When searching for the best real estate investment opportunities, you know that one of the biggest challenges is finding ways to reduce your tax burden. Fortunately, investing in a syndication can offer some significant tax benefits. Here is a look at some of the key ways that syndications can help you save when you pay taxes.
What is a Syndication?
A syndication is a solution for individuals that want to invest in commercial rental properties without the ability to present 5-10 million dollars at one time.
A real estate syndication allows deals to be structured in a way that permits individual investors to purchase a fractional share of commercial property and earn passive income.
The syndication is led by a “General Partner” or GP that will find the property and coordinate with the limited partners of LPs to raise equity to purchase the property.
When you invest in income-producing property, you are able to take advantage of a number of lucrative tax benefits. One of the most valuable is depreciation. Depreciation is a way of writing off the cost of an investment property based on its wear and tear over time. By taking advantage of depreciation, you can significantly reduce your taxable income. In addition, depreciation can be used to offset any capital gains you may realize when you sell the property. As a result, it is important to understand how depreciation works and how it can be used to your advantage.
How Does Depreciation Work?
The IRS allows investors to depreciate the cost of an income-producing property over a period of 27.5 years. This is known as the recovery period. For residential properties, the depreciation is based on the expected life of the property. For commercial properties, the depreciation is based on the expected life of the building.
What is Depreciation Recapture?
The term “depreciation recapture” is used by the Internal Revenue Service (IRS) to describe their policy that an individual cannot claim a depreciation deduction for an asset and then sell it later for a profit without being taxed on that same profit.
Investors may avoid paying income tax on depreciation recapture by converting a rental property into a primary residence or performing a 1031 tax-deferred exchange. When an investor dies and their rental property is passed on, the basis is stepped up, and the heirs pay no tax on depreciation recapture or capital gains tax.
Investors are required to pay long-term capital gains taxes when there are investment profits on sale under current tax law. Investors may also indefinitely delay them by using a “1031 exchange”.
The tax on the profits of a sale is postponed as long as the sales proceeds are reinvested in another property that is “like kind” to the sold property within a set time frame in this initiative.
There is no upper limit to the amount of 1031 Exchanges that can be completed, so an investor might use this strategy to continue rolling from one property to the next, resulting in their money accumulating tax-free over a long time.
Lower Capital Gains Rates
Another significant tax benefit of investing in syndication is the lower capital gains rates that apply to long-term investments. Capital gains are the profits from selling an asset. This is then counted towards your income and will be taxed.
If you hold an investment for more than one year, you will pay a lower tax rate on any profits you realize when you sell.
If you sell within less than a year you will be subject to short-term gains and will be taxed at your ordinary income tax rate.
Many commercial real estate assets are financed with commercial mortgage debt, and the interest paid on this debt may be deductible. Though the deduction rules can be complex, owners may be able to deduct interest and closing costs in some cases. Any money received in a cash out refinance is usually considered a loan rather than income, so it may also not be taxed.
How to Minimize Real Estate Syndication Income Taxes
The income from these syndication properties pays for the property’s maintenance, such as taxes, insurance, and upkeep. The difference between revenue and operating costs is constantly called “Net Operating Income” (NOI) or “Operating Profit.”
If a property has a loan on it – as most do – the required debt service is subtracted from NOI, which leaves an amount of money to distribute to investors.
Syndication investors nearly always qualify as passive investors, meaning they can only use losses to offset other passive income. This is outlined in the depreciation section of this article. A syndication investor could get the $25,000 allowance by playing an active role in a syndication. However, the majority of these deal agreements limit an investor’s role to capital investment.
From a tax perspective, the above means that syndication investors often end up with losses that cannot be deducted. They have more taxable losses in a single year than passive income to offset. This does not mean that investors do not receive the advantage of these losses- they are only postponed. Any losses that are not allowed in a specific year are carried over until they can either offset passive income or the asset is sold.
Jose A. Ramirez is an experienced and sought-after tax strategist who helps investors through the process of utilizing real estate syndication tax benefits and strategy. He specializes in Short-Term Rentals such as AirBNB and VRBO, Landlords, Wholesalers, Rehabbers, Flippers, Real Estate Brokers, and Realtors. Schedule an appointment with Jose A. Ramirez a tax professional for any additional questions you may about how you can strategize your tax preparation and offset passive gains. Make sure you are subscribed to the Advanced Tax Advisors email list so you can receive current events just like this in the future.