For active real estate investors seeking to gain a deeper understanding of the tax implications for passive investors, this comprehensive guide delves into the five crucial elements that are essential to comprehending the tax landscape of passive real estate investments: the depreciation benefits, accelerated depreciation via cost segregation, depreciation recapture, capital gains tax at sale and the 1031 exchange. We'll explore the intricacies of these elements to help you unlock valuable tax benefits for your passive investors.
Disclaimer: This is for your information only. Since we are not a tax advisory firm, we refer all general tax-related real estate questions from investors back to their accountants. However, we will say that investors often seek real estate opportunities to invest in due to the tax advantages that may come from debt write-offs and losses due to depreciation. But we don't include any assumptions about these tax advantages in our projections.
Depreciation is the amount that can be deducted from income each year as the depreciable items at the property's age. The IRS classifies each depreciable item according to its useful life, which is the number of years of useful life of the item. The business can deduct the full cost of the item over that period.
The most common form of depreciation is straight-line depreciation, which allows the deduction of equal amounts each year. The annual deduction is the cost of the item divided by its useful life. The IRS considers the useful life of real estate to be 27.5 years. So, the annual depreciation on an apartment building worth $1 million (excluding the land value) is $1 million divided by 27.5 years, or $36,363,64 per year.
Generally, the depreciation amount is such that your passive investors won’t pay taxes on their distributions during the hold period.
2. Cost Segregation
Cost segregation is a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes. A cost segregation study performed by a cost segregation engineering firm dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 years, the useful life of a residential building. The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7, and 15 years.
For example, we performed a cost segregation on our portfolio for 2017. On one of the properties, we showed a loss from depreciation of greater than 412% than we would have seen with the straight-line depreciation using the 27.5-year useful life figure.
To perform a cost segregation, you will need to hire a cost segregation specialist. This can cost anywhere between $10,000 and $100,000 depending on the size of the property.
3. Depreciation Recapture
Depreciation recapture is the gain received from the sale of depreciable capital property that must be reported as income. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is “recaptured” by reporting it as income.
For example, consider an apartment that was purchased for $1 million and has an annual depreciation of $35,000. After 11 years, the owner decides to sell the property for $1.3 million.
The adjusted cost basis then is: $1 million – ($35,000 x 11) = $615,000.
The realized gain on the sale will be: $1.3 million - $615,000 = $685,000.
Capital gain on the property can be calculated as: $685,000 – ($35,000 x 11) = $300,000
And the depreciation recapture gain is: $35,000 x 11 = $385,000.
Let’s assume 15% capital gains tax and that the owner falls in the 28% income tax bracket. The total amount of tax that the taxpayer will owe on the sale of this rental property is (0.15 x $300,000) + (0.28 x $385,000) = $45,000 + $107,800 = $152,800. The depreciation recapture amount is $107,800 and the capital gains amount is $45,000.
4. Capital Gains
When the asset is sold and the partnership is terminated, initial equity and profits are distributed to the passive investors. The IRS classifies the profit portion as long-term capital gain.
As of 2023, the capital gains tax bracket breakdown is as follows:
- $0 to $44,625 taxable income = 0% capital gains
- $44,626 to $492,300 taxable income = 15% capital gains
- More than 492,300 taxable income = 20% capital gains
5. 1031 Exchange
IRS Code section 1031, also known as a 1031 exchange, is a transaction where a taxpayer takes advantage of exchanging one property with another through deferring capital gains taxes. The requirements for a 1031 exchange are that a replacement property must be identified within 45 days of the sale, and the identified property must be closed on within 180 days of the sale.
The replacement property must be a “like property,” so it must be an apartment community. You cannot, for example, purchase farmland.
The LP cannot exchange their sales proceeds into a personal investment. The taxpayer that sold the property must also purchase the property, with the taxpayer being the LLC.
All investors in the deal do not need to 1031 exchange. A portion of investors can be cashed out while the remaining investors 1031 exchange into another syndication.
At the end of each year, you will send your passive investors a Schedule K-1, which is a tax document that includes all of the pertinent tax information that they will use to fill out their own tax forms.
As an active investor, grasping the intricacies of tax considerations for passive investors provides valuable insights into maximizing your investment strategy and optimizing your financial outcomes, making it an essential knowledge bridge for a well-rounded real estate portfolio.
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.