Are syndications "extremely tax efficient"?

[Michael Plaks]

This post was prompted by this quote from the website of an established syndicator, emphasis mine:

"What kind of tax impact is there? Apartment syndications are very tax efficient. As a partner in our limited partnership, you will benefit from your portion of the investment’s deductions for property taxes, loan interest and depreciation which are the big ones. We like to use a cost segregation strategy as well to accelerate depreciation since we don’t plan on holding onto the asset for a long time. 

You will get a K-1 statement from the partnership in March of the following year for the current tax year. It’s not unusual on a $100K investment to experience a min 8% preferred return or cash in your pocket of $8K while experiencing a paper loss on your annual K-1. Additionally, any refinances or supplemental loans are reviewed as a return of equity so no tax impacts. At time of sale, there may be an opportunity to 1031 exchange into another property that the sponsor wants to buy to continue to defer your long-term gains tax. 

Keep in mind some depreciation recapture may occur at time of sale if a 1031 exchange does not occur in addition to the long-term capital gains tax you would be responsible for paying on the gains."

Like they say on CNN, let's fact-check this very appealing presentation, shall we?

1. K-1 losses.

So, you're getting cash distributions and at the same time your K-1 shows tax losses. Your cash flow is up while your tax bill is down! Does it get any better than this? Not often, I agree. However, don't rush to celebrate your lower tax bill. It may not happen. You can apply these losses against passive investment income from something else. For instance, if you also receive positive net income from other real estate investments. But if all you have is this one syndication, your K-1 losses are useless to you today. These losses will sit on the shelf until the property is sold, and they will be applied against your gains at sale. You do get to take them eventually, just not now. Bummer, I know.

2. Depreciation. 

Say you buy a $4M apartment complex and allocate $1M of it to land. Normally, you have the other $3M to depreciate over 27.5 years, which is roughly $100k of depreciation deduction per year. Let's say that the annual rent collected is $800k and all regular expenses (mortgage interest, taxes, insurance, repairs, utilities, management) are $700k. You now have a taxable profit of $100k to be allocated to partners, increasing their tax liability, Ouch. Now, we add the "freebie" depreciation and - voila! - suddenly it's zero taxable profit. Life is good.

3. Depreciation recapture.

After-depreciation life is good. But only temporarily. Over the first 5 years, a typical syndication lifetime, the syndication deducts $500k in depreciation. Then the property is sold for $5M. Not only you have a capital gain tax on the $2M appreciation ($5M - $3M), but you also have a depreciation recapture tax, up to 25%, on all prior depreciation of $500k. 

Here is how I suggest to think about depreciation. It is not a freebie. It is a loan. You enjoy extra tax deductions for a few years, but eventually in the end you have to pay it all back. Passive investors still benefit from the time value of money and often from the rate arbitrage, so they are still winning a little bit but not nearly as much as they believe, based on the syndicator's presentation.

4. Cost segregation.

Cost segregation accomplishes one thing only: it accelerates depreciation. In my example, we had a $100k of depreciation per year for 5 years, $500k total. Now you do cost segregation, and suddenly you can deduct maybe 4 times as much: $2M over 5 years. Sweet! Until you remember about depreciation recapture. So in the end you have as high as 25% depreciation recapture tax on the $2M, not on $500k. You quadrupled your depreciation deductions, but you also quadrupled your depreciation recapture tax, essentially ending in a wash.

So what's the point then? Well, it's not a complete wash, because of the two factors I mentioned: time value of money and possibly rate arbitrage. However, the most significant benefit is psychological, not monetary: everybody loves to see K-1 losses, and nobody likes it when it shows taxable profit. So the syndicator looks good when he distributes K-1 losses. Is it worth investing tens of thousands of dollars into cost segregation for a temporary, refundable extra tax deduction which is basically a loan? Your call. It depends.

Now, if you recall our discussion of K-1 losses above, they may be useless for many passive investors, depending on their overall personal financial situation. So, if you have a positive taxable profit before cost segregation, then it's probably something you'd want to pursue. However, if you're below zero already, with regular depreciation, what does cost segregation accomplish? It increases your K-1 losses that you cannot take anyway until the last year! And in that final year, when you can take the losses, you must simultaneously return them via depreciation recapture. And you pay $$$ for cost segregation to play this stupid game. Again - different situations for each partner, so the syndicator has a tough task balancing everyone's selfish interests. Well, at least she gets paid for this job.

5. 1031 exchanges.

Those magic silver bullets that eliminate concerns about capital gain taxes and even depreciation recapture! Not that fast, pardner. If you read the full sentence from the syndicator that I quoted, he casually mentions something crucial after touting the allure of 1031: "...into another property that the sponsor wants to buy..." You can only do a 1031 exchange of your syndication investment if you stay as an investor in the same syndication, and the group reinvests their property into another property. 

This almost never happens. Inevitably, some partners just want to cash out and move on. It is technically possible to have some partners cash out and the remaining partners reinvest in a 1031, but it's highly complicated and usually has undesirable tax consequences for the involved parties. What happens in real life is that all investors cash out and then some of them may regroup for another investment opportunity. But this is not an exchange, and they are hit with the full capital gain plus depreciation recapture taxes anyway.

6. Refinances.

I have no idea what this sponsor means by "return of equity", but he is right about no tax impact. There never is. It is not some syndication magic. It works the same way with a single-family house you own personally. 

Let's take a simplified example and ignore confusing things like depreciation and amortization. Bought a house for $200k with a $150k loan, $50k equity. Then when its value jumped to $230k, you refinanced it into a $180k loan and pulled $30k cash, tax-free. Same $50k equity now.  So far so good.

However, later you sell it for $250k. You still have the $180k refinanced loan, so your equity is now $70k. Equity grew from $50k to $70k - so there should be a capital gain tax on $20k, right? Wrong! The capital gain is $50k, calculated as $250k minus the original $200k. What gives? Why $50k and not $20k? Because that $30k cash-out that was "tax-free" really was not. Only temporarily so. You pay tax on it now. Don't shoot the messenger.

Conclusion

If you go back now and re-read the sponsor's description of the tax rules for syndications, can you find anything incorrect? I cannot. Technically, he is right on every single point.

But somehow his statement that "Apartment syndications are very tax efficient" sounds much less exciting after we dissected it. Do you feel the same now? Then I've done my job. In case you wonder what it was, my job is to help you make well-informed investment decisions based on solid analysis and not hype. 

Syndications are great as an investment concept. Tax strategies are great. They just need to be well matched to each other and to your personal investment goals and circumstances.