How Real Estate Investing Can Save You Big in Taxes
Taxes definitely aren’t exciting in the grand scheme of real estate investing, but comprehensive tax planning and tax strategy can help you reduce your taxable income and hopefully save you a bundle. High-income investors would much rather concentrate on investing in their next commercial property or real property development rather than thinking about capital gains or their tax liability, but it comes with the territory of real estate ownership and investing.
Passive investors can realize significant tax benefits when they invest in a real estate syndication. The deal sponsor of the syndication will take advantage of as many tax benefits as possible that can be passed along to you the passive investor in the deal. Investing in real estate is a great way to help you reduce your tax liability unlike stock market investing in mutual funds and stocks.
As with any investment, you want to conduct your own due diligence to understand the tax ramifications of that investment and also gain an understanding of the best ways to decrease your overall tax bill.
This blog post will give you an overview of tax strategies you can utilize as a real estate investor. These real-estate-related tax deductions that are allowable in the eyes of the IRS and the tax code can generate significant tax savings.
Deciding On Your Entity Election
Real estate investors may think that they can claim more allowable deductions if they use a particular entity when conducting their investment business. However, allowable deductions such as real estate business expenses, won’t be different if you are a sole proprietorship versus a single-member LLC versus operating as a corporation. LLC’s do not pay taxes directly. The profits and losses are passed through to members who then claim those profits or losses on their individual tax returns. The tax deductions remain the same and include all business-related expenses.
A C-corporation is one type of entity that is not generally formed to run your investment gains through because of the double taxation component with C-corps. That’s not to say that you should never form a C-corp because there is a place for that type of entity in your real estate business. For example, your C-corp could be the “manager” of your real estate properties, and the C-corp could have its own set of operating expenses. But you want to consult with your tax accountant to determine which entities make sense for you to form and for which functions within your business.
Entity Formation & Asset Protection
Typically most real estate investors form a single-member LLC or S-Corp when they are getting started. Additionally, real estate syndications generally operate within a multi-member LLC structure and are taxed as partnerships.
The entity formation is generally designed to create asset protection. In order to be compliant and avoid a piercing of a corporate veil, you must be sure to avoid co-mingling your personal expenses with your business expenses. The best way to achieve that is to have separate accounts for personal use and expenses and another for your business activities. It’s wise to have a corporate credit card exclusively for business expenses as well.
You should know that any expenses in the startup phase of your business, such as legal fees, accounting fees, travel, research, etc, are tax-deductible. You do not need to have formed your entity to take those deductions.
Taxes And Real Estate Syndications
The typical entity used in real estate syndications, as mentioned earlier, is a limited liability company (LLC). The LLC is taxed as a partnership, so what that means is that the real estate syndication is not taxed because the taxes are passed along to the members of the LLC meaning it is formed as a pass-through entity.
The deal sponsor team (or general partnership) and the passive investors (or limited partnership) all get taxed individually and will receive a Schedule K-1 form from the general partner’s accounting team. All income and expenses, gains, and losses flow down from the partnership entity to all of the co-owners of the deal. Each member of the syndication will be responsible for their share of gains or losses accordingly.
It is important to note that the cash flow distributions you receive will be taxed as dividends. The K-1 does not reflect the actual dividend distributions that you have received from the real estate syndication.
Taxes And Rental Real Estate
Limited partners in a real estate syndication earn passive income distributions. There is an important distinction between earned income, or active income from your W-2 income, and passive income. Because passive income is received as a dividend it means that for tax purposes the real estate losses, which are usually paper losses, can offset the gains from the passive income received but cannot be applied to offset your active income. Passive losses can only offset passive gains or passive income.
There are exceptions, however, if you have rental income losses and if your adjusted gross annual income is $150,000 or less in active income as a married couple, then you qualify to be able to take a passive loss of up to $25,000.
Real estate professionals, which include full-time real estate investors and real estate agents, have a special designation called real estate professional status (REP) that enables them to offset their earned income with passive losses because their earned income is derived from real estate.
How Do You Obtain REP Status For Tax Benefits?
There are (2) requirements to qualify:
1.) You must spend at least 750 hours in a calendar year on “real property trades or businesses” during the year. That could mean real estate acquisition, real estate development, real estate leasing, real estate brokerage, etc. If you do have other sources of income outside of the real estate industry, then you might want to keep a time log to document your real estate activities in the event you are ever challenged by the IRS.
2.) Over 50% of your working hours in all trades or business activity during the tax year must be devoted to real estate-related trades or businesses in which you materially participated.
If you or your spouse can qualify to obtain REP status, it could be a game changer as you build your passive income and your wealth with passive investments in real estate syndications.
Before you take that leap to get the designation, you will want to discuss that with your CPA to make sure you are compliant and to be sure no rules have changed. Tax codes change quickly, every year in fact, so it’s always best to continually consult with your tax advisors before embarking on obtaining a new designation.
The Power Of Depreciation And Cost Segregation
Depreciation is a powerful tax advantage that investors can capitalize on to offset their gains. The IRS tax code recognizes that buildings have wear and tear and that they depreciate over time. So, as an investor, you are allowed to depreciate the building, which means you have a depreciation schedule of write-offs (the straight-line depreciation method) that you can take every year during that depreciation time period. A residential real estate rental asset such as an apartment building has a depreciation schedule that allows write-offs over 27.5 years and other non-residential commercial properties can be written off with a depreciation schedule of 39 years.
That depreciation creates a deferment in the taxes you owe during the time you own that property within the depreciation schedule parameters. This means you aren’t required to pay taxes on the gains from the depreciation of the asset until the asset is sold. Then you have what is called depreciation recapture. Depreciation recapture is the portion of your gain attributable to the depreciation you took on your property during prior years of ownership, also known as accumulated depreciation. Depreciation recapture is generally taxed as ordinary income up to a maximum rate of 25%.
Cost Segregation – Depreciation on Jet Fuel
Then there is a way to accelerate depreciation with what is called bonus depreciation deduction or cost segregation done through a cost segregation study. Cost segregation accelerates the tax benefits even further by shortening the depreciation schedule of various components of the building, which front-end loads the depreciation deductions drastically, thereby creating greater tax advantages.
If you are holding the building long-term, then the straight-line depreciation method would prove to be more advantageous because the tax benefits will be more uniform throughout the hold term of the asset. On the other hand, with real estate syndications, the typical hold term is between five and seven years, so in that instance, the cost segregation approach with the front-end loaded depreciation schedule has the most tax benefits for investors.
Tax Benefits Of Investing In Real Estate
The bottom line is that real estate investors (active investors or passive investors) receive significant tax benefits. The tax code was written in a way that favors real estate investors. The tax deductions allowable through real estate investing can offset your other income in ways other investments simply cannot, which can greatly reduce your tax obligation each year.
Building wealth is not just about saving money or even investing money. It’s also about understanding ways to keep more of the money you earn through legitimate tax strategies available to you with real estate investments. Investing in real estate syndications allows you to gain all of those benefits of real estate investing while helping you to build wealth quickly, mitigate your risk, and enjoy a truly passive investment.
As always, we are never offing tax advice or legal advice or imparting financial planning strategies in any way. We always recommend that you consult with your CPA or tax advisor to assess your particular tax situation and determine which investment strategies best fit your financial goals.
Ready to Learn More?
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