How is depreciation calculated as a passive investor?

Question

I've read a lot about how depreciation helps when you own a small apartment complex. How does depreciation work when you are a passive investor in a syndication? Do passive investor get the benefit of yearly depreciation when the syndication is held as a LLC? Thx.

Bill Exeter · Answer

Hi @Tony Lin,

Yes, if you meet the reinvestment requirements of trading equal or up in value and reinvesting the appropriate amount of net equity (net cash), your capital gain and depreciation recapture taxes are all deferred into your new replacement properties.

It also that the capital gain and depreciation recapture amounts would not be included on your income tax return and would not count toward/trigger the Medicare Surcharge.

The beauty of the 1031 Exchange is that it keeps all of your funds in your pocket working for you in building wealth for you instead of the federal and state governments.

You do not necessarily have to pay Uncle Sam a big tax in the future. This is true should you decide to sell and merely cash out of a property. You would incur and pay all of the capital gain and depreciation recapture taxes if you merely sell and cash out. However, if you continue to 1031 Exchange throughout your lifetime and never sell and never cash out and leave the property to someone upon your death, your heirs will inherit the property and receive what is called a "stepped up" cost basis. This means that the capital gain and depreciation recapture amounts completely disappear and your heirs will start their depreciation all over again.

Bill Exeter · Answer

Hi @Jonathan Twombly,

You are absolutely right.  Investors often jump into various syndication investments without thinking about their "exit strategy."  Syndications are often structured as formal partnerships or multiple member limited liability companies, which are usually treated as partnerships for income tax purposes.  The investor does not own real estate in these investment structures; they actually own a membership/partnership interest in the entity (the entity actually owns the real estate).

The sale of the property down the road is actually a sale by the partnership (entity) and not the individual investor; the individual investor merely receives a cash distribution, which is not exchangeable under Section 1031.

There are ways to address the issue.  The earlier the investor addresses the exit strategy issue the more options the investor will have to solve the problem.  The option of "drop and swap" that you mention is certainly a strategy used by many, but the safest way to do that is well before the property is even listed for sale.  Personally, I would suggest at least 24 months to be safe.  The issue is that the "seller/taxpayer" must have had the intent to hold the relinquished property for rental, investment or business use.  The partnership (entity) can easily prove they had the intent because they have held the property for investment purposes for quite sometime.  However, if the property is dropped out of the partnership into the partner's/investor's name and then immediately sold, an auditor could take the position that the individual never had the intent to hold the property but merely acquired title in order to defer their taxes and their 1031 Exchange could be disqualified.

There are many possible solutions and variations here depending upon the circumstances, including the amount of time available for planning, the desire of the partners to cooperate.

Jonathan Twombly · Answer

@Tony Lin I just had a long talk with my CPA and am just wrapping up a blog post about the tax benefits of MFRE.  But one thing to beware of is that, if you invest in a syndication, you cannot do a 1031 exchange with your deal profits, because you own a security (your membership interest) rather than a direct interest in real estate.  The LLC that owns the real estate would have to do the exchange, and you would have to remain a member of the LLC to benefit from it.  This may not be an issue if the number of investors in the deal is small and a consensus to roll your profits over is easy to reach.  But if people want to cash out and are willing to pay the tax, then it becomes harder to pull off.

There are other strategies, like changing the corporate form of the partnership from LLC to Tenancy in Common (TIC) just before the sale, but this is complicated and you definitely need to consult with an accountant and a tax lawyer to see how to pull this off.

Ivan Barratt · Answer

@Tony Lin in other words yes. the investor gets his/her pro-rata share of the depreciation (and typically other benefits associated with owning real estate) UNLESS the operating agreements spell out something different.

Daniel Dietz · Answer

@Dave Foster (or others),

This is the part that is confusing to me..........

"3. A stalling game to take advantage of tax free sales in the post retirement years when taxable income drops below the thresh hold for the 0% capital gain rate (note this is taxable income not adjusted gross income.  It's possible to have an agi of over 100K and still qualify for tax free capital sales)"

I still dont quite understand that difference. I am at least a decade or two from retirement, but want to understand ahead of time to plan properly. Let's say I had 20K in SSI, and took 10K out of my Traditional IRA. I also took 10K from my ROTH IRA. My rentals are showing a break even due to depreciation.

So it looks like to me I am under the 40K or so limit to stay in the 0% capital gains column.

Now I also sell a rental that I will have 30K of recapture and 50K of capital gains. How much of that can be taxed at the 0% rate?

Also, if I did a cash out refi of a rental, I *think* that the 'cash out' part is NOT taxable, but the interest is also NOT deduct able if I use it for 'personal use'?

Thanks, Dan Dietz

Jonathan Twombly · Answer

@Bill Exeter  very helpful! Please PM me to connect!

Dave Foster · Answer

@Tony Lin, There are some incredibly powerful strategies that can be coupled with the 1031 exchange to mitigate and eliminate any capital gains tax on real estate in your lifetime and beyond.  The strategy mentioned above of holding property passively for income and then willing to your heirs at a stepped up basis is a good one.  You just want to pay attention to estate limits and of course you have to die to get it - so it wouldn't be my first choice.

Many investors are putting several strategies together.

1. Life time holding of real estate structured more and more passively.

2. Periodic conversion of investment real estate to primary residence to gain a prorated part of the gain tax free.

3. A stalling game to take advantage of tax free sales in the post retirement years when taxable income drops below the thresh hold for the 0% capital gain rate (note this is taxable income not adjusted gross income.  It's possible to have an agi of over 100K and still qualify for tax free capital sales)

4. The elimination of tax by death.

It's always been said the only two sure things in life are death and taxes.  The 2nd is at least partly negotiable!

Tony Lin · Answer

Great. A follow-up question. If doing a 1031 exchange the depreciation capture is delayed and rolls over into the next property correct? Meaning your entire cashflow+equity can be tax-free recapture-free used in the next property.

1031 sounds great although you'll have to pay Uncle Sam a big tax at the last property.

Michael Le · Answer

Depreciation would be done at the property level and would already be factored in when you get your Schedule K-1. So most likely your K-1 will be zero dollar or even negative.

How is depreciation calculated as a passive investor?

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