These Are The Six Tax-Related Benefits Every Passive Real Estate Investor Should Know
- Thousand Doors Group
- Dec 16, 2022
- 9 min read
These Are The Six Tax-Related Benefits Every Passive Real Estate Investor Should Know
When you first begin investing in real estate, it is very normal for you to not give much thought to the taxes that may be incurred as a result of your activities. The reason for this is that, in contrast to investing in stocks and mutual funds, investment in real estate typically results in a decrease, rather than an increase, in one's tax liability. You did read that sentence correctly. While at the same time providing you with excellent returns on your investment, investing in real estate can frequently reduce the total amount of taxes that you are responsible for paying.
You might be asking, "But how is that even possible?"
The Internal Revenue Service regards gains made in the stock market very differently than gains made in real estate. This difference is actually rather substantial. And that is precisely what we are going to talk about in this post, specifically from the perspective of a passive investor in a real estate syndication.
But Before That, an Important Disclaimer
I would like to make it clear that I am not a tax professional, nor do I intend to pursue such a career in the future (those people have really tough jobs). As a result, the only source for the ideas and viewpoints presented in this post is my own personal experience.
You need to have a conversation with your certified public accountant (CPA) to obtain additional data and specifics on your circumstance. Now that we've gotten that out of the way, let's proceed with the discussion.
#1 – The Tax Code Favors Real Estate Investors
You may have heard that investing in real estate is the single most common way for people to make millions of dollars, surpassing any other means. And whether you want to believe it or not, a significant part of that is determined by the tax law.
Because of this, the Internal Revenue Service acknowledges the significance of real estate investing is providing living mediums for individuals to occupy. As a result, the tax code is constructed in such a way that it provides incentives to real estate investors for purchasing real estate, performing maintenance and upkeep on the units they own, and implementing improvements over time (more on these benefits in a moment).
#2 – As A Passive Investor, You Get All The Tax Benefits An Active Investor Gets
This is a really important matter. Whether you are an active or passive investor, this indicates that you are eligible for the full range of tax benefits available, regardless of whether or not you are actively involved in the management of the property.
When you invest in one of the apartment syndication projects with Thousand Doors Group, you are investing in an entity (typically an LLC or LP) that owns the property, and that entity is disregarded in the eyes of the IRS (these entities are sometimes referred to as "pass-through entities"), this is why.
This indicates that any tax savings accrue directly to you, the investors, rather than to the corporation being invested in.
Take note that the rules are different when it comes to investing in REITs. Investing in a real estate investment trust (REIT), as opposed to investing directly in individual properties, means that you will not receive the same tax benefits.
Common tax advantages of investing in real estate include the ability to deduct expenses related to the property (such as repairs, utilities, payroll, and interest), as well as the ability to deduct the value of the property over the course of time.
Let's pay attention to something that's called depreciation.
#3 – Depreciation Is VERY Powerful
The value of an asset can be written off over time through a process called depreciation. This is based on the amount of wear and tear that an asset experiences as well as its useful life.
What is the meaning of depreciation?
To illustrate this point with a straightforward illustration, let's imagine you recently invested in a brand new laptop. The very first day, that laptop functions perfectly. However, after some use, the keyboard will become sticky, the CPU will become less efficient, and the battery will only last for a few minutes at most. In the end, the entire thing will be rendered useless and will be worth very little, if anything at all. This is the crux of the matter when it comes to depreciation.
In essence, the Internal Revenue Service (IRS) is admitting that, if the property is used constantly and you make no efforts to maintain or improve it, then, over the course of time, the property will degrade as a result of natural wear and tear, and at some point in the future, the property will become uninhabitable. This is an acknowledgment that the IRS has made (just like when that laptop eventually dies).
You may probably guess that the useful life of each asset is different. One should not anticipate that a laptop will continue to function for more than a few years. On the other hand, you would anticipate that a house will still be standing after a number of years or even decades had passed.
The Internal Revenue Service (IRS) enables individuals to deduct the cost of residential real estate purchases over a period of 27.5 years.
Take note that only the building itself can qualify for depreciation benefits; the land itself does not. The Internal Revenue Service is perceptive enough to see that the land will still exist in 27.5 years and will retain the same value, if not increase in value.
Take a look at this example:
Suppose you spent one million dollars on the acquisition of a property. Consider that the value of the land is $175,000, whereas the value of the structure is $825,000.
Using the most fundamental method of depreciation, which is referred to as straight-line depreciation, you will be able to write off the same amount of the $825,000 each year for the next 27.5 years. This indicates that you are eligible to claim a tax deduction of $30,000 annually owing to depreciation ($30,000 multiplied by 27.5 years equals $825,000).
The following is the reason why this is such a significant issue: Let's imagine that during the first year you own the property, it generates cash-on-cash returns (also known as cash flow) in the amount of $5,000. You will not have to pay taxes on the $5,000, and you will be able to keep it in a tax-deferred account (i.e., without having to pay taxes on it until the property is sold).
*Disclaimer: The specifics of how your taxes are structured will determine how this affects you. We ask that you consult your tax preparer.
Because of the depreciation of $30,000, it appears that you have actually lost money, despite the fact that in reality, you have made $5,000.
Additionally, properties acquired after September 27, 2017, are eligible for bonus depreciation, which can significantly amp up the tax benefits for that first year. This eligibility period runs from the date of acquisition to the end of the following year.
The power of depreciation comes from this very reason.
#4 – Cost Segregation Is The Advanced Version of The Depreciation
In the last illustration, we went over a concept known as straight-line depreciation, which enables the owner of an asset to write off an equivalent portion of the asset's value each year for a period of 27.5 years.
However, the majority of the apartment syndications in which we invest require a hold term of only about five years or less. Therefore, if we were to make the same deduction each year for 27.5 years, we would only receive those benefits for a total of five years. We would be passing up the benefits of depreciation for the remaining 22.5 years of the asset's life.
The concept of cost segregation is introduced here.
The practice of cost segregation recognises the reality that not all of the property's assets are created equal in value. A good illustration of this would be the fact that the roof on top of the building has a significantly longer lifespan than the printer in the back office.
An engineer will do a cost segregation analysis on a property in order to categorize the various components that make up the whole. These components will include things like outlets, wiring, windows, carpeting, and fixtures.
There are some things that can have their depreciation calculated over a shorter period of time, such as 5, 7, or 15 years, rather than over 27.5 years. This has the potential to significantly increase the advantages of depreciation in the early years.
Take a look at this example:
A real estate syndication business made the purchase of an apartment building in December of the year that it was built a few years ago. This indicates that the investors only had possession of the asset for one month of the given calendar year.
However, the depreciation schedule was sped up for a great number of the objects that were a part of the property. This included things like the landscaping and the carpeting. This was mostly because cost segregation was used.
If you had invested $100,000 in that real estate syndication, the K-1 form that was mailed out to investors the following spring stated that you would have incurred a paper loss of $50,000 if you had done so.
That amounts to fifty percent of the initial investment.
Simply for the fact that you owned the property for even just one month during that particular tax year. And if you meet the requirements to be considered a real estate professional, you may be able to apply that paper loss to the remainder of your taxes, including any taxes that you owe based on your salary, other investment gains, or side business.
#5 – Capital Gains And Depreciation Recapture Are Things You Should Plan For
You didn't seriously believe that investing in real estate would result in a complete absence of tax liability, did you?
Sadly, the Internal Revenue Service (IRS) wants to be a part of everything. When it comes to real estate investing, the manner that they get their cut is through the payment of capital gains taxes upon the sale of a real estate asset, and sometimes, depending on the sale price, by the payment of depreciation recapture as well.
If you participate in a real estate syndicate that retains a property for five years, you won't need to be concerned about paying taxes on capital gains or depreciation recapture until the asset is sold in year five.
The particular amount of capital gains and depreciation recapture is contingent not only on the duration of the hold time but also on the individual tax rate that you fall into.
According to the new tax law for 2018, the following tax rates and percentages will be in effect:
$0 to $77,220: 0% capital gains tax
$77,221 to $479,000: 15% capital gains tax
More than $479,000: 20% capital gains tax
#6 – Some People Invest In Real Estate Solely For The Tax Benefits
Because of the significant positive impact that investing in real estate can have on one's tax situation, many people, particularly those with greater financial resources, choose to do so solely for the purpose of maximizing their potential return on investment. You see, if they invest in real estate, they are able to take advantage of the significant write-offs, and then they are able to apply those to the other taxes that they owe, which results in a reduction in their overall tax bill.
This is how tycoons in the real estate industry are able to make millions of dollars while owing almost nothing in taxes.
It does not violate any laws, and it is an effective method for accumulating riches. Additionally, one does not need to have a lot of money in order to enjoy the tax benefits that come with investing in real estate. The Internal Revenue Code ensures that every person who invests in real estate can take advantage of the numerous financial advantages associated with doing so.
Conclusion
When you invest in real estate, particularly as a passive investor in a real estate syndication, you won't need to be concerned about paying taxes as a result of your investment, as I said at the beginning of this post. You will have the opportunity to generate money through cash-on-cash returns in the majority of situations; but, you will not be required to pay taxes on the money you make as a result of perks such as depreciation.
To summarize, the following are the six aspects of taxes that I believe every real estate investor should be aware of:
The tax code favors real estate investors.
As a passive investor, you get all the tax benefits an active investor gets.
Depreciation is hecka powerful.
Cost segregation is depreciation on steroids.
Capital gains and depreciation recapture are things you should plan for.
Some people invest in real estate solely for the tax benefits.
If you choose to invest in real estate using a passive strategy, you won't need to "do" anything in order to reap the financial rewards that come with this type of investment. Being a passive investor has many advantages, and this is one of them. There is no requirement for you to keep any receipts or list the repairs. You simply obtain that wonderful K-1 each year, give it to your accountant, and that's it. There are no further steps.
WE'RE HONORED TO BE IN BUSINESS WITH YOU
Building wealth doesn’t always require you to do all the work you normally would as an independent real estate owner/investor. You can also accomplish the same goal by taking advantage of a syndicated real estate project.
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