Passive real estate investing offers an outstanding long-term path to wealth. While investors focus on their day jobs and other financial pursuits, these investments can command outstanding returns – without an enormous commitment of time. But, it’s important to recognize that, as passive investments, these opportunities come with unique tax considerations. As a result, we’ll use this article to outline the major tax implications of passive real estate investing.
Specifically, we’ll cover the following topics:
IRS Income Categories
IRS Real Estate Investor Tax Classifications
Tax Implications: REITs
Tax Implications: Real Estate Syndications
Tax Implications: Private Lending
Tax Implications: Real Estate Notes
Tax Implications: Turnkey Properties
IRS Income Categories
Prior to discussing the tax implications of passive real estate investing, we need to provide an overview of how the IRS classifies different types of income. This income classification directly relates to 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.
Moving forward, we will use these terms to explain the tax implications of certain passive real estate investments.
IRS Real Estate Investor Tax Classifications
In addition to classifying income types, the IRS also breaks down real estate investors into different categories. Each of these categories provides its own tax implications. As such, it’s important to understand exactly how the IRS will categorize an 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.
Real Estate Professional
This is a formal IRS tax classification. Simply 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 typically 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 p articipate in a real estate investment.
Per IRS guidance, 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 stated, passive real estate losses can typically only offset other passive income. 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 (AGI) less than $100,000, active investors can deduct up to $25,000 in passive real estate losses against active income. But, with modified AGI 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 modified AGI, 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, this is the classification people will receive with the passive real estate investment options outlined in this article. Most of these options provide passive income to passive investors. And, while this provides the least favorable real estate investor tax treatment, passive investing also provides the tremendous benefit of time. Simply put, passive real estate investing allows investors to A) profit from real estate, while B) not committing their time and effort to the active management of that real estate.
Tax Implications: REITs
Overview
Frequently, investors choose to begin their real estate journey with shares of a Real Estate Investment Trust, or REIT. Many of these entities are publicly traded, so they can be easily purchased and sold.
But, when investors purchase shares of a REIT, they purchase the company – not the underlying real estate. This provides the advantage of gaining investment exposure to real estate without needing to make any management-related decisions. Additionally, many REITs focus on a particular property niche (e.g. multi-family, office, industrial, etc.), providing investors further ability to diversify their portfolios.
Tax Implications
Among other requirements, REITs must pay out at least 90% of their taxable income as dividends to qualify as a REIT. This typically leads to higher dividend rates than most stocks and mutual funds. However, these dividends have unique tax treatments that investors need to understand. Of note, while investing in REITs may seem passive, the IRS considers REIT dividends portfolio income. As such, these dividends will receive one of the following tax
treatments, depending on their nature (as defined on the REIT’s annual 1099-DIV sent to shareholders):
Ordinary dividends: The majority of dividend income will result from the REIT’s business operations. As a result, it qualifies as ordinary income to the investor and will be taxed at the investor’s marginal tax rate.
Capital gain dividends: Some dividends will result from the sale of underlying REIT property. If held for more than a year, the dividend proceeds from these sales will qualify as capital gains. This means they will be taxed at the investor’s more advantageous capital gains tax rate of 0%, 15%, or 20%.
Nontaxable return of capital: If a REIT’s distributions exceed its earnings, typically due to depreciation, it can provide investors a nontaxable return of capital. However, investors indirectly pay a tax on these distributions, as it reduces their tax basis. This means that, when they eventually sell their shares, they’ll face a larger capital gains tax bill.
Tax Implications: Real Estate Syndications
Overview
Real estate syndications offer an investment vehicle for multiple people to pool their capital for a real estate deal. And, these deals include two parties: the deal sponsor and the investors. The sponsor finds, underwrites, and manages the day-to-day operation of the deal, and the investors provide the capital for an equity stake.
For example, 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 is the general partner, while the investors gain limited partner stakes.
Syndications provide an outstanding passive investment opportunity. They typically command higher returns than REITs, and they provide investors a direct ownership stake in the underlying property.
Tax Implications
Passive investment in real estate syndications provides two primary cash flows: rents and proceeds from property sales. With both, investors 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.
Rental income/losses: Any rental income will be taxed at the investor’s ordinary income rate – the same as owning any rental property. And, this income qualifies as passive. As such, any losses can only be used to offset other passive income (unless the investor qualifies as a real estate professional). Of note, limited partners typically do not play an active role in a syndication, meaning that they cannot claim the $25,000 of allowable passive activity losses available to active investors.
Property sale proceeds: When a syndication sells its property, passive investors will be taxed on any gains from the sale at their capital gains rates (assuming the property has been held for longer than a year). Additionally, investors 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.
Tax Implications: Private Lending
Overview
As the name suggests, private lending involves any non-traditional lender – typically an individual. For example, if someone has $250,000 in capital, he or she could choose to lend that money to real estate investors, collecting interest on the outstanding balance.
From a real estate perspective, private loans are typically used in a short-term context. For example, fix-and-flip investors often use private loans to buy and rehab a distressed property that wouldn’t qualify for traditional financing. Upon sale of the renovated property, these investors pay back the private money lender. Due to the short-term nature and rehab-related risk of these loans, private lenders typically charge much higher interest rates than traditional mortgages.
Tax Implications
As a lender, you take a position as a creditor on a property – not an owner. Therefore, you do not receive a portion of any of the property’s rental income or sale proceeds. Instead, the owner/borrower pays the private lender interest on the outstanding loan balance. The borrower’s interest expense represents interest income for the private lender. And, as with most interest income, this is taxed at the private lender’s ordinary income tax rate as portfolio income (despite the fact that private lending is generally considered a passive investment activity).
However, private lenders do h ave an option for receiving tax-free interest income. If lenders use funds from a self-directed IRA (SDIRA) and comply with all associated guidelines, they can collect interest income tax-free. This offers outstanding tax benefits – and returns – for individuals who have significant savings in tax-advantaged retirement accounts.
Tax Implications: Real Estate Notes
Overview
Similar to private money lending, many passive real estate investors purchase real estate notes. Purchasing notes provides investors an option to collect interest income related to real estate – without owning the underlying property. However, whereas private lenders originate loans, investors in notes purchase those notes from an original lender. As such, investors can purchase first- or second-position notes, with the latter typically providing a higher interest rate due to the increased risk.
Tax Implications
As with private lending, real estate notes provide investors with interest income. This generally qualifies as portfolio income taxed at an investor’s ordinary income rate. Furthermore, notes typically have very few associated expenses, meaning they provide solid cash flow – assuming the borrower continues making payments. However, this lack of expenses also means that investors have few available deductions to reduce their taxable income.
Tax Implications: Turnkey Properties
Overview
Turnkey investing is a direct investing strategy. That is, investors actually purchase and own a property, but they do so via a third party that manages the investment’s day-to-day operations. This means that a third party finds the deal, completes the rehab work, leases the property, and then manages it. Put simply, you own the property, but the third party does all the work.
Tax Implications
Rental income generated from turnkey properties qualifies as passive income – like owning any rental property. As a result, investors have the benefit of offsetting rental income with necessary property expenses, to include depreciation. This means that owners often come out cash flow positive while taking a tax loss due to depreciation.
With that said, how the IRS treats that passive income loss depends on the investor’s involvement. If the investor makes no management decisions, he or she will be considered a passive investor. Accordingly, passive losses could only be used to offset other passive income. On the other hand, if the particular arrangement allows the investor to take a role as an active investor in the eyes of the IRS, the $25,000 passive loss allowance may be available.
Upon sale of a turnkey property, investors need to pay the capital gains and depreciation recapture taxes associated with any rental property. However, investors also have the possibility to defer these taxes by executing a Section 1031 exchange and rolling the gains into another property.
Final Thoughts
Passive real estate investing provides tremendous opportunities for building wealth – without massive commitments of time and energy. However, in addition to assessing potential returns, investors must also consider the tax implications of each one of these strategies. By balancing their desired returns, level of involvement , and tax burdens, investors can make the best choice for pursuing passive real estate investment opportunities.
And, if you’d like to discuss different options for your unique situation, we’d love to chat! Schedule a call, and we’ll talk about available passive real estate investment opportunities.