All Forum Posts by: Mark Kenney

Anyone here ever get blindsided by a massive tax bill on a real estate deal?

I have.
And I know plenty of others who are freaking out right now from unexpected tax hits.

A lot of people jump into real estate for the tax advantages—and yes, they can be incredible. But if you don’t understand how those advantages actually work (and when they come due), they can turn into a ticking time bomb.

Here’s how it goes:

• You invest in a deal.
• You get juicy “paper losses” from depreciation (especially with cost seg + bonus depreciation).
• Your taxable income drops—you're pumped!
But here's the hard truth:
Those aren't permanent savings. They're deferrals.

And when that deal sells or refinances, the IRS comes knocking. Hard.

A few truths most people don’t hear about:

• You can lose your entire investment and STILL owe taxes.
It’s happening right now.
• If your capital account goes negative (from depreciation + operating losses), you’re in for a nasty surprise on your tax return.
• Depreciation recapture isn’t always capped at 25%—it can hit your highest tax bracket.
I personally got hit with an extra $140,000 tax bill from one deal because I didn’t plan for this properly.

This isn’t fear-mongering. It’s reality.

I know investors who lost money and couldn’t pay their tax bills.

I even had an investor reach out after a sale of a deal that did perform and say:

“You sent me a K-1 with a $302,362 gain. That’s about a $45,000 tax bill. When will that distribution be sent to me?”

Answer:
It won’t.
Because they already got that money over the years—from the refinance, the cash flow, and the sale.

They just didn’t know to set some money aside.

And most CPAs don’t specialize in real estate, so they don’t educate investors on how this works.

Bottom line:

Real estate is still one of the best ways to build wealth.
But you have to understand how taxes really work—or they’ll eat you alive.

@Melanie P.

I don’t think anyone would disagree that having liquidity in the stock market is a major advantage over real estate — and there’s been comments on that point already from others and myself.

As for the idea of requiring accredited investors to also be “sophisticated.” I am not an SEC attorney and not providing any legal advice. 

But…

To my knowledge, there is absolutely no current SEC requirement that accredited investors also need to meet a “sophisticated” standard. Unless I’ve missed something, this remains true today.

There was a proposed amendment floating around about five years ago that hinted at potentially adding a sophistication requirement to the accredited investor definition. But as far as I know, that has never been formally adopted.

I’m not saying it’s not a good idea to expect accredited investors to be sophisticated. But the bigger question is: who defines sophistication? It's a subjective term, and trying to standardize it could get messy — fast. And, if the SEC (who regulates all of this) does not require this, then you are always going to have accredited investors who invest and might not be sophisticated (whatever "sophisticated" even means to you vs. someone else).

@Alan F.

Thanks for the comment!

Some people might not be aware of what the "waterfall model" is. A definition is below. 

"A waterfall in an investment—especially in private equity or real estate syndications—refers to the hierarchical structure that dictates how profits (and sometimes losses) are distributed among investors and sponsors after an investment begins generating returns."

I certainly would not want to speak for anyone else, but in general, I don't think most people have an issue with a "waterfall" structure; it is "what" the actual waterfall is for a given deal where people can have issues. For example, a waterfall could be set up to be extremely favorable to LPs; have no GP fees whatsoever; etc. And, while this example uses a waterfall, it is much more favorable to the LPs.

And, while I don't want to speak on your behalf or anyone else's behalf,



And, while I don't want to speak on your behalf or anyone else's behalf,

A waterfall in an investment—especially in private equity or real estate syndications—refers to the hierarchical structure that dictates how profits (and sometimes losses) are distributed among investors and sponsors after an investment begins generating returns.

@Chris Howell, 

I think self-managing is a great idea based on your background!

Raising capital…there is a ton about raising capital. Probably better for a totally different post, but a few things to consider…

- Be clear on the type of deals you plan to do.

- It is ok to start small.

- Educate your investors…the more your investors know, the better off you are.

- Decide if you are going to allow just accredited investors or also non-accredited. There is a big difference on what you can/cannot do based on this decision.

- Get a good securities attorney.

- Build your list and communicate with them.

- Over-raise for reserves and working capital.

- Cautiously partner with others.

- Know that once you raise from others, you now have new people you answer to.

@Eric Bilderback

There are certainly a lot of differences between stocks and real estate investments. I do agree stocks are liquid which is a big advantage, but that doesn’t mean everyone actually sells before they lose money. I would also say an advantage of buying a stock is that typically someone investing in a stock would not invest nearly as much as they would in a syndication (generally, $50k+). So, the loss on a syndicated deal arguably would be a bigger hit for the average investor which is an obvious disadvantage. There are some advantages to real estate investing that stocks simply don't provide.

On the point related to upper middle class and below being better off investing by themselves in smaller deals…there is obviously not a one-size-fits-all answer to this. In many cases, I would argue No, they are not better off for various reasons…

- Many people invest in a syndication because they don’t have to be active…if they buy a small deal on their own, they are likely more active.

- Someone who invests on their own in smaller deals doesn’t’ mean they are somehow isolated from all the issues that have been discussed in this post. These issues are not isolated to the syndication model.

- Their investment would likely be even more than a typical syndication which means their loss could be even larger.

- They likely know less than the average syndicator.

- They likely have full recourse debt for a smaller deal which is considered higher liability.

There is no question that the “hype” around syndication in multifamily deals is much higher than the last cycle. But, it is not like anyone is forced to invest. I am a GP, but I am also an LP and I take full responsibility for my LP investment decisions even when a deal unfortunately doesn’t perform.

@Evan Polaski, thanks for the comment! As a follow-up from your yield maintenance/prepayments...100% agree. 

For those that might be newer, Evan's comment is spot on as the yield maintenance/prepayments go down/go away over time. Even if you don't hold long-term, many loans are assumable by a new buyer and then the yield maintenance/prepayments are not relevant. And, on some loans the new buyer can execute on a supplemental loan to get more proceeds, if the deal supports it.

For those that are potentially newer to the syndication model, it is important to understand what syndication is/is not.

Syndication is "pooling" money together from investors...typically to purchase a larger property than someone can buy on their own. There are General Partners (who manage the investment and make most decisions) and Limited Partners (who invest passively and typically have very little decision-making rights).

Syndication is not unique to real estate. Many opportunities outside of real estate are syndicated. A syndication can be for a fund (includes multiple assets); just like a fund in the stock market. Or, a syndication can be for an individual asset; just like buying an individual stock.

So, it is important to understand what the syndication model is/is not. The problems that have been mentioned above by others and myself are not unique to the syndication model itself. I personally know many people who purchased real estate properties on their own and did not syndicate and they have the exact same issues that syndicated deals are experiencing. There are also very large institutions that have had the same issues. 

Generally speaking, the biggest difference between a smaller syndicator and a large institution is if an institution has issues, they generally have the funds/capital to sustain while many individual syndicators do not. Also, even if a large institution defaults on a deal, they generally have the relationships with lenders to not have this be as big of a deal. And, the larger institutions are in fact defaulting on deals...they are also much better from a PR perspective to limit the negative press. 

Another comment I think is important to mention is...others and I have talked about long-term fixed debt. There is no question this would have helped on many deals. But, even long-term debt has a number of "gotchas" that a lot of people do not understand. And, not all long-term debt is created equal. The people that had long-term debt at the peak of the market and decided to sell, likely still made money because the market was at the peak, but they also paid significant pre-payment penalties. We sold a lot of deals in 2021 all at profits, but in many cases our prepayment penalties were equal to or more than our initial equity. Yes, we made profits, but if some of those deals were in fact on Bridge debt, our profits would have increased by an additional 100%+.

With all this said, I personally like the correct long-term debt and would accept lower returns in exchange for the more certainty and options that long-term debt provides. Before you buy new properties or refinance one of your current properties, you really need to understand the various long-term debt options.

Losses are not isolated to syndicators. There are trillion dollar funds taking losses on real estate.

@John J Kelly III, can you please clarify your comment about a syndicated deal going to zero vs just taking a loss when a deal doesn't work out. Any investment can go to $0.

@John J Kelly III, 

I personally do not think you missed the opportunity to get into REI. But, that does not mean you don't need to be cautious. Knowing what some of the issues are and how to pivot going forward will be key. There are no doubt going to be some really good opportunities out there.

There is not a single reason why there is distress. It is a combination of a number of factors.

The good news is that many of the issues can be avoided going forward and many of these factors have also started to significantly improve more recently.

Some of the factors causing distress include:

- Floating Interest Rates – Rates jumped from the 4’s to over 10%.

- Rate Cap (like an insurance/hedge) to help protect how high your interest rate can go. As loans matured and needed to be extended, the rate cap pricing in some cases went up over 3400%. For example, an initial $98k rate cap a few years ago went to $3.4M+. This is real money that you have to give to the lender to extend the loan.

- Insurance Increases – Some areas saw 100%+ increases. We have an example where our insurance went from $1.2M to over $3M.

- No Rent Increases – Putting money into a deal to rehab units simply didn’t generate the rent increases like many people projected. In many cases, rents actually went down across the country.

- Evictions – Some of the cities are NOT landlord friendly and it was taking well over a year to evict…which means a lot of tenants just didn’t pay.

- Property Tax Increases – Increased significantly in some areas even as value went down.

- Lenders Requiring Loan Buy-Downs – As borrowers looked to extend their loans, some lenders were/are requiring a loan buy-down. This is real money that the Borrower has to come up with. On a recent example, we have a $12M loan and the lender is requesting a $3M buy-down.

- Cash Reserves – Ran out for factors listed above.

To reiterate...learn from all these tough lessons and going forward can be much less painful.

@Eric Bilderback, my opinion is the risk is not related to the syndication model, it is if you need/want control. As an LP you won't typically have control in a syndicated deal, just like you don't have control when you invest in the stock market.