How Much Passive Income Can We Write off?
What do you think of cake without icing? It can stand alone; it can be pretty delicious, but it becomes much sweeter when we add the icing. This is the way I view the tax advantages of real estate. A good investment with solid returns can stand on its own, but the tax advantages? Well, that is just icing on the cake.
It is always tricky when investors come to me seeking accounting or legal advice. I never feel comfortable, as I am neither an accountant nor an attorney. Still, people want to know what portion of their distributions and gains can be written off.
Passive investors, just as active investors gets all the tax benefits of real estate. This is major. Even though you're not actively unclogging toilets or answering late-night tenant phone calls, you still get all the benefits.
You invest in an entity when you invest in a real estate syndication as a passive investor. That entity owns the property. That entity is disregarded in the eyes of the IRS (these entities are sometimes called "pass-through entities"). That means that any tax benefits flow right through that entity, to you, the investor.
I would like to offer an example in hopes you might gain some clarity. But first, here is my disclaimer: I am not an accountant, so please consult with our tax professional.
It is always easy to work in round numbers, so let us assume you invested $100,000 into syndication, and it came with a projected preferred return of 8% COC. To keep things simple, we can say distributions started in January, so by the end of the year, you'll have earned $8000. Your distributions show up in Box 19 of your K1.
In Box 2 of your K1, you will find your Net rental real estate income (loss). This is the net of revenues fewer expenses, including depreciation expense "passed through" to the Limited Partners. In the early years of the syndication, you will find an operating loss resulting from accelerated depreciation or "Bonus Depreciation." Loss? That sucks. Actually, it is beautiful because we take that loss and hold it against our passive distributions on the ledger.
Again, as an assumption, we can say that revenues minus expenses resulted in a $50,000 loss passed through to your K1. We show that ($50,000) loss against our $8000 total of distributions in year 1. And therein lies the beauty. No tax is paid on that $8000 because of the loss "passed through" from the syndication. We carry that net loss forward throughout the life of the hold. If we assumed a consistent 8%/year (we all know it varies) and a five-year hold, the burn off of the loss would look like this:
Yr1 - $50k - $8k = 42k
Yr2 - $42k - $8k = 34k
Yr3 - $34k - $8k = 26k
Yr4 - $26k - $8k = 18k
Yr5 - $18k - $8k = 10k (of loss remaining).
We now fast forward to year 5, and the market and asset are ripe for a sale. We add another assumption that the projected equity multiple on the deal was 2x, so your returned capital totals $200,000, with $100,000 of that being your profit or capital gain. We can carry our forwarded loss of $10k to shave off 10% and make our capital gain $90,000. This is pretty steep, and unfortunately, we will also owe some depreciation recapture tax. Since we do have to pay the piper, what percentage do we have to hand over? Here are capital gains taxes as of 2021:
One method to reduce the tax burden is to immediately invest in another deal in the same calendar year with the operator. Things do have to align well for this to happen, but from my understanding, this can reduce your capital gains tax. This is where I need to reiterate to consult with your tax professional.
Of course, another tried and true method of reducing Uncle Sam's slice is a refinance. When your capital is returned to you, say in year three via a refinance, it is tax-free. You then reinvest it into a deal that same year, and it will add to your paper losses, which will offset the future capital gain. This all helps to put you in a lower tax bracket. We know this is better come tax time.
As far as I know, there is no tax-free investment, but one thing you will find with the wealthy is that they own lots of real estate. Besides being a sound way to build wealth, they also know that the tax code favors real estate investors. In addition to improving the performance of our portfolios, we are improving communities. The government rewards us for this. The government can only do so much to improve infrastructure, so they depend on private investment to more than pitch in, and they incentivize us to do so.
Tax-free cash flow is a great thing and one of the many advantages of investing in syndications. I seek good returns in good markets first. The tax advantages of investing in syndications? That, to me, is just icing on the cake.