Tax implications of equity syndication deals

[Jacob Vorreuter]

What are the tax implications of investing in an equity syndication deal as a limited partner?

I’m considering investing in commercial multi-family equity syndication deals through a crowdfunding platform. I’ve reviewed the tax sections of several PPMs, but I’m still struggling with the legal language.

I’d like to understand the following:

1. How are gains taxed? Limited partners would expect to receive regular cash distributions, followed by proceeds from the exit event (sale or refinance). This is all considered passive income, correct? Are the regular cash distributions taxed as ordinary income or capital gains? And are the proceeds from the sale or refinance taxed as long-term capital gains?
2. What passive losses can be claimed by limited partners to offset the above passive income? It seems clear from the PPMs that LPs can claim depreciation deductions proportional to their share of the value of the property. Are LPs typically able to claim deductions on a portion of loan interest, property taxes and other commonly deductible expenses?

I understand every investment is different, but any insight into the LP tax implications of a typical apartment syndication deal would be greatly appreciated.

[Brian Burke]

@Jacob Vorreuter the tax implications are pretty much the same as if you owned the real estate yourself, except for the limitations on deductions for passive losses.  More specifically:

1. Gain on sale is capital gain.  Distributions are not taxed but income is taxed as ordinary income (distributions and income are not the same thing).  

2. I think @Basit Siddiqi gave a great answer about the limitations of passive losses.

To expand on my answer to your question #1, income consists of rental & other income minus all expenses such as property taxes, mortgage interest, management fees, utilities, insurance, payroll, etc.  You also subtract depreciation and amortization.  And because of those last two, it is possible for the property to produce positive cash flow but negative income.  This is why I say that distributions and income are not the same thing.  You can actually receive distributions yet still have a tax loss.  But remember, when the property is sold you'll have to recapture that depreciation.  But it will be at a lower tax rate than the ordinary income.

In the many syndications I've sponsored, generally our investors have had tax losses in the first year or two, then break-even for a year or two, and then small positive income after that.  This varies from deal to deal but in most cases the investors have received sizable distributions despite the tax losses, which they receive thanks to depreciation.  That's one of the reasons why investing in real estate, whether via direct ownership or through a syndication is so desirable and advantageous as compared to many other investment vehicles.

And on a side note, you don't have to figure all of this stuff out and make these calculations yourself.  The syndicator should be filing an informational tax return for the entity and sending you a K-1, which has all of the data that your tax preparer needs to complete your personal tax return, with all of the expenses and depreciation already factored in.