One of the main reasons people are drawn to investing in real estate syndications is the tax benefits.
However, there is a lot of misinformation out there about the true nature of these benefits.
For example, many investors are led to believe that you can shelter your W2 or 1099 income using the (paper) losses from these syndications.
The truth is, you can’t.
However, that doesn’t mean that investing in real estate syndications doesn’t come with other tax goodies. In fact, there are actually several very significant tax benefits of investing in real estate syndications.
In this article, from Semi-Retired MD, we’ll cover the tax benefits and more!
If you’re new to investing in real estate syndications or even if you’ve invested in a few deals, you might still be a bit fuzzy about the tax benefits.
That’s not surprising because there’s a lot of misinformation about the tax benefits of investing in real estate syndications.
Here’s an example: “[Passive] investors can receive the same tax advantages that come with ownership of real estate.”
Here’s another example: “This investment vehicle, referred to as a real estate syndication, can help give investors true passivity in their investment with all the same property tax advantages of being a full-time operator. This simply isn’t true.
The differences between a passive investor and a full-time operator are night and day different. On the one hand, a full time operator likely qualifies for something called real estate professional status (REPS). REPS is a valuable tax status that allows you to use the losses from a syndication deal to shelter W2 or 1099 income.
The reason they can access this benefit is that real estate is probably their primary profession, and they spend a ton of time on the day-to-day of the operations of the properties they’re syndicating.
On the other hand, a passive investor cannot use these same losses in the same way. These losses are passive and cannot be used to offset W2 or 1099 income.
Passive income can only be used to offset passive income. If you don’t have any passive income, the losses become “suspended passive losses,” which means they’re suspended until you have passive income in the future or the property is sold.
So you can see how the tax advantages are NOT the same.
With that said, this doesn’t mean that there aren’t any tax benefits. The truth is, there are several VERY significant tax benefits of investing in real estate syndications.
Let’s go through them one by one.
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Shelter Passive Income with Passive Losses
While you can’t use the passive losses from a real estate syndication to shelter W2 or 1099 income, this doesn’t mean that these losses aren’t valuable.
If you have passive income, you can shelter this passive income dollar for dollar with passive losses. So for example, if you have $50,000 of passive income and the real estate syndication provides a $50,000 loss, then your taxable income from this passive income goes to zero.
So for anyone who has passive income, the tax benefits from investing in real estate syndications are substantial.
You might be wondering, how can you generate passive income? There are lots of ways to do this.
One way to do this is to buy rental properties. Rental properties are by definition passive investments. So the income or losses they generate are considered passive. So if you buy a multifamily property, office, retail or other type of rental, the income it generates will be passive and can be offset by passive losses from syndications.
One way to think about it is, if half of your yearly income comes from passive sources and you shelter it completely with passive losses, then you’ve cut your effective tax rate in half. This is a tax efficient move that will help you grow your wealth more quickly.
Capital Gains Tax
When you invest your money in a syndication, they typically give you a timeframe for when you get your payout. This can range from 3 to 10 years with 5 years being fairly common.
A typical return in a 5 year timeframe is two times the amount of money you put into the syndication. This is often referred to as an equity multiple. So if you invest $100,000, in five years, you get your original investment back plus an additional $100,000 or a total of $200,000. So your gain in rough terms is $100,000.
Now there are a lot of calculations that go into calculating your actual taxable gain. Your accountant (ideally a real estate specialist) will most certainly take into account the suspended passive losses we mentioned above, but there may be other income/expenses that have to be accounted for to calculate the taxable portion of the gain. [Note: If you need a referral to a real estate accountant, CLICK HERE to be connected to one of the ones we recommend]
From there, the gain will be taxed as a long-term capital gain, which is significantly lower than your income tax rate assuming you are a high-income professional who is being taxed at the highest rates.
This differential in tax rate is another substantial benefit of investing in real estate syndications.
Defer Taxes with a 1031 Exchange
Another potential tax benefit of investing in a real estate syndication is the ability to defer the taxes on the gain described above using a 1031 exchange.
We are calling this a “potential” benefit because in order to do this, you need to re-invest your original investment and your gain into the next deal that the deal sponsor acquires. This means your money is going to be tied up for another investment cycle of 3-10 years. From there, if you want to keep deferring the tax on the gain, you have to keep re-investing your money into future deals. At some point, if you decide to take your money out of the deal, you will be taxed on the entire gain, going back to the first syndication deal. This could be a huge tax bill, but the benefit of doing a 1031 exchange for all of those years is that your money had an opportunity to grow tax free. Tax-free growth is significantly more efficient than paying your taxes along the way.
Shelter W2 or 1099 Income, in Rare Cases
We mentioned above that there are rare instances when a passive investor in a syndication may be able to use the losses from the syndication to offset their W2 or 1099 income.
What is this rare instance?
This can potentially happen when a passive investor qualifies for real estate professional status (REPS) from their own rental portfolio that is separate from the syndication deal.
As mentioned above, REPS is a tax status that you can achieve when you spend a considerable amount of time buying and managing your own rental properties. A deal sponsor can achieve this status because they are the ones buying and managing the syndicated property. However, most passive investors aren’t going to qualify for REPS because they prefer to be…passive, not active in their investments.
So if you’re willing to learn how to buy and manage your own rental properties, it is very possible to build up a portfolio of rentals, qualify for REPS and then add in an investment in a passive syndication so you can use those losses to shelter W2 or 1099 income.
If you’re planning to do this, you should consult with a real estate CPA because there may be nuances that prevent you from sheltering your income using the losses form real estate syndications.
The Last Word
If this is part of your plan, be sure to learn HOW to buy rental properties profitably. What you don’t want to do is to buy rental properties just for the tax benefit. If you don’t know what you are doing and you buy a property that loses money, you can lose more money from this rental than the amount you save in taxes. If you want to learn how to buy a profitable long-term rental or short-term rental, be sure to sign up for the waitlist for our long-term rental course (Zero to Freedom) and/or our short-term rental course(Accelerating Wealth).