By Joe Firmin 3-minute read
OK, Fine I lied. Glad I got that off my chest. Taxes will never be your best friend. Sorry. BUT - wait...
BIG FAT DISCLAIMER
So you're aware, I am not a tax professional, nor do I want to become one, ever, those folks are sharper than me. That being the case, all thoughts and insights (hopefully) in this article are from my experience, research or discussions with tax professionals only and in no way represent expertise or legal advice.
For your situation, please speak with your CPA for more details. They'll be impressed.
Got it. Good. Let's get on with it.
While taxes might not be your best friend, the IRS love real estate investors and business owners. The tax code was written to incentivize behavior.
What? Yes, it's true. As Nobel Prize-winning economist Milton Friedman famously said,
"If you want more of something, subsidize it."
Governments know that in order to keep people from revolting they need to meet the basics: food, shelter, clothing and... apartments.
Something like that... Anyway, the gist is, if those things keep people happy, then they need to provide them and since we live in the grand ole USA and not Cuba, the government has to incentivize good citizens to provide these needs.
Thus, when people like real estate investors do these things - the government throws a few bones their way. If you invest passively in real estate through a syndication, you also benefit because you are doing what the government needs - improving local communities.
What's that? Oh - "What are these benefits??" You say? Well... Here they are:
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Deductions
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Depreciation
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Cost Segregation
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1031 Exchange
There's plenty more, but let's start simple.
DEDUCTIONS
More of them. These are business expense deductions. All the expenses you have for your business - yes, business - are deductible. If you are a passive real estate investor, you are investing in a business, part of an entity that owns real estate. That business has expenses - gas, water, electric, maintenance, legal, etc. In addition, your own travel expenses, costs for legal or accounting, etc.
"Any one may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury. There is not even a patriotic duty to pay one's taxes."
Judge Learned Hand
DEPRECIATION
Technically, this is a deduction too. But, since it is such a sweet deduction, it gets its own spot. Commercial property is depreciated over 39 years, BUT... residential properties can be depreciated over 27.5 years. Yet one more reason we love multifamily.
"Woah, woah woah, hold up, what's depreciation?"
Say you buy a lawn mower. First week, it purrs like a tiger, cuts soooo fine. Bob, your neighbor, #jealous. The next summer - um yeah... it is a little clunkier, blade is worn down, you have to make a couple passes, it starts up with a sputter... After a couple summers, it's dead and you're thinking about just hiring someone to cut your dang grass. That's essentially depreciation - an asset loses its useful life over time, the IRS is just acknowledging that fact.
So, let's use a real estate example - Jim. Jim is a passive real estate investor and just took part in a syndication that purchased a multifamily apartment complex for $30 million dollars. Nice!
The land is worth $2.5 million, and you can't depreciate land - it doesn't lose value over time like a normal asset does. God only made so much of it you know? So, since you can't depreciate land, then you're left with $27.5 million in value of the multifamily apartment complex. The IRS will let you deduct $1 million dollars each year.
Based on Jim's part of the syndication, he received $10,000 in returns that year from this investment. It so happens his portion of that $1 million in depreciation, is - $15,000.
Since he can use the depreciation as a deduction, on paper, Jim lost money. But he actually received cash flow that year of $10,000 - TAX FREE.
What!?
Yep.
Depreciation can assist in turning an operating gain into a paper loss... sweet sweet magic. But we're not done...
COST SEGREGATION
So now we see how beautiful depreciation is, cost segregation is like a depreciation machine with a rocket strapped to its back! Heck yeah!
Normal depreciation, in technical terms - straight line depreciation, is the example above of the complex and 27.5 years. Cost segregation comes in where the IRS says, "Ya know what, a refrigerator isn't going to last 27.5 years! So let's lower that depreciation timeline." It allows you to hire a cost segretation "engineer" to identify and separate out all the different personal property (appliance, doors, shutters, etc...) of a property and depreciate them on different schedules. This results in some serious depreciation sooner than later!
That paper loss could look a whole lot larger now. Am I right? Yes.
1031 EXCHANGES
This one is pretty neat. A way to not kill the fattened calf, but to keep letting that calf get bigger and bigger...
Typically when you sell an investment property, you have to pay tax on the profit from the sale, the capital gains. Unless... you use the magic of the "1031 exchange."
It's referred to as 1031 because that the part of the tax code where it talks about this stuff and "exchange" because that's what it is - you can sell the one investment property, and, within 180 days, "exchange" that asset for another like-kind investment property. So instead of getting the cash profit paid to you, it goes directly towards the purchase of a "like-kind" investment property that you've traded up for. Pretty cool huh? Don't pay tax and you get a bigger, badder property? Yes, please.
This is great and easier to do if it is your investment property and yours alone. If you are part of a real estate syndication, this is tougher. In order for it to work in a syndication, ALL of the passive investors must agree to a 1031 exchange to make it a possibility. This means they can't take out their profits from the sale...
Tough to execute but can be done. Make sure you talk to the sponsor of the opportunity you are going to invest about this option up front.
CONCLUSION
I know that was some heavy stuff, but the great thing for passive investors is they don't have to do anything about it. The sponsor of the deal will handle the execution and the passive investor will get their K-1 tax document which will have taken all these great benefits into account.
As always, make sure to consult with your own CPA or tax professional as your particular situation can be different and you want to plan to benefit as best you can.
If you’d like to discuss with me, I’d be happy to jump on a call with you. Schedule a call HERE.
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