When I began learning about real estate, I kept hearing about the tax benefits of investing in this type of asset class, yet I was unsure how it applied to me. I heard about investors that paid $0 in taxes and thought that was pretty awesome and wondered, could that work for me? I have learned, in fact, that, it is possible to significantly reduce and even eliminate your tax obligation when you follow specific strategies; yet everyone’s situation is different. My hope is that this article will shed some light on what may apply for you.
But First, a Disclaimer
I am not a tax professional, nor do I plan to become one. The insights and perspectives provided in this article are for informational purposes only and may be useful to you when you speak with your CPA on the specifics of your situation.
Let’s begin.
5 Big Things to know about Taxes and Passive Investing in Real Estate
Here are 5 big things every passive investor in a real estate syndication should know about taxes:
- The tax code favors real estate investors.
- As a passive investor, you get all the tax benefits an active investor gets.
- Depreciation is magical and cost segregation is powerful.
- Capital gains and depreciation recapture are things you should plan for.
- 1031 exchanges are amazing, yet do not apply in all situations.
#1 – The tax code favors real estate investors.
Why do many wealthy people pay little to nothing in taxes?
They reduce their tax liability by “partnering’ with the government. They understand and utilize tax incentives.
The IRS recognizes how important real estate investing is in providing quality housing. The tax code is written, in such a way that it rewards real estate investors for investing in real estate, maintaining those units, and making upgrades over time. One reason for this, is that the government recognizes that leveraging and incentivizing professionals to provide housing is much more cost effective and efficient than doing it themselves.
#2 – As a passive investor, you get all the tax benefits an active investor gets.
This is pretty cool! Even though you play no active role in the management of a property, you still benefit from the tax advantages.
This is because, as a passive investor in a real estate syndication, you invest in a business entity (typically a Limited Liability Company (LLC) or a Limited Partnership (LP)) that holds title to the property, and is disregarded in the eyes of the IRS (LLC and LP are sometimes called “pass-through entities”).
This means that any tax benefits flow right through the LLC or LP entity, to you, the investor.
Note: Investing in REITS is different. With a REIT, you are investing in a company, not directly in the underlying real estate, and hence you won’t get the same tax benefits.
Common tax benefits from investing in real estate include writing off expenses related to the property (including things like repairs, utilities, payroll, and interest), and being able to write off the value of the property over time (this is called depreciation).
Let’s focus on depreciation next.
#3 – Depreciation is magical and Cost Segregation is powerful.
Depreciation lets you write off the value of an asset over time. This is based on wear and tear and the useful life of an asset.
What is depreciation?
Let’s use an example here. Most people are pretty familiar with depreciation as it relates to cars. Let’s say I buy a brand new Jeep Wrangler today for $45,000. Over time, the value of the vehicle depreciates, because it gets closer to the end of its useful life and eventually it will be worth very little or even nothing.
The IRS is acknowledging that an apartment building has a useful life too. When people are living in and using a property each day, if nothing was done to maintain, improve, and replace the components of the building, it would eventually be uninhabitable and useless; just like a beat up used Jeep Wrangler.
Different assets have different lifespans. A vehicle may have a life of 10-20 years (depending on maintenance), yet you would expect a building to be useful for 50+ years in most cases.
For residential real estate, the IRS allows you to write off the value of the property over 27.5 years.
Note: Only the property itself is eligible for depreciation benefits, not the land. The IRS is smart enough to realize that the land will still be there in 27.5 years and will still be worth the same, or more.
Here’s an example.
Let’s say you purchased a property for $1,000,000 and the land is worth $200,000 while the building is worth $800,000.
With the most basic form of depreciation, known as straight-line depreciation, you can write off an equal amount of that $800,000 every year for 27.5 years. That means, each year, you can write off $29,090 due to depreciation ($29,090 x 27.5 years = $800,000).
Why does this matter? Excellent question. When you invest in real estate, you typically expect a consistent return or “cash flow”. If you make $10,000 in cash flow that first year, you have a $29,090 loss to offset that return. Instead of paying taxes, you keep the cash flow amount tax-deferred, meaning you don’t need to pay taxes until the property is sold (more on that later).*
This is an example of and is called a “paper loss”.
*Disclaimer: This depends on your individual tax situation. Please consult your CPA .
Now let’s talk Cost Segregation.
In the last example, we talked about something called straight-line depreciation, which allows you to write off an equal amount of the value of the asset every year for 27.5 years. For many real estate syndications, the hold time is around five years. So if you were to deduct an equal amount every year for 27.5 years, you would only get five years of those benefits. You’d be leaving the remaining 22.5 years of depreciation benefits on the table.
This is where cost segregation comes in.
Cost segregation acknowledges that different assets within a building have different lifespans. A roof generally lasts longer than carpet.
In a cost segregation study, an engineer itemizes the individual components that make up a property, including things like outlets, wiring, windows, carpeting, and fixtures.
Some items can be depreciated on a shorter timeline – 5, 7, or 15 years – instead of over 27.5 years. This can drastically increase the depreciation benefits in those early years.
Here’s an example.
Let’s say you invest $100,000 in a real estate syndication that closes in November and a cost segregation study is done on that asset before the year ends.
The cost segregation will likely accelerate the depreciation for many of the components of that property.
You will receive a “K-1” (tax form) in the first quarter of the next year and while you invested $100,000, you may show a paper loss of something like $50,000 due to that accelerated depreciation.*
*Disclaimer: How that paper loss impacts your tax obligation depends on your individual tax situation so this is where you consult your CPA.
#4 – Capital gains and depreciation recapture are things you should plan for.
We say that investing in real estate is “tax-advantaged”, yet that does NOT necessarily mean “tax-free”. This is the area I feel isn’t discussed enough, because as investors, we should know what to expect so we can plan accordingly.
There are two ways the IRS collects its share; capital gains tax and sometimes depreciation recapture. It is common for a real estate syndication to plan for a sale somewhere around years 5-7 and this is when these taxes would be relevant.
Current capital gains tax rates are 0%-20% spending on your tax bracket . Depreciation recapture is taxed as ordinary income.
Capital gains may be offset by a 1031 exchange (more on that soon) and there are strategies to offset depreciation recapture as well.
For example, let’s say you invested in an apartment syndication that is selling this year and due to cost segregation, you have enjoyed $50,000 in passive losses that have helped to reduce your tax liability up to this point. One way that you may be able to continue to kick the can down the road and delay paying taxes, is to invest in another syndication in the same year that will generate additional passive losses that could offset the depreciation recapture.*
*Disclaimer: I am not a tax professional, so please consult with your CPA to better understand how this example may apply in your tax situation AND to stay up to date on the most current tax laws.
#5 – 1031 exchanges are amazing.
One potential way to avoid capital gains tax and depreciation recapture is a 1031 exchange.
A 1031 exchange allows you to sell one investment property, and, within a set amount of time, swap that asset for another similar investment property.
Instead of having the sale proceeds paid directly to you, you instead roll them into the next investment and thus, avoid paying any capital gains tax on the sale of the first property.
Real estate syndications generally do not offer 1031 exchanges as an option. The majority of investors in a syndication would have to agree to a 1031 exchange, thus making it more difficult and less likely to work. You cannot do a 1031 exchange on just your shares in a real estate syndication.
Every sponsor is different and approaches 1031 exchanges differently. If a 1031 exchange is something you’d be interested in, be sure to ask the sponsor about it directly.
Recap
Investing passively in real estate offers 5 Big Things in tax advantages that are an integral part of many savvy investors’ tax planning strategies. Laws change over time of course, yet given the national housing shortage that exists , I believe it is likely that the government will continue to incentivize investors to invest in real estate and that’s good news for us.
To recap, here are the five big things I think every real estate investor should know about taxes:
- The tax code favors real estate investors.
- As a passive investor, you get all the tax benefits an active investor gets.
- Depreciation is magical and cost segregation is powerful
- Capital gains and depreciation recapture are things you should plan for.
1031 exchanges are amazing, yet do not apply in all situations.
As a passive investor, you don’t have to “do” anything to take advantage of the tax benefits that come with investing in real estate. That’s one of the benefits of being a passive investor. You don’t have to keep any receipts or itemize repairs. You just get that K-1 every year, hand it over to your CPA or accountant, and let them apply the tax benefits to your situation .
*If you would like to learn more about taxes and real estate investing, I recommend the Real Estate CPA Podcast as a resource.