As real estate syndication grows in popularity, more investors are coming to see the many benefits of this strategic alternative to traditional real estate investing.
Like real estate crowdfunding, syndication pools funds from several investors to finance specific real estate projects. The project could be as simple as a home flip or as complex as a multi-family development. Projects can even include long-term rentals. In any case, having the funding distributed across multiple investors means that you can buy into a deal with a low minimum investment. And you get to leverage the expertise of the project sponsor, who acquires the property and manages the project on your behalf.
To learn more about the concept of syndication, check out our detailed article, Real Estate Syndication Explained.
The Tax Benefits of Real Estate Syndication
While the tax benefits of investing in real estate are well documented, many investors have questions about the specific tax benefits of investing in syndication.
- Can you still take a depreciation deduction on your income taxes?
- Are there ways to invest in syndication with a tax-advantaged retirement account?
- How do 1031 exchanges work with real estate syndication?
In this article, the real estate experts at Gatsby Investment are answering all your questions about real estate syndication tax benefits. We’ll show you the seven primary tax benefits of real estate syndication, and explain how each benefit works.
Let’s start with a classic real estate tax benefit: the depreciation deduction.
Rental property depreciation allows investors to enjoy an income tax deduction based on the idea that all physical structures eventually deteriorate.
The General Depreciation System (GDS) allows a 27.5-year “life” for structures. This means that, if you were to purchase a building today, the IRS would expect the structure (not the property, only the structure on the property) to be “worthless” in 27.5 years. So, the IRA allows you to divide your acquisition cost plus the cost of improvements over 27.5 years, and claim that amount as a deduction on your annual income tax returns for the next 27.5 years.
The same applies to real estate syndication projects. Let’s say that you invest $20,000 in a single-family rentalsyndication project. If you divide your $20,000 investment by a 27.5-year life, you find that you earn a depreciation deduction of $727.27 each year. That’s $727.27 worth of earnings that you will not be taxed on each year!
A Note About Depreciation Recapture
It’s important to understand that, despite the IRS’s formula, most structures are not worthless at the 27.5-year mark. In fact, many properties appreciate in value, despite the wear and tear on the property, so the investor never realizes a loss from depreciation. This is why the IRS includes a “depreciation recapture” clause; this clause requires the investor to repay the amount of the depreciation deduction used if the property sells for a profit.
However, it is possible to defer this depreciation recapture through a 1031 exchange (which we’ll be discussing later in this list).
Depreciation vs. Cost Segregation
It’s also important to note that the General Depreciation System is not the only method of calculating depreciation deductions. Some syndication projects qualify for cost segregation, which allows for an accelerated depreciation rate.
With cost segregation, different elements of the structure are assigned a useful life of 5, 10, or 15 years rather than 27.5. Since the acquisition and improvement value is divided over fewer years, the annual deduction is higher.
Depreciation recapture still applies with cost segregation as with the GDS model.
2. Lower Tax Rate on Capital Gains
When real estate investors sell a property, the government typically levies a tax on the proceeds, which is called a capital gains tax.
Interestingly, long-term capital gains taxes (defined by the IRS as the gains on assets owned for a year or longer) are calculated using a lower tax rate than earned income. Short-term capital gains are taxed as earned income.
In 2023, for example, the standard marginal income tax brackets follow this table:
- 37% for individual single taxpayers with incomes greater than $578,125 ($693,750 for married couples filing jointly);
- 35% for incomes over $231,250 ($462,500 for married couples filing jointly);
- 32% for incomes over $182,100 ($364,200 for married couples filing jointly);
- 24% for incomes over $95,375 ($190,750 for married couples filing jointly);
- 22% for incomes over $44,725 ($89,450 for married couples filing jointly);
- 12% for incomes over $11,000 ($22,000 for married couples filing jointly);
- 10% for incomes of single individuals with incomes of $11,000 or less ($22,000 for married couples filing jointly).
But the 2023 capital gains taxes are much lower. According to the IRS: “The tax rate on most net capital gain is no higher than 15% for most individuals. Some or all net capital gain may be taxed at 0% if your taxable income is less than or equal to $41,675 for single [...], $83,350 for married filing jointly.”
High-income earners may pay as much as 20% on capital gains. And certain investment types are subject to capital gains rates of 28%, but real estate syndication does not fall into that category.
Investing in real estate syndication may allow you to pay a favorable tax rate on your investment proceeds.
3. Mortgage Interest Deductions
As with real estate investment properties that are directly owned, assets held in a real estate syndication qualify for mortgage interest deductions.
This simply means that the amount of the mortgage payment that goes toward interest can be deducted from your taxable income.
Most syndication companies keep careful financial records and pass the mortgage interest deductions on to investors. Investors all receive a Schedule K-1 each year, listing their prorated share of the mortgage interest expense incurred. This is the amount you may deduct on your income tax returns.
4. Carried-Over Losses
Before we proceed with our discussion of carried-over losses, we want to emphasize that Gatsby Investment has never lost money on a deal. But losses are possible in real estate investing, and it’s important to understand how to make the most of losses in case they happen. In most cases, you can use any losses to offset some of your investment profits for the year.
The carried-over losses tax benefit allows investors to carry any losses into future tax years if the full tax benefit of a loss cannot be applied to the current tax year.
To understand carried-over losses, you have to understand how the IRS allows investors to offset losses against income. Syndication investors are typically considered to be “passive investors” by the IRS. This is because syndication investing doesn’t require any active management on behalf of the investors. And, from a tax perspective, this means that any losses can only be used to offset passive income (as opposed to offsetting any portion of earned income).
For example, if you were to have $10,000 in losses for a single year, but your passive income for the year was only $6,000, you may use the loss to offset your $6,000 from this year and carry the remaining $4,000 loss into the next tax year. This allows you to receive the full tax benefit of losses over multiple years if you don’t earn enough in the current year to offset your losses.
5. 1031 Exchanges
Real estate investors use 1031 exchanges to defer capital gains taxes and depreciation recovery on the sale of real estate assets. A 1031 exchange allows you to roll the proceeds from one real estate investment into another real estate investment. With this tool, taxes aren’t due on the proceeds of your sale because you don’t technically realize those proceeds; they go straight into another investment.
There are lots of rules governing the use of 1031 exchanges. For example, 1031 exchanges only apply to “like-kind property.” The definition of like-kind is loose, but it generally means that you can only exchange one property for another property in the same asset class (exchanging one residential property for another residential property, for example).
Another rule is that the deal must be facilitated by a “qualified intermediary”. This is a third party whom you trust to accept the funds from the sale of the first party and use them for the acquisition of the replacement property. To handle the funds yourself would be to realize the gains, which would trigger the taxes due.
Furthermore, your new investment must be worth at least as much as your previous investment, and if any debt financing is used, you must retain at least as much debt in the new asset as in the old.
It’s important to remember that a 1031 exchange only defers the taxes due; it does not waive the taxes or allow you to profit tax-free from an investment. The benefit is that, by deferring the taxes, you have more funds available now to roll into your next investment, which allows you to grow your portfolio faster than you would if you had to pay taxes immediately.
A 1031 exchange can be used to defer taxes on real estate syndication projects in the same way that it would be used to defer taxes on directly-owned real estate investments.
6. Self-Directed Retirement Accounts
Retirement accounts are tax-advantaged by nature. Traditional IRAs and 401(k)s, for example, use pre-tax dollars, allowing you to contribute more to your retirement account than you would be able to if your contributions had to be taxed upfront. Roth IRAs, on the other hand, use post-tax contributions, but allow you to withdraw from the account without paying income tax on the withdrawals during retirement.
If you qualify for a self-directed retirement account, you can invest in real estate with your 401k or IRA. This provides an additional tax advantage to your real estate holdings while allowing you to diversify your retirement investment portfolio.
7. Cash-Out Refinancing
One inherent benefit of real estate investments is their tangibility. Real estate ownership represents a physical property with obvious utility. And you can leverage the value of this tangibility by exchanging a portion of your equity for tax-free cash-in-hand.
Cash-out refinancing allows you to borrow against your ownership in a property. And because the IRS correctly treats this as a loan rather than income, there is no tax due on a cash-out refi.
Savvy syndication companies might refinance assets in order to return investors’ original contributions back to them. Consider a built-to-rent multi-family property, for example. A syndication company might take a loan to finance the acquisition of the lot and use the investors’ contributions to fund the construction. Once the property is stabilized with reliable renters, the syndication sponsor could use a cash-out refinance to help investors recoup their original investments. This would mean the investors are still entitled to ongoing passive rental income, but their original funds are now freed up for other investment opportunities.
Minimize Your Tax Liabilities by Investing with Gatsby Investment
Gatsby Investment is a California-based real estate syndication company with an exceptional track record of successful projects. From 2017 through 2022, our average annualized net return was an impressive 24.22%!
Our team includes real estate analysts with a deep understanding of tax law. We know how to leverage the tax benefits of real estate syndication to reduce the tax burden on our investors, and, ultimately, allow you to keep a greater percentage of your earnings!