Ah, tax season – the time of year almost no one enjoys. For doctors, it’s the time of year to realize just how much of their incomes are being given to their silent partner: good old Uncle Sam.
I used to be very concerned about how much I was losing by paying taxes. Not only because as a physician in a high-paying specialty, I’m in one of the highest federal tax brackets, but I also live in a state with a high state income tax anyway…I never enjoyed tax season. At all.
But then my CPA told me something that shifted the way I think about things. He said that I shouldn’t spend so much energy trying to minimize the impact taxes had on my “day job” income. After all, there’s only so much I can do – even as a 1099. If I were a W2 employee? Forget it; there’s basically nothing anyone can do.
What I should focus on is investing my capital in a way that is extremely tax-efficient. I’ve already talked about the importance of taking your hard-earned capital and converting as much of it as possible to passive income, which is taxed much more favorably.
This tax efficiency is yet another reason I think that investing in real estate is one of the best ways to preserve and grow wealth.
So for this post specifically, I want to discuss the tax benefits of investing in passive, private real estate opportunities.
As a quick refresher, the type of deals I’m referring to are the ones where I invest my capital as a limited partner. These deals are managed by the general partners or operators. They’re referred to as “syndications” or “real estate funds.”
I really focus heavily on these because all I need to do is make the investment. Then I sit back and let the professionals put my capital to work: purchasing real estate (often multifamily properties/apartments), renovating them, and ultimately selling them for a profit.
The return on investment these types of opportunities provide can be great, but they’re made even better by the many ways real estate can benefit from tax breaks and incentives.
Remember, the tax code is, in essence, a series of incentives written by the IRS to tell people how to spend and invest their money.
And they’ve created huge incentives for investments in passive real estate.
Here are some of the top tax benefits of investing in a real estate syndication or fund.
Disclaimer: I am not a CPA, please consult a tax professional for your particular situation.
This deduction is huge – and often overlooked. In tax terms, depreciation is when the IRS allows you to deduct the cost of business items that have a “shelf life,” such as the building itself. It sounds simple, but some consider depreciation to be the most powerful tax benefit of investing in real estate.
You see, over time, the real estate in which you’ve invested is going to start breaking down. Fortunately, you're allowed to write off income-producing property based on wear and tear.
How does this work?
First, you have to determine the value of the actual building (apart from the land) and divide that value by the useful life of the property. According to the IRS, that lifespan equates to a number: 27.5 for residential property and 39 for a warehouse/commercial property. Then, each year, you deduct that precise amount.
For example, if your rental property (the building itself) is valued at $500,000, you would divide that by 27.5 years (~$18,000). Now, you can deduct $18,000 as a depreciation expense each year for 27.5 years. This deduction allows you to report a smaller profit to the IRS, thereby reducing the amount you ultimately owe in taxes. In this way, you can greatly offset the gains.
Normally, if you show a loss on paper as a result of depreciation, you can only use it to offset passive gains from other properties or investments. But, if your modified adjusted gross income is less than $100,000, then you can offset $25,000 of your income. (That's not typically physicians though.) Otherwise, if there is an excess loss, you have to carry it forward to the next year.
However, there is a way to offset some of your active income and I mention it in a section below.
The Tax Cuts and the JOBS Act of 2017 changed some of the rules around depreciation. Businesses are now able to accelerate the timeline of the depreciation and take it earlier in the lifespan of the property.
This increases the amount an owner can depreciate and deduct early on. In fact, because of bonus depreciation, you’re able to deduct about 25% of the purchase price of the building in the first year (very roughly).
For example, if the building was $4 million dollars, investors are able to deduct $1 million in the first year alone.
This has a huge impact on what shows up on your K-1.
I’ve invested in deals and received distributions, and on paper, my net income was, in fact, a loss due to the large amount of depreciation early on. So yes, I didn’t need to pay taxes on the distributions received. In fact, it offset gains from other real estate investments I made (a little more on that later)!
Now, all these deductions you’ve taken do need to be accounted for when the property is sold. Uncle Sam needs his cut. However, the rate is still maxed at 25% – much better than the top income tax bracket. Not only that, but you’ve deferred paying taxes for some years.
2) Capital Gains
As you likely already know, capital gains are the profits from selling an asset. Of course, this is counted as income and will be taxed.
Interestingly, though, the tax rate is different than the rate for traditional income. For comparison, take a look at the following tables. The first is the 2020 income tax brackets:
Compare this to the 2020 brackets for long-term capital gains (read more about “long-term” versus “short-term” here):
Real estate income income when held for more than a year is treated as long-term capital gains. And as you can see, the tax rate caps at 20% – a far cry from the 35% or 37% you might have to pay on your day job income. Compound those gains over time and it becomes even more significant.
So to make it more clear, the income you create from investing in real estate is far more tax efficient than what you make in your day job as a physician. This is what I mean when I say that not all income is created equal.
Refinancing is a great way to purchase additional assets, if that’s your goal. Essentially, with a refinance, you can borrow against the appreciation and increased equity of a property tax-free.
For example, let’s say you bought an apartment building for $500,000. You renovate the property and command higher rents. The market also improves.
The property is now worth $1 million. You do a cash-out refinance and pull out $500,000 to put toward the purchase of the next building. This process is completely tax-free, and you can utilize this cash to continue growing your streams of passive income – without paying more in taxes.
4) Mortgage Interest Deduction
This one’s pretty straightforward, but it’s important to keep in mind when tax season rolls around.
You may know that in the early part of a loan, the majority of payments goes toward the interest of the loans. These payments can be deducted.
Just as with a traditional home mortgage, interest payments from a rental property can also be deducted. This can certainly add up, especially in the first few years after purchasing a property.
5) Losses carried over to future gains or can offset current income
All of these deductions may actually end up showing as a net loss – on paper, at least. Now, normally, these deductions and losses can really only be used to offset other passive income gains.
This can be a great thing, because all the distributions you receive are essentially tax-free. If the losses exceed your gains, then you can carry those losses forward to offset other passive income.
However, there is a way to carry these losses beyond just other passive income and into the realm of “active” income, thereby greatly reducing your overall tax rate.
You see, in the eyes of the IRS, “passive” income (such as that from a rental property) and “active” income (such as your day job) are quite different. I talk a lot more about this here, but to summarize, losses from passive income can only be used to offset other passive income. Likewise, to offset losses from active income, you’d need to show active losses.
With something known as Real Estate Professional Status (REPS), however, all of your passive real estate income & losses can be considered active.
In other words, if you can obtain REPS, you can use any real estate losses to decrease the amount of income taxes you are liable for – even your physician income.
This can be hugely beneficial. There are a few requirements in order to obtain Real Estate Professional Status, however, so that is something to consider. Again, visit this link to learn more.
Adding up all these deductions and benefits can result in huge gains as an investor. Compound these gains over time, and it’s pretty clear how this can result in significant gains.
This is, of course, in addition to the profits you’ll accrue from these passive ventures. With a little knowledge and strategy, that profit can be maximized to its true potential – even when Uncle Sam comes knocking.
And if you’d like even more in-depth knowledge so you can confidently in invest in these private, passive real estate deals, be sure to check out our course: Passive Real Estate Academy. This course will cover everything you’ll need to know – including actionable steps you can take right away.
Join the waitlist here to get access to a discounted price on the course.