Real estate syndication offers passive investors an opportunity to realize current income while increasing equity through forced principal pay down and asset appreciation.
These structural advantages help make direct real estate investments an attractive alternative to bonds, stocks or REITS.
However, real estate’s tax benefits – which are largely undervalued (or ignored) by investors when comparing returns by asset type – are perhaps even more compelling.
I know, taxes are boring, but consider the following story.
A few years ago a messy and very public divorce between the then owners of the Los Angeles Dodgers, Frank McCourt and his wife Jamie, revealed that the couple had earned $108 million over a six year period yet hadn’t paid one dime to the IRS.
How could this be possible? Why are they not in jail for tax evasion? Believe it or not, their tax accounting, while likely uber-aggressive, was apparently legal (they were investigated, but it appears they were cleared). How is this possible? Well, the McCourts owned a ton of commercial real estate and were able to pull out tax free cash via refinancing several assets and claim huge paper losses to offset distributable cash flow from their investments.
Lessons from this story:
1. Try very, very hard to avoid divorce.
2. Invest in more real estate.
If you have a full time job that won’t afford you the opportunity to build your own empire of tax efficient real estate, you can still benefit from its superior tax treatment by investing in a real estate syndication, which simply pools investor capital to purchase assets.
Typically, the managing member of each syndication is also the investment’s Sponsor. The Sponsor identifies and operates the property. The investors are limited partners (passive investors) and benefit from the Sponsor’s deal flow and expertise.
Tax Efficient Investment Structures
Passive investors looking to take advantage of real estate’s tax benefits, must ensure that each investment is properly structured. Most real estate operating entities are organized as limited partnerships or more often, limited liability companies, which offer investors slightly more flexibility then LPs.
Both of these entities are pass-through vehicles that avoid the double taxation of a corporation structure. This pass-through feature enables investors to claim depreciation (paper losses) and loan interest deductions to shelter distributable cash flow from taxes.
Mortgage Interest Deduction
The mortgage interest deduction is not exclusive to primary residences. Investment properties can utilize debt to acquire larger properties and shelter current income with interest payments. While principal payments are not deductible (for obvious reasons), the vast majority a mortgage payment during the first 10 years will be allocated to interest that can be used to shelter the property’s income.
The government allows real estate owners to deduct a portion of their depreciable basis (generally the purchase price less the value of land, which is not depreciable) from cash flow. The depreciation schedule is 39 years for office properties, 27.5 for apartment buildings and approximately 15 years for a typical mobile home park (in most non-costal markets).
However, real estate doesn’t deteriorate at such expedited schedules. In fact, with reasonable maintenance, many properties will not only last much longer than their respective depreciation schedule would suggest, but they will likely experience dramatic appreciation over that time period. In most major cities there are brick and timber constructed buildings that have lasted 80+ years. The ability to depreciate a cash flow productive, appreciating asset is a tremendous tax benefit afforded to real estate investors.
Net Operating Losses (NOLs)
Occasionally, a property might generate excess deductions or net operating losses to offset income stemming from other passive investments. The ability to take advantage of these paper losses is contingent on the IRS’s passive loss rules. However, if an investor can utilize a property’s NOLs, the yearly after tax cash flow returns will actually be higher than the before tax returns.
Of course, if the investor elects to sell their property, taxes will be collected through depreciation recapture and capital gains taxes. However, an investor in a real estate syndication can defer taxes further if they trade their share of the investment into another asset via a 1031 exchange. This would provide them with a new depreciable basis and start the “tax free” cycle all over again.
Until then, investors in real estate syndications will have largely tax-free use of distributable cash flow, which is essentially a zero interest loan from the IRS.
Here are four words you don’t here too often, “thank you, tax law!”