7 powerful tax strategies that every passive real estate investor should know
If you’re anything like me, taxes are one of the last things on your mind when starting a new business. It’s far more enjoyable to fantasize about all the luxurious vacations you’ll take and the new automobiles you’ll buy than it is to consider the taxes you’ll have to pay.
Well, I’m here to tell you that it’s perfectly fine if taxes aren’t on your mind when you first start investing in real estate. That’s because, unlike stocks and mutual funds, real estate investments tend to decrease rather than increase your tax bill.
You read that correctly. Even if you’re generating fantastic returns on your investment, investing in real estate can often help you reduce the amount of taxes you owe.
You might be wondering, how is it possible?
There is a significant distinction between how the IRS perceives stock market profits and how they view real estate gains. And that’s exactly what we’ll talk about in this article, from the perspective of a passive investor in a real estate syndication.
But First, a Disclaimer
To be clear, I am not a tax professional and have no plans to become one (those people have really tough jobs). As a result, the opinions and ideas presented in this post are solely based on my personal experience.
For more information and specifics on your situation, you should consult your CPA.
Let’s get started now that that’s out of the way.
The 7 Things You Should Know about Taxes and Real Estate Investing
Okay, get ready to have your socks knocked off. As much as taxes can knock one’s socks off, anyway.
Here are seven main things I think every passive investor in a real estate syndication should know about taxes:
1. The tax code favors real estate investors.
2. As a passive investor, you get all the tax benefits an active investor gets.
3. Depreciation is hecka powerful.
4. Cost segregation is depreciation on steroids.
5. Capital gains and depreciation recapture are things you should plan for.
6. 1031 exchanges are amazing.
7. Some people invest in real estate solely for the tax benefits.
#1 – The tax code favors real estate investors.
You may have heard that more people become millionaires through investing in real estate than through any other path. And believe it or not, the tax code plays a big role in that.
The IRS understands the importance of real estate investing in providing good houses for individuals to live in. As a result, the tax system is intended to encourage real estate investors to invest in real estate, maintain those units, and upgrade them over time (more on these benefits in a moment).
As a real estate investor, you’re like a teacher’s pet for the IRS.
There are worse things, after all.
#2 – As a passive investor, you get all the tax benefits an active investor gets.
This is a big deal. This means that whether you’re an active or passive investor, you’ll still get full tax benefits even if you’re not actively fixing toilets or climbing on roofs.
Because you invest in an entity (usually an LLC or LP) that owns the property as a passive investor in a real estate syndication, that entity is ignored by the IRS (these entities are also referred to as “pass-through entities”).
That means that any tax savings flow to you, the investors, through that corporation.
Note that investing in REITs is different. Because you’re investing in a company rather than the underlying real estate when you buy a REIT, you won’t enjoy the same tax benefits.
The ability to deduct property-related expenses (such as repairs, utilities, wages, and interest) as well as the ability to deduct the property’s value over time (depreciation) are two common tax advantages of real estate investing.
Let’s hone on the concept of depreciation.
#3 – Depreciation is extremely powerful.
Depreciation is one of the most powerful wealth building tools in real estate. Period.
Depreciation is a method of reducing the cost of an asset over time. This is based on asset wear and tear and its usable life.
What is the meaning of depreciation?
Consider the following scenario: you recently purchased a new laptop. That laptop performs admirably from the start. However, the keyboard becomes sticky over time, the processor slows down, and the battery lasts only a few minutes. The whole thing will eventually fail and be worth very little, if anything. This is how depreciation works.
Essentially, the IRS is recognizing that if the property is used on a daily basis and you do nothing to fix it, the property will succumb to natural wear and tear over time, and will become uninhabitable at some point in the future (just like when that laptop eventually dies).
Every asset, as you might expect, has a different lifespan. A laptop is unlikely to last more than a few years. On the other hand, you’d expect a house to continue standing for several years, if not decades.
For residential real estate, the IRS lets you write off the value of the property over 27.5 years.
Note that only the property itself, not the land, is eligible for depreciation deductions. The IRS is wise enough to see that the land will still exist in 27.5 years and will be worth the same, if not more, as it is now.
Here’s an illustration:
Let’s say you paid $1,000,000.00 for a home. Assume that the land is worth $175,000 and the structure is worth $825,000.
With the simplest form of depreciation, called straight-line depreciation, you can write off an equal amount of that $825,000 every year for 27.5 years. That means you can deduct $30,000 in depreciation per year ($30,000 x 27.5 years = $825,000).
This is why this is such a significant event. Let’s say you make $5,000 in cash-on-cash returns (i.e., cash flow) on that property in the first year. You get to keep $5,000 instead of paying taxes on it because it is tax-deferred (i.e., without having to pay taxes on it until the property is sold).
Wait, really?
Yes, really.*
*Disclaimer: This depends on your individual tax situation. Please consult your CPA.
That $30,000 in depreciation means that, on paper, you actually lost money, while in reality, you made $5,000.
Plus, properties acquired after September 27, 2017, are eligible for bonus depreciation, which can really amp up the tax benefits for that first year.
This is why depreciation is extremely powerful.
#4 – Cost segregation is depreciation on steroids.
But wait, there’s more!
We discussed straight-line depreciation in the previous example, which allows you to write off an equal amount of the asset’s value every year for 27.5 years.
in However, most of the real estate syndications we invest in have a five-year hold period. So, if we deduct the same amount every year for the next 27.5 years, we’d only get five years of those benefits. The remaining 22.5 years of depreciation advantages would be forfeited.
This is where cost segregation comes into the equation.
Cost segregation recognizes that not all assets in a property are created equal. For example, the printer in the back office has a substantially shorter lifespan than the roof on top of the building.
In a cost segregation study, an engineer itemizes the property’s separate components, such as outlets, wiring, windows, carpeting, and fixtures.
Certain items can be depreciated over a shorter period of time, such as 5, 7, or 15 years, rather than 27.5 years. This can significantly boost depreciation advantages in the early years.
Here’s an example
Let me give you an example. And this one is based on a true story.
Several years ago, a real estate syndication business acquired an apartment complex in December. This means that the investors only held the asset for one month during the given calendar year.
But because of cost segregation, the depreciation schedule was sped up for many things on the property, like landscaping and carpeting.
The K-1 that was sent out to investors the following spring showed that, if you had invested $100,000 in that real estate syndication, you showed a paper loss of $50,000.
That’s 50% of the original investment.
Just for owning the property for a single month during that tax year.
And, if you qualify as a real estate professional, that paper loss can apply to the rest of your taxes, including any taxes you owe based on your salary, side hustle, or other investment gains.*
*Again, this depends on your individual situation, so please consult your CPA.
This is a game-changer, folks.
#5 – Capital gains and depreciation recapture are things you should plan for.
You didn’t think that investing in real estate would be 100% tax-free, did you?
Sadly, the IRS enjoys being included in everything.
When a real estate asset is sold, they get their cut through capital gains taxes and, depending on the sale price, occasionally through depreciation recapture.
In a real estate syndication that holds a property for 5 years, you wouldn’t have to worry about capital gains taxes and depreciation recapture until the asset is sold in year 5.
The amount of capital gains and depreciation recapture is determined by the length of the hold period as well as your tax bracket.
Here are the brackets and percentages based on the new 2018 tax law:
- $0 to $77,220: 0% capital gains tax
- $77,221 to $479,000: 15% capital gains tax
- More than $479,000: 20% capital gains tax
For more details and the most up-to-date laws and info, I recommend you discuss the specifics with your CPA.
#6 – 1031 exchanges are amazing.
When a real estate asset is sold, capital gains taxes (and, in many instances, depreciation recapture) are owed. There is, however, a way around this. This is done through a 1031 exchange.
This is done through a 1031 exchange.
A 1031 exchange allows you to sell one investment property and swap it for another like-kind investment property within a certain time frame.
Instead of receiving gains directly, you roll them over into the following investment. As a result, when the first property is sold, you owe no capital gains tax.
Only a few real estate syndications provide the option of a 1031 exchange. To make a 1031 exchange possible, the majority of the investors in a syndication must agree to it.
Unfortunately, you can’t do a 1031 exchange on just your shares in the real estate syndication.
The sponsors must decide whether or not to do a 1031 exchange on the entire package. All or nothing.
Every sponsor is different, and each handles 1031 exchanges in a different way. If you’re thinking about doing a 1031 exchange, make sure you ask the sponsor about it.
#7 – Some people invest in real estate solely for the tax benefits.
The tax benefits of real estate investing are so powerful that some people (particularly the wealthy) invest only for the tax advantages. They can take advantage of substantial write-offs by investing in real estate, which they can then apply to other taxes they owe, lowering their overall tax burden.
This is how real estate moguls may make millions of dollars while paying virtually no taxes.
It’s completely legal, and it’s a fantastic way to grow wealth. You also don’t have to be affluent to profit from the tax advantages of real estate investing. The tax code makes the advantages of investing in real estate accessible to all real estate investors.
Recap
Like I mentioned when I started this article, you don’t have to worry about taxes when investing in real estate, especially as a passive investor in a real estate syndication. In most cases, you’ll be able to make money via cash-on-cash returns, yet you won’t owe taxes on those returns due to benefits like depreciation.
To recap, here are the seven things I think every real estate investor should know about taxes:
- The tax code favors real estate investors.
- As a passive investor, you get all the tax benefits an active investor gets.
- Depreciation is hecka powerful.
- Cost segregation is depreciation on steroids.
- Capital gains and depreciation recapture are things you should plan for.
- 1031 exchanges are amazing.
- Some people invest in real estate solely for the tax benefits.
As a passive investor, you don’t have to “do” anything to take advantage of the tax benefits that come with investing in real estate. That’s one of the benefits of being a passive investor. You don’t have to keep any receipts or itemize repairs. You just get that sweet K-1 every year, hand that over to your accountant, and that’s it.