Investing in a real estate syndication means more income – and that means more taxes. But taxes shouldn’t deter you from investing. In fact, investing in real estate is one of the best asset classes to invest in because it comes hand-in-hand with tax advantages. Passive multifamily investing allows for those tax advantages to be passed onto investors earning them even better returns on their investments.
What Is Real Estate Syndication?
Syndication is a real estate investment vehicle involving multiple investors pooling funds together to finance the purchase of an income-producing property, usually a multifamily asset.
A syndication has two key stakeholders: general partners (GPs) and limited partners (LPs). The general partners manage the investment, and the limited partners benefit from passive income and appreciation. That means LPs don’t have to deal with finding, acquiring, or managing an asset as they would if they were to purchase a property with full ownership.
Tax Advantages of a Syndication
Real estate investing almost always has tax advantages, but when investing through a syndication, those tax advantages differ from full ownership. Therefore, when considering investing in a syndication, it’s critical that investors understand what tax benefits they’ll be entitled to.
While tax benefits of a syndication are often not directly itemized on an LP’s tax return, they are passed down through greater cash flow and appreciation, as is clear through their K-1 tax filings.
In real estate syndications, there are five notable tax benefits.
Tax Advantage #1: Depreciation Deductions
As assets age, they also deteriorate. Multifamily properties usually have extensive systems, networks, and fixtures with a designated usable life. Fortunately, the IRS created a tax law provision that allows an expense deduction for depreciation, which appears on the assets income statement and effectively lowers the asset’s net operating income.
Depreciation is considered a non-cash expense and reflects the decrease in the asset’s value over time. Therefore, fixtures are depreciated over different time periods. For example, an appliance usually has a depreciable life of 5 years, while an HVAC system can be depreciated over 27.5 to 39 years.
Why is Depreciation Important to Syndication Investors?
A depreciation deduction can reduce the taxable income generated by the property, which can then indirectly reduce the tax liability of the investors. In some cases, the depreciation deduction can be large enough to offset some or all of the income generated by the property, resulting in a net tax loss for the investors.
Depreciation is also a significant financial benefit because it can help increase the cash flow generated by the property. Given that depreciation deduction reduces the taxable income generated by the property, it can result in lower taxes and higher cash flow for the investors.
Tax Advantage #2: Bonus Depreciation
The Tax Cuts and Jobs Act (TCJA) boosted depreciation for a limited time. In 2022, businesses and investors could purchase assets (like appliances and fixtures) with a usable life of 20 years or less and claim 100% depreciation on its value in that year. In 2023, that dropped to 80% and will continue dropping by 20% each consecutive year until bonus depreciation ultimately ends in 2027. However, bonus depreciation remains an excellent tool for real estate investors, new development, and our value-add projects.
Why is Bonus Depreciation Important to Syndication Investors?
Bonus depreciation is a fantastic tax advantage for value-add and new construction multifamily because it allows syndications to take an immediate deduction of an eligible expense in the first year instead of over the depreciable life. This strategy can help offset tax obligations and increase investor returns.
Tax Advantage #3: Refinancing
Many real estate investors overlook the benefits of a cash-out refinance to pull out equity and instead prioritize minimal debt. While having lower debt amounts is great, there are often better investment strategies.
Not only does refinancing allow GPs to secure more attractive finance terms, but it also allows us to effectively access the property’s equity without paying tax.
When we complete a value-add project, equity in the property increases, which means that our loan-to-value decreases. By completing a refinance, we can withdraw some, if not all, of our investors’ initial capital investment without paying tax.
Why is Refinancing Important to Syndication Investors?
When a cash-out refinance takes place, investors receive part, if not all, of their initial capital investment while maintaining their ownership share (and accompanying cash-flow benefits). These funds are then free to be allocated to another investment without having to pay capital gains tax until the asset is divested (sold). As a result, cash-out refinancing helps our investors maximize their real estate portfolios.
Tax Advantage #4: Capital Gains Tax
Here’s a secret: the rich don’t get wealthy by paying 37% in taxes yearly, and you certainly don’t stay wealthy by paying those tax rates. We know there’s a better option; capital gains tax rates on long-term investments are far lower than the income tax bracket that most of our investors fall under. Long-term capital gains tax rates are applied to investment assets that are held for more than a year. Capital gains income is taxed between 0-20%, depending on your income level.
How Do Syndication Investors Benefit from Capital Gains Tax?
When investing in a syndication, if there’s an increase between your initial investment and your return (and we target a significant increase), this difference will be subject to capital gains tax but not income tax. That means an overall lower tax rate on proceeds generated by the investment.
Tax Advantage #5: 1031 Exchanges
A 1031 Exchange, also known as a like-kind exchange, is a tax incentive allotted to real estate investors and is one of the best tools for building generational wealth. As defined under section 1031 of the IRS Code, a 1031 Exchange is a strategy that allows investors to defer paying capital gains taxes on an investment property.
A tax-deferred exchange means that when one investment is sold and another is acquired of an equal or greater value using those same funds, then the capital gains tax that would have been due upon sale gets deferred. For example, if an investor were to sell a small multifamily asset for $1,000,000 through the necessary procedures of a 1031 Exchange, then purchase another income-producing property with those funds, they would not be required to pay capital gains.
Alternatively, a 1031 Exchange is an excellent tool, in certain circumstances, when exiting a syndication or investment fund. Instead of paying capital gains on proceeds, they can be reallocated to another investment.
When structured and administered correctly, 1031 Exchanges are a highly effective tool for building generational wealth. Using this strategy, capital gains would only be payable when the asset is sold, and a new one is not purchased.
Where a 1031 Exchange becomes such an incredible generational wealth tool is upon the investor’s death. When an asset is inherited, the cost basis gets stepped up, and the capital gains that would have been payable are forgiven. So ultimately, investors can complete as many 1031 Exchanges in their lifetime, defer capital gains, and then pass on that wealth to their heirs, who would pay minimal or no tax on the asset.
How Do Syndication Investors Benefit from 1031 Exchanges?
When set up correctly within a syndication, investors can use a 1031 Exchange tax strategy by reinvesting their returns in another like-kind real estate investment, the same as if they had held full ownership. That means they can use their proceeds to invest in another passive multifamily asset with Fish Capital Investments or to purchase another asset independently.
Because 1031 Exchanges can be used ongoing, they are undoubtedly one of the best tools for building and maintaining generational wealth.
The tax benefits of a real estate syndication both directly and indirectly help investors. At Fish Capital Investments, we work diligently with our trusted investors to help create the best strategies that maximize their returns while minimizing their tax exposure. For more details on the tax benefits for your situation, contact Fish Capital.