In commercial real estate, raising enough money for a deal can pose a major obstacle. Fortunately, real estate syndication models offer a creative funding solution. Syndications allow multiple investors to pool their money to fund a given project. This pooling provides access to deals that single investors couldn’t afford on their own.
But, before diving into a syndication, investors should understand the associated tax treatment of this model. As such, we’ll use this article to outline the tax implications of investing in real estate syndications. Specifically, we’ll cover the following:
- What Is a Real Estate Syndication?
- IRS Income Categories
- IRS Real Estate Investor Tax Classifications
- Tax Implications of Investing in Real Estate Syndications
- Final Thoughts
What Is a Real Estate Syndication?
Commercial real estate typically requires far larger initial investments than residential real estate. For example, assume a 20-unit apartment building costs $2,000,000. With an 80% loan-to-value (LTV) mortgage, an investor would need a $400,000 down payment. And, this amount doesn’t include transaction and potential renovation costs. For a single investor, these sums can pose insurmountable obstacles to entering the commercial real estate world.
Fortunately, real estate syndications provide an investment vehicle to solve this problem. With syndications, multiple people pool their capital to execute a real estate deal. These deals include two parties: the sponsor and the investors. The sponsor finds, underwrites, and manages the day-to-day operations of the deal, and the investors provide capital for an equity stake in the project.
Assume a deal requires $1,000,000 in up-front capital. The sponsor may personally contribute $100,000 and then raise $900,000 in funds from investors. From a legal perspective, these deals are either established as LLCs or limited partnerships. With an LLC, the deal sponsor acts as the managing member and the investors act as passive members. With a limited partnership, the sponsor serves as the general partner, while the investors gain limited partner stakes.
For investors, syndications provide an outstanding passive investment opportunity. They typically command higher returns than other passive options (e.g. REITs, real estate ETFs, etc.), and they provide investors a direct ownership stake in the underlying property. For sponsors, the syndication model offers access to significantly larger deals than one could pursue solo. Instead, sponsors trade their time and expertise – and generally some capital – to control a commercial deal.
IRS Income Categories
To understand syndication tax treatment, investors need to first understand how the IRS classifies different types of income. These income categories directly affect the associated tax treatment. According to the IRS, three types of income exist: active, portfolio, and passive.
- Active income: This includes all earned income (e.g. wages, tips, and active business participation). For self-employed individuals, business earnings also qualify as active income. Of note, in certain situations, real estate investment income also qualifies as active. We will discuss these exceptions in the next section.
- Portfolio income: Investment income such as capital gains, interest, and dividends qualify as portfolio income. And, investors can generally only offset portfolio gains with portfolio losses. However, it’s important to note that, while people refer to stocks and bonds as “passive” investments, the IRS treats this income separately from passive income.
- Passive income: The IRS states that this includes the income earned from rents, royalties, and limited partnership stakes. This income type proves particularly relevant to real estate investors. For most investors, real estate investment income qualifies as passive. This means that, in general, passive losses in real estate can only offset other passive income – not active or portfolio income.
In the next section, we’ll explain how these income types directly affect real estate investors.
IRS Real Estate Investor Tax Classifications
The IRS breaks down real estate investors into different categories. Each of these categories comes with its own tax implications. As such, it’s important to understand exactly how the IRS will categorize a syndication investor, because this will dictate the investor’s tax treatment.
According to the IRS, three types of real estate investors exist: 1) real estate professional, 2) active investor, and 3) passive investor. We’ll outline them below, from most to least advantageous from a tax perspective.
Of note, syndication sponsors will generally qualify as a real estate professional or active investor. Syndication investors, on the other hand, typically qualify as passive investors.
Real Estate Professional
Working in the real estate industry does not mean someone qualifies as a real estate professional. Instead, individuals need to meet detailed criteria outlined by the IRS. However, as a real estate professional, investors receive tremendous tax benefits.
As stated above, the IRS treats real estate investment income as passive. This means that investors generally cannot use real estate losses to offset active income. As a real estate professional, the IRS categorizes real estate investment income as nonpassive. This means that investors can use real estate investment losses to offset their active income – potentially leading to tremendous tax savings.
Active Investor
Active real estate investors gain more tax benefits than passive investors, but not as many as real estate professionals. To qualify as an active investor, the IRS states that an individual must actively participate in a real estate investment. Investors actively participate in real estate if they make management decisions in a significant and bona fide sense. This could include decisions such as approving tenants, deciding lease terms, and approving property expenses.
Active investors potentially receive an exception to the above passive loss limitations. As an active investor, an individual may be able to deduct up to $25,000 in passive real estate losses from active income. With a modified adjusted gross income (MAGI) less than $100,000, active investors can deduct up to $25,000 in passive real estate losses against active income. But, with MAGI greater than $150,000, the IRS does not allow any losses against active income. The allowable passive activity losses gradually phase out in between these two amounts. For instance, at $125,000 in MAGI, investors can deduct up to $12,500 in passive losses ($25,000 / 2).
Passive Investor
Passive real estate investors receive the least favorable tax treatment. They do not actively participate in their real estate investments, and they can only deduct passive losses against passive income. For example, a $15,000 loss on a rental property could offset $15,000 in passive income from another property. But, none of these losses could be used to offset wages or other active income.
Generally speaking, syndication investors fall into this final category. But, while passive investors receive the least favorable tax treatment, this approach also provides the tremendous benefit of time. Investing in a syndication allows individuals to A) profit from commercial real estate, while B) not committing their time and effort to the active management of these deals.
Tax Implications of Investing in Real Estate Syndications
Participating in real estate syndications – as a sponsor or investor – provides two primary profit sources: rents and proceeds from property sales. With both, syndication members receive a pro rata share based on their ownership percentage. For example, a 5% limited partner will receive 5% of the property’s income and 5% of its expenses.
However, syndication sponsors and investors fall into different IRS real estate investor categories. This means that, while both parties receive the same profit sources, the associated tax treatment will differ.
Rental Income/Losses
The IRS taxes rental income at the syndication member’s ordinary income rate – the same as owning any rental property. However, syndications also pass through rental property expenses to their members. This means that both deal sponsors and investors receive the tax benefits of depreciation. Depreciation is a cashless expense, meaning that it often leads to positive cash flow from a deal despite a taxable loss.
But, this taxable loss qualifies as passive income. Consequently, how syndication members apply these losses depends on their IRS investor classification. Often, deal sponsors qualify as real estate professionals, meaning they can use these passive losses to offset nonpassive income. At a minimum, due to their level of involvement, sponsors will qualify as active investors. As active investors, sponsors can potentially take advantage of the $25,000 passive activity loss special allowance (depending on their MAGI).
On the other hand, syndication investors nearly always qualify as passive investors, meaning they can only use losses to offset other passive income. In theory, a syndication investor could actively participate in a syndication, opening the door to the $25,000 allowance. But, most of these deal agreements explicitly limit an investor’s role to capital contribution.
From a tax perspective, the above means that syndication investors often end up with unallowed losses. In other words, they have more taxable losses in a given year than passive income to offset. This does not mean that investors lose the benefit of these losses – they’re just deferred. Any unallowed losses in a given year carry forward until either A) they can offset passive income, or B) the underlying asset is sold.
Property Sale Proceeds
When a syndication sells its property, the associated gains pass through to the sponsor and investors in the same pro rata fashion as rental income. For instance, if an investor owns a 5% stake, he or she will receive 5% of the gains from a sale.
The IRS taxes sponsors and investors on these gains at their capital gains rates (assuming the property has been held for longer than a year). Additionally, both parties will need to pay a depreciation recapture tax of 25% on the difference between the property’s adjusted cost basis at sale and original tax basis.
But, another potential difference in tax treatment exists here due to IRS investor classifications. Due to their more advantageous tax treatment as real estate professionals or active investors, syndication sponsors often have fewer unallowed losses than investors when selling a property. This means they will likely have a lower adjusted cost basis, leading to larger capital gains taxes. On the other hand, syndication sponsors likely have multiple years of unallowed losses, resulting in a lower capital gains tax bill.
Syndication Sale Example
Here’s a simplified example of syndication tax treatment at sale. Assume a syndication has a sponsor (20% stake) and two investors (each with a 40% stake). Now, say the property’s original tax basis (i.e. purchase price plus necessary rehab costs to place the property in service) totals $1,000,000. At sale, the syndication has depreciated $800,000, leading to an adjusted cost basis of $200,000. Now, assume the members sell the property for $2,200,000, leading to a gain of $2,000,000.
The syndication members will receive pro rata shares of that gain, and they’ll need to pay a combination of depreciation recapture and capital gains tax on their respective shares. With the above equity, here’s what each member would receive in gains:
- Sponsor: $400,000 ($2,000,000 gain x 20%)
- Investor 1: $800,000 ($2,000,000 gain x 40%)
- Investor 2: $800,000 ($2,000,000 gain x 40%)
Assuming the sponsor deducted all annual losses against other income as a real estate professional, he or she will not have any unallowed losses at sale. But, say that Investor 1 had $100,000 in prior year unallowed losses and Investor 2 $150,000 in unallowed losses. At sale, the investors’ respective gains are reduced by these unallowed losses:
- Investor 1: $700,000 gain ($800,000 gain minus $100,000 in unallowed losses)
- Investor 1: $650,000 gain ($800,000 gain minus $150,000 in unallowed losses)
As this simplified example illustrates, syndication investors still receive incredible tax treatment. But, they generally don’t see the full benefits of this treatment until a syndication disposes of its property.
Final Thoughts
Real estate syndication tax treatment differs slightly for sponsors and investors. Both parties, though, receive the tax benefits of real estate ownership, making syndications a solid investment vehicle.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available commercial real estate syndication opportunities – and the associated tax implications.