Updated: Apr 30, 2020
If you're anything like us, you probably rolled your eyes as soon as you saw the word "taxes". Historically, taxes were our least favorite topic to talk about. However, as real estate investors, the word doesn't hold such a strong negative connotation anymore. It's incredibly important to understand the tax benefits of investing in real estate because it plays a huge role into your investing strategy and overall financial plan. Once you get a better understanding of just how amazing these tax breaks are, we think you too will see taxes in a whole new light. There are people that invest in real estate solely for the tax breaks. Everyone likes to talk about the benefits, (ie. the returns) you'll get out of an investment, but few people are going to tell you the downside (ie. taxes). They will always refer you to a tax professional. So do we, but in our case, we want you to verify what we tell you and get advice that is specific to your situation. In their case, it's usually a cop out. They want your cpa to be the one to break the bad news. I'm sure you're thinking, the last thing I want to think about when I'm investing in a new venture is taxes. It’s much more fun to think about luxe vacations, fancy cars, home renovations, etc. But unlike when you invest in stocks, mutual funds, etc., investing in real estate tends to lower your tax bill, rather than make it higher. Yes, you read correctly. Investing in real estate can often help lower the amount of taxes you would otherwise owe, even though you’re already making returns superior to other investment opportunities.
How is that possible, you ask?
There’s actually a HUGE difference between the way the IRS views stock market gains and the way they view real estate gains. And further still, there's a difference between the way they view short term vs long-term real estate gains. Although there are many tax rules related to real estate, we will stick to discussing taxes from the standpoint of a passive investor in a real estate syndication.
But First, a Disclaimer
As I’m sure you know by now, we are not tax professionals. As such, the perspectives and insights provided in this article come from our experience only.
You should speak with your CPA for more details, and specifics on your situation.
Okay, now that that’s out of the way, let’s dive in.
The 7 Things You Should Know about Taxes and Real Estate Investing
Okay, get ready to have your socks knocked off. As much as taxes can knock one’s socks off, anyway.
Here are seven main things we believe every passive investor in a real estate syndication should understand 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 incredibly powerful.
Cost segregation is depreciation on steroids.
Capital gains and depreciation recapture are things you should plan for.
1031 exchanges are amazing.
Some people invest in real estate solely for the tax benefits.
#1 – The tax code favors real estate investors. If you’ve looked around our website or perhaps on the internet somewhere, you’ve heard that more millionaires are made through real estate than any other industry. One thing that has helped make that possible is the tax code. The IRS, thankfully, understands the importance that real estate investing plays in providing quality housing for Americans. As such, the tax code is written in a way that incentives investors to purchase, maintain and upgrade those units over time. #2 – As a passive investor, you get all the tax benefits an active investor gets. This is huge! So, even though you wouldn’t be actually fixing or managing anything, you would still get all of the tax benefits, as if you were, whether you’re an active or passive investor.
This is possible as a passive investor in a real estate syndication because you invest in an entity (typically an LLC or LP) that owns the property, and that entity is disregarded in the eyes of the IRS (they are sometimes called “pass-through entities”).
As a result, any tax benefits flow right through the entity, to the investors, meaning you!
This is one of the differences between investing in a syndication vs a REIT. With a REIT, you are investing in a company, not directly in the real estate it invests in, and as such, you wouldn’t get the same tax benefits.The types of things you can write off as a real estate investor relating to the property are payroll, repairs, interest and utilities. Additionally, you can write off the the value of the property over time. This is called depreciation. I’d like to further explain this thing called depreciation.
#3 – Depreciation is incredibly powerful depreciation is one of the most powerful wealth building tools in real estate Period. Depreciation allows you write off the value of an asset over time. This is to account for the wear and tear of the property and depends on the useful life of the asset or given system.
So,what is depreciation?
To keep it simple, let’s say you bought a new cell phone. I’m convinced that as a part of their marketing strategy, these companies build their products with planned obsolescence. So, within a given period of time, it’s expected that the battery will start losing it’s life, maybe the processor will be slower, you will run out of space, etc. And they will have a new product just in time for you to buy the latest one. So one day it’s working just fine, and eventually the whole thing is going to go kaput and be worth very little if anything. Rant over. But this is more or less what depreciation is. The IRA understands that if the property is being used daily and you don’t constantly repair and/or improve it, at some point it will become uninhabitable. (Not unlike when your cell phone finally gives out on you). As you can imagine, every asset has a different lifespan. The reality is that a cell phone isn’t designed to last more than a couple of years. On the flip side, you can expect a house to still be standing years, or even decades, later. For residential real estate, the IRS allows you to write off the value of the property over 27.5 years.
While the property itself is eligible for depreciation benefits, the land is not. The IRS knows that just like diamonds, land is forever and the value may actually increase over time without having to do anything additional to improve it. For example:
Hypothetically, you bought a property for $1.2M. Let’s say the land is worth $200,000 and the building is worth $1M.
With the most basic form of depreciation, aka straight-line depreciation, you can write off equal amounts of the $1M every year for 27.5 years. That means that, you can write off $36,364 each year due to depreciation ($36,364 x 27.5 years = $1M).
The reason that this is such a huge deal is because if you make $5,000 in cash-on-cash returns (i.e., cash flow) on that property, instead of paying taxes on that $5,000, you can keep it, tax-free.
Wait, really? Yes, really.*
*Disclaimer:This depends on your individual tax situation. Please consult your CPA. That $36,364 in depreciation means that, on paper, you actually lost money, while in reality, you made $5,000.
Plus, properties acquired after September 27, 2017, are eligible for bonus depreciation, which can really ramp up the tax benefits for the first year.
This is why depreciation is so incredibly powerful. #4 – Cost segregation is depreciation on steroids.
But wait, that’s not it!
In the previous example, we talked about straight-line depreciation, which allows you to write off equal amounts of the cost of the asset every year for 27.5 years.
But, for majority of the real estate deals we offer, the hold time is give or take 5 years. So if we were to deduct an equal amount every year for 27.5 years, we’d only get to deduct for five years. We’d be leaving the remaining 22.5 years of depreciation on the table. This is where our awesome friend “cost segregation” comes in. Cost segregation acknowledges the fact that not all assets are created equal, so different parts of an asset will depreciate at different rates. For example, the toilet flapper is probably going to wear down much faster than the kitchen cabinets. Ina syndication deal, a cost segregation study is done. We would have an engineer itemize each component that makes up a property, including things like plumbing, electricals, windows, roof, flooring, fixtures, etc.
Certain things can be depreciated on a much shorter time frame – for example 4, 8, or 16 years – instead of over the traditional 27.5 years. This can dramatically increase the depreciation benefits in those early years.
Here’s an example
A real estate syndication group purchased an apartment building in December. This means that they only held that asset for one month of that calendar year.
However, due largely to cost segregation, the depreciation schedule was accelerated for many items that were part of the property, including things like flooring and landscaping.
The tax forms that were sent to investors the following spring showed that, if you had invested $100,000 you had a paper loss of $50,000. That’s 50% of their original investment having only owned the property for a single month during that tax year.
The unbelievable part about all of this is that that paper loss doesn’t only apply to returns you make on that particular property. You can even apply those paper losses to the rest of your taxes, including taxes you owe from your personal salary, side gig, or other investment gains.*
*Again,this depends on your individual situation, so please consult your CPA. But this truly is a game changer, folks. Don’t sleep on the benefits of cost segregation. #5 – Capital gains and depreciation recapture are things you should plan for. Now, I’m sure you guessed that investing in real estate isn’t 100% tax-free, well it isn’t. Unfortunately, the IRS gets their hands in everyone’s pots. You can’t hide. In real estate, the way they get their share of taxes is through capital gains when a real estate asset is sold, and sometimes, through depreciation recapture, depending on the sale price.
So, in a real estate deal that keeps an asset for 5 yrs, you wouldn’t have to worry about capital gains taxes and depreciation recapture until the asset is sold in the 5th yr.
The specific amount of capital gains and depreciation recapture depends on the length of the hold time, as well as your individual tax bracket.
Here are the brackets and percentages based on the 2018 tax law:
$0 to $77,220: 0% capital gains tax
$77,221 to $479,000: 15% capital gains tax
More than $479,000: 20% capital gains tax
There are additional ways to reduce the amount of capital gains. For more details and the most up-to-date laws and info, I recommend you discuss the specifics with your CPA. #6 – 1031 exchanges are amazing I mentioned earlier that when a property is sold, you would owe capital gains taxes (and often, depreciation recapture). However, there is a way around this through a 1031 exchange.
A 1031 exchange allows you to sell one investment property, and, within a set amount of time, you can swap that property for another “like-kind” investment property.
Doing so means that, instead of having the profits paid out directly to you, you would roll them into the next investment. As such, you wouldn’t owe any capital gains when the first property is sold.
You can 1031 the profits of the sale of your personal investment property into a syndication, but not all real estate syndication’s offer 1031 exchanges as an option. But the ones that due are truly incredible opportunities. There is additional prep work that goes into allowing a 1031 exchange, and the majority of the investors in the syndication have to agree to make it a reality. On the back end, you can 1031 the profits of a syndication into another syndication.
Unfortunately however, you can’t do a 1031 exchange on just your shares. The sponsors must decide to do a 1031 exchange on the whole shebang. So It’s an all or nothing kind of thing. Every team is different and approaches 1031 exchanges differently. If a 1031 exchange is something you’d be interested in, be sure to ask about it directly. #7 – Some people invest in real estate solely for the tax benefits. The tax benefits of investing in real estate are so powerful that some people (namely, wealthy folks) do so entirely for the tax benefits. You see, by investing in real estate, they can take get significant tax write-offs, and can apply those to the other taxes they owe from their salary or otherwise, thereby decreasing their overall tax bill. This is how major real estate gurus can make millions of dollars and still owe next to nothing in taxes. The unbelievable part is that it’s all perfectly legal, and it’s a powerful wealth building strategy. But you don’t have to be wealthy to take advantage of these tax benefits. The tax code makes them available to anyone investing in real estate.
As stated earlier in this article, I mentioned that you don’t have to worry about taxes when investing in real estate, especially as a passive investor in a syndication. In most cases, you’ll be able to make money from the monthly cash flow returns, but you will owe little to no taxes on those returns due to benefits like depreciation. The amount of taxes you owe on the capital gains when the property is sold can range anywhere from nothing to 20% based on your personal situation.
So these are the things everyone should remember 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 incredibly powerful
Cost segregation is depreciation on steroids
Capital gains and depreciation recapture are things you should plan for
1031 exchanges are amazing
Some people invest in real estate solely for the tax benefits
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 don’t have to hire a bookkeeper. You simply get your annual tax document, the K-1, and hand that over to your accountant when you do your taxes, and that’s it. #taxsavings #taxes #taxefficientinvesting #realestatesyndications #passiveincome #passiveinvesting