As financial advisors, many of our clients have asked us questions about real estate investing. This blog post focuses on important considerations from a tax and financial planning standpoint. Our firm recently released a podcast on this topic specifically, and you can listen to this here:

1. Click here to listen on Spotify.
2. Click here to listen on Apple Music.
3. Click here to watch on YouTube.

Considerations Before Investing

As with any investment, it is important to consider the following:

1. Time Commitment: How much of your time will the investment demand? Some real estate ventures require significant involvement, while others may offer more passive income streams if you take the role of limited partner for example.
2. Rate of Return: What is the potential return on your investment? This is obviously critical as it directly impacts on your overall profitability.
3. Peace of Mind: Does the investment align with your risk tolerance and long-term goals? It is important that this investment ultimately supports your life by design and does not cause extra stress.

 

At EWA, we advise all of our clients to start here when making any big investment (not just real estate). Ultimately a good financial plan should support you and your family to reach your long-term goals, and real estate investing should be treated no differently.

Next we will dive into a few points to keep in mind when it comes to investing in real estate.

Understanding Depreciation

Depreciation allows property owners to account for the wear and tear that naturally occurs over time and can be claimed as an expense for tax purposes. While applicable to various properties, it holds special significance for income-generating properties:

1. Residential buildings can be depreciated over 27.5 years.

 

2. Commercial buildings can be depreciated over 39 years.

 

For example, if a residential building is purchased for $1 million, you can take a depreciation expense of $36,363 ($1M divided by 27.5 years). This is especially helpful if the property is rented because this can directly offset rental income and reduce tax liability (and hopefully make the rental income largely / entirely tax-free).

It is also important to consider depreciation recapture, which occurs when a property owner sells a property that they have previously claimed depreciation deductions on. If the property is sold for a price higher than its adjusted basis (which is reduced by the accumulated depreciation deductions taken over the years), the recaptured depreciation is the difference between the selling price and the adjusted basis. This recaptured amount is then taxed at a higher rate than the standard capital gains tax rate, which is the taxpayer’s ordinary tax rate (capped at a maximum of 25%).

Tax Benefits: Mortgage Interest Deduction

Mortgage interest deductions offer another financial advantage to real estate investors. For personal and your primary residence, interest on the first $750,000 of the mortgage can be deducted annually, provided you itemize your taxes.

For rental properties, this deduction applies to loans utilized for property acquisition, improvement, or refinancing. Unlike the capped deductions for personal residences, rental property mortgage interest is fully deductible.

Active vs. Passive Income:

Real estate income can be categorized as either active or passive:

1. Active Income: Earned through direct participation and active efforts, such as a job or business. It’s subject to various taxes, including federal, state, and FICA taxes.

 

2. Passive Income: Generated with minimal involvement, such as rental income or royalties. While it’s still taxed at federal, state, and local levels, it’s exempt from self-employment taxes (FICA).

 

If real estate income is considered as active income and you are considered a real estate professional, this opens the door for additional strategies from not just a tax standpoint, but also for retirement planning. For example, you can open your own 401(k) plan or SEP IRA and save up to $66k/year ($73.5k/year if over 50) for the 2023 tax year. This is beyond the scope of this blog, but you can learn more about this here: Retirement Planning for Business Owners: SEP IRA vs 401(k)

Unfortunately for most working professionals (who do not exclusively do real estate for their primary means of income) it is very difficult to meet the requirements needed to shift real estate to active participation and take advantage of the tax / retirement benefits.

There are 2 key components to being a RE professional:

1. 50% Test- real estate professionals must work over half of their annual working time in a real property trade / business.”
2. 750 hours test- In addition to meeting the 50% test requirement, material participation needs to occur for a minimum of 750 hours per year.

Although it is tough for most to pass these tests, it is possible in certain situations. For example, if a married couple files a joint return but only 1 spouse works a W2 job, the non W2 income earner could take an active role in real estate endeavors to meet the 50% test and 750 hours test. If both tests are passed, all of the retirement and tax planning could be implemented and additional deductions can be taken to directly offset taxes owed on the W2 side, which could potentially lead to big tax savings (for example offsetting top 37% tax rate if applicable).

The Power of the 1031 Exchange

The 1031 exchange offers investors a way to defer taxes upon selling a property. Within 180 days of the sale, you can roll the proceeds into another property which avoids all taxes attributable to sale. This tactic facilitates property portfolio growth and strategic financial planning.

However, this low basis continues to carry forward, and eventually if you sell, then the capital gain tax is still paid at a later date.

The only way to avoid this would be to wait until you die and pass the properties to your kids. At the time of writing, at someone’s death, a step up in basis can occur, but this is on the docket for some politicians to potentially remove this provision to increase tax revenue to the USA.

Exploring Real Estate Syndicates

Real estate syndicates allow multiple investors to pool their resources for larger ventures. However, they warrant careful consideration due to their complexities and potential risks. General partners (GPs) manage the investment and bear personal liability, while limited partners (LPs) contribute capital with less decision-making influence and liability. Real estate syndicates can be tempting, but thorough due diligence and a well-established track record of success by the management team are essential before diving in.

LPs in a real estate syndicate typically receive income through a Schedule K-1 form. A Schedule K-1 is a tax document that reports the partner’s share of the syndicate’s income, deductions, credits, and other relevant tax information. This form is used for tax reporting purposes, and the income reported on it is then included in the LP’s personal tax return.

The taxation of LP income from a real estate syndicate varies based on the nature of the income but is generally considered passive income. As mentioned above, passive income is subject to ordinary income tax rates, but it’s not subject to self-employment taxes like active income.

Here are four key considerations to have before deciding to participate in a real estate syndicate:

1. Management Expertise: Research the management team’s track record and expertise in similar projects
2. Investment Strategy: Ensure the syndicate’s strategy aligns with your investment goals and risk tolerance.
3. Risk and Return: Evaluate potential risks against projected returns to determine if the investment is worthwhile.
4. Fees: Understand the syndicate’s fee structure and how it affects your overall returns. These typically range from 1 – 3%, and then a profit share that occurs to the general partners managing the fund. We have seen this a lot of times lead to fees as high as 4%+ on your investment on an annual basis.

Qualified Opportunity Zones

Qualified Opportunity Zones (QOZs) incentivize investment in designated areas by offering tax benefits. While they operate similarly to real estate syndicates, individuals can establish their LLCs and invest directly in qualified projects. This approach may yield better control and potentially lower expenses compared to traditional syndicates.

Qualified Opportunity Zones (QOZs) offer several tax benefits to investors, making them an attractive option for financial planning:

1. Deferred Capital Gains: One of the primary benefits is the ability to defer the recognition of capital gains from the sale of any asset (such as stocks, real estate, or other investments) by reinvesting those gains in a QOZ fund within 180 days of the sale.

 

2. Partial Reduction of Capital Gains: If the investment in the QOZ fund is held for at least 5 years, the investor receives a 10% reduction in the deferred capital gains tax liability. If held for at least 7 years, the reduction increases to 15%.

 

3. Tax-Free Growth: Perhaps the most significant benefit is the potential for tax-free growth on the QOZ investment itself. If the investment is held for at least 10 years, any capital gains generated from the appreciation of the QOZ investment are entirely tax-free.

 

4. Basis Step-Up: After holding the QOZ investment for 5 years, the basis of the initial capital gains reinvested is increased by 10%. After 7 years, this basis is increased by an additional 5%. This reduction in taxable gain upon exit is a valuable advantage.

 

5. Alignment with Estate Planning: QOZ investments can be included in estate planning strategies, potentially allowing for a stepped-up basis for heirs, further minimizing tax implications.

 

6. Social Impact: Investing in QOZs allows high net worth families to contribute to the revitalization of economically disadvantaged communities, aligning financial goals with positive societal impact.

At EWA, we always advise to never let the tax tail wag the dog. Meaning always make investments that support your life by design, and are intentional towards your freedom of time and peace of mind.

Navigate Real Estate Landscape with Confidence

Investing in real estate presents its own unique set of opportunities and challenges, each requiring careful consideration. By understanding key concepts like depreciation, active vs. passive income, and investment structures like syndicates and QOZs, you can navigate the real estate landscape with greater confidence. Remember, education, due diligence, and alignment with your financial goals are paramount to achieving success in real estate investment.