Often commercial real estate syndication returns are quoted as an annual percentage rate. While this is a useful and important way to think about returns, it overlooks one key component: tax savings.
In this article, we are going to describe some of the key tax benefits of real estate investing. For each tax strategy, we will describe what it is, how it works and why it is beneficial. By the end, the goal is for readers to have enough information to determine if a syndicated real estate investment is a good fit for their own preferences.
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What is a Syndication in Real Estate?
Individual investors interested in purchasing a high quality commercial real estate asset face two hurdles. First, properties are incredibly expensive – $5MM to over $100MM. As a result, there are very few single individuals that have the resources needed to purchase a commercial rental property on their own. Second, the assets are also very time consuming to manage. Even if an individual has the resources to purchase commercial real estate on their own, they probably don’t have the time to manage it.
So, the real estate syndication deal structure is borne out of an effort to solve both of these issues.
A “syndication” is a commercial real estate transaction structure that allows individual investors to purchase a fractional share of a commercial property and earn passive income for their efforts. It works like this.
A deal leader, known as a “General Partner” or GP, finds a property to purchase. They manage the due diligence and arrange the debt financing. Then, they raise equity from individual real estate investors, known as limited partners or LPs. When the transaction is complete, the deal leader does all the hard work of managing the property while individual investors earn their pro rata percentage of the income produced by the property.
For individual investors, the two hurdles above are cleared because they don’t need to purchase the whole property, just a fractional share, and they don’t need to manage it because the general partner handles that.
Tax Benefits of a Real Estate Syndication
Again, real estate syndicators typically lead their pitch with the returns that can be earned from the passive income and price appreciation produced by a property. These are important, but they don’t fully capture the tax benefits of the investment. There are six that are notable.
1. Depreciation Deductions
Over time, the physical condition of a commercial property deteriorates due to exposure to weather and normal wear and tear. To account for this, IRS rules allow property owners to “depreciate” or expense a certain portion of a property’s value in each year of its useful life. This is a non-cash expense, but it serves to reduce the amount of taxable income produced by the property, therefore providing a reduction in the amount of taxes that must be paid.
Property owners may even choose to be somewhat aggressive about the depreciation deductions taken, choosing to accelerate them using a “cost segregation study,” which allows the investors to bucket the asset into different components and depreciate them at an accelerated rate. This sort of “bonus depreciation” can reduce taxes further.
It is also important to note that depreciation deductions can be a double-edged sword. When a property is sold, the deductions may be subject to “depreciation recapture” in which accumulated depreciation may be subject to income tax. For this reason, it is important to speak with a CPA and/or tax attorney before deciding on how to take depreciation.
2. Lower Tax Rate on Capital Gains
If there is a difference between the sale price of a property and its cost basis, it is known as a gain and it is taxable. But, the benefit here is that the capital gains tax rate is lower than the income tax rate.
The exact capital gains tax rate paid varies by the amount of time a property is held and the filing status of the real estate investor. Short term capital gains on properties held for less than 12 months are taxed as ordinary income, which has a top rate of 37% for the highest tax bracket. Gains on sale for properties held for more than 12 months are taxed at the long term capital gains tax rate, which has a top bracket of 20% – clearly lower than 37%.
Most commercial real estate assets are financed with commercial mortgage debt and there may be some tax benefits when this debt is refinanced. The deduction rules can be complex, but owners may be able to deduct certain interest and closing costs. In addition, any money received in a cash out refinance tends to be viewed as a loan, not income, so that may not be taxed either.
In this particular case, it is very important to note that the deductions available from a refinance can vary widely from one deal to another. Again, it is always important to consult a CPA and/or tax attorney to ensure those taken are valid.
4. Mortgage Interest
In a commercial property, mortgage interest is deductible as a line item expense on the income statement. Like depreciation, this deduction reduces the amount of taxable income produced by the property.
5. Carried Over Losses
It is an unfortunate fact that not all real estate investments are profitable and some even result in the loss of principal for investors. While this is never pleasant, there is a silver lining to this cloud. Losses reduce an investor’s taxable income. More importantly, if the loss is big enough it can be carried forward into future years to also reduce taxable income in those years.
For example, assume that an investor had $100,000 in taxable income and experienced a $1MM loss. This loss is quite large and could potentially be carried forward for 10 years, where taxable income is reduced to $0 in each year. Again, the math and the IRS rules for this scenario are complex and there may be certain limits on the amount of losses that can be deducted each year so it is important to consult a tax professional.
6. 1031 Exchanges
Above, it was discussed that current tax law requires investors to pay long term capital gains taxes when there are investment gains on sale. This is true, but savvy investors can defer them indefinitely using a “1031 exchange.” In this program, capital gains taxes are deferred as long as the sales proceeds are reinvested into another property that is “like kind” to the sold property within a certain time frame.
There is no limit on the number of 1031 Exchanges that can be completed, so it is theoretically possible that an investor could continue to roll from one property to the next, allowing their money to grow tax free over a long period of time.
Why Tax Benefits Are Helpful to An Investor
For passive real estate investors, the bottom line is that the numerous tax benefits result in lower taxes. By extension, lower taxes mean more distributions/cash flow/profits for individual investors. For this reason, commercial investment property is a popular choice for high income earners and those looking for strategies to lower their taxes.
How is Real Estate Syndication Income Taxed?
To understand how real estate syndication income is taxed, it is first important to understand how they operate.
Commercial properties produce income from the rent that is charged to the tenants who occupy it. This income is used to pay for the expenses required to operate the property – property taxes, insurance, maintenance, legal, etc. The difference between income and expenses is known as “Net Operating Income” or NOI.
If a property has a loan on it – most do – the required debt service is subtracted from NOI and the result is an amount of money that is left to distribute to investors.
Once distributed, the money received by investors is combined with their regular income and taxed according to the bracket in which they fall. This exact calculation can be quite complicated and it varies for each individual. For this reason, it is always a good idea to hire a CPA or tax professional to make sure it is done correctly.
One of the commonly overlooked benefits of a commercial real estate investment is its ability to lower an individual’s tax burden.
This is done in a number of ways including: depreciation, operating expenses, the tax rate on capital gains, and 1031 Exchanges. In their own way, each of these items works to reduce the amount of taxes paid by an investor.
But, these strategies are complex, and they become more so as an investor’s portfolio grows. For this reason, it is important that a CPA be consulted to make sure everything is done correctly.
When it is, a syndicated real estate investment can be an effective strategy for high income earners to reduce the amount of taxes that must be paid each year.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.