For most people, when you are ready to pull the trigger and get involved in a new investment opportunity, taxes couldn’t be further from your mind.
You’re thinking about the amazing ways the money you will earn can improve your life.
While perhaps not as sexy of a topic, it’s still worth keeping a bit of focus on your taxes.
The great thing about real estate investing is that it usually reduces the amount you have to pay in taxes.
Pretty different from investing in the stock market, huh?
Maybe you’re wondering how that could work.
The point of investing is to get earn a return on your money.
If you’re making money off of the investment, why would that cause your tax bill to go down?
The thing a lot of people don’t know (and you don’t learn in school) is that the government treats real estate a little bit differently and it has its own unique tax advantages unlike any other investment vehicle.
The great thing is, even as a completely passive investor in a real estate syndication, you benefit from all the same advantages as an active investor.
You might be wondering why that’s the case. The truth is, the government wants to encourage real estate investing, since it is so important to the economy. It’s tied to real property, housing, and commerce.
Real estate is arguably the backbone of the national economy and the real estate industry as a whole accounts for nearly 20% of the nation’s GDP.
As a result, the government tends to look favorably on real estate investors and they pay far less in taxes than their counterparts in other realms of investment.
By reducing the tax liability of real estate investors, it incentivizes investment and frees up more dollars in the investors’ pockets for proper maintenance and preservation of the nation’s housing stock.
This is obviously in the government’s best interest, especially today as our nation is facing a severe housing shortage.
It’s one of the reasons why real estate has produced more millionaires than any other industry.
It’s much easier sailing with those government headwinds pushing you along.
So, wait, even if I’m a completely passive investor in a real estate syndication, I’m still benefiting the same way active landlords are?
You heard that right!
You don’t have to get your hands dirty dealing with leaky sinks and replacing old windows, but you’re still piling high all those sweet tax advantages.
The reason for this is how real estate syndications are structured.
The general partners do all the work, but the passive investors are still owners of the property in the form of limited partners.
The IRS still views you and the other passive investors as owners of the property.
Please remember that we are only talking about real estate syndication investments here.
REITs are another passive investment vehicle that allows people to get involved in real estate, but they do not provide all of these tax benefits.
Investing with a REIT involves buying a share of a company that invests in real estate, so you don’t actually have any ownership stake of the REIT’s real estate portfolio.
With a real estate syndication, you are one of the owners of the property legally, so all the benefits flow to you as a property owner.
Before we dive into the list, remember that I am not a CPA and you should discuss any specific tax strategies you want to implement with your accountant.
This article is pulled from my own experience as a real estate investor and developer and do not replace consulting with a licensed tax professional.
Let's Get Excited
Have you ever felt excited when discussing taxes? We’re going to get you there by the end of this article, so brace yourself.
These are my five “greatest hits” of tax advantages that passive and active real estate investors alike receive when they invest in a real estate syndication:
- You Can Deduct Property-Related Expenses
- Depreciation is your Best Friend
- Cost Segregation Gives Depreciation a Boost
- Be Aware of Depreciation Recapture
- The Power of 1031 Exchanges
1. You Can Deduct Property-Related Expenses:
First among the tax benefits real estate provides are the generous deductions you can take from your rental income. If you take proper advantage of all the deductions available, this reduces the taxable income the property produces each year significantly.
Here’s a quick list of some of the things you can deduct from your taxable income:
- Interest: This is usually the largest expense you can deduct from your income. The cool thing here is that this isn’t just the interest on the loan to acquire the property. This also includes interest for any construction loans, credit cards, or lines of credit used for property improvements.
- Repairs: Any repairs made to the property are fully deductible.
- Insurance: This is another major annual expense that can be fully deducted.
- Travel: This is an interesting one that many people might overlook. The cost associated with traveling to and from your properties can also be deducted. This can be a big deal if you have lots of properties in various markets across the country.
- Payroll and Independent Contractors: The expenses involved with any employees or independent contractors that were incurred for property upkeep and improvements are fully deductible.
- Professional and Legal Services: You can even deduct your accountant and lawyer’s bills that were charged for services related to your properties.
2. Depreciation is your Best Friend:
Depreciation moves mountain in the real estate world. This is one of the cornerstones of real estate’s wealth earning power.
Depreciation allows you to deduct the full value of your building in yearly installments.
The idea is that from the moment you buy a property, physical wear and tear causes it to slowly lose value each year.
Think of it like when you buy a new car. Right out of the car dealership it should be running perfectly, but after 50,000 miles a lot of the value is lost because it’s just not that new car anymore.
This same principle is applied to real estate.
Now, it’s important to keep in mind that we’re only talking about the buildings (also known as improvements) on the property here.
The land that the property is built on is not eligible for depreciation benefits because land obviously cannot reduce in value due to wear and tear.
With depreciation, the government makes an assumption that the useful lifespan of residential real estate (including multifamily apartments) is 27.5 years.
What that means is that you can slowly deduct the value of the building each year for 27.5 from your taxes.
That probably doesn’t sound like anything special to you if you’ve never looked into it before. What’s so special about that?
When you’re talking about multifamily apartment buildings, for example, the full value of the building is usually a very large sum of money.
Let’s use an example of a multifamily building you bought for $20,000,000.
The $20,000,000 is called the “basis of the property.” This basis includes not only the building, but also the land.
We need to separate the land and the building from each other because we cant’ depreciate land.
The way we typically do this is to look up the property’s assessed value.
They will separate the land and the building values from one another and you can then look at the proportion they use and apply it to your purchase price.
Let’s say for our purposes that the building value was stated to be $15 million and the total property value was $18,000,000.
15 million / 18 million = 83 percent of the total property value
Next, we simply apply this ratio to our purchase price to find the value of the building we can use for our depreciation deductions.
$20 million x .83 = $16.6 million value for the building itself
Once you’ve determined the value of the building, you then can calculate your straight line depreciation deductions. This is known as straight line depreciation because you deduct equal installments every year until you’ve fully depreciated the value at the end of 27.5 years.
$16.6 million / 27.5 years = $606,060.00 deduction per year
As you can see, due to the high purchase price of the property, you’re getting some really serious deductions through depreciation.
It’s not unheard of that you’ll be showing a loss and have no taxes to pay on the property!
3. Cost Segregation Gives Depreciation a Boost:
Depreciation in and of itself is great, but you can speed up the rate at which you can claim your deductions using something called a cost segregation study.
As a passive investor in a real estate syndication, the investment period is typically between 2-10 years.
You don’t have 27.5 years to wait to take advantage of the full depreciated amount. You’re missing out on years of depreciation deductions!
That’s where the Cost Segregation Study kicks in.
The idea behind a cost segregation study is to piece out all of the constituent parts of the building that have a shorter lifespan and then separately calculate the lifespan of those items.
These shorter lifespan parts can fall into the 5 year, 7 year, and 15 year lifespan categories. To give you an example, electrical outlets have a 5 year lifespan, much shorter than the 27.5 years for the building as a whole.
The study will then categorize any components of your building that have a lifespan of less than 20 years.
While a significant portion of your building’s value will still fall under the 27.5 year category, you’ll be amazed at how much of your building falls into these shorter categories.
You’ll typically want to hire a construction engineer that specializes in cost segregation to perform these, as they need to have a well rounded knowledge of construction, engineering, architecture, and cost estimating.
Look for professionals certified by the American Society of Cost Segregation Professionals.
When you combine cost segregation with something called bonus depreciation, however, your deductions are boosted even further.
Bonus depreciation allows you to claim your depreciation deductions up front in year one from any of those component parts of your with a lifespan of less than 20 years.
In other words, for the 15 year category of items, you can claim all fifteen years of depreciation in year one; for the 7 year category, you can claim all 7 years in year one, and so on.
As you can imagine, this provides tremendous benefits and can leave you with no tax liability for the property in year one.
4. Be Aware of Depreciation Recapture:
You’ll still end up paying back for some of those depreciation deductions when you go to sell the asset.
This is called depreciation recapture.
The way it works is you are taxed on the difference between the price you sell the asset for and the remaining basis of the property after the depreciation you’ve taken up to that point.
The amount of profit that can be attributed to your depreciation deductions is taxed based on your ordinary tax rate with a cap of 25%. Any additional profits will be taxed as capital gains.
For example, let’s stick with the $20 million property from before.
Let’s say that after 5 years you’ve depreciated the property by $5 million, making your current depreciated value $15 million.
You are now selling the property for $25 million.
Of that $10 million difference, $5 million is due to your depreciation deductions and will be taxed as such.
The remaining $5 million are treated as capital gains
Remember that, even though the government circles back at the time of their sale to get back some of the benefits you’ve received, you’re still coming away with far more than you’re giving up.
With bonus depreciation and cost segregation, you can frontload all of your benefits to year one, which offsets the capital outlay you had to make to get involved in the investment, and is also more valuable to you now than in the future due to the time value of money.
Furthermore, you’re only taxed on the value you’ve realized at the time of sale with a 25% cap.
5. The Power of 1031 Exchanges:
Another tax superstar in the real estate world, 1031 exchanges allow you to pay no taxes on the sale of a property, so long as you have officially marked those funds to be re-invested immediately into another property.
The rationale here for the government is that you are simply reinvesting those dollars directly back into real estate, so you shouldn’t be penalized with capital gains.
These are pretty rare in real estate syndications as it can be tricky to get every partner on board with continually re-investing their capital.
Typically, real estate syndications have a time frame of around 5 years, after which time the property is sold and the investors’ funds and profits are distributed.
That said, it is also possible to sell a property you own and then 1031 exchange your profits into purchasing shares of a syndication offering.
This is a powerful tool when used strategically as you trade up into larger investments.
By now you can probably see why real estate is the place to be if you’re looking for a tax-friendly investment vehicle.
You might be surprised to find that many people invest in real estate solely to get access to these tax advantages.
If you have a very high net worth and a large tax liability each year, all of those deductions can add up big time.
If you’ve ever wondered why some wealthy people end up paying so little in taxes, real estate is the answer you’re looking for.
Just remember that you don’t have to be super rich to get benefits from this. As you can see from this article, anyone who gets involved in real estate investing can obtain tremendous benefits.
Even better, if you’re a passive investor in a real estate syndication, you’re getting all of these benefits that are normally reserved for real estate professionals without having to do any of the work!
When the government encourages you to reduce your taxes passively, it might be something worth looking into.