Tax Strategies for Real Estate Investors

by | Mar 7, 2023 | Investing Process, Passive Investing, Real Estate Investing 101 | 0 comments


Taxes aren’t the most exciting aspect of real estate investing, but they’re important to understand nonetheless. As a real estate investor, it’s much more fun to focus on great returns and upgrading your lifestyle, but you must be sure to not overlook taxes completely. 

As a passive investor in a real estate syndication, your sponsor team will guide you through tax season and help you ensure you’re getting the tax benefits you deserve. The beauty of investing in real estate is that your investments lower your tax obligation rather than increase it, unlike some other investment vehicles, such as mutual funds, and stocks. 

Any time you’re investing your hard-earned money, you should do your due diligence to gain a working knowledge about how you may be taxed as a result of your investment and explore the best strategies to decrease your tax bill. 

Keep reading for an overview of the best tax strategies and to learn how to maximize the tax advantages available to you as a real estate syndication investor.

Note: BluSky Equity Partners is not a professional tax advisory service. This information is believed to be accurate as of the time of publication and has been vetted by a tax professional, but it is not all-inclusive. Always consult your own tax advisor for your unique tax situation.

Deciding on Your Entity Election

Oftentimes, real estate investors ask how setting up their entity will change the amount of deductions they’re allowed to take on their taxes. The allowable deductions don’t change whether you’re investing under your personal name and social security number, through a single-member limited liability company (LLC), or through a multi-member LLC or corporation. The tax deductions are the same and include all business-related expenses.

As a real estate investor, it’s wise to avoid electing C-corporations to set up your real estate investing business. With a C-corporation, all your earnings can be taxed more than once – the corporation is taxed, and your personal earnings are taxed. To simplify things as you’re just starting out, we recommend forming a single-member LLC in a state that offers single-member LLCs good asset protection (not all of them do). Keep in mind that you don’t have to be the sole member…it might be your estate plan, and you’re just the manager. There are many ways to form your entity, so we recommend consulting an attorney.

Keep in mind that in order to receive the benefit of asset protection, you need to keep your personal and business assets separate. You should have separate business and personal bank accounts and be sure not to intermingle the funds. Maintaining separate accounts allows you to protect the integrity of your business entity.

During the startup phase of your business, it should be noted that any costs you incur, even before opening your entity, are tax-deductible. These startup expenses include, but aren’t limited to, legal fees, research, travel to look for and tour properties, and other professional fees. 

Taxes and Real Estate Syndications

Real estate syndications are typically set up as multi-member LLCs and file tax returns as a partnership. The lead syndicator, or sponsor, is typically a general partner and the investors are the limited partners.

The real estate syndication itself is not taxed. It’s a pass-through entity, meaning that the items of income and expenses that occur at the syndication level, as well as the gains and losses, are passed on to the partners. The partnership tax return is for information only and to calculate the individual portions reported on the investor K-1 statements. There will be separately stated items on the K-1 that each syndication member will be liable for and taxed on accordingly.

The items reported on the K-1 and your cash distributions are different. The cash distributions you receive as returns are not subject to tax, to the extent of your tax basis in the syndication. Simply put, your tax basis is your initial capital investment into the real estate syndication deal, so maybe $50,000, plus any current year contributions and pass-through income, minus any losses and expenses. Expect the tax basis to go up and down every year. As long as you maintain a positive tax basis, any cash distributions are tax-free. Any excess cash distributions you receive will be taxed as dividends. 

The lead syndicators have flexibility in how they choose to allocate the various items. The real estate syndication operating agreement can be written to reflect the various allocations, depending on the needs of the partners. 

Taxes and Rental Real Estate

As a limited partner in a syndication, you’ll be earning passive income. Passive income is different from earned income, or W-2 income. Passive income is considered the same way as interest dividends. Generally speaking, passive losses can offset passive income to reduce your taxes, but passive losses can’t offset earned income. 

There is a special allowance for rental losses. If your adjusted gross income as a married couple is $150,000 or less, you can take up to $25,000 of these passive losses. However, if your adjusted gross income is higher, you cannot take any passive rental losses against earned income unless you qualify as a real estate professional under IRS rules. Real estate professionals have a special designation that allows them to take passive losses against their earned income since the majority of their earned income is also from real estate.

It’s common for real estate investors to qualify for this designation. There are three parameters that must be met in order to qualify for this designation. The first is that at least 51% of all the investor’s working time and services must be in real estate-related activities. Also in one calendar year, the investor has to do more than 750 hours in a rental real estate trader business. Third, the real estate professional has to materially participate in their business’s real estate activities (passive investing doesn’t qualify as material participation). A real estate trader business can include rental property management, syndication deal sourcing, brokering properties, etc. 

Be sure to discuss your personal situation with a CPA. Changes can happen quickly, and what you qualify for one year may be different the next year. Small changes can impact you greatly at tax time, so always seek professional advice from your CPA or tax advisor. 

The Power of Depreciation and Cost Segregation

Since wear and tear on a property over time is expected, you’re allowed to write off the depreciated value of an asset over time. You’re allowed to write off the value of residential rental assets (including apartments) over 27.5 years and commercial properties can be written off over 39 years. 

Depreciation affects you, as the investor, because when you receive cash flow distributions, the tax on the amount you receive is deferred; this means you aren’t required to pay taxes on the earnings from the asset until it’s sold (as long as the basis is positive). 

Cost segregation amps up the tax advantages even further. In typical real estate syndications, the property is held for around five years. With straight-line depreciation, properties depreciate the same amount every year. By the sponsor utilizing cost segregation, we’re able to take into account the various components of the property that depreciate at a quicker rate. For instance, the signage of an apartment complex is expected to deteriorate quicker than the roof. Cost segregation can speed up depreciation benefits, so investors can take more depreciation earlier on, even within five years’ time. When available, bonus depreciation can maximize the benefit of cost segregation even further.

Tax Benefits of Investing in Real Estate

By investing in real estate, either actively or passively, you can qualify for significant tax advantages. You can use the deductions earned from real estate investments to offset your other income and ultimately decrease your tax bill each year. 

To build wealth, it’s not enough to earn income; you also have to know what strategies can best help you maximize the tax benefits available to you. Investing in real estate syndications gives regular people the chance to build wealth quickly and sustainably, while also mitigating risk.

As always, be sure to consult your CPA or tax advisor to assess your personal situation and determine what strategies best fit your needs and financial goals. 

Further reading: High-Level Concepts – Fuel for Your Wealth-Building Strategy