Raising sufficient capital for a transaction can be a significant challenge in commercial real estate. Fortunately, unique financial options are provided by real estate syndication models. A project can be funded by a group of investors joining together through syndication. The access to transactions made possible by this pooling is something that individual investors alone couldn’t have.
Investors should be aware of this model’s accompanying tax treatment, though, before jumping into syndication. In light of this, we will discuss the tax repercussions of real estate syndicate investment in this post. We’ll discuss the following topics in detail:
- What Exactly Is Real Estate Syndication?
- IRS Income Classifications
- IRS Tax Classifications for Real Estate Investors
- Real Estate Syndications and Tax Implications
- Final Thoughts
What Exactly Is Real Estate Syndication?
Compared to residential real estate, commercial real estate often demands far bigger initial investments. Think about the $2,000,000 price tag for a 20-unit apartment complex. A down payment of $400,000 would be required for a mortgage with an 80% loan-to-value (LTV). Additionally, this sum does not account for transactional fees or prospective refurbishment expenditures. These sums might be overwhelming for a lone investor seeking to enter the commercial real estate market.
Thankfully, real estate syndications offer an investing platform to address this issue. A real estate transaction is carried out through a syndicate, which consists of several investors pooling their funds. The investor and the sponsor are both participants in these agreements. The investors provide money in exchange for an equity share in the project, while the sponsor locates, underwrites, and oversees the daily operations of the transaction.
Assume that $1,000,000 in upfront financing is needed for a contract. The sponsor can put up $100,000 out of his or her pocket and then attract $900,000 in investment capital. Legally, these transactions are structured as limited liability companies (LLCs) or limited partnerships. The management member of an LLC is the transaction sponsor, while the passive members are the investors. The sponsor acts as the managing partner in a limited partnership, while the investors receive limited partner interests.
Investors have access to fantastic passive investing opportunities through syndications. In addition to giving investors a direct ownership position in the underlying property, they frequently provide larger returns than alternative passive choices (such as real estate investment trusts, exchange-traded funds, etc.). Sponsors have access to transactions that would be impossible to pursue alone because of the syndication approach. Sponsors, on the other hand, exchange their time, knowledge, and typically some funds to influence a business deal.
IRS Income Groups
Investors must first comprehend how the IRS categorizes various forms of revenue to grasp how syndication tax treatment works. The corresponding tax treatment is directly impacted by these income categories. Passive, portfolio and active income are the three categories of income recognized by the IRS.
All earned money is considered active income (e.g. wages, tips, and active business participation). Earnings from a self-employed person’s business also count as active income. Noteworthy is the fact that, under certain circumstances, income from real estate investments also counts as active. In the part that follows, we will talk about these exclusions.
Income from investments, including dividends, interest, and capital gains, is referred to as portfolio income. Additionally, portfolio losses may often only be used by investors to offset portfolio profits. The IRS regards this income differently from passive income, although stocks and bonds are sometimes referred to as “passive” assets.
Rent, royalties, and interest on limited partnership holdings are all considered forms of passive income, according to the IRS. Real estate investors find that this form of revenue is particularly pertinent. The majority of investors consider real estate investment income to be passive. Because active or portfolio income cannot be used to offset passive losses in real estate, only other forms of passive income can be used to do so.
We’ll go through how these different forms of revenue have an immediate impact on real estate investors in the section that follows.
IRS Tax Classifications for Real Estate Investors
Real estate investors fall under many categories according to the IRS. There are specific tax ramifications for each of these groups. Since the IRS’s classification of a syndication investor will determine how the investor is taxed, it is crucial to comprehend this classification precisely.
There are three different categories of real estate investors, according to the IRS: real estate professionals, active investors, and passive investors. From most favorable to least advantageous in terms of taxes, we’ll list them all below.
Noteworthy is the fact that syndication sponsors will often be able to claim to be real estate specialists or active investors. In contrast, syndicate investors are often considered passive investors.
Real Estate Expert
A person does not automatically qualify as a real estate professional just because they work in the real estate sector. Individuals must instead adhere to stringent requirements specified by the IRS. Investors, on the other hand, gain greatly from taxes as real estate professionals.
The IRS considers real estate investment income to be passive, as was previously mentioned. Thus, losses on real estate normally cannot be used by investors to offset gains from active business. The IRS classifies real estate investment income as non passive since it is earned by a real estate professional. As a result, investors may be able to significantly reduce their tax burden by using real estate investment funds to make their active income.
Active Investor
However, compared to real estate experts, active investors have a greater number of tax advantages than passive investors. The IRS stipulates that a person must actively engage in a real estate investment to be considered an active investor. If investors make important and genuine management choices, they are actively involved in the real estate market. This might involve choices like admitting renters, choosing the conditions of a lease, and authorizing costs for the property.
The restrictions on passive loss described above may be suspended for active investors. An investor who is actively investing may be eligible to deduct up to $25,000 in real estate losses from their active income. Active investors who have a modified adjusted gross income (MAGI) of under $100,000 are eligible to deduct up to $25,000 in passive real estate losses from their active income. However, if your MAGI exceeds $150,000, the IRS will not allow you to deduct any losses from your active income. Between these two values, the permissible passive activity losses steadily drop off. For example, investors can write off up to $12,500 ($25,000 / 2) in passive losses at $125,000 in MAGI ($125,000 / 2).
Passive Investor
The least advantageous tax treatment is given to passive real estate investors. They are only permitted to offset passive income with passive losses since they do not actively participate in their real estate assets. For instance, a loss of $15,000 on a rental property might be compensated by a passive income of $15,000 from some other asset. All of these losses, however, could not be utilized to reduce earnings or other active revenue.
Investors in syndicates often come under this last classification. However, although passive investors are subject to the worst tax treatment, this strategy has the huge advantage of time. Individuals can earn from commercial real estate by investing in syndications since they A) don’t have to actively handle these projects, and B) they can do so without spending a lot of time and energy on it.
Tax Effects of Real Estate Syndication Investments
The two main profit streams for those who participate in real estate syndications as sponsors or investors are rentals and sales revenues. In both cases, syndication participants are given a portion that is prorated according to their ownership stake. A 5% limited partner, for instance, would be entitled to 5% of the property’s revenue and 5% of its outgoing costs.
However, there are other IRS real estate investor groups that syndication sponsors and investors belong to. This implies that, even if both parties get identical profit sources, the tax treatment will be different.
Rental Earnings/Losses
The IRS taxes rental revenue at the regular income tax rate of the syndication member, just like it would for any other rental property. Syndications, however, also charge their members for the costs associated with renting out property. Depreciation’s tax advantages are thus enjoyed by transaction sponsors as well as investors. Depreciation is a cashless item, which means that even while it results in a taxed loss, it frequently generates positive cash flow from a deal.
However, this taxable loss is considered passive income. In light of this, the IRS investor categorization of syndication participants determines how they apply these losses. Deal sponsors frequently meet the requirements to practice real estate, which enables them to deduct these passive losses from nonpassive income. Sponsors will be considered active investors at the very least owing to their degree of commitment. Sponsors may benefit from the $25,000 special allowance for passive activity loss as active investors by utilizing this provision (depending on their MAGI).
Syndication investors, on the other hand, almost invariably fall under the category of passive investors, which limits them to simply using losses to reduce other passive income. The $25,000 allotment would theoretically be available if a syndication investor actively participated in syndication. But the majority of these trade agreements expressly stipulate that an investor’s contribution must be financial.
The aforementioned indicates that syndication investors frequently incur disallowed losses from a tax viewpoint. To put it another way, they have more taxable losses to offset in a given year than passive income. The advantage of these losses is only delayed; investors do not lose out on them. Any losses that aren’t permitted in a particular year continue over until they either A) can be used to offset passive income or B) the underlying asset is sold.
Proceeds from Property Sales
The profits from the sale of a syndication’s property are distributed pro rata to the sponsor and investors, much as the money received from rent. For instance, a shareholder who owns 5% of the company will get 5% of the proceeds from any sales.
Sponsors and investors are subject to taxation by the IRS on these gains at the capital gains rates (assuming the property has been held for longer than a year). Moreover, a 25% depreciation recapture tax on the discrepancy between the property’s adjusted fee basis at the sale and the original tax base should be paid by both entities.
However, because of how the IRS classifies investors, there is another possible distinction in tax treatment here. Syndication sponsors frequently suffer lower unallowed losses than investors when selling a property because of their more favorable tax position as real estate professionals or active investors. As a result, their adjusted cost basis is probably going to be lower, which implies their capital gains taxes would be higher. The cost of capital gains tax is smaller for syndication sponsors since they probably have several years’ worth of unallowed losses.
Example of Syndication Sale
Syndication tax treatment upon sale is illustrated in the following simple example. Let’s say there are two investors (each owning a 40% investment) and a sponsor in syndication. Let’s imagine the home’s initial tax basis was $1,000,000. This sum would be made up of the purchase price plus any renovation expenses required to put the home in use. A cost basis adjustment of $20,000 results from the syndication’s $800,000 depreciation at the sale. Let’s now imagine that the members make a $2,000,000 profit when they sell the property for $2,200,000.
The members of the syndicate will get pro rata shares of the gain, and they will be required to pay a mix of depreciation recapture and capital gain on their portions. With the aforementioned equity, each member would get the following gains:
Sponsorship: $400,000 ($2,000,000 gain x 20%)
Investor 1: $800,000 (40 percent of a $2,000,000 gain).
Investor 2: $800,000 (40 percent of a $2,000,000 gain).
The sponsor won’t have any unused losses at the sale if they offset all of their annual losses against other revenue while working as a real estate professional. However, suppose Investor 1 had $100,000 in unallowed losses in the previous year and Investor 2 had $150,000 in unallowed losses. These disallowed losses upon selling lower the corresponding gains of the investors:
Investor 1: $700,000 profit ($800,000 profit – $100,000 in unallowable losses)
Investor 1: $650,000 profit ($800,000 profit less $150,000 in unallowable losses).
Syndication investors continue to benefit greatly from favorable tax treatment, as shown by this condensed example. They usually don’t get the full rewards of this approach, though, until the syndicate sells its assets.
Final Thoughts
The tax status of real estate syndication varied somewhat between sponsors and investors. Syndications, however, are a reliable investment vehicle since both parties benefit from the tax advantages of real estate ownership.
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