Taxes aren’t the most exciting aspect of real estate investing, but they’re important to understand nonetheless. As a real estate investor, you have access to some great tax deductions that can save you thousands of dollars each year.
However, it’s important to understand how your tax liability may change with each real estate investment decision so that you don’t end up paying a higher tax rate than you need to. In this blog post, we will discuss the basics of tax benefits, capital gains, and passive income. We’ll cover allowable deductions, the tax implications of investing in a real estate syndication, and more!
As a passive investor in a real estate syndication, your sponsor team will guide you through tax season and ensure you’re getting the tax benefits you deserve. The beauty of investing in real estate is that your investments lower your tax obligation rather than increase it, unlike some other investment vehicles, such as mutual funds and stocks.
Any time you’re planning to invest your hard-earned money, you should perform thorough due diligence to gain a working knowledge about that investment strategy, whether your earnings will be considered active income or passive income, and for tax advice around the investment opportunity.
Keep reading for an overview of how real estate syndication investors can maximize the tax advantages available while also generating passive income.
Tax Strategies For Passive Investors Begins With An Entity Selection
Oftentimes, real estate investors ask how setting up an entity will alter the value of the deductions they’re allowed to take on their taxes. Allowable deductions don’t change whether you’re investing with your personal name and social security number, whether you have a single-member LLC, or if you have a multi-member LLC or corporation. The tax deductions are the same and include all business-related expenses.
As a real estate investor, it’s wise to avoid electing C-corporations to set up your real estate investing business. With a C-corporation, all your earnings can be taxed more than once. To simplify things as you’re just starting out, we recommend forming a single-member LLC. Most real estate syndications are formed as multi-member LLCs and are taxed as partnership.
Keep in mind that in order to receive the benefit of asset protection, you need to keep your personal and business assets separate. You should have separate business and personal accounts and be sure not to intermingle the funds. Maintaining separate accounts allows you to protect the integrity of your business entity.
During the startup phase of your business, it should be noted that any costs you incur, even before electing your entity, are tax-deductible. These startup expenses include, but aren’t limited to, legal fees, research, travel to look for and tour properties, and other professional fees.
Passive Income, Taxes, And Real Estate Syndications
Real estate syndications are typically set up as limited liability companies (LLC) and taxed as a partnership. The lead syndicator, or sponsor, is typically in the role of the general partner and the investors are the limited partners.
The real estate syndication itself is not taxed. It’s a pass-through entity, meaning that the items of income and expenses, as well as the gains and losses that occur at the syndication level are passed on to the limited partners. There will be separately stated items on the K-1 that each syndication member will be liable for and taxed on accordingly.
The items reported on the K-1 and your cash distributions are different. The cash distributions you receive as returns on your investment are not subject to tax, to the extent of your tax basis in the syndication. Simply put, your tax basis is your initial capital investment into the real estate syndication deal, so maybe $50,000, plus any current year contributions and pass-through income, minus any losses and expenses. Expect the tax basis to go up and down every year. As long as you maintain a positive tax basis, any cash distributions are tax-free. Any excess cash distributions you receive will be taxed as dividends.
The lead syndicators have flexibility in how they choose to allocate the various items. The real estate syndication operating agreement can be written to reflect the various allocations, depending on the personal needs of the partners.
Taxable Income And Rental Real Estate
As a limited partner in a syndication, you’ll be earning passive income, which is different from earned income, or W-2 income. Passive and active losses are treated separately as well. Passive income is considered the same as interest dividends are and, generally speaking, passive losses can be offset by passive income.
There is a special allowance for rental losses. If your modified adjusted gross income as a married couple is $150,000 or less, you can take up to $25,000 of these passive losses. However, if your adjusted gross income is higher, you cannot take any rental, passive losses against earned income, unless you’re a real estate professional. Real estate professionals (REPS) have a special designation that allows them to take more passive losses against their earned income since the majority of their earned income is also from real estate investments.
It’s common for real estate syndication investors to qualify for this designation. There are three parameters that must be met in order to qualify for this designation. The first is that 51% of all the investor’s active income activities must be related to the real estate industry. Also in one calendar year, the investor has to exceed 750 hours in a rental real estate trader business. The third is that you must materially participate in your business’s real estate activities. A real estate business can include residential property management, commercial rental properties, sourcing real estate syndication investment opportunities, etc.
Be sure to discuss your personal situation with a CPA. Understanding passive activity rules can be powerful when it comes to your tax liability, capital gains, and qualifying for a particular tax treatment. Changes can happen quickly and what you qualify for one year, may be different from the next year. Small changes can impact you greatly at tax time, so always seek professional advice from your CPA or tax advisor.
How Capital Gains Taxes Work With Real Estate Investments
The Tax Cuts and Jobs Act (TCJA) changed the way that long-term capital gains taxes are calculated for real estate investors. The act doubled the amount of gain that’s eligible for the 20% exclusion, but it also eliminated like-kind exchanges.
Previously, an investor could sell a property they had held for years and not pay any taxes on the first $500,000 of gain. Under the new law, investors can exclude up to $250,000 of gain from taxation. Married couples filing jointly can now exclude up to $500,000 in capital gains.
If you sell a property for more than your tax basis (the amount you invested plus current year contributions and pass-through income), you will pay capital gains taxes on the difference. The Tax Cuts and Jobs Act also increased the tax rate for long-term capital gains from 15% to 20%.
The Power Of Depreciation And Cost Segregation
Wear and tear on a property over time is expected and you’re allowed to write off the depreciated value of an asset over time. You’re allowed to write off the value of residential rental assets over 27.5 years and commercial properties can be written off for 39 years.
Depreciation affects you, as the investor, because when you earn cash-on-cash returns, the tax on the amount you receive is deferred. This means you aren’t required to pay taxes on the earnings from the asset until it’s sold. You also have the option to elect bonus depreciation, if you choose, which can even further maximize your tax benefits.
Cost segregation amps up the tax advantages even further. In a typical real estate syndication, the property is held for around five years. With straight-line depreciation, properties held for many years receive the most benefit.
By utilizing cost segregation, you’re able to take into account the various aspects of the property that will depreciate at a quicker rate. For instance, the signage of an apartment complex is expected to deteriorate quicker than the roof. Cost segregation can speed up depreciation benefits, so investors can have further tax advantages even within five years’ time.
Tax Benefits Of Investing In Real Estate
So, what does all this mean? As a syndication investor, it’s important to be aware of how tax code changes will impact each taxpayer’s marginal tax rate. If you or your spouse can qualify for REPS, you’ll want to make sure that you strategically reduce taxable income using the rules laid out in the Internal Revenue Code to your advantage. Tax laws are always changing, so it’s important to stay up-to-date and consult with your CPA or tax professional each tax year.
By investing in real estate, either actively or passively, you can qualify for significant tax advantages. You can use the deductions earned from real estate investments to offset your other income and potentially decrease your tax bill each year.
In order to build wealth, it’s not enough to earn ordinary income, you also have to know what strategies can best help you maximize the tax benefits available to you. Investing in real estate syndications provides regular people like you and I the chance to build wealth quickly and sustainably through passive income, while also mitigating risk.
This article is not to be taken as tax advice. As always, be sure to consult your CPA or tax professional to assess your personal situation and determine what strategies best fit your needs and financial goals.