It’s time to talk about everyone’s favorite topic when it comes to investing: taxes.
When taxes and investing come up, your mind might jump to capital gains taxes. We don’t blame you, as this is a common tax levied on gains from your investments.
If you invest in a real estate syndication you might not be paying capital gains taxes though. In fact, the taxes you pay depend on your role in the syndication if you are an active or passive investor. What’s more, there are some tax benefits to investing in a real estate syndication that other investments may not offer.
In this article we’re going to break down how real estate syndication returns are taxed, what your income qualifies as depending on your role in the deal, and the tax benefits of investing in a real estate syndication.
What is a real estate syndication
A real estate syndication is where a group of individuals or companies pool their money together to purchase a property and benefit from the rental income and potential appreciation that property provides.
Real estate syndications are comprised of two groups:
- The syndicator(s)
- Passive investors
The syndicators are general partners in the deal; they are responsible for finding, structuring, underwriting, performing due diligence, financing, raising capital, completing the purchase, and finally, exiting the deal, among other things. The syndicators spearhead the transaction and perform the critical overhead tasks to make a deal for the property, and ensure the investors receive their pro rata share of available funds.
About those investors: passive investors help by providing the capital needed to purchase the property and in return, they receive equity in the property. Typically, these investments can range from a minimum of $50,000 – $100,000 to several million dollars.
Real estate syndications are structured around a set timeframe for holding the property. The average hold is five years, after which the property is sold, benefiting the investors who share in the profit of the sale in addition to receiving dividends during ownership, when available.
Can you make money in a real estate syndication?
We cannot guarantee you will make money, however we can illustrate how you could benefit from investing in a real estate syndication. To show that, let’s look at how real estate syndications make returns.
Recall the groups in a real estate syndication, the syndicators and the passive investors.
It’s the syndicator’s job to raise the necessary capital to purchase the investment property, and clearly communicate to potential investors the expected projected returns for the investment. This way, the passive investors can evaluate the property and get a sense of what their return on investment will look like on a pro forma basis.
A good general partner will provide a clear view on the expected income as compared to the operating expenses of the property, which is communicated in two metrics:
- Internal rate of return (IRR)
- Equity multiple
Internal rate of Return (IRR)
IRR is a metric used by financial analysts to estimate a potential investment’s profitability, including the income stream plus the sales proceeds upon exit.
In simplest terms, IRR measures the annual growth rate of an investment (as opposed to total growth, which ROI, or Return on Investment would track). IRR is a handy way to compare a future investment’s value in today’s dollars. The higher the IRR, the more attractive the investment, making IRR a useful metric to compare properties. A simple approximation of IRR is this: If a 15% IRR is achieved, this equates to a doubling of funds invested within a five year period, or a 2X multiple.
The equity multiple is a simpler metric that calculates how many times your initial investment you can expect to get back. Based on the IRR example above, a 2.0 (2X) equity multiple means you receive back your initial investment plus a 100% profit.
How do real estate syndication returns get paid now that we understand how real estate syndication returns are estimated?
How are syndication distributions taxed?
Before we dive into real estate syndications, let’s take a step back to look at how the IRS views and taxes income.
The IRS qualifies income into 3 groups:
Active income is all earned income (wages, tips, business participation). If you have a job or are self-employed then your earnings qualify as active income.
Portfolio income consists of investment income such as capital gains, interest, and dividend payments. Investors can generally only offset portfolio gains with portfolio losses. While some people may refer to stocks and bonds as passive income, the IRS treats them separately.
Passive income is income earned from REITs, royalties, and limited partnership stakes. This is where real estate comes into play.
Now, what implications are there for real estate syndication investments?
The IRS breaks real estate investors into 3 groups:
- Real estate professionals
- Active investors
- Passive investors
When it comes to a syndication, the sponsor typically qualifies as a real estate professional/active investor while the syndication investors usually qualify as passive investors.
Of the three groups, passive investors receive a less-favorable tax treatment in that they are limited to treating their earnings as passive income (so losses cannot offset active income).
However, while passive investors miss out on that benefit, this approach also provides the tremendous benefit of time. Investing in a syndication allows individuals to profit from commercial real estate without the hassle of managing the property or exposure of owning the property.
Still, there are tax benefits to investing in a real estate syndication that we can explore.
What are the tax benefits of investing in a real estate syndication?
So now we know how real estate syndication returns are taxed, but what are the tax benefits?
- Because the payment distributions from a real estate syndication quality as passive income, they are not taxed as earned income. This means that if you are able to support yourself via your passive income distributions then you do not need to pay self employment taxes.
- Due to age and wear and tear of a property the IRS allows owners to depreciate (expense) a portion of the property’s value each year. Syndication depreciation flows to the investors (you), pro rata.
- Suppose the property is held for over a year. In that case, the difference between the purchase and sale price will be subject to capital gains tax, which is lower than ordinary income tax.
- Properties can be refinanced, bringing in tax implications and benefits, though this can get a bit complex. Basically, you can receive some or all of your original investment back, but retain ownership in the property.
- Mortgage interest on the property is deductible, reducing the tax income burden.
- In the event an investment is not profitable, those losses can be carried over and deducted from future taxable income.
So even for passive investors, there are a host of tax benefits you can reap, come April. Not too bad for benefits, especially when you factor in the potential for passive income among the other benefits of investing in real estate.
Ready To Start investing in Real Estate?
Real estate syndications provide numerous benefits and advantages when investing in commercial real estate while remaining removed from managing the property yourself. While returns cannot be guaranteed, you can see that a real estate syndication could generate stable passive income and a profit for its investors.
At Colony Hills Capital we are experts in the acquisition, ownership, and management of property in growing markets around the country. While we cannot guarantee results, we always aim to provide consistent and above average passive income to our investors. Past performance is no guarantee of future results. Interested in investing? Contact us today to learn more.