The Investor’s Guide to Maximizing Tax Benefits with Passive Real Estate Investments
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As we approach tax season, it's important to consider how passive real estate investing, such as investing in syndications and funds, can benefit you as an investor from a tax perspective. In this article, we will examine various ways that investors can maximize their tax benefits through passive real estate investing.
However, it's important to note that I am not a tax professional, CPA, or trained professional, and the information presented here is not meant to replace professional advice.
My goal is to provide useful insights to help you understand the tax benefits of passive real estate investing. Let’s explore the benefits of passive real estate investing from a tax perspective.
BENEFITS OF PASSIVE REAL ESTATE
As a busy physician, I continually look for ways to find the best use of my time and expertise. That's why passive real estate investing makes sense for many high-income professionals. It also provides several tax benefits that can help us maximize our returns.
Active real estate investing can be time-consuming. While passive real estate investing allows investors to leverage the expertise of others and still receive the benefits of real estate investing. By investing in syndications and funds, we can take advantage of the experience and knowledge of seasoned real estate professionals.
However, it's important to note that the tax benefits of passive real estate investing can vary based on location and jurisdiction.
For example, I live in California, so you can imagine I get a bigger hit than those of you who might live in states like Florida or Texas, which don’t have any state income tax. To fully understand the tax implications of your investments, it's important to educate yourself and partner with a tax professional who can provide personalized advice.
In this article, we are talking about passive real estate investing, specifically through syndications and funds, which offer unique tax benefits that can help investors save on taxes. But what exactly is passive real estate investing?
Passive real estate investing involves investing in someone else's real estate deal. A sponsor is responsible for finding and managing the properties, dealing with tenants and property managers, and ultimately handling the sale or disposition of the property. As a passive investor, you can leverage their expertise, experience, and capital to earn returns without actively managing the property yourself.
So for many people out there, passive real estate investing might be the way to go. In fact, whenever I pull audiences, I get about 75% of people who say they prefer passive versus active investing. Now myself personally, I do both, because I like to take advantage of both the pros and all the benefits that come with both. I tried to maximize that while minimizing the time I put into it, but you have to figure out what is best for you.
That said, here are some of the common tax benefits available to passive real estate investors:
Depreciation is a tax benefit that applies to real estate investments. Buildings, carpets, or other items within a property have a lifespan, and their value decreases over time. The government allows active real estate investors to write off this decrease in value each year. However, passive investors can also benefit from depreciation. When investing in a syndication or fund, you own a share of the building and can take advantage of its depreciation value.
Cost segregation is a way to further maximize this benefit. By hiring someone to do a study of the property, the value of each item within the building can be accurately determined, and you can get an idea of what the depreciation cost will be. This creates passive losses on paper, which can offset active income. However, there is a wall between passive and active losses that the government has created to prevent high-income professionals from taking advantage of this loophole.
It's important to ask syndicators about their plans for cost segregation and depreciation, as it can impact the amount of passive losses you can claim. Bonus and accelerated depreciation are options that allow you to take more of the depreciation value upfront, which can be beneficial for your tax situation.
For example, investing $100,000 in a syndication can cause a paper loss of $50,000 or $70,000, depending on the aggressiveness of the sponsors in utilizing cost segregation and depreciation. Understanding the impact of depreciation and cost segregation can help you maximize your tax benefits as a passive real estate investor.
2. PASSIVE LOSSES
Passive losses, as mentioned earlier, refer to losses from your real estate investments that can offset any gains or distributions received from the property. These losses can be incredibly beneficial to investors, especially in terms of tax savings. For example, if you have a passive loss of $70,000 and receive $20,000 in distributions, you would only have a negative $50,000 balance, which means you wouldn't have to pay taxes on that distribution. This benefit continues throughout the investment's lifetime until you make enough profit to offset that initial passive loss.
Furthermore, passive losses can also be used against other investments, creating a situation where you can offset other gains and pay less in taxes. This is a powerful technique that many passive investors use to minimize their tax burden. Some even refer to it as the “lazy man's syndication 1031 exchange,” which is another way to defer capital gains and kick the tax can down the road.
It's important to note that while passive losses can be a powerful tool for tax savings, consult with a tax professional to ensure you are using them correctly and within the law. Nonetheless, it's a technique that can make a significant difference in your investment returns and, ultimately, your bottom line.
3. SYNDICATION LADDER
The third tax-saving strategy for passive real estate investors is the Syndication Ladder. This technique involves investing in multiple syndication deals simultaneously and strategically timing them to maximize gains and offset losses. Here's how it works: if you anticipate a large gain from one syndication deal in a particular year, you can invest in another syndication deal in the same year that you know will create a loss, which can offset the gain from the first deal. This technique, known as the syndication ladder, can be a powerful way to minimize your tax liability.
By discussing this strategy with your CPA, you can determine the best approach for your personal situation. The syndication ladder allows you to kick that tax can down the road and continue to defer your taxes. However, the ultimate goal is to gain tax-free profits, which is a huge benefit for high-income professionals who are typically taxed heavily on their income.
4. 1031 EXCHANGE
The fourth benefit of a real estate syndication is the 1031 exchange. It allows investors to defer capital gains taxes by reinvesting the proceeds from the sale of a property into a “like-kind” property within a specific timeframe. When a property is sold, the proceeds are placed into a separate account and can be used to invest in another deal. By doing this correctly, you can avoid paying taxes on the proceeds at the time of the exchange and kick the tax liability down the road. You can continue exchanging properties until the final disposition or exit of the investment when you'll pay taxes on the gains.
However, if the owner passes away before realizing the full investment, the property is passed on to their inheritors, who receive a stepped-up basis. This means they inherit the property at its current value, not the original value, and all the profits and taxes reserved are wiped out. This creates a significant benefit for future generations and is why real estate syndication can create generational wealth. It's important to note that not all syndications offer this option, and it's crucial to discuss this with your CPA and the syndication sponsor before investing.
For instance, one story involves a person who invested $60,000 in a syndication in 1995. Since then, he exchanged his investment several times, reinvesting the proceeds into other syndications. Today, his asset value is worth $2.36 million, and he received $1.6 million in tax-free cash flow from the investment. The 1031 exchange is a powerful tool that can help you compound your investments over time, but it's important to understand the rules and qualifications before entering any deal.
I have a friend named Jeff, whose uncle has been investing in syndications for many years. Jeff shared with me an amazing story of his uncle's success…
In 1995, his uncle invested $60,000 in a property. He eventually sold the property in 2001, but instead of pulling out the money, his uncle exchanged it for the next property, which was held for another 15 years, until he sold it again in 2016. The proceeds from that sale were then exchanged for the next property, which was sold in 2020. His uncle was able to take the proceeds from that sale and invest in two different real estate investments.
Today, if you look at his initial $60,000 investment, his asset value is equivalent to $2.36 million from these investments. His uncle compounded his gains over time through 1031 exchanges.
Since 1995, his uncle also received $1.6 million in distributions, meaning profit from these investments. There have been several refinances, which also did not get taxed throughout these passive investments. In addition, his uncle was able to cash out on another $1.6 million for his initial $60,000 investment.
This story shows the power of investing in real estate through syndications and utilizing 1031 exchanges to compound gains over time. It's amazing to think that starting with just $60,000, his uncle was able to achieve an asset value of $2.36 million and receive $1.6 million in tax-free cash flow.
5. TAX-DEFERRED ACCOUNTS
Another tax benefit of real estate investing is the ability to use tax-deferred accounts such as self-directed IRAs and self-directed 401(k)s. It's important to consult with your tax professional and those who manage these accounts, but you can often invest in real estate using retirement funds. While you may not get all of the tax benefits available, investing with retirement funds allows you to benefit from compounding your profits over time and deferring taxes until a later date.
6. REAL ESTATE PROFESSIONAL STATUS
The sixth benefit of investing in real estate is taking advantage of real estate professional status. Real estate professional status is when you, your spouse, or partner meet certain criteria in terms of time and involvement in real estate deals, and it must exceed your current day job.
If you qualify, you can use the losses on your real estate as passive losses to offset your day job income. This is a powerful strategy for those with a high amount of W-2 income. Even with passive investments, you can still take advantage of this strategy by being actively involved in managing the investments.
For some who qualify as real estate professionals, they can invest passively in syndications and funds, and still take massive losses on their capital invested income. This is a great way to leverage time, income, and capital while taking advantage of depreciation and cost segregation. However, it is important to note that tax laws can be complex and can vary depending on the state and area you are in.
The world of passive real estate investments offers many opportunities for maximizing tax benefits. While not all of these strategies may apply to every individual, it is important to be aware of them and ask the right questions of your tax professional. By taking advantage of these benefits, you can impact your bottom line and keep more money in your wallet.
As high-income professionals, time is a precious commodity, and investing in passive real estate can help you regain control of it. So go out there and explore the possibilities, and remember to consult with your trusted tax advisor for guidance along the way.
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Disclaimer: The topic presented in this article is provided as general information and for educational purposes. It is not a substitute for professional advice. Accordingly, before taking action, consult with your team of professionals.