Real estate crowdfunding is a growing investment opportunity for investors looking to share in real estate gains without managing properties themselves. Crowdfunding pools funds from multiple investors to finance a real estate project (the project could be almost any type of real estate: a single-family house flip, a multi-family development, or a commercial real estate rental, just to name a few possibilities). The project is then managed by a real estate sponsor, which secures the property on behalf of the investors, oversees the design and construction of the property, and facilitates the sale or ongoing property management of the asset.
Crowdfunding is particularly appealing to several groups of investors, including those who
- Aren’t willing or able to fund an entire project on their own,
- Don’t have the time, knowledge base, or desire to manage the project themselves,
- Wish to invest in one of the best cities for real estate investing, even if they don’t live near one of those cities,
- Want to leverage the network of well-connected sponsors who benefit from discounts on materials, labor, and project management software, or
- Want to take advantage of the many real estate crowdfunding tax benefits.
In this article, we are going to explain the tax benefits of real estate crowdfunding for investors. You’ll find out how an investment in crowdfunded real estate can potentially save you money on your income taxes.
One quick note before we proceed: if you’re new to crowdfunding, you can explore the ins and outs of this unique real estate investment model in our article, Real Estate Crowdfunding Explained. Now, on to the tax benefits of real estate crowdfunding.
Key Tax Advantages of Real Estate Crowdfunding
The tax advantages available to you as a crowdfunding investor depend on whether you are a “debt investor” or an “equity investor.”
A debt investor acts like a lender, owning the debt, but not a share in the underlying real estate. Being in debt investor comes with some tax benefits, but not the full range of possible tax advantages.
An equity investor acts as an owner, holding an ownership stake in the property. As an equity investor, you are entitled to many of the same general tax benefits of real estate investments as an individual. We will note which type of ownership is required for each of the tax advantages as we list them.
The key tax advantages of real estate crowdfunding are:
1. Lower Tax Rate on Long-Term Capital Gains
2. Depreciation Deductions
3. Funding with Tax-Advantaged Retirement Accounts
4. Mortgage Interest Deductions
5. 1031 Exchanges in Crowdfunding
6. Use Any Losses to Offset Taxable Gains
1. Lower Tax Rate on Long-Term Capital Gains
“Capital gains” is the financial term for proceeds from investments. To encourage long-term investing, the IRS charges lower tax rates on long-term capital gains (for assets held for one year or longer) than on earned income. Side note: short-term capital gains (for assets held for less than a year) are taxed as ordinary income.
Lower tax rates on long-term capital gains apply to both debt and equity investors.
Example of Long-Term Capital Gains Savings
Let’s assume you are a high-income earner using crowdfunding as one of your high-net-worth investment strategies. At the highest-income tax bracket, your ordinary income is taxed at a rate of 37% (using the 2023standard marginal income tax bracket). However, the long-term capital gains rate for real estate investments is currently 20% according to the IRS.
If you were to earn $50,000 on your long-term crowdfunding investments in 2023, you would likely pay $10,000 in capital gains taxes (20% of $50K). Compare this to paying $18,500 at the ordinary income rate (37% of $50K), and you see a tax savings of $8,500!
2. Depreciation Deductions
Rental property depreciation is an accounting tool that allows real estate investors to deduct a scheduled percentage of the value of the property from their income tax calculations each year. The theory behind the depreciation deduction is that structures physically deteriorate over time, and investors should be able to claim this “value loss” on their tax returns.
It is important to note that this depreciation applies only to the structure, not the land. This is because the value of land does not typically deteriorate over time due to normal wear and tear as structures do.
This tax-saving deduction can be used by equity investors in crowdfunded rental properties.
Example of a Depreciation Deduction
The formula for calculating rental property depreciation is a bit complex, but here is a simplified example of how your income taxes could be reduced by depreciation.
Let's assume you invest $20,000 in a crowdfunded single-family rental. By dividing your $20,000 investment over the IRS’s projected 27.5-year lifespan of a residential structure, you can claim a depreciation deduction of $727.27 each year. This translates to $727.27 in earnings that are not subject to taxation annually.
In the real world, structures do not become worthless as projected by the IRS’s depreciation schedule. In fact, many structures appreciate in value despite wear and tear. Consequently, the IRS has introduced a "depreciation recapture" clause, which requires investors to repay the amount of depreciation deductions claimed if the property is sold at a profit. Having said that, it is possible to defer depreciation recapture through a 1031 exchange, a topic we will discuss later in this list.
3. Funding with Tax-Advantaged Retirement Accounts
Retirement accounts inherently offer tax advantages. Traditional IRAs and 401(k)s, for example, allow pre-tax contributions. This means you don’t have to pay upfront income taxes on the money you contribute to these retirement accounts, and without that tax expense, you have more money available to invest. Roth IRAs, on the other hand, take post-tax contributions (so you do pay upfront income tax on the amount of income contributed to the account), but then you can pull your money out tax-free during retirement.
You can invest in real estate crowdfunding with tax-advantaged retirement accounts through the use of a “self-directed retirement account.” A self-directed retirement account is simply a retirement account that allows for more investment types than traditional stocks, bonds, and funds.
You can earn these tax benefits regardless of whether you act as a debt investor or equity investor.
Example of Funding with Tax-Advantaged Retirement Accounts
Let’s say you decide to invest $5,000 in real estate crowdfunding with a self-directed IRA. Immediately, you get a tax benefit because this $5,000 is not subject to income tax. So, if you’re in the 24% tax bracket for example, this equates to a tax savings of $1,200, which you can use to invest more and grow your real estate portfolio faster!
Note: You should review the retirement account contribution limits imposed by the IRS before investing for retirement account tax breaks.
4. Mortgage Interest Deductions
The mortgage interest deduction allows investors to deduct the portion of their mortgage payment allocated to interest from their taxable income.
If you are an equity investor in a crowdfunded project with a mortgage, you are entitled to this deduction. Reputable crowdfunding platforms should keep meticulous financial records and provide the relevant tax forms to each investor each year with details on their prorated share of the mortgage interest expenses incurred.
Example of a Mortgage Interest Deduction
Let’s say you are a 10% equity investor in a mortgaged crowdfunded project. If the mortgage interest expense for this year is $2,000, you can deduct $200 from your taxable income.
5. 1031 Exchanges in Crowdfunding
A 1031 exchange is a way to defer capital gains taxes and depreciation recovery on the sale of real estate assets. With a 1031 exchange, you reinvest the proceeds from the sale of one real estate investment into another real estate investment; since you don’t actually receive the income from the sale at that point, taxes are not due. Taxes will only become due when you realize the proceeds by selling the replacement property. In the meantime, your real estate holdings are essentially appreciating tax-free.
The rules governing 1031 exchanges are complicated. In 1031 Exchanges Explained, we go into detail on how a 1031 exchange works. But for the purpose of this article, you need to know that:
- You must own equity in the underlying real estate for both the relinquished property and the replacement property to initiate a 1031 exchange.
- The value of the replacement property must be greater than that of the relinquished property.
- The crowdfunding platform you choose must have the ability to facilitate 1031 exchanges with a qualified intermediary.
Example of a 1031 Exchange in Crowdfunding
Let’s say you own a $25,000 equity stake in a crowdfunded multi-family rental with a crowdfunding platform that facilitates 1031 exchanges. You are able to sell your stake for $40,000 to another investor, and you decide to invest this full $40,000 for an equity deal in a similar investment property with a higher value. The crowdfunding platform coordinates the exchange so that the proceeds from your sale flow directly into your new acquisition, and you file the appropriate tax forms with the IRS.
In this case, you would not be taxed at this point on the $15,000 profit you made from selling your equity stake in the relinquished multi-family rental. Assuming a 15% capital gains tax rate, this would result in a deferment of $2,250.
6. Use Any Losses to Offset Taxable Gains
While investors don’t look to lose money on a deal, it is important for investors to understand how to take advantage of the tax implications of a loss in case it ever occurs. In most cases, you can utilize any losses to offset a portion of your investment profits for the year. But you may also be able to use the “carried-over losses” tax benefit to carry any losses into future tax years if the full tax benefit of a loss cannot be applied in the current year.
Importantly, the IRS has rules about how losses can be used to cancel out income. For example, crowdfunding investors are generally considered "passive investors" by the IRS since crowdfunding investing does not require active management on their part. From a tax standpoint, this means that losses can only be used to offset passive income, as opposed to offsetting earned income.
Example of Offsetting Gains with Losses
Let’s say you had $10,000 in losses from a real estate crowdfunding deal gone horribly wrong in a particular year. In that same year, your passive income from other investments amounted to only $6,000. In this case, you could offset the $6,000 in passive income and carry forward the remaining $4,000 loss to the next tax year. This would reduce your taxable income by $6,000 for the current year and $4,000 for the next year, enabling you to save money on your income taxes to help offset your loss.
Risks and Considerations
Tax law is extremely nuanced, and the tax implications of your real estate investments will vary depending on your unique financial situation. It is generally advisable to meet with a CPA (Certified Public Accountant) or tax advisor before investing, particularly if the potential for reducing your income tax burden is a key factor in your decision to invest.
Invest with Gatsby Investment Today
Gatsby Investment is a California-based real estate company specializing in a special form of crowdfunding called real estate syndication. Syndication offers a more stable legal structure than basic crowdfunding and provides access to unique deals for accredited investors.
Gatsby’s wide range of investment opportunities covers both debt and equity investment options, as well as options for both short-term and long-term investors. And with an average annualized return of 24.22% from 2017 through 2022, our investment record speaks for itself!
While the tax benefits of real estate crowdfunding covered in this post are valuable, there are many other compelling reasons to invest in crowdfunding with Gatsby Investment. Learn more about the many advantages of investing with Gatsby, and get started today!