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