Nothing in this blog is or should be construed as tax advice. Consult with your tax professional to understand how the tax implications of investing in real estate apply to your individual situation.
Investing in Real Estate often confers significant tax benefits to investors. Tax benefits may come at a bit of a cost. Preparing tax returns for a syndication (and even more so for a fund) can be quite complex and time-consuming, often resulting in the need to file an extension with the IRS. Most experienced real estate investors understand and accept this trade-off as the cost of investing in real estate. While some may be concerned that filing an extension exposes them to additional audits or other risks, our conversations with tax experts and former IRS agents suggests that this is not necessarily true. Investing in real estate has the potential to generate tax advantages in three primary ways:
- Long-Term Capital Gains: Most successful real estate projects will generate a sizeable amount of capital gain at the sale of the property. Capital gain is the difference between the net proceeds received at closing and the total cost basis up to that point. Long-term capital gains are treated at a lower tax rate than ordinary income for the vast majority of investors. However, a real estate investment needs to be held for at least one year to be granted long-term capital gains treatment.
- Interest Deductions: Most real estate projects are financed using a combination of debt and equity. For equity investors specifically, another source of tax relief is that the IRS allows the interest paid on the principal mortgage to be expensed. Unlike depreciation, there is no requirement by the IRS to recapture interest expenses at the time of sale.
- Depreciation: Most real estate projects include a significant opportunity to claim depreciation. Depreciation is treated as an expense, often generating significant tax losses, and thus offsetting operational income that is being generated. A sophisticated manager may even perform what is called a cost segregation (or “Cost Seg”) analysis. This analysis identifies the useful life of various elements of a property. The IRS has specific guidelines for how long a building and its various internal components can decline in value over a set time-period. A close analysis of the tax code can enable the Cost Seg to accelerate the amount of depreciation claimed on an investor’s K-1 tax statement. Note that this acts merely as a deferral of taxes; when the project sells the IRS guidelines require a “recapture” of the depreciation. This creates a separately categorized gain that is taxed at ordinary income tax rates. The extent of the tax benefit an investor could receive from depreciation depends on the investor’s specific circumstances.
Taxes are a highly complex and specialized area and each individual investor will have a unique set of circumstances that should be taken into account. We strongly recommend finding a CPA that has experience in real estate taxes and K-1 filings.
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There are many moving parts when it comes to private real estate investment, especially in the middle market space. This blog provides a high-level summary of some basic definitions and concepts important to understanding some tax concepts relevant to private real estate. It is not intended to be comprehensive or definitive.