7 Crucial Tax Issues
7 Crucial Tax Issues Every Passive Real Estate Investor Must Know
When we invest in something new, most of us focus on the potential gains. Dreams of a new car, an exotic vacation, or financial independence are top-of-mind—not the potential burden of taxes.
Fortunately, real estate investors are much more likely to lower their tax bill when compared to those investing in stocks, bonds, and/or mutual funds—doing nothing proactive.
The Internal Revenue Service (IRS) approaches real estate gains in a manner that differs vastly from their approach to stock market gains, which is what this article will discuss in greater detail, primarily from the perspective of a passive investor in a real estate syndication.
Disclaimer: The author is not a tax expert. The insights that follow were gained from experience, so you are encouraged to seek guidance from a tax professional for the specifics of your situation.
7 Things You Must Know about Taxes and Syndicated Real Estate Investing
The following seven takeaways are key for any passive investor in a real estate syndication:
1) Real estate investment has created more millionaires than all other forms of investment. As you will come to understand, that tax code has a significant role in this. The IRS understands the importance of real estate investment in the broader financial well-being of the country, such as providing for affordable, quality housing, maintaining it, and upgrading it so that people can live comfortable lives.
2) Active and passive investors receive exactly the same benefits. This is a very important point. As a passive investor, you are not fixing a backed-up toilet or repairing a leaky roof, but you still receive full tax benefits. Even though your investment in a syndication, typically structured with a Limited Liability Corporation (LLC) or limited partnership (LP) as the owner of the property, the IRS disregards that entity, often called a pass-through entity, so any tax benefits flow through the LLC or LP to you, the investor.
Importantly, a Real Estate Investment Trust (REIT) is not a pass through entity. If you invest in a REIT, you are not investing in the underlying real estate; you are investing in a company, so you will not receive similar tax benefits, such as write-offs for repairs, utilities, interest, etc. and you will not receive depreciation benefits.
3) Depreciation is a singularly powerful wealth building tool, which allows you to write off an asset’s value. Depreciation follows a schedule based on wear and tear throughout the asset’s useful life.
The following example provides a clear understanding of depreciation as it relates to real estate.
A real estate investment usually comprises two parts: 1) the land, and 2) the building. The land portion of the investment is not subject to depreciation, only the structure is eligible for depreciation.
For example, a property sells for $1 million, the value of the land in this example is $200,000. The structure is valued at $800,000. IRS regulations acknowledge that absent maintenance, the building will yield to normal wear and tear. With residential structures, the IRS has determined the useful life of such residential buildings to be 27.5 years.
Using basic straight-line depreciation, this means you can write off about $29,091 per year (800,000/27.5 = 29,090.90) under the current tax code. This is a huge benefit!
Consider that in the first year, you make $5000 on the property. Rather than owing taxes on this profit, you keep $5000—tax deferred until you sell the property. On paper, because you can claim $29090.90 in depreciation, the IRS perceives this tax year to be a net loss. Property acquired after September 27, 2017 will qualify for bonus depreciation, which further increases your tax benefit and wealth building opportunities.
4) Cost segregation is an enhancement which allows the real estate investor to speed up the depreciation schedule by separating out individual building components (usually done by an engineer) such as wiring, windows, carpets, fixtures, etc. Many of these building components are eligible for depreciation on shorter timelines than 27.5 years. Some components can be fully depreciated over as little as 5 years!
This has the positive effect of increasing depreciation benefits dramatically in the early years of the investment and can be an important ploy for the syndicated investor, who may hold on to his investment for 5 years or fewer.
For example, a few years back, a real estate syndicate purchased an apartment building in early December, which means the investors held the property for less than one month of the calendar year. By using cost segregation, the investors could accelerate depreciation on several items, such as carpeting and landscaping.
The schedule K-1 sent to investors reflected a loss on paper of about fifty percent of the original investment. If you are an investor who also qualifies as a real estate professional, that paper loss may apply to your overall tax liability. Of course, this depends on your individual circumstances, so please consult your tax professional.
The takeaway here is that cost segregation can be a game changer.
5) Plan for depreciation recapture and capital gains because real estate investing is never one-hundred percent tax free. The IRS smiles favorably on real estate investment, but they will take their bite of the apple.
They get their bite of the apple when the real estate is sold through capital gains tax, and occasionally through depreciation recapture, depending upon the selling price, the time the asset has been held, and your individual tax bracket.
Based on 2018 tax laws, the breakdown is:
Income Bracket - $0.00 to $77,220
Capital gains Tax - 0 percent
Income Bracket - $77,221 to $479,000
Capital gains Tax - 15 percent
Income Bracket - More than $479,000
Capital gains Tax - 20 percent
Again, you are urged to consult with your tax professional.
6) The 1031 exchange is an amazingly useful tactic for managing capital gains taxes and, sometimes, depreciation recapture. A 1031 exchange lets you sell the original property and, within a specified period, exercise a like-kind exchange for the acquisition of another property.
By exercising the 1031 option, when the original property is liquidated, you will not pay any capital gains tax.
Unfortunately, not all real estate syndications offer a 1031 exchange option, and those that offer the option usually need the majority of the syndicate’s investors to agree. You cannot exercise the 1031 option based solely on your shares. This option is an all-or-nothing scenario, so if you are interested in such an option, discuss it in advance with the syndicate’s sponsor, because every sponsor is unique in their approach.
7) Many wealthy investors choose to invest real estate because of the tax benefits. You have seen how lucrative these benefits can be, so that should come as no surprise.
Investing in real estate allows the wealthiest among us to take full advantage of valuable write-offs, applying these write-offs to other tax obligations and cutting their overall tax burden substantially.
These facts will give you new insights into how real estate magnates can make millions of dollars, yet owe almost nothing in taxes. A perfectly legal and highly effective wealth building strategy and you need not be rich to take advantage of real estate investment. The current tax code applies to every real estate investor, regardless of net worth.
Final thoughts
At the beginning of this article, I said that you need not be proactive regarding taxes when investing in real estate, especially if you are a passive investor in a real estate syndication. In most scenarios, you’ll be able to earn money by cash-on-cash returns, and you won’t owe taxes on those returns because of benefits such as depreciation.
To summarize, these are the seven key takeaways about real estate investing and taxes:
Those who invest in real estate are favored by the tax code.
Passive investors get the same tax benefits as active investors.
Depreciation is a powerful tool for wealth building.
Cost segregation fast-tracks depreciation.
Plan for capital gains and depreciation recapture.
1031 exchanges are awesome opportunities.
Some invest in real estate entirely for the tax benefits.
Passive investors need not do anything proactive to reap the tax benefits inherent in real estate investing. As a passive investor, you need not keep receipts or itemize repairs. You just look forward to that sweet annual K-1, hand it to your tax preparer, and forget about it!