It’s tax season. Hopefully, you’re not completely shocked by your tax bill this year. Likely, you’re looking at the dollar amount on your 1040 and thinking about all the things you can do with that money. Did you know that passively investing in apartments can drastically reduce the amount of taxes you pay?
To illustrate how this works, it may be helpful to briefly discuss how your income is categorized and taxed, and then we'll dive in to how passively investing in real estate can help you reduce your tax bill. Of course, if you're interested in taking advantage of these tax savings while still earning a solid return, you can schedule a call with us at any time on our website.
Types of income
The Internal Revenue Service (IRS) lumps income into three categories, and each category has different rules on how income is treated and taxed.
This category includes all income that you earn from direct involvement. W2 income falls in this category. If you are a freelancer and receive 1099 income, that is also active. If you are self-employed or a small business owner and actively participate in running the business, it’s most likely that you receive active income. Active income is the least tax-friendly of the three and is taxed on a graduate income tax schedule, and those with higher incomes will pay a much higher rate, up to 37% in 2021. Single person earning over $85,500 will fall into the 22% income tax bracket and will contribute over $1 of every $5 earned to Uncle Sam. High income earners are donating $1 of every $2.70.
This category includes income received from stocks, bonds, mutual funds, exchange traded funds, and other investments that are not considered passive. Portfolio income from assets held less than one year are considered short-term capital gains and are taxes with active income at a rate up to 37%... Long term capital gains in 2020 are either taxed at 0%, 15% or 20%. If your single with an adjusted gross income of less than $40k, or married with less than $80k, your long term capital gains are NOT taxed. A person or married couple earning more than that and up to roughly a $500k income will pay only 15% on their long-term capital gains. The highest income earners still will only pay 20% of their long-term capital gains as taxes, which is far less than they would for their active income. In its tax treatment, long-term capital gains are preferable to active income.
This category includes all income received from rents or royalties in a property or business in which there was no material participation. Income from investing as a limited partner, silent partner, or passive investor in a business or property all fall into this category. Passive income is taxed at the active income tax rate, which by itself is not very beneficial, but there is one HUGE advantage to passive income when real estate is involved – and that’s depreciation.
Depreciation is the reduction in value of an asset due to the passage of time. Conceptually, to illustrate what depreciation is, imagine you buy a new car and pay $20,000. A year from now, even if you don’t drive it, the car will naturally lose value and may only be worth $18,000. In this case, you’ve essentially lost $2,000 due to depreciation. If the purchase of the car was for a business and not personal use, the IRS will allow you to count depreciation as an expense or a LOSS on your taxes.
Depreciation works the same with real estate, but with one huge advantage. It doesn’t matter how old a property is when you buy it, the IRS will consider the property as brand new on the day of purchase, and depending on the property type, will allow you to count the property's depreciated value as an expense on your tax return.
What does this mean? Well, even though the actual value of the property is INCREASING due to inflationary pressures, and even though you actually make money with a passive investment, you can still legally report a LOSS on your tax return every single year. As a passive investor, the depreciation expense and potential losses are passed on to you according to your ownership percentage in the property.
But wait, it gets better. Residential and multifamily real estate can be depreciated over a 27.5 year period, meaning 3.6% of the property's value (minus land) can be used as an expense, but there's much more than bricks and mortar in an apartment complex and different assets are depreciated over different timelines. For example, computers and other office equipment are depreciated over 5 years (or 20% of their value per year), furniture and fixtures over 7 years, and land improvements over 15 years. If a property owner conducts a cost segregation study, they essentially are lumping every single item on the property into either the 5-, 7-, or 15-year bins which will allow for a much higher overall depreciation rate in the first several years of ownership. Additionally, tools like accelerated and bonus depreciation can add significant losses to the first few years of ownership.
That means each year, even if the rental property is producing cash flow, the depreciable losses will offset the passive income, and in most cases produce a passive loss on you tax statement. How much?
The average first year depreciation for an apartment syndication is 35-40% of the amount invested. So, for a $100,000 investment, there will be $35,000 in depreciable expenses in the first year. If that property produced an 8% cash return in the first year, or $8,000, the total passive loss would be $27,000. In later years, however, the depreciation losses are lower, so there may be a positive number on the tax statement, but even so, it’ll be far less than the amount actually received.
Effect of depreciation on your taxes
Now, let’s return to your taxes and talk about how passive losses are handled.
If you have a passive loss on a single investment, that loss will first offset other passive income. So, a loss on one property can cancel out any other passive income you earn regardless of the source.
The effect that passive losses have on active income depends on your situation. For income earners with adjusted gross income (AGI) less than $150,000, passive losses can off-set up to $25,000 of your active income (more specifically, $25,000 for those who's income is less than $100,000, which gradually gets phased out as your income approaches $150,000).
What if you have passive losses that you can’t use to offset active income? Maybe you earn over $150,000 and don't qualify, or your passive losses exceed $25,000. Well, you get to carry forward any passive losses you didn’t use to future income tax returns. So, if you passively invested in a syndication, received $35,000 in passive losses, and because of income restrictions, were only able to use $10,000 to offset active income, you carry the remaining $25,000 in passive losses forward to future income tax returns. As with the current tax year, the amount carried forward can offset all of your passive income, and will be subject to the cap in place for active income.
Qualified Real Estate Professional
But wait, there's more. If you (or your spouse, if married filing jointly) qualify as a real estate professional, the income tax treatment is even better. Your passive losses can actually cancel out your active income no matter how much you make… no restrictions.
When investing passively in real estate (especially via syndications) using the tools the IRS has given you can drastically reduce the amount of income taxes you pay. At a minimum, you will pay less in taxes on the returns you receive than you would for active income or even long-term capital gains; best case scenario, you can reduce your tax bill to $0. And that’s so much better than doing what your tax advisor suggests and putting your money into an IRA…