrade their jobs. Bonddad Blog
Tapped Out: A deluge of applications has forced some states – including New York, New Jersey and Texas – to shut their federal rental assistance programs earlier than expected. CNBC
Pulling Up: The SFR category continues to get more attractive to big investors and cap rates are approaching parity with traditional multifamily. Globe Street
The Great Migration: Pandemic rent growth was largely reflective of migration patterns. Rents spiked in places people where moving to while they fell in places that people were moving from. Multi-Housing News
Chart of the Day
We are truly in uncharted territory.
Source: RealPage
WTF
Perfect Crime: A man who was arrested for stealing $350 worth of sex toys from a Pennsylvania adult store was identified because he had recently applied for a job there. The Smoking Gun
Wasn’t Me: A man who was arrested with a bag of meth in his pocket claimed that the sweatpants he was wearing weren’t his. The Smoking Gun
Basis Points – A candid look at the economy, real estate, and other things sometimes related.
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