In March of every year our accountants are working hard to get our Schedule K1 Partnership forms to our investors. The K1 provides the tax accounting on the asset’s prior year of operations. One of the best things about investing in commercial real estate syndications are the tax benefits. Investors see this very clearly when they open their K1 statements and usually experience a paper loss.
I have some investors call me when they receive their statements and wonder if everything is sound with their underlying investment. I tell them that the Schedule K1 is for tax reporting purposes and we are excited to see losses. The passive losses can be used to offset passive gains in other areas of their portfolio. It has no direct relationship to the health of the underlying asset.
Some of the most common deductions are:
- Property Taxes
- Interest on the property loan
- Depreciation on the property
As a limited partner, the investor gets to share in these deductions based on their proportional ownership interest in the overall limited partnership. These deductions make investing in commercial real estate assets very tax efficient.
Depreciation is often accelerated. Through a cost segregation study, a determination can be made to accelerate certain aspects of the asset to say 7 years for a commercial building that normally may be 25 years straight line. As a result, we see significant deductions on appreciation in the early years of the asset contributing a healthy chunk to creating paper losses. There is some recapture that may occur by the time one sells the asset.
It’s common for value-add syndicators to optimize the value of a property (i.e. an apartment) over say two years and once renovations are completed (higher rents are achieved), go to the bank and refinance the property since the value most likely increased and pull equity out. There is no taxable event when you return a part of an investor’s equity.
A 1031 exchange allows one to swap a like kind property for another like kind property and defer the capital gains tax on the sale of the first property. Most syndications are not setup to take in a 1031 exchange from an investor’s personal property. Nor if they are invested in our syndications at sale, take the sale proceeds and 1031 into another investment property they may want to buy for their own portfolio. However, I have been involved in several 1031 exchanges from one syndication deal to another syndication deal under the same sponsor. That is workable and is highly beneficial to investors.
Self-Directed IRAs / Solo 401ks:
Investing with your self – directed IRA and solo 401ks. If these real estate investments are so tax efficient, why then are folks investing w/their IRAs and solo 401ks and not just their savings money, isn’t that redundant? Simply put, there is a lot of money sitting in these qualified retirement plans and investors are interested in diversifying and putting more money in cash flowing and more stable assets like real estate.
That said, there is a UBIT (Unrealized Business Income Tax) that is in play. The IRS didn’t want investors in these qualified plans to take advantage of leverage which most real estate deals have. In order to take that unfair advantage away, they created the UBIT which is a tax on the profits of the leveraged portion of the asset.
UBIT is to be reported by the syndication on your Schedule K1. Your accountant will determine if you owe any taxes. This seems to impact SD-IRA account holders and not solo 401k holders. So, if you have a choice, since investing in real estate is highly tax efficient, using your regular savings money may be the most attractive way to go. Solo 401ks would be right there with them. IRAs would not be the top investment vehicle as a result of UBIT. However, since a lot of money in IRAs sits idle or is over exposed to the volatile stock market, investors may still find that even with the UBIT tax, its worth considering investing in real estate with their IRA.
In sum, syndication commercial real estate properties are highly tax efficient. From the standard property tax, loan interest and accelerated depreciation opportunities to refinances, potential 1031 exchanges and qualified plans, the IRS currently has provided ample ways to keep more profits in your pocket or defer paying the taxes for some time in the future.
As a person involved in real estate syndications, these are brief summaries and not a recommendation or advice. Please consult with a tax professional regarding your tax and real estate investment situation to learn more about these strategies and how they may apply to you.