As we approach tax season, it’s important to consider how passive real estate investing, such as syndications and investing in funds, can benefit you as an investor from a tax perspective. In this article, we will examine several ways that investors can maximize their tax benefits through passive real estate investing.
However, it is important to note that I am not a tax professional, CPA, or trained professional and the information presented here is not intended to replace professional advice.
My goal is to provide useful insight to help you understand the tax benefits of passive real estate investing. Let’s explore the benefits of passive real estate investing from a tax perspective.
Advantages of passive real estate
As a busy physician, I am constantly looking for ways to make the best use of my time and skills. This is why passive real estate investing makes sense for many high-income professionals. It also offers several tax benefits that can help us maximize our returns.
Active real estate investing can be time consuming. However, passive real estate investing allows investors to leverage the skills of others and still receive the benefits of real estate investing. By investing in syndication and funds, we can leverage the experience and knowledge of experienced real estate professionals.
However, it is important to note that the tax benefits of passive real estate investments can vary based on location and jurisdiction.
For example, I live in California, so you can imagine I’d take a bigger hit than those of you who might live in states like Florida or Texas, which have no state income tax. To fully understand the tax implications of your investments, it’s important to educate yourself and partner with a tax professional who can provide personalized advice.
In this article, we are talking about passive real estate investing, especially through syndications and funds, which offer unique tax benefits that can help investors save taxes. But what exactly is passive real estate investing?
Passive real estate investing involves investing in someone else’s real estate deal. A sponsor is responsible for finding and managing properties, dealing with tenants and property managers, and ultimately managing the sale or disposition of the property. As a passive investor, you can use their skills, experience and capital to generate returns without actively managing the property yourself.
So for many people out there, passive real estate investing can go. In fact, whenever I pull an audience, I get about 75% of people who say they prefer passive versus active investing. Now me personally, I do both, because I like to take advantage of the benefits of both and all the benefits that come with both. I tried to maximize it while minimizing the time I put into it, but you have to find what works best for you.
That said, here are some common tax benefits available to passive real estate investors:
1. Depreciation
Depreciation is a tax benefit that applies to real estate investments. Buildings, carpets or other items in a property have a lifetime and depreciate over time. The government allows active real estate investors to offset this decline in value each year. However, passive investors can also benefit from depreciation. When investing in a syndication or fund, you own a part of the building and can take advantage of its depreciation value.
Cost segregation is one way to further enhance this benefit. By hiring someone to study the property, each item within the building can be accurately valued and you can get an idea of what the depreciation cost will be. This creates passive losses on paper, which can offset active income. However, there is a wall between passive and active damages that the government has built to prevent high-income professionals from taking advantage of this loophole.
It’s important to ask syndicators about cost segregation and depreciation plans, as this can affect the amount of passive losses you can claim. Bonus and accelerated depreciation are options that allow you to take the depreciation value in advance, which can be beneficial to your tax situation.
For example, a $100,000 investment in a syndication could result in a paper loss of $50,000 or $70,000, depending on the sponsors’ aggressiveness in using cost-sharing and depreciation. Understanding the impact of depreciation and cost segregation can help maximize your tax benefits as a passive real estate investor.
2. Passive Loss
Passive losses, as mentioned earlier, refer to losses from your real estate investment that can offset any gains or distributions received from the property. These losses can be incredibly beneficial to investors, especially in terms of tax savings. For example, if you have a passive loss of $70,000 and you receive a $20,000 distribution, you will only have a negative $50,000 balance, which means you will not have to pay taxes on that distribution. This benefit continues throughout the life of the investment until you make enough profit to offset that initial passive loss.
Furthermore, passive losses can also be used against other investments, creating situations where you can offset other gains and pay less tax. This is a powerful strategy that many passive investors use to reduce their tax burden. Some also refer to this as a “lazy man’s syndication 1031 exchange,” which is another way to defer capital gains and avoid taxes down the road.
It’s important to remember that while passive losses can be a powerful tool for tax savings, consult a tax professional to make sure you’re using them correctly and within the law. Still, it’s a strategy that can make a significant difference in your investment returns and, ultimately, your bottom line.
3. The syndication ladder
A third tax-saving strategy for passive real estate investors is the syndication ladder. This strategy involves investing in multiple syndication deals simultaneously and timing them strategically to maximize profits and offset losses. Here’s how it works: If you expect a big profit from a syndication deal in a given year, you can invest in another syndication deal in the same year that you know will be a loss, which can offset the profit from the first deal. This technique, known as a syndication ladder, can be a powerful way to reduce your tax liability.
By discussing this strategy with your CPA, you can determine the best approach for your individual situation. The syndication ladder allows you to kick those taxes and defer your taxes. However, the ultimate goal is to earn tax-free profits, which is a huge advantage for high-income professionals who are usually heavily taxed on their income.
4. 1031 Exchange
A fourth benefit of real estate syndication is the 1031 exchange. It allows investors to defer capital gains tax by reinvesting the proceeds from the sale of a property in a “similar” property over a specified period of time. When a property is sold, the proceeds are placed in a separate account and can be used to invest in other contracts. By doing it right, you can avoid paying tax on the income during the exchange and kick the tax liability down the road. You can continue to exchange property until final disposition or exit of the investment while paying tax on the gains.
However, if the owner dies before realizing the full investment, the property is passed on to their heirs, who receive it in a step-by-step manner. This means they inherit the property at its current value, not the original value, and all retained earnings and taxes are wiped out. This creates a significant benefit for future generations and is why real estate syndication can create generational wealth. It is important to note that not all syndications offer this option and it is important to discuss this with your CPA and syndication sponsor before investing.
For example, one story involves a man who invested $60,000 in a syndication in 1995. Since then, he has traded his investment several times, reinvesting the proceeds in other syndications. Today, his net worth is $2.36 million, and he has $1.6 million in tax-free cash flow from investments. A 1031 exchange is a powerful tool that can help you compound your investments over time, but it’s important to understand the rules and qualifications before entering into any agreement.
I have a friend named Jeff, whose uncle has been investing in syndication for many years. Jeff shared with me an amazing story of his uncle’s success…
In 1995, his uncle invested $60,000 in a property. He finally sold the property in 2001, but instead of cashing out, his uncle exchanged it for a later property, which held for another 15 years, until he sold it again in 2016. The proceeds from those sales were then exchanged. The latter property, which was sold in 2020. His uncle was able to take the proceeds from that sale and invest in two different real estate investments.
Today, if you look at his initial $60,000 investment, his net worth is equivalent to $2.36 million from this investment. His uncle compounded his gains over time through a 1031 exchange.
Since 1995, his uncle has also received $1.6 million in distributions, meaning profits from these investments. There are many refinances, which are not taxed across these passive investments. Additionally, his uncle was able to cash out another $1.6 million for his initial $60,000 investment.
This story shows the ability to invest in real estate through syndication and use a 1031 exchange for compounding gains over time. It’s amazing to think that starting with just $60,000, his uncle was able to achieve $2.36 million in asset value and $1.6 million in tax-free cash flow.
5. Tax-deferred accounts
Another tax advantage of real estate investing is the ability to use tax-deferred accounts such as self-directed IRAs and self-directed 401(k)s. It’s important to consult with your tax professional and those who manage these accounts, but you can often invest in real estate using retirement funds. While you may not get all the tax benefits available, investing with retirement funds allows you to compound your gains over time and benefit from tax deferral until a later date.
6. Real Estate Professional Status
A sixth benefit of investing in real estate is taking advantage of real estate professional status. Real estate professional status is when you, your spouse, or partner meet certain criteria in terms of time and involvement in real estate deals that must exceed your current day job.
If you qualify, you can use your real estate losses as passive losses to offset your day job income. This is a powerful strategy for those with high amounts of W-2 income. Even with passive investing, you can still take advantage of this strategy by actively engaging in investment management.
Some who qualify as real estate professionals, can invest passively in syndications and funds and still make huge losses on their capital invested income. This is a great way to leverage time, income and capital while taking advantage of depreciation and cost segregation. However, it’s important to remember that tax laws can be complicated and vary depending on the state and territory you’re in.
In conclusion…
The world of passive real estate investing offers many opportunities to maximize tax benefits. While not all of these strategies may apply to every person, it’s important to be aware of them and ask the right questions of your tax professional. By taking advantage of these benefits, you can impact your bottom line and keep more money in your wallet
As a high-income professional, time is a precious commodity, and investing in passive real estate can help you regain control of it. So get out there and explore the possibilities and be sure to consult your trusted tax advisor for guidance along the way.
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