“The government grants tax and legal loopholes to real estate investors to encourage them to do a job that the government can’t.”
― Garrett Sutton
Since a syndicated investment holds real estate in a special purpose entity (SPE) such as an LLC, which is a pass-through-entity, the entity does not get taxed. All the income, expenses, and tax benefits are passed through to investors and their respective tax returns as a result of being members (owners) in the LLC. These benefits are summarized on a year-end tax document called a Schedule K-1, which is prepared by the LLC's accountant. Each passive investor gets a share of these benefits in proportion to their ownership. It is not uncommon for the passive investors to have little or no tax liability due to tax efficiencies or benefits like depreciation, cost segregation, business expense deductions, refinance, supplemental loan, 1031 exchanges, and self-directed IRAs.
The concept of depreciation is based on the idea that an asset will experience “wear and tear,” so the IRS allows the asset to be written off or depreciated over a period of time. Depending on the real estate asset, this depreciation schedule is 27.5 or 39 years, and it can be used for the entire asset except for the land component. In reality, real estate assets do not become obsolete like computers or vehicles, which do have a limited service life and are depreciated in a typical business. This is why depreciation is also known as a “phantom” loss (the terms “paper” or “passive loss” are also commonly used) as this loss can be taken even when the asset is appreciating and producing income. Passive losses will offset the annual cash flow (passive income) from an asset.
Furthermore, real estate depreciation can be accelerated through a cost segregation analysis. This entails a study performed by a trained professional to identify property components that can be accelerated to a 5, 7, or 15-year period. The cost segregation accelerates the passive losses and front-loads them in the earlier years of ownership, reducing the tax liability on any income. The time value of money created by this benefit can be substantial.
As in any business, in real estate, all operating expenses such as property taxes, insurance, mortgage interest, repairs, and maintenance are tax-deductible. These expenses are deducted from the asset's gross income before the taxable income is determined. A W-2 employee should ask himself how many expenses can he deduct before receiving his paycheck?
Refinances and supplemental loans are typically used to pull equity from an appreciated asset. The pulled equity is passed along to the investors, and this money is non-taxable as this is borrowed money. Harvesting equity in this manner can be used to invest in another real estate opportunity and the process can be repeated. Savvy investors will not allow real estate equity to sit idly, but will always look to refinance when practical and increase the velocity of their money.
If an asset is to be sold, a 1031 Exchange can be used to defer any taxes on the asset. A 1031 Exchange allows the asset to be exchanged for a like-kind asset, which can be any type of domestic real estate such as raw land, multifamily, residential, retail, office, and so forth. It is important to clarify that this is a tax deferral strategy, not a tax reduction strategy. If a 1031 Exchange is implemented correctly, it can be repeatedly done until the owner passes away. At that point, the owner's heirs inherit the property and get a stepped-up basis that resets the cost basis to the market value at the time of inheritance. This wealth transfer is used by astute investor families to transfer legacy wealth from one generation to the next. It is important to note that many real estate syndications are not set up to accommodate a 1031 exchange either into or out of the opportunity.
Passive investors should first check with the sponsor if interested in using a 1031 Exchange. There are rules for a 1031 Exchange that are beyond the scope of this article, and it is advisable to consult a tax professional or qualified exchange company for more information.
Self-directed IRAs can be used to invest in real estate syndications. Most retirement accounts are typically held by a custodian that allows access to pre-selected stocks, mutual funds, and bonds; however, a self-directed IRA is much broader and can be used to invest in assets such as raw land, residential homes, commercial properties, notes, businesses, and also syndicated investments.
The tax benefits available to the real estate investor are tremendous. There are more advanced tax strategies that are complex and require a more meticulous delineation than this article provides. A motivated passive investor may construct a diversified portfolio of real estate assets to generate passive income and utilize tax benefits such as passive losses to offset as much passive income as possible.