Real estate syndications give investors the chance to participate in a real estate project for a fraction of the overall needed capital. In addition, investors get to keep more of their returns in their pockets thanks to hearty tax benefits that syndications may pass along to limited partners. These tax advantages increase investors’ profit margins and make syndication investment even more lucrative.
Limited Partners Receive a Schedule K-1
Syndications are particularly rewarding because investors directly receive their portion of income and expenses via a Schedule K-1. The income is offset by the expenses, even if the expenses are just paper losses such as depreciation.
Receiving the K-1 helps investors realize greater profits through reducing taxable income. In the first few years of a syndication, the deductions may be so generous that they exceed the income earned from the project. If this happens, the syndication deductions can also offset earnings from other streams of passive income.
Those who qualify for Real Estate Professional Status (REPS) see even greater savings from the syndication tax benefits. Anyone who can claim the REPS designation on their taxes can use the syndication deductions to reduce taxable income for all forms of income, including ordinary income as from traditional W-2 work. REPS does not require a degree or license; instead, to qualify, an individual needs to work a minimum of 750 hours per year in a real estate related position, such as a property manager, broker, agent, or investor. They must also generally work in this position for more hours than any other job they have.
Depreciation Decimates the Tax Burden
Of all the tax advantages, deprecation usually adds up to the single most valuable one offered by real estate syndications.
Depreciation reflects the concept that while the land lasts forever, structures deteriorate over time and have a finite usable life. As the structures age, their value decreases. As such, the Internal Revenue Service allows property owners to account for that loss in value by reducing their taxable income via the depreciation deduction.
Real estate is unique in that while the IRS allows you to take depreciation losses, in reality, real estate appreciates in value over time. Therefore, as an investor, you get the compounding benefit of an appreciating asset with reduced tax liabilities.
To find the annual depreciation amount, divide the property’s purchase price, excluding the value of the land, by the number of years in the property’s lifespan. The IRS sets the lifespan of residential properties at 27.5 years and commercial or warehouse properties at 39 years.
Since 2017, the depreciation deduction has been particularly beneficial for real estate syndications thanks to the Tax Cuts and the JOBS Act. The Act created a system called bonus depreciation, whereby owners can choose to front-load the depreciation deduction.
Rather than evenly allocating the total depreciation deduction across the property’s usable lifetime, owners can instead take it on an accelerated timeline. Syndications usually hold a property for a short amount of time, so the bonus depreciation scheme significantly reduces taxes during the project’s lifetime. For the average limited partner, the bonus depreciation amount in the first year may entirely offset the taxes that would have been assessed on the preferred return.
Unfortunately, bonus depreciation is not a carte blanche method for eliminating taxes. If the property is sold before the end of its usable life, then the IRS will recapture a proportional amount of the accelerated depreciation.
Refinancing Returns Limited Partners’ Initial Investment Tax-Free
Syndications help investors avoid paying taxes on the same earnings twice by returning the initial investment tax-free using a loan refinance.
Syndications acquire properties, intending to improve or streamline them to increase income, and consequently, value. They usually refinance the subject property after making several physical and operational changes that increase the value and improve the income production of the property.
After obtaining a demonstrable increase of value, the sponsor completes a cash-out refinance of the property to create an influx of cash to repay the initial contributions made by the limited partners.
Alternatively, syndications with a multi-property business plan may use the cash-out refinance to fund another property, generating even more revenue.
Mortgage Interest Deduction
Syndications get to deduct the mortgage interest paid from the annual taxable income just as single-family homeowners do. The mortgage interest deduction is another one that turns out to be especially helpful to syndications because they hold properties for relatively short periods. In the early years of a mortgage, most of the scheduled payments go toward interest. As such, expect a substantial mortgage interest deduction.
Any Remaining Syndication Income Will Be Taxed at the Capital Gains Rate
Finally, when the deductions no longer cover the entirety of the earnings from the syndication, investors will be taxed at the capital gains rate, rather than the often-higher ordinary income tax rate. For long-term capital gains, the maximum tax rate is only 20 percent, which compares very favorably to the ordinary income rates that reach as high as 37 percent for the highest earners.
When evaluating potential syndication for investment, be aware of the company’s plan to share the tax perks with limited partners. Real estate syndication tax benefits will impact your total profit just as much as the projected returns.