With the “joy” of tax season exiting the rearview mirror, it is a great time to consider how real estate investors can optimize their tax strategy for the upcoming year. Taxes aren’t the most exciting aspect of real estate investing, but they’re essential to understand. As a real estate investor, it’s more fun to focus on returns and upgrading your lifestyle, but tax strategies can’t be overlooked. The tax conversation becomes even more important this year since 2022 is the last year for 100% bonus depreciation, which we will further explore in a future blog post.
As a passive investor in a real estate syndication, your sponsorship team will guide you through tax season and help ensure you get the tax benefits you deserve. The beauty of investing in real estate is that your investments lower your tax obligation rather than increase it, unlike other investment vehicles, such as mutual funds and stocks.
Any time you invest your hard-earned money, you should do your due diligence to explore the best strategies to decrease your tax liabilities.
Deciding On Your Entity Election
Often, real estate investors ask how setting up their entity will change the number of tax deductions they are allowed to take. Allowable deductions do not change whether you invest in your name and social security number, in a single-member LLC, or in a multi-member LLC or corporation. The tax deductions are the same and include all business-related expenses.
It is wise to avoid electing C-corporations to set up your real estate investing business. With a C-corporation, all earnings can be taxed more than once. To simplify things as you’re starting, we recommend forming a single-member LLC.
To receive the benefit of asset protection, you should keep your personal and business assets separate. You should have separate business and personal accounts and be sure not to intermingle the funds. Maintaining individual accounts allows you to protect the integrity of your business entity.
During the startup phase of your business, any costs you incur before electing your entity are tax-deductible. These startup expenses include legal fees, research, travel to tour properties, and other professional fees.
Taxes And Real Estate Syndications
Real estate syndications are typically set up as limited liability companies (LLC) and taxed as partnerships. The lead syndicator, or sponsor, generally is in the role of the general partner, and the investors are the limited partners.
The real estate syndication itself is not taxed. It is a pass-through entity, which means that income and expenses and gains and losses that occur in the syndication LLC are passed to the partners.
Taxes And Rental Real Estate
When the property is stabilized, you’ll earn passive income, which is different from earned or W-2 income. Passive income is considered the same as dividends and can be offset by passive losses.
If your adjusted gross income as a married couple is $150,000 or less, you can take up to $25,000 of these passive losses to offset earned income. However, if your adjusted gross income is higher, you cannot take passive losses against earned income unless you qualify for real estate professional tax status. Real estate professionals have a special designation allowing them to take more passive losses against earned income.
Three parameters must be met to qualify for the coveted real estate professional tax status:
- 51% of the investor’s working time and services must be in real estate-related activity.
- The investor has to do more than 750 hours in a rental real estate trader business in one calendar year.
- The real estate professional has to materially participate in their business’s real estate activities.
Be sure to discuss your situation yearly with a CPA, as small changes can impact you significantly at tax time.
The Power Of Depreciation And Cost Segregation
Wear and tear on a property is expected; therefore, you are allowed to write off the depreciated value of real estate assets over time. The IRS allows owners to write off the value of residential rental assets over 27.5 years, while commercial properties can be depreciated over 39 years.
Depreciation benefits investors because it is used to offset yearly cash flow distributions. If the depreciation amount is large enough, investors may not pay taxes until the asset’s sale.
Cost segregation improves the tax advantages by depreciating certain asset items sooner than others. For example, the signage of an apartment complex can be depreciated sooner than the roof. Cost segregation allows this accelerated depreciation so you can realize these tax losses sooner in the hold period.
Tax Benefits Of Investing In Real Estate
By actively or passively investing in real estate, you can qualify for significant tax advantages that can offset passive gains and reduce earned income tax liability in certain situations.
When building wealth, it’s not enough to earn income; you also have to understand strategies that can help you maximize tax benefits. Investing in real estate syndications allows regular people to build wealth quickly and sustainably while diversifying their portfolios away from stock market volatility.
Consult your CPA or tax advisor to assess your situation and determine what strategies best fit your needs and financial goals.