Tax Impacts of Private Money Investment

As tax time draws closer, it's time to spend some time discussing the impact that private money has on yours and your private investors income tax returns.

It's no secret that if you're making money flipping houses or buying apartment buildings that Uncle Sam is going to take a bite out of it. This is simply inevitable, but probably a good problem rather than a bad problem. Good problems are those that result from making money or those that put money in your pocket. Bad problems lighten your wallet and give you restless nights. As long as you keep your books and records straight, you shouldn't have any bad problems with the IRS. But...

You may want to reduce the size of Uncle Sam's tax bite. The good news is that real estate investing offers some of the best tax advantages over all other asset classes. The two biggest advantages real estate offers you and your private investors - from a pure tax standpoint - are: depreciation and 1031 exchanges.

With depreciation, taxable income may be less than cash flow on a property. For instance, if you owned an apartment building with private investors as limited partners, the depreciation taken on the fixed assets of that building (building structure, improvements) would flow through proportionally to each investors tax return, via form K-1. If the projects is cash flow positive $100,000 for the year, you and your private investors may not owe taxes on the entire $100,000 - the taxable income may be $90,000 or even less.

With 1031 exchanges, you can roll the capital gains from one project into another one of equal or greater value. You must identify the exchange property within 45 days and close the transaction within 180 days in order to defer the capital gains from the sale  of the first property. If you think this isn't a big deal, think again. If you have a $1,000,000 capital gain and owe 20% taxes on it, $200,000 would exit your coffers and go to the government. But, with a 1031, you can roll your profits into a new project and defer paying that $200,000 in taxes. You can effectively use the money owed to the government to increase your wealth.

Bear in mind the tax reporting requirements that come with getting private money. You have an obligation to get the proper tax forms to your investors each year so they can file their income tax return. 1099's for private money lenders or stock holders who received dividends and K-1's for LLC members and limited partners. There is some additional responsibility that comes with raising capital, but if you keep good books and records and retain a good CPA or tax attorney, this should be no problem.

Use the tax benefits of real estate investing to attract investors to your opportunity. There aren't many tax advantaged investments left, and some of your investors will gladly hand their money to you instead of Uncle Sam.