5 Amazing Tax Strategies Every Passive Real Estate Investor Should Know
No one really likes to think about taxes or tax strategies when they are making money.
It’s a lot more fun for most people to think about how they’re going to spend their money than it is learning how to avoid paying too much in taxes.
Well, let me tell you a great tax strategy right here: investing in real estate, unlike investing in the stock market, can actually lower your tax bill even if you’re receiving amazing returns on your investment. Yep, it’s true!
As a passive investor in real estate syndications (or investing in real estate in general) you receive the IRS tax code benefits that the IRS extends to those that provide housing options. They want to encourage individuals to create or manage housing options for communities, and in exchange, they give real estate investors tax advantages.
We are not tax specialists nor tax advisors, nor is our intention to give any financial advice whatsoever in this article. Please seek a licensed professional before making any tax, financial or investment decisions.
So, let’s tackle the variety of different ways that passive real estate investing can help you avoid paying too much in taxes and help you keep more of what you earn.
The 5 Tax Strategy Tips That Every Passive Investor Should Know When Investing In Real Estate
- The IRS tax code creates advantages for real estate investors.
- Passive investors can receive all of the same benefits as active investors.
- Depreciation can reduce an excessive tax bill.
- Cost segregation is another powerful depreciation tool.
- A 1031 exchange can help you build legacy wealth.
#1 – The IRS tax code creates advantages for real estate investors
You may know that 90% of all millionaires became wealthy by and large by investing in real estate than by any other path, and one of the main reasons that is the case is because of the IRS tax code.
The IRS sees real estate investors as vital to the economy and an integral part of producing a thriving community by way of providing safe, clean, and affordable housing to individuals. As such, the IRS provides tax benefits to those who provide the much-needed housing.
Real estate investors fulfill a need, the need for shelter, and so, therefore, they are “rewarded” for this fulfillment by receiving tax advantages.
#2 – Passive Investors Can Receive All Of The Same Benefits As Active Investors
This is a pretty amazing advantage for passive investors. You essentially receive all of the same tax advantages as an active investor who is in the trenches taking care of the day-to-day management of the project – which is a lot of work.
As a passive investor who is investing in a real estate syndication, you are investing in an LP or an LLC – an entity. An entity such as this allows for a “pass-through” vehicle for the tax benefits that you as the investor receive.
When you invest directly into a real estate asset you receive these tax benefits. You would not be eligible for these same tax benefits if you were to invest in a REIT (Real Estate Investment Trust) because you are not investing directly in an asset but rather with REITs you are investing in a corporation, so there would be a different taxing structure.
#3 – Depreciation Can Reduce An Excessive Tax Bill
One of the best wealth-building instruments we have in real estate is the use of depreciation.
What is depreciation?
Depreciation is the reduction of the value of an asset with the passage of time, due to wear and tear. So as a result, you get to write off that portion of the incrementally reduced value of the asset each year over a specified period of years, which is 27.5 years for residential real estate.
The depreciation schedule does not include the land, only the building itself, so the estimated value of the land would need to be backed out of the value of the entire asset – just the building only can be depreciated.
So, let’s look at an example:
Say you invested in a property that was valued at 10,000,000, and the land was worth 1,750,000 that would mean that the depreciable amount of the building itself would be 8,250,000.
Using a simple straight-line depreciation over 27.5 years would mean that there would be an allowable deduction of $300,000 per year over those 27.5 years to account for the anticipated wear and tear on the building.
This is where depreciation gets interesting because if, for example, you receive $10,000 in distributions from the cash flow on the property in that first year, because of that $300,000 deduction in depreciation you may not have to pay taxes on your distributions at all – caveat: depending on the tax bracket you are in and your tax situation overall, of course.
You will need to consult with your CPA to find out how depreciation would affect the taxation on your particular returns.
The $300,000 in depreciation reflects a “paper loss” even though the project may have made a profit. That’s why the wealthy always have some portion of their net worth in real estate.
Real estate is an extremely powerful wealth-building tool in large part because of how depreciation allows for such significant deductions as this.
#4 – Cost segregation Is Another Powerful Depreciation Tool
As we discussed, the straight-line depreciation method allows you to deduct an equal amount of the asset’s value over 27.5 years.
But cost segregation, on the other hand, allows for even greater deductions because what it does is instead of depreciating the building as a whole, cost segregation (or a cost segregation study conducted by an engineer) breaks out the building into individual components.
These separate components like the windows, the carpeting, the lighting, etc., allow for each of those certain items to have an accelerated depreciation schedule such as 5 years or 7 years, or 15 years instead of the entire asset being depreciated as a unit over 27.5 years. This can dramatically increase depreciation deductions because it “front-loads” the depreciation in the early years.
Because we invest in real estate syndications that are typically held for 5 – 7 years, the straight-line depreciation method would only allow us 5-7 years of those deductions. We wouldn’t be able to capitalize on the remaining years of the depreciation schedule, but with cost segregation, most of the deductions are taken earlier on during the hold term of the asset.
This is why cost segregation is so powerful.
#5 – A 1031 Exchange Can Help You Build Legacy Wealth
Just to be clear, real estate investing is by no means a tax-free venture. However, there are ways that you can keep more of what you earn by participating in a 1031 exchange.
A 1031 exchange allows an investor to sell one asset, and the investor must within a specified period of time (45 days) identify another “like-kind” asset that will be purchased within a specified period of time (180 days) with the proceeds of the original, relinquished asset.
Because the profits from the original asset are rolled into the next asset, this tax savings technique allows you to avoid having to pay capital gains on those profits.
This technique may or may not be eligible for the real estate syndication opportunity you are looking to invest in, and that is because not every deal sponsorship group offers a 1031 exchange option.
Oftentimes, the investors all have to be in agreement that a 1031 exchange will be offered, and that is not always the case. You cannot conduct a 1031 exchange with just your portion of the proceeds with a real estate syndication.
If you are interested in participating in a 1031 exchange you can simply ask the deal sponsor if that would be an option.
Real estate in general is a powerful way that many people utilize tax strategies to grow their wealth. The substantial deductions allow individuals to decrease the taxes that they owe. This is one of the many ways in which the wealthiest among us became so -by way of real estate investing.
These are all legal strategies, and you don’t have to be the wealthiest among us to benefit from the extraordinary tax advantages that real estate investing affords.
As a passive investor you are able to capitalize on the best of both worlds: getting great returns while not having to do any of the work on the project AND being able to take advantage of these tax strategies to lessen your yearly tax bill. You literally don’t have to work to receive these benefits. And you may not even have a tax bill from your distributions with these tax strategies in place when you invest passively in a real estate syndication.
We hope this moved the needle a bit more in helping you to Earn Passively & Live Abundantly! Until next time…
Ready to Learn More?
The best way for you to learn more about passive investment opportunities in commercial real estate syndications is to join the PCRP Passive Investor Club.
Through the PCRP Passive Investor Club, you’ll get a priority review of all the deals we offer. We’ll work with you to determine your investing goals and then present you with the best deals to meet those goals. We’ll then guide you every step of the way as you invest in those deals.
So if you’re ready to start investing passively in institutional-grade, commercial real estate in fast-growing, climate-resilient markets in the U.S., join the PCRP Passive Investor Club – IT’S FREE! – and get started on your path to EARN PASSIVELY and LIVE ABUNDANTLY!
If you would like to know more about what we do and how it may be of value to you, please reach out to us anytime. We’re always happy to help!