For background what transpired, see these posts:
- Why and How I Sold Most of My Rental Properties
- Why and How I Sold My Last Rental Property
- My Real Estate Syndication Investing Journey
At the time of this writing, here’s what my real estate syndication portfolio looks like (including my private loans which are very similar in nature to syndications):
- 10 different deals — five are multi-family apartment complexes, two are land, one is storage fund, one is a mobile home park fund, and one is a multi-family fund
- 7 different syndicators — I have two deals with one syndicator and three with another; all the others are one deal only. These were initially recommended to me in the Millionaire Money Mentors forums (based on who people had experience with and liked) and then I called to chat with them to see if they were a fit for me.)
- Total invested: $1,025,000
- Three are interest only (then return of principal) while the other seven are interest plus appreciation at sale
- Eight are long-term deals (5-7 years) and two are year-only deals
- Three deals are in the same market but the other seven are all in different markets across the US (many of them are in multiple markets — for example, the funds cover many different markets even within themselves).
- Annual income: $75,000
It’s a decent portfolio and does two things I really LOVE:
- Generates a good amount of income.
- The income is passive — I don’t have to look over 50 pages of financials each month and ask several questions like I did with my rentals.
As you can see, my strategy has been to spread out the risk and diversify by:
- Type of real estate
- Time frame
- Amount of money in any given deal
In addition, this money is “extra” for me. If it all went away tomorrow, my financial life would not change one bit.
That said, I don’t want that to happen (of course) and it would be painful, but I am playing with the house’s money at this point.
I want to make that clear as I am not recommending (or saying not to invest either) real estate syndication deals, just telling you what I am doing. You can make your own decisions from there as to what’s right or wrong for you.
In addition, I do NOT consider myself an expert in this area. This sort of investing is new to me (less than a year in) so I’m still learning.
That’s why when I wanted to have a post on the tax benefits of real estate syndication deals (one of the main advantages of them) I called on my buddy Dr. Jeff Anzalone from Debt Free Doctor.
Those who have read ESI Money for some time already know Jeff as he’s written several guest posts here including:
- Five Reasons You Should Invest in Storage Units and Three Ways to Do So
- How to Get Started Investing in Real Estate Syndications
- How to Save Money On Medical Costs
- 7 Financial Numbers You Should Keep Track Of
He’s also Millionaire Interview 80.
In addition to this, Jeff runs the Passive Investors Circle where he recommends real estate syndication deals to his members.
FYI, I am a member of the Passive Investors Circle and do see his deals, but I have not participated in any yet. This is because by the time I found out he was doing this, my funds were allocated and I’m fairly set for now.
Anyway, I asked Jeff to write a bit about the tax advantages of real estate syndication investing and this post is what he created.
With that said, let me turn it over to Jeff…
Most of us don’t think too much about taxes until April comes around. Then we quickly realize just how much of our income is being given to our silent partner (Uncle Sam).
When I started practicing dentistry in 2005, I used to be concerned by the amount of taxes I was paying. Going from a residency where little to no taxes are paid to having an annual six-figure tax bill was VERY eye opening.
To say that the majority of high-income professionals don’t enjoy tax season is an understatement.
After practicing a few years and paying boat loads to the IRS, I started educating myself about taxes and began to shift in the way I thought about them.
(Disclaimer: I am not a CPA, please consult a tax professional for your particular situation.)
A CPA recommended that I shouldn’t spend so much time and energy trying to minimize the impact of taxes on my “day job” income as there’s only so much one can do to lower them.
At the time I was already in the process of taking advantage of using depreciation with my building and equipment along with investing in an office retirement account.
The CPA stated that I should focus on investing in tax-efficient assets. In turn, he told me that these assets would produce passive income which is taxed much less than earned income from the practice.
In essence I’d be working smarter and not necessarily harder. Sounded good to me!
After researching and networking with several multi-millionaires, it seemed that real estate was the asset class that could provide BOTH passive income AND tax advantages to preserve and grow wealth.
But I had one problem….
Active vs Passive Investing
When I first started learning about real estate investing, I thought the only way was to be an active investor or landlord. It wasn’t until attending a conference in Dallas that I realized that were several ways to invest, including passively.
Several of my friends locally manage property for their families. After speaking with them and being able to see what goes on “behind the scenes,” I quickly realized that active investing was a full time job.
As a periodontist and father of two teenagers, I wasn’t looking to acquire something that was going to take my wife and I away from our kids’ activities and school functions. They’re only kids once and we didn’t want to miss out.
This made it an easy decision for us. Active investing was out. Passive investing was in. Which led to another problem…how can I invest passively?
Enter real estate syndications.
For an overview of syndications, check out this video:
Which makes syndications a great choice.
For today’s discussion, I want to get into everything you need to know regarding tax benefits you could take advantage of while passively investing in syndications.
As I explained in the video above, these are deals that involve a General Partner and Limited Partners.
1) General Partner (GPs) – This group is also known as the sponsor or syndicator. They are the ones that:
- Place the asset under contract
- Perform inspections
- Obtain the loan
- Get and keep the asset leased
- Manage the property
2) Limited Partner (LPs) – This represents equity investors (AKA the passive investors) within the partnership with limited risk.
Some of the most common tax deductions LPs value most in syndications are:
- Accelerated Depreciation
- Property Tax
- Mortgage Interest
- Operating Expenses
Any investments in a syndication will be considered “passive” activities and each limited partner gets to share in these deductions based on their proportional ownership interest in the overall limited partnership.
During tax season, the GP (sponsor) group will issue a K1 tax form to each LP. This form typically reflects a paper loss (due to lucrative tax benefits) created by the asset that can offset passive gains in other areas of your portfolio.
After you make an investment as an LP, your job is to simply sit back and let the GP do their job. They’ll take your capital and immediately put it to work which typically involves purchasing a property, renovating and then ultimately selling for a profit.
During this “hold period” which is usually 5-7 years, expect to receive quarterly distributions ranging from 6-9% annually.
Even though the returns on these investments are fantastic, they’re made even better by the numerous tax breaks and incentives real estate provides.
The IRS created the tax code not so much to tell us how to pay taxes, but to tell people how to spend and invest their money.
Trust me, the government does NOT want to be in the landlord business. And because of this, they’ve created huge incentives for investments in real estate.
Let’s get into some of those incentives and benefits that investing in a real estate syndication provides.
7 Best Real Estate Syndication Tax Benefits
Although commercial real estate typically appreciates over time, the IRS allows you to depreciate its value called a paper/phantom loss. They classify each depreciable item according to its useful life, which is the number of years of “useful life” of the item.
An example is that they allow owners of resident occupied real estate to depreciate the property over a 27.5 year period. This is called the straight line depreciation method.
An example would be an apartment complex purchased for $3.5 million.
In this situation, the land, which is not depreciable, was valued at $750,000.
That leaves the remaining $2.75 million to be depreciated which looks like this:
$2.75 million/ 27.5 years = $100,000
One of the things that I’ve learned being an apartment syndication investor is that one of the main tax benefits to investing is depreciation. This allows the Limited Partners (passive investors) to not have pay taxes on their distributions during the hold period. In essence, this “passive income” is basically tax-free.
What Is Depreciation Recapture?
As we just discussed, depreciation offers real estate investors a way to reduce taxes at their ordinary income tax rate. It also helps to reduce the property’s cost basis which determines the loss or gain during the sale.
If the property is held for at least a year, long-term capital gains tax is paid which is currently between 0-20% depending on your income.
However, not all gains benefit from the long-term capital gain tax rates due to “depreciation recapture.”
This is something implemented by the IRS to “recapture” the taxes you would have paid over the years without the benefit of claiming depreciation.
The depreciation recapture rate on this portion of the gain is 25%.
The reasoning the IRS came up with this is that since the taxpayer received the benefit of a deduction that offset ordinary income tax rates (up to 40% for most high-income earners), the government isn’t going to grant the more favorable capital gains rates (0-20%) on the portion of the gain relating to these prior depreciation deductions.
Check with your CPA regarding ways to help with the depreciation capture that takes place when the syndication sells. I had two deals go full cycle this year and we were able to use depreciation from a new syndication that I invested in this year to help “offset” some of the depreciation recapture.
#2 Cost Segregation
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 identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations.
This type of study is typically performed by qualified engineers or CPAs.
The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) instead of the 27.5 years that was discussed above.
- 5-year tax-life components: personal property assets (carpeting, secondary lighting, process related systems, cabinetry, ceiling fans, etc.)
- 7-year tax-life components: all telecommunication related systems (cabling, telephone, etc.)
- 15-year tax-life components: land improvements (parking lots, driveways, sidewalk, curbs, landscaping, etc.)
Reducing tax lives results in:
- Accelerated depreciation deductions
- A reduced tax liability
- Increased cash flow
#3 Bonus Depreciation
Tax law changes under the Tax Cuts and Jobs Act of 2017 gave a boost to cost segregation and depreciation.
Investors were given the ability to accelerate the timeline of depreciation and take it earlier in the lifespan of the property.
Bonus depreciation was increased from 50% to 100% on certain qualifying assets.
Real estate investors received immediate expensing of certain 5, 7 and 15 year property.
The Act also allows used property that was acquired after Sept. 27, 2017 to qualify for this special depreciation treatment.
That means real estate investors can deduct 100% of 5, 7, and 15 year property all in the first year which leads to significant tax savings.
#4 Capital Gains
A capital gain occurs when an asset is sold for more than it was purchased for.
Capital Gain = Selling Price−Purchase Price
Not only does the government want a cut of your income, it also expects one when you realize a profit on your investments (capital gains tax).
Trust me, they’re going to get your money in as many was as they can.
According to IRS.gov, almost everything you own and use for personal or investment purposes is a capital asset.
- your primary residence
- personal-use items like household furnishings
- stocks or bonds
How much these gains are taxed depends on how long you hold before selling.
Short-term capital gains are taxed as though they are ordinary income.
What this means is any profits received from the sale of an asset held for one year or less is taxed at your normal income tax rate.
Long-term capital gains tax are based on profits received from the sale of an asset held for more than a year.
Depending on your taxable income and filing status, the long-term capital gains tax rate is 0%, 15% or 20%.
As you can see, capital gains are taxed at a lesser tax rate than earned income.
This is a much better tax rate for people in the highest marginal tax bracket.
#5 1031 Exchange
This tax incentive comes from Section 1031 from the IRS which is also known as “Like-Kind Exchanges“:
Like-kind exchanges — when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or “like-kind” — have long been permitted under the Internal Revenue Code.
Generally, if you make a like-kind exchange, you are not required to recognize a gain or loss under Internal Revenue Code Section 1031.
This section allows taxpayers a way to defer taxes by exchanging one property and replace it with a like-kind property. This means that you’re able to take all of the proceeds from the sale of one property and buy another and the taxes on the transaction are deferred.
Most syndications are not set up to take in a 1031 exchange from an investor’s personal property. But there are ways that you could do a 1031 exchange from one syndication deal to another.
Most of the time this can take place under the same sponsor if that type of opportunity presents itself down the road.
#6 Cash-Out Refinancing
Many of the apartment syndications (I’m personally invested in) are set up as a value add syndication. This means that one of the sponsor’s goal is to optimize the value of a property over the first few years once renovations are completed.
By doing this, the rents can be increased and the property is then refinanced (pull out the equity) due to the increase in value of the property.
This process is completely tax-free, and you can utilize this cash to continue growing your streams of passive income without paying more in taxes.
#7 Self-Directed IRAs
A self-directed individual retirement account (SDIRA) is an individual retirement account (IRA) in which investors are in charge of making their own investment decisions.
The main difference between a SDIRA vs Roth or Traditional IRA is that the self-directed option provides a greater opportunity for asset diversification outside of the traditional stocks, bonds, and mutual funds.
Lately there’s been an increase in the number of people using SDIRAs to invest in non-traditional investments.
For example, funds in a SDIRA can be used for:
- Real estate
- Undeveloped or raw land
- Promissory notes
- Tax lien certificates
- Gold, silver and other precious metals
- Cryptocurrency (Bitcoin)
- Water rights
- Mineral rights, oil and gas
In 2019, I used some of the funds in a traditional IRA and converted into a SDIRA. This way, I was able to have more control over what to invest in while still having the tax deferred benefits that an IRA offers.
The process was fairly easy and straightforward and allowed me the opportunity to invest in a multifamily syndication deal as a limited partner.
Real estate syndications can be a highly tax efficient investment vehicles for the busy high-income professional.
From the accelerated depreciation opportunities to refinances, potential 1031 exchanges and qualified plans, the IRS currently provides us with multiple ways to shield profits from taxes.
If you want to learn more about investing in syndications, check out ESI’s real estate syndication investing journey.