Tax Questions: What are the Tax Benefits for Passive Investors?

Question

Hi everyone, I've been trying to puzzle through the tax situation for passive investors and thought I'd ask you all for help.

It seems like the main incentives are depreciation and capital gains. An LP using depreciation can claim a tax loss on their K-1 equal to the amount depreciated, and the LP can augment how much they get to depreciate through cost segregation and bonus depreciation. And profit made from capital gains is taxed at a lower rate than many investors income taxes.

However, it seems like there are two major limitations to depreciation: recapture, and the fact that the depreciation cannot offset active income, only passive income. I'm interested in understanding the impact of these limitations for passive investors.

First, what qualifies as passive income in a syndication? Would it simply be the cash flow payments?

(1) Using depreciation, an LP can delay paying taxes on their cash flow and only their cashflow. They will eventually have to pay those taxes on sale, but in the meantime they can invest it for a profit.

(2) Any profit made through capital gains is taxed at a lower rate than their personal income.

I have some more questions but for now, what do you guys think of this?

Charles LeMaire · Answer

Note I am a fairly active (50 syndications) LP and not an RE pro.  I am not an accountant, CPA or tax attorney!

First, it is not GP vs LP that makes the difference.  It is RE Pro vs non-RE pro.  So lets assume you are asking about the non-RE pro.

Good tax avoidance is paying taxes later and/or paying taxes at a lower rate.  Remember avoidance OK, evasion is illegal.

In my opinion, syndication sponsors over sell the benefit of Bonus Depreciation and Cost Seg to beginners.  Also oversell IRA investing, but that's another topic.

Say you invest $100K in your first syndication and you get about $50K of depreciation in year one.  You will likely continue to get about $2K more each year.

I minimal amount, about $3K, can be used against W-2 if your W-2 is not too large.  The rest will sit there until you sell something with a passive gain.  Perhaps you sold your Apple or Amazon stock to get the initial $100K; that passive gain would be offset (no tax).  Or perhaps it will sit around until you sell this property and will just keep you basis where it was, so that you will only owe a Cap Gain on the increase.

Or perhaps you will invest in a new syndication and get another bundle of depreciation which can be used to offset the Cap Gain in the property you just sold.

Realize each time you delay the tax on a Cap Gain, you just pushed the tax to be paid until later - good tax planning!  If you happen to be able to control your total income and move your Cap Gain rate down from 23.8% to 20% or perhaps 15%, you lowered the rate -- again good tax planning!

You do have the risk of becoming a serial syndicator as you join this 'Merry Go Round of Real Estate'.  Buy, Sell & Buy to cover gain, Sell & Buy to cover gain, wash rinse repeat.  The potential tax will just keep moving out and someday you will pay it or your estate will pass on a reset basis on the remaining properties.

The possible fly in the ointment is that if the rates go up (currently they are low) and you push your gain off to the future.  Say the GMVT removes the benefit of Cap Gain.  You will not be happy, but the economy will tank anyway, so what the heck!

Regards,

Charles LeMaire

Alex Olson · Answer

@Shafi Noss I am no expert. If you are just starting out, first stop is to buy the book on Real Estate Loop Holes as part of the Rich Dad Poor Dad series. Its invaluable. Then, network to find the best real estate CPA in your area. Sit down with them and hammer out all of your questions. Taxes are (dare I say) complicated and everyone has different scenarios - not a single 1 are the same.

Brian Briscoe · Answer

@Charles LeMaire -- loved your post.  Great to get the experienced LP point of view.  This is the first year we distributed K1s and had a hard time explaining all of the benefits.  Your post really shows how a little bit of knowledge and planning can reduce the tax burden...  Thanks a ton!!

Yannik Cudjoe-Virgil · Answer

For long-term capital gains tax, it's always great to pay them at a lower rate than short term. The thing about the tax benefits regarding depreciation is the concept of TVM (time value of money). Using those dollars today is an extreme benefit than tomorrow.

Roni E. · Answer

Hello, @Shafi Noss here are some more articles but I would speak with your CPA for guidance and advice.

https://www.therealestatecpa.com/knowledgebase/tax-benefits-when-investing-in-a-syndication

https://aop.alphaflow.com/resources/articles/the-tax-implications-of-real-estate-crowdfunding/

John L. · Answer

It’s worth noting that in some ways the taxes don’t matter when starting out. If you have passive income outside of real estate (or one specific syndication) then you can use depreciation right away to offset taxes due on the proceeds from the specific deal and other passive income. If you don’t have any passive income outside of this investment and the tax depreciation exceeds the proceeds, then it accrues until you can use it. So, in  the future the depreciation can offset the gains in a sale.

Roni E. · Answer

First off not this not legal or tax advice so I would speak to an attorney or CPA. I would read the below article to help you understand per IRS rule RE professional but again speak to your CPA and or attorney for guidance.

https://www.thetaxadviser.com/issues/2017/mar/navigating-real-estate-professional-rules.ht

So you invest $100k, and let's just say for argument sake it is a 6% cash on cash return so you will make $6k in Year 1 and go up from there. You will then get a K1 from the sponsor/manager/syndicator. I do not want to guess on how much of a loss would on the K1 as too many factors. Usually you should be able to go multiple years with no taxable income.

Marlen Weber · Answer

@Shafi Noss I am following this thread as I am interested in this topic as well. Great question.

Shafi Noss · Answer

Hey @Roni Elias, thanks for the article, it's extremely helpful. And for the note @John L.

@Charles LeMaire, I'd assumed LPs were always non RE pros and vice versa for GPs but not for any good reason, thanks for pointing the distinction out.

Could I ask a few follow up questions? I hadn't heard about a small W-2 offset, where can I learn more about that? And also, this would have been my next post, what else counts as passive income? From your example it sounds like previous syndication and profit from stocks count as passive, not just the cashflow or dividend payments from those investments? Really specific and helpful info, I'd love to talk more about this if you're open to it.

Tax Questions: What are the Tax Benefits for Passive Investors?

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