5 Tax Benefits Every Passive Real Estate Investor Should Know About
Tax Day just passed, and let’s be honest, it’s the time of the year that no one enjoys. Almost every person I know thinks he or she pays too much in taxes. And they’re probably right.
As physicians, we’re high income earners, and a large percentage of our paycheck goes to Uncle Sam. Year after year, we swallow the bitter pill and just pay the tax man what we owe.
But what if I told you that there are ways to legally reduce or even eliminate your taxes through real estate investing?
The U.S. tax laws are written to favor business owners and investors, primarily real estate investors. As Tom Wheelwright, author of “Tax-Free Wealth” puts it, the government isn’t in the business of providing housing and commercial space to the public. Therefore, it rewards people through tax incentives to supply housing and commercial spaces.
So why fight the IRS when you can partner with them, keep more of your money and pay less taxes? Real estate syndication is attractive to many investors due to the lucrative tax benefits. And that’s what we’ll discuss in this article.
But first, a disclaimer: I’m not a tax professional, and this is not accounting advice. The insights and perspectives provided in this article are for educational purposes only. You should consult with your CPA about your particular situation.
Okay, now let’s get started. Here are the 5 tax advantages for the passive investor in real estate syndications:
#1) Depreciation Creates Phantom Losses
Depreciation is the most powerful, straightforward way for passive investors to reduce taxable income.
So first off, what is depreciation? To give you a simple example, let’s say you purchased a brand new car. Over time, the tires start wearing down, the windows crack, and the engine loses its power. Eventually, the whole car would break down and be worth no more than its scrap value.
Like a car, the IRS acknowledges that all real estate properties are subject to wear and tear causing a reduction in value, and without continuous maintenance, would lose most of their initial value. Buildings age, just like we all do. So the IRS allows property owners to write off a property’s worth (excluding the land it’s built on) over 27.5 years for residential real estate. Due to depreciation, the IRS will regard a property that is actually earning money as losing money.
Here’s an example:
Let’s say you purchased a property for $2,000,000, and the land is worth $350,000 and the building is worth $1,650,000. With the most basic form of depreciation (i.e. straight-line depreciation), you can write off $60,000 each year ($1,650,000/27.5 = $60,000).
So if you made $10,000 in cash flow on the property during the first year, you won’t pay any taxes on it. The $60,000 depreciation shows that you lost money on paper, but in reality you made $10,000! Instead of paying taxes on that $10,000, you get to keep it tax-deferred (i.e. you won’t have to pay taxes on it until the property is sold).
Pretty powerful stuff, right?
Moreover, properties purchased after September 27, 2017, can enjoy bonus depreciation, further increasing the tax benefits during the first year. With bonus depreciation, investors can accelerate the rate at which they can claim depreciation and front-load the deductions rather than claiming them throughout 27.5 years. This is great for real estate syndication investors who will likely only own the property for 5-10 years before the syndication ends by the sale of the property.
#2) Mortgage Interest Deduction
Just as a homeowner can deduct mortgage interest paid on a primary residence, passive investors can deduct mortgage interest on an investment property’s loan.
Like depreciation, mortgage interest deduction is highest in the early years, when most of the mortgage payment goes to interest. So investors get the maximum benefit in the beginning. This is great for passive investors who are unlikely to hold the property long-term.
#3) Capital Gains Taxed at a Lower Rate
But did you really think that real estate investing is 100% tax-free? Unfortunately not. After all, Uncle Sam likes to have their hands in everything. With real estate investing, they get their share through capital gains taxes when the property is sold.
When an investor gets profits from selling an investment, that return is known as capital gains. In real estate syndications, the hold period is on average 5 years, so you don’t have to worry about capital gains taxes until the property is sold in year 5.
But the good thing is that capital gains are taxed at a lower rate than earned income. Long-term investments, such as real estate held for more than a year, cap out at a 20% tax rate. This is far better than what most physicians are used to paying (i.e. 37% marginal tax bracket).
#4) 1031 Exchange: A Tax-Deferred Way to Keep the Investment Pipeline Moving
In the previous section, I mentioned that when a real estate asset is sold, capital gains taxes are due. However, there is a way around this through a 1031 exchange.
The 1031 exchange allows your original real estate investment and the profit from the sale to be rolled into another investment without paying taxes at the sale of the previous property. This means you can defer your long-term capital gains (and any depreciation recapture) when the property is sold.
For example, let’s say that you sold an investment property with a net proceed of $300,000. With federal capital gains taxes, depreciation recapture, and state capital gain taxes, you may only end up with $100,000 to invest in the next property. But if you decide to do a 1031 exchange, the entire $300,000 would be available to you to purchase your next investment property.
Are you seeing how you can build wealth using money that you’d otherwise be handing over to the government?
It should be noted that when you invest in a real estate syndication as a limited partner, the decision about whether to do a 1031 exchange is determined by the sponsor. If you choose to invest passively and want to 1031 into subsequent syndications with that sponsor, make sure that is part of their strategy before investing.
So in summary, while individual investors cannot use their shares of a syndication to perform a 1031 exchange, when the syndication as a company does do a 1031 exchange, those savings are passed onto the passive investors.
5) Refinancing
Refinancing is another tax benefit that real estate investors enjoy. Basically, you can pull out money from a property’s equity without paying any taxes.
Here’s an example. Let’s say you bought an apartment building for $500,000. The property was renovated and commanded higher rents. In turn, the property gained an additional $500,00 in appreciation and is now worth $1,000,000. You can do a cash-out refinance and take out $500,00 tax-free to buy another property.
Conclusion
As you can see, investing in real estate is an awesome way to grow wealth without lining Uncle Sam’s pockets. The tax benefits with real estate investing are so powerful that you can see why some people make millions of dollars but owe zero in taxes legally.
As a passive investor, you get all the tax benefits that an active investor gets, without having to do any work. It’s pretty nice not to have to deal with broken toilets, leftover renter trash, or any of your own accounting. As a passive investor, you just wait for that K-1 to come at the end of the year, hand it over to your CPA and reap the tax benefits without lifting a finger.
