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Tax Benefits of Investing in Real Estate

August 17, 20237 min read

“Now, one thing I tell everyone is learn about real estate. Repeat after me: real estate provides the highest returns, the greatest values and the least risk.” - Armstrong Williams

Real estate syndication offers multiple tax benefits for passive investors, such as:

Depreciation: Depreciation on commercial real estate assets, particularly multifamily properties, is a significant tax advantage. The IRS allows depreciation of the building (not the land) over 27.5 years. Cost segregation studies can accelerate depreciation by assigning 5, 7, and 15-year depreciation schedules to various property components, enabling large paper losses in the first year.

Example: Let's assume a syndication purchases a multifamily property for $10 million, with $8 million allocated to the building and $2 million to the land. Using straight-line depreciation, the annual depreciation for the building would be $8 million / 27.5 years = $290,909.

If a cost segregation study assigns $3 million of the building's value to 5, 7, and 15-year depreciation schedules, the accelerated depreciation for the first year could be up to 80% of this amount, or $2.4 million. With this bonus depreciation, the first-year paper losses for the syndication would be $290,909 (straight-line) + $2,400,000 (bonus) = $2,690,909.

Cost Segregation: Cost segregation studies can accelerate depreciation by assigning 5, 7, and 15-year depreciation schedules to various property components, enabling large paper losses in the first year. An engineer performs a cost segregation study, breaking down the building and property items and allocating them to the different depreciation schedules. Up to 80% of items under the 5, 7, and 15-year schedules can be expensed in year one.

Example: In a $10,000,000 deal, an investor could potentially write off 15-25% of the purchase price in the first year. This means that if an investor invested $100,000, they could leverage $100,000 in paper losses during that first year.

Carrying Over Passive Losses: Excess paper losses from bonus depreciation in the first year can be carried over to subsequent years, potentially offsetting taxes on cash flow distributions throughout the syndication's 5-7 year hold period.

Example: If an investor's share of the first-year paper losses is $50,000 and their cash flow distribution is $10,000, their net loss on the K-1 tax form would be -$40,000 ($10,000 - $50,000). This excess loss can be carried forward to year 2, offsetting taxes on future distributions.

Cash-Out Refinance: A cash-out refinance offers tax-free liquidity to passive investors in a real estate syndication by distributing surplus loan proceeds after repaying the original loan.

Example: The original loan for a property is $5 million. After several years, the property's value increases to $10 million. The syndicator secures a new 70% LTV loan of $7 million. After repaying the original $5 million loan, the remaining $2 million ($7 million - $5 million) is distributed to investors tax-free, as it is considered a loan and not a gain.

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Lower Capital Gains Tax Rate: With all the policial policies currently circulating reguarding the increase to capital gains, like this. "Top Combined Capital Gains Tax Rates Would Average 48 Percent Under Biden’s Tax Plan". Its is extremely important that you stratigize how this could impact you and minimize your exposure. Profits from property sales held for more than 12 months are classified as long-term capital gains, which have lower tax rates than short-term capital gains or ordinary income.

Example: If an investor's share of a property's sale profit is $100,000 and the property was held for over 12 months, the long-term capital gains tax rate would apply, potentially ranging up to 20% instead of the ordinary income tax rate, which can be as high as 37%. This results in significant tax savings for the investor.

Mortgage Interest: The annual interest paid on a mortgage can be used as a deduction, helping to further shelter the syndication's income from taxes.

Example: If a syndication pays $200,000 in mortgage interest for a year, this amount can be deducted from the taxable income, reducing the overall tax liability for the investors.

1031 Exchange: This powerful real estate investment strategy allows investors to defer capital gains tax liability by exchanging a property for a "like-kind" property within 180 days of the sale. Although this can be complex in a syndication with multiple investors, it's possible if all partners agree to participate in the 1031 exchange together.

Example: A syndication sells a property for a profit of $2 million. By utilizing a 1031 exchange, they can defer capital gains taxes by reinvesting the proceeds in a like-kind property. This allows the investors to maintain their capital in real estate investments while deferring tax liability.

Real Estate Professional

Understanding Income and Losses in Real Estate: Tax Implications

Real estate endeavors are predominantly viewed as passive activities. The distinction in how the income and losses from these activities are taxed is determined by your level of engagement with the property.

Real Estate Professionals Defined by the IRS:

To be classified as a real estate professional by the Internal Revenue Service (IRS), one must invest over half of their work hours in real estate activities such as development, acquisition, construction, or management. Furthermore, a minimum of 750 hours annually must be dedicated solely to your rental real estate businesses.

For those who meet these criteria, their real estate endeavors are not pigeonholed as merely passive. Instead, the income derived from these activities is labeled active or non-passive. This categorization empowers professionals to counterbalance their income with losses, be it from salaries, dividends, or other sources. Additionally, if the property yields income, professionals can sidestep the 3.8% net investment tax.

Deep Dive into Material Participation:

Material participation is an elevated form of engagement compared to active participation. If you fit the mold of a real estate professional and engage materially in the rental property, your income and losses fall under non-passive tax classifications. This facilitates the offsetting of various income forms and evasion of the net investment tax.

The IRS has stipulated several criteria to determine material participation. If you meet any of the subsequent conditions, you qualify:

  1. Over 500 hours of involvement in the activity within a year.

  2. Sole responsibility or a predominant role in the activity's tasks.

  3. A minimum of 100 hours committed to the activity yearly, matching or exceeding others' contributions.

  4. A significant participation activity (SPA) with a commitment of over 500 hours.

  5. Material involvement in the activity for any five years in the previous decade, in any sequence.

  6. Engagement in a service-centered activity with material participation in any three of the former tax years.

  7. Continuous, significant, and regular involvement throughout the year, based on factual evidence.

The Nuances of Active Participation:

Active participation requires less intensive involvement than its material counterpart. The IRS perceives active participation as making meaningful and genuine managerial decisions. These might encompass:

  • Endorsing potential tenants.

  • Establishing rental conditions.

  • Approving budgetary outlays.

By actively partaking and holding a stake of at least 10% in the venture, you may be eligible for deductions on certain passive losses.

The IRS has outlined a special rule regarding passive loss in relation to active participation. Should your modified adjusted gross income (MAGI) be $100,000 or lower, you may deduct passive losses up to $25,000. This deduction becomes incremental as your MAGI scales from $100,000 to $150,000. Beyond a MAGI of $150,000, deductions on passive losses aren't feasible. Excess losses exceeding $25,000 can transition to the subsequent year.

Navigating Passive Activities:

Conversely, if your engagement with the rental property remains as an auxiliary investment without material participation, it is categorized under passive activities. Losses emanating from these passive activities can solely counterbalance passive income. Therefore, leveraging these losses against other taxable income isn't permissible. Instead, they transition forward until you either secure passive income or liquidate the investment.

In conclusion, real estate syndications offer significant tax benefits, allowing investors to maximize returns and reinvest their earnings. By leveraging depreciation, carrying over passive losses, utilizing cash-out refinancing, taking advantage of lower capital gains tax rates, deducting mortgage interest, and using 1031 exchanges, investors in real estate syndications can grow their wealth more efficiently. These tax advantages enable investors to focus on their core competencies and create a cycle of investment and growth while preserving their hard-earned dollars..

Real Estate TaxIncome OffsetPassive LossesNet Investment TaxReal Estate Professional
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Christopher Borden

Chris Borden is a seasoned executive with over 25 years of business expertise spanning operational, financial, marketing, and commercial real estate strategies. Previously President of Hawaii's second-largest retail food chain, Chris has transitioned from his earlier roles to become a leading figure in the real estate investment sector. Alongside managing six businesses focused on real estate investing, Chris and his wife have founded two non-profit organizations aimed at bolstering education and economic growth in underserved regions. A proud family man, Chris has transacted over $14 million in investment debt loans in the first year and a half and expanded into large commercial investments totaling over 500 units. His dedication, industry acumen, and adaptability have earned him a reputation as a reliable and trustworthy partner in the sector.

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