Tax Drag Reduction Strategies for Investors

Investment returns are often discussed in pre-tax terms. After-tax return, however, is what investors actually keep and compound. The gradual erosion of returns by recurring tax liabilities is known as tax drag, and over the multi-year holding periods common in real estate, it can quietly compound into a high cost.

Unlike market performance, tax drag is not entirely beyond an investor's control. Tax drag reduction strategies work by limiting taxable income, deferring when taxes come due, or reducing how often taxable events occur. Real estate investors are especially well positioned to use them, and this overview examines the strategies they apply to keep more of what their portfolios earn.

Tax Drag Reduction Strategies: A Comparison

The strategies below reduce tax drag by addressing one or more of its three drivers: taxable income, gain realization, and tax deferral. Real estate is distinct in that it can address more than one at once.

The sections below explore these tax drag reduction strategies in detail.

1. Reduce the Tax on Annual Investment Income

One of the most direct ways to reduce tax drag is to lower the tax owed on each year's income, either by reducing the rate applied to it or by reducing the amount subject to tax.

Investors typically accomplish this in two ways: by favoring income that receives preferential tax treatment and by owning assets that generate tax deductions alongside cash flow. Real estate can do both.

Favor Preferentially Taxed Income

Not all investment income is taxed equally. Interest income, non-qualified dividends, and short-term capital gains are generally taxed at federal ordinary income rates of up to 37%, while qualified dividends and long-term capital gains are taxed at preferential federal rates of 0%, 15%, or 20%,⥉ depending on taxable income.

For real estate, this plays out across two income types. Rental income is generally taxed at ordinary rates, while gains on a property held longer than a year qualify for preferential long-term treatment. Selling within a year versus after several years can mean materially different tax on the same gain.

REIT income sits in between: most REIT dividends are taxed as ordinary income, but the Section 199A deduction lets investors exclude 20% of qualified REIT dividends⥉ from taxable income, lowering the effective rate.

Use Depreciation to Shelter Income

Depreciation lets real estate owners deduct a portion of a building's value each year, with residential rental property generally depreciated over 27.5 years.⥉ Because the deduction is non-cash, an owner can collect rental income while reporting less of it as taxable.

Cost segregation can accelerate the benefit. A study reclassifies components of a property, such as appliances, flooring, and certain site improvements, into shorter recovery periods of 5, 7, or 15 years.

Under current law, components with a recovery period of 20 years or less qualify for 100% bonus depreciation, letting an owner deduct their full cost in the first year rather than over decades. The One Big Beautiful Bill Act⥉ made this permanent in 2025 for property acquired and placed in service after January 19, 2025.

For a multifamily acquisition, this can move a meaningful share of depreciation of the purchase price into the current year, producing a sizable first-year deduction, subject to the passive activity rules that govern how real estate losses are applied.

How much of the depreciation benefit an investor captures depends on two things:

• How the property is held. Investors who own real estate directly⥉, through a partnership (with depreciation reported on a K-1), or through a DST (where investors are treated as direct fractional owners of the underlying property) receive depreciation that offsets their share of rental income. REIT investors do not receive a direct deduction. The REIT depreciates at the entity level, and the benefit reaches shareholders indirectly, mainly through distributions being treated as Return of Capital instead of qualified or ordinary income.
• When the property is sold. Depreciation is a timing advantage, not a permanent exemption. It lowers the property's cost basis, and at sale the building's accumulated depreciation is generally recaptured at a federal rate of up to 25%⥉, while accelerated deductions on shorter-lived components are recaptured at ordinary rates. Either can be deferred through one of the structures discussed later in this article.

2. Reduce Gain Realization

The second driver of tax drag is the realization of gains. A sale is what triggers tax, and on a long-held property the bill stacks up: capital gains tax, depreciation recapture, the 3.8% net investment income tax for higher earners, and state tax on top. The longer an investor can avoid that event, the more capital stays invested and compounding.

Real estate investors have two primary ways to limit taxable events:

Hold Low-Turnover Investments

Direct property and private REIT investments are typically held for years, so appreciation compounds untaxed until the investor chooses to sell, regardless of how the underlying portfolio performs along the way. A long-held multifamily position does this structurally, the way a low-turnover fund does by design, but often more powerfully, since a single asset can be held for decades.

Borrow instead of selling

An investor who wants to access appreciation can refinance and borrow against the property rather than sell it. Loan proceeds are not taxable, so the investor withdraws equity without triggering capital gains or recapture. The tradeoff is added leverage and debt service, but the gain stays deferred.

Holding and refinancing defer the eventual tax rather than erase it. When an investor does want out, the structures in the next section defer the gain at exit, and holding a property until death can eliminate the deferred gain entirely by providing heirs with a stepped-up basis.

3. Defer Taxes

The third driver of tax drag is the ability to postpone taxes. Deferral lets investors delay recognition, so more capital stays invested and compounding. Taxes are generally not eliminated, but deferring them can materially improve long-term after-tax outcomes.

The model below shows the compounding cost of each level of tax drag on a $1M investment held over 20 years, assuming an 8.0% pre-tax annual return.

The Long-Term Cost of Tax Drag: Deferring in Real Estate vs. Redeploying Into Taxable Markets. $1M at 8.0% Pre-Tax Annual Return.

Model assumptions: $1,000,000 initial investment; 8.0% pre-tax annual return; annual compounding; tax drag applied as a uniform annual return reduction. Figures rounded to the nearest $1,000. The taxable-portfolio scenarios represent the same capital redeployed into liquid markets, illustrating the opportunity cost of exiting real estate without deferral. ETF and mutual fund tax drag figures are sourced from American Century Investments, "Managing Tax-Cost Ratios for Tax-Savvier Portfolios," based on Morningstar data for the ten years ended December 31, 2024. The high-drag figure is a conservative illustrative estimate for high-turnover taxable strategies; Morningstar's tax-cost-ratio methodology documents ratios between 0% and 5%, with actively managed high-turnover funds in some cases exceeding 3%. The full-deferral scenario assumes returns accrue as deferred appreciation through a 1031, DST, or 721 UPREIT structure during the hold period; current income distributions, which may be partially sheltered by depreciation, are excluded from the model. Values shown are pre-liquidation. Deferred taxes remain payable upon a taxable exit unless further deferred or eliminated through basis step-up. This table is for illustrative purposes only and does not represent a guarantee of future results or actual investment performance. Actual tax impact will vary by vehicle, account type, individual tax rate, and holding period. Consult a qualified tax or financial advisor before making investment decisions.

**Assumes appreciation remains tax-deferred throughout the 20-year model period through a 1031 exchange, DST, or 721 UPREIT structure. The model does not assume taxes are eliminated. Taxes may be due upon a later taxable disposition unless further deferred or otherwise affected by applicable tax treatment.

The gap isn't marginal. In this illustration, deferral preserves roughly $1.7 million over 20 years, before any eventual tax on exit.

Use Tax-Advantaged Accounts

Traditional IRAs and 401(k) plans let investments grow tax-deferred, while Roth accounts provide tax-free qualified withdrawals. Because income and gains are not taxed annually inside the account, investors avoid the ongoing drag that erodes compounding elsewhere.

The limitation is scale. Annual contribution limits cap how much capital can benefit, leaving many high earners and real estate investors with substantial assets outside these accounts. For deferral at the scale a real estate portfolio requires, the structures below are not subject to contribution limits.

Use Tax-Deferred Real Estate Structures

Three structures let real estate investors defer tax across a full position. Take an investor who acquired an apartment building years ago for $3M that is now worth roughly $8M. A conventional sale would trigger capital gains tax on the appreciation, plus depreciation recapture on years of deductions, leaving much less to reinvest.

Each structure below lets that investor reposition the full equity while deferring the tax.

• 1031 Exchange. An investor can defer capital gains and depreciation recapture by reinvesting sale proceeds into another qualifying property. Strict timelines apply, though: the replacement property must be identified within 45 days of the sale and acquired within 180 days, or by the due date of that year's tax return, including extensions if that comes sooner. This route tends to suit active investors upgrading or repositioning their holdings.
• Delaware Statutory Trust (DST). An investor can complete a 1031 exchange into fractional ownership of professionally managed real estate. DST interests qualify as like-kind replacement property, so the investor maintains deferral while stepping out of day-to-day management. This route suits a longtime owner ready to leave behind tenants, repairs, and leasing without giving up real estate exposure. It also gives owners whose property does not meet a REIT's direct contribution criteria a path toward a 721 UPREIT, since a DST interest can in some cases later be contributed to a REIT's operating partnership.
• 721 UPREIT Exchange. An investor can contribute real estate directly into a REIT's operating partnership in exchange for operating partnership (OP) units, deferring tax while gaining diversified exposure and a path toward future liquidity. Bonaventure offers this path through BMIT®, its perpetual NAV REIT*, which can accept qualifying properties. A direct contribution requires a property that meets BMIT's criteria, typically institutional-quality multifamily assets of sufficient scale. The most common candidates are long-term multifamily owners who want to exit active management while staying invested.

Managing Tax Drag Over the Long Term

Reducing tax drag is one of the most effective ways to improve long-term after-tax performance. Most investors don't feel the full weight of tax drag until they are sitting on a highly appreciated property and trying to figure out what comes next. By then, years of depreciation and appreciation have built up, and the exit decision determines how much of that gain is lost to tax and how much keeps compounding. Selling outright can trigger capital gains and depreciation recapture in a single year, while holding, exchanging, or contributing the property can defer that tax.

This is the problem Bonaventure is built to solve. The firm structures tax drag reduction strategies, including 1031 exchange, DST, and 721 UPREIT exchange pathways, for property owners, advisors, and accredited investors focused on reducing tax drag and improving after-tax outcomes. For large and complex transitions over $7M, it builds custom tax equity solutions around each investor's specific tax, ownership, and reinvestment constraints

Exit decisions reward early planning. Bonaventure helps investors and their advisors choose the pathway that fits.

Discuss Your Tax Drag Reduction Strategy

Educational
The article (information, material, communication) is for informational and educational purposes only and not intended to be all-inclusive and may be changed at any time without notice or obligation to update. The information contained herein does not constitute legal, compliance, tax, or financial advice. This communication is not a recommendation of any security, strategy, or service. Any such recommendation or solicitation would be made under separate cover.

Tax
Bonaventure does not provide tax, legal, or accounting services. Tax laws and regulations are subject to change, and individual circumstances vary. Investors should consult their own tax professional regarding their specific situation before pursuing any of the strategies discussed.

⥉Third-party
The articles linked throughout were produced by independent third parties and should not be considered a solicitation or recommendation. Any such recommendation or solicitation would be made under separate cover. We do not endorse or accept responsibility for the content of any third-party website.

This material is not an offer to sell or a solicitation of an offer to buy any interest in the Bonaventure Multifamily Income Trust or any fund sponsored by Bonaventure or its affiliates. Any offering is made only pursuant to a confidential private placement memorandum (PPM) and related offering documents, which should be reviewed in full and which control in the event of any inconsistency with this material. Certain statements are forward-looking and subject to risks and uncertainties. BMIT interests are not registered under the Securities Act of 1933 or any state securities laws, and BMIT is not registered under the Investment Company Act of 1940. Investment is for Accredited Investors Only. Securities offered through Preferred Capital Securities, member FINRA/SIPC.

THE RISKS ASSOCIATED WITH INVESTING IN A REAL ESTATE PRIVATE EQUITY FUND GENERALLY INCLUDE:

Limited Regulatory Oversight - Since private equity funds are typically private investments, they do not face the same oversight and scrutiny from financial regulatory entities such as the Securities and Exchange Commission ("SEC") and are not subject to the same regulatory requirements as regulated investment companies, including requirements for such entities to provide certain periodic pricing and valuation information to investors. Private equity offering documents are not reviewed or approved by the SEC or any US state securities administrator or any other regulatory body. Also, managers may not be required by law or regulation to supply investors with their portfolio holdings, pricing, or valuation information.

Strategy Risk - Many private equity funds employ a single investment strategy. Thus, a private equity fund may be subject to strategy risk, associated with the failure or deterioration of an entire strategy.

Use of Leverage and Other Speculative Investment Practices - Since many private equity fund managers use leverage and speculative investment strategies such as options, investors should be aware of the potential risks. When used prudently and for the purpose of risk reduction, these instruments can add value to a portfolio. However, when leverage is used excessively and the market goes down, a portfolio can suffer tremendously. When options are used to speculate (i.e., buy calls, short puts), a portfolio's returns can suffer and the risk of the portfolio can increase.

Past Performance - Past performance is not necessarily indicative and is not a guarantee of a private equity fund's future results or performance. Some private equity funds may have little or no operating history or performance and may use hypothetical or pro forma performance that may not reflect actual trading done by the manager or advisor and should be reviewed carefully. Investors should not place undue reliance on hypothetical or pro forma performance.

Limited Liquidity - Investors in private equity funds have limited rights to transfer their investments. In addition, since private equity funds are not listed on any exchange, it is not expected that there will be a secondary market for them. A private equity fund's manager may deny a request to transfer if it determines that the transfer may result in adverse legal or tax consequences for the offering.

Tax Risks - Investors in certain jurisdictions and in private equity funds generally may be subject to pass -through tax treatment on their investment. This may result in an investor incurring tax liabilities during a year in which the investor does not receive a distribution of any cash from the Fund. In addition, an investor may not receive any or only limited tax information from private equity funds may not receive tax information from underlying investments in a sufficiently timely manner to enable an investor to file its return without requesting an extension of time to file.

Reliance on Fund Manager; Lack of Transparency - A private equity offering's manager or general partner has total investment authority over the private fund. There is often a lack of transparency as to a private equity offering's underlying investment. Because of this lack of transparency, an investor may be unable to monitor the specific investments made by the offering or to know whether the investments are consistent with the sponsor's historic investment philosophy or risk levels.

Due to the risks mentioned above, it is important to perform proper due diligence in evaluating and choosing private equity managers to place your money with. There have been occasions when private equity fund managers took on too much risk in their portfolio and lost a substantial amount of their investors' money.