Updated: May 4, 2019
It’s that time of year again: tax time. Real estate investors don’t dread tax time because they are able to leverage the tax code and receive tax benefits that allow them to make their money work for them. They actually lower the amount of taxes they owe, while making great returns on their investments. It’s a win-win!
Disclaimer: I am not a tax professional or seeking to give tax advice, please consult your CPA
The Government Loves Real Estate Investors
The government rewards real estate investors in the form of tax deductions, as they are fulfilling a need that provides housing for communities.
Among these potential deductions are loan interest deductions and depreciation. More often than not, our investments show a loss on paper, while the asset is still performing and making money through cash flow. These losses are a big reason why people invest in real estate syndications, as they can help offset other income.
These “losses on paper” are on your K1. This time of year, our accountants are working to get our schedule K1 partnership documentation to our investors. For those of you who may be new to the K1, here’s a little information on what you can expect.
What is the K1?
The K1 provides the tax accounting of the asset’s prior year of operations. This is one way that investors can see the powerful benefits of investing in commercial real estate syndications. Like I previously mentioned, the K1 usually reflects a loss, which is actually great! How can that be when you’ve been seeing quarterly reports that show income, and have been receiving monthly cash flow distributions? That’s the power of depreciation, and other tax writes offs.
Don’t get alarmed when you see the K1 and wonder if the investment is still profitable. The K1 is merely for tax reporting purposes and shouldn’t be confused with the performance or health of the asset, which you get in the quarterly reports. The passive losses can be used to offset passive gains in other areas of your portfolio.
As a passive investor in real estate syndication, you qualify for these deductions based on your proportional ownership interest in the overall limited partnership.
Here are some other powerful deductions and strategies that make investing in commercial real estate assets very tax efficient.
Depreciation allows you write off the value of an asset over time, based on wear and tear and the useful life of an asset. The IRS allows you to write off the value of the property over 27.5 years. However, we usually hold our assets for 5 years, which means we are getting those benefits for those remaining years. That’s where the process of cost segregation comes in.
Depreciation can be accelerated through a cost segregation study. Cost segregation is a big win for commercial real estate investors. It sounds complicated, but it boils down to the fact that there are some parts of the asset that can be depreciated over a shorter timeframe, say 7 years. With this, we have large deductions in the early years of owning the assets which contributes to the large paper loss on the K1. Real Estate investors don't escape taxes entirely. You should plan for capital gains taxes when the real estate is sold. However, it is not a taxable event when the property is refinanced and the investors get part of their equity out.
It’s common for value-add syndicators to optimize the value of a property after 2-3 years, after the renovations are completed and the higher rents are achieved. The syndicator then can refinance the property after pushing up the value and can then pull out equity and investors benefit with a partial payout at the time of a refinance.
Another solid tax strategy is 1031 Exchange.
A 1031 exchange allows an investor to swap a property for another similar property, allowing them to defer the capital gains tax on the sale of the first property. Upon selling an asset, a syndicator often does a 1031 to exchange their current property for a new property. This allows them to defer the capital gains from selling the first property and use their capital to get into another value add asset. Investors can get their investment and equity out upon the sale of the property, even if the sponsor is purchasing another one through a 1031 Exchange. However, some investors might want to be a part of the new investment, especially if they are longer term IRA investors.
Self-Directed IRAs / Solo 401ks:
Many investors want their IRA to be protected from the volatile stock market, and are able to receive great returns from investing in real estate. That can be accomplished by moving to a self-directed IRA or solo 401Ks, which can be used to invest in real estate syndications.
Investors need to be aware of UBIT (Unrealized Business Income Tax). The IRS doesn’t want investors in these qualified plans to take advantage of leverage (when financing a property). To eliminate this unfair advantage, the government created the UBIT, which is a tax on the profits of the leveraged portion of the asset.
You need to consult your tax professional and assess your own personal situation, but often times, investors do the math on the UBIT and find that all the other benefits to investing in these assets still make a lot of sense, particularly if your IRA is over exposed to the volatile stock market.
As you see, there are many ways that investing in commercial real estate syndications are highly tax efficient, from the standard property tax, loan interest, and accelerated depreciation opportunities to potential refinances and 1031 exchanges. Many investors choose to put their IRA money to work through self-directed IRAs that are invested in real estate syndications.
Again, I am not a tax professional and this article is not meant to give tax advice. Every individuals tax situation is unique, so reach out your tax professional to learn more about how these strategies may benefit you.