It's that time of the year again when most people start dreading taxes but if you're a passive investor in a commercial real estate syndication you might actually be looking forward to receiving your K-1 because of the potentially large "paper loss" you could see due to the very lucrative tax benefits real estate provides.
In addition to the capital preservation and cash flow benefits, one of the main reasons passive investors seek to invest in a real estate syndication is because of the tax benefits; which prove superior to many other passive investments. There are a number of significant tax benefits that come with investing in real estate, but arguably the number one benefit is the deductions investors get to take advantage of.
Some of the most common deductions are:
Depreciation (Accelerated)
Mortgage Interest
Property Tax
Operating Expenses
Repairs
The first thing to understand is that an equity investor in a syndication is actually a limited partner in the partnership. Investments in syndications will generally be considered “passive” activities and each investor gets to share in these deductions based on their proportional ownership interest in the overall limited partnership which make investing in commercial real estate assets very tax efficient.
As a passive investor you'll receive a K-1 for tax reporting purposes which has no direct relationship to the health of the underlying asset. In most cases you'll see a passive loss (due to lucrative tax benefits) which can be used to offset passive gains in other areas of an investor's portfolio. In fact, we have many high-net worth individuals who began investing just to solve their tax problems!
Why do real estate investors get so many great tax benefits?
One of the main reasons the government offers real estate investors great tax benefits is because they're enticing us to stimulate the economy. The government has determined the best way to do that is to create tax loopholes benefiting those who are “more productive” by creating wealth for not only themselves but for others as well. These are the entrepreneurs who start businesses, investors who fund those businesses and real estate investors. To these groups, the government gives tax incentives in the form of tax deductions to encourage their activities and stimulate the economy.
Real estate investors get special treatment from the government because on top of the usual business deductions, they get the gift of depreciation, which is an extra write-off that is unique to real estate. Because of depreciation, it’s common for a cash-flowing property to look like it is losing money each year. This means that your properties can generate real income that you put in your pocket, and you don’t pay any taxes on it.
Why do real estate investors get this special treatment? In his book, Tax-Free Wealth, Tom Wheelwright explains that the government needs someone to provide housing and commercial space to the public since it’s not in the market of supplying it. If there weren’t real estate investors building and running commercial properties, who would provide and manage the country’s rental market?
Lucrative Tax Benefits
Depreciation
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value. The most common form of depreciation is straight-line depreciation, which allows the deduction of equal amounts each year. The annual deduction is the cost of the item divided by its useful life. The IRS considers the useful life of real estate to be 27.5 years. So, the annual depreciation on a commercial real estate asset worth $1,000,000 (excluding the land value) is $1,000,000 / 27.5 years = $36,363,64 per year.
As one of the tax benefits of commercial real estate syndications, the depreciation amount is such that a passive investor won’t pay taxes on their monthly, quarterly, or annual distributions during the hold period. They will, however, have to pay taxes on the sales proceeds.
Depreciation is often accelerated on large commercial assets through what is known as a cost segregation study.
Cost Segregation (Bonus/Accelerated Depreciation)
Cost segregation is a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes. A cost segregation study performed by a cost segregation engineering firm dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 years, the useful life of a residential building. The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7, and 15 years. As a result we'll see significant deductions which can result in a sizable "paper loss" in the early years of owning the asset.
Bonus Depreciation - One of the major changes with the Tax Cuts and Jobs Act of 2017 was the bonus depreciation provision, where business can take 100% bonus depreciation on a qualified property purchased after September 27th, 2017.
Accelerated Depreciation - Accelerated depreciation is any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of the life of an asset.
Capital Gains
When the asset is sold and the partnership is terminated, initial equity and profits are distributed to the passive investors. The IRS classifies the profit portion as long-term capital gain.
Under the new 2018 tax law, the capital gains tax bracket breakdown is as follows:
Taxable income (individual or joint)
$0 to $77,220: 0% capital gains tax
$77,221 to $479,000: 15% capital gains tax
More than $479,000: 20% capital gains tax
Cash-Out Refinance
It’s common for value-add syndicators to optimize the value of a property (i.e. an apartment) over ~2 years once renovations are completed (higher rents are achieved), go to the bank and refinance the property since the value most likely increased and pull equity out. There is no taxable event when you return a part of an investor’s equity.
1031 Exchanges
A 1031 exchange allows one to swap a like kind property for another like kind property and defer the capital gains tax on the sale of the first property. Most syndications are not setup to take in a 1031 exchange from an investor’s personal property but you could do a 1031 exchange from one syndication deal to another syndication deal under the same sponsor if that type of opportunity presented itself down the road. Most syndicators will try to make this happen because deferring your investment gains many years into the future is highly beneficial to investors.
Self-Directed IRAs
A growing number of retirement savers are becoming aware that they can choose investments other than the traditional offerings of stocks, bonds, mutual funds, ETFs and CDs within an Individual Retirement Account (IRA). Self-Directed IRAs offering non-traditional investments have increased in popularity in recent years and are somewhat more accessible for investors compared to 1974 when the IRA was first introduced. These Self-Directed IRAs allow you to invest in real estate, precious metals, notes, tax lien certificates, private placements and many more investment options.
Investing in real estate through a Self-Directed IRA can be a great way to diversify your retirement account. Traditional and Roth IRAs can be converted into Self-Directed IRAs, where the individual has more control over what to do with the cash and still has the tax deferred benefits that an IRA offers. 401(k) plans work a little differently; if the individual is still employed by the company that sponsors the 401(k) plan, he or she can't move the money around. If it's an old 401(k), a rollover is completely possible. In fact, that's what I did for my first two multifamily investments, having rolled over a traditional IRA to a Self-Directed IRA. The process was fairly easy and straightforward and allowed me the opportunity to begin investing in multifamily syndication deals as a limited partner.
In closing, commercial real estate syndications are highly tax efficient investment vehicles. From the standard property tax, loan interest and accelerated depreciation opportunities to refinances, potential 1031 exchanges and qualified plans, the IRS currently has provided ample ways to keep more profits in your pocket or defer paying the taxes for some time in the future.
As a person involved in real estate syndications, these are brief summaries and not a recommendation or advice. Please consult with a tax professional regarding your tax and real estate investment situation to learn more about these strategies and how they may apply to you.