Commercial real estate can generate significant investment returns. But, these assets also typically have a far higher barrier to entry than residential real estate – in terms of capital, experience, and time. Fortunately, passive real estate investing exists as an alternative to executing all aspects of a commercial deal. As such, we’ll use this article to answer the question: what is passive real estate investing?
Specifically, we’ll cover the following topics:
- An Overview of Passive Real Estate Investing
- Passive Real Estate Investing Options
- Final Thoughts
An Overview of Passive Real Estate Investing
What is Passive Real Estate Investing?
Conceptually, passive investors seek a return on capital from the managerial efforts of others. In other words, passive investors contribute money to a deal. But, someone else manages that deal, with investors collecting some return on their contributed capital.
In real estate, passive investing often occurs when an experienced real estate investor finds a solid deal but lacks the cash necessary to make that deal happen. To bridge this cash gap, these individuals can seek passive investors. The passive investors contribute the funds necessary for the deal, and the experienced individuals handle the underwriting and day-to-day management of the deal.
This system serves as a win-win. Passive investors can invest in a commercial real estate deal, even if they lack the time, experience, or desire to personally execute the deal. And, experienced investors or real estate developers can raise the funds necessary to make deals happen.
However, this is not the only option for passive investing. As we’ll outline below, a variety of strategies exist to passively invest in real estate. But, at their core, each strategy entails contributing funds and seeking a return based on the real estate expertise and managerial efforts of others.
Real estate taxes can become extremely complicated, and our goal in this article is not to provide a detailed explanation. However, it’s worth noting two tax considerations to passive real estate investing.
First, when you directly invest in income-producing real estate (i.e. own a portion of a rental property), you gain the benefit of depreciation. As a “cashless expense,” depreciation reduces your tax bill without a corresponding cash outlay. Accordingly, many rental properties generate positive cash flow with taxable losses. (NOTE: The IRS claws some of this depreciation benefit back when you sell a property through a tax called depreciation recapture. However, strategies like Section 1031 like-kind exchanges can defer this tax hit).
But, there’s another caveat to these taxable losses, which leads directly into the second tax consideration. When you invest in rental real estate, the IRS generally categorizes the associated income or loss as passive. This means that you can only use losses from a rental property to offset other passive income – not your W-2 or self-employment income.
Exceptions to this passive treatment exist for investors A) classified as real estate professionals by the IRS, or B) with modified adjusted gross incomes (MAGI) below $150,000. But, as a general rule, passive real estate investors shouldn’t expect to use losses generated by an investment property to offset non-passive income.
Passive Real Estate Investing Options
Having provided the above overview, here are three common strategies for passively investing in real estate:
Option 1: Invest in a Deal as a Limited Partner
Many commercial real estate deals are structured as limited partnerships. At the simplest level, a limited partnership has two partners. The general partner manages the partnership and handles its day-to-day operations. The limited partner contributes capital and receives an ownership interest in the partnership but doesn’t have any managerial role. In other words, the limited partner serves as a passive investor, receiving the benefits of direct ownership (i.e. a share in profits/losses and depreciation) without any day-to-day responsibilities.
Many real estate developers want to bring limited partners into deals to A) raise cash, while B) not giving up any managerial control. As a result, establishing relationships with local real estate developers can be an outstanding way to learn about passive real estate investment opportunities.
Option 2: Join a Real Estate Syndication
Unfortunately, investing as a limited partner depends on your ability to actually find a general partner willing to bring you on as a partner. Real estate syndications, on the other hand, offer the benefits of limited partnerships without these same relationship requirements.
In a syndication, a deal sponsor (or syndicator) finds, underwrites, and manages the day-to-day operations of a deal. To raise money, the sponsor markets the deal to investors through a pooled capital model called syndication. Typically structured as LLCs, the deal sponsor serves as the managing member, and the passive investors act as investor members.
While structurally similar to a limited partnership, real estate syndications often include more opportunities for multiple investors to join a deal. With the passage of the 2012 JOBS Act, deal sponsors (with certain restrictions) can “crowdfund” syndications online. This has created a number of websites connecting sponsors with passive investors. Accordingly, people looking for passive investment opportunities don’t need to know experienced real estate professionals – they just need to vet potential deals through one of these syndication portals.
Option 3: Buy Shares of a REIT
Both of the above options include direct ownership of investment properties. Real estate investment trusts, or REITs, offer passive investment opportunities without the associated direct ownership. And, as many of these REITs trade publicly, they offer far more liquidity than syndications or limited partnerships. If you want to invest in a debt, equity, or hybrid REIT, it’s as easy as buying shares in one through your online brokerage.
However, this lack of direct ownership means that, when you hold REIT shares, you do not receive pass-through depreciation. Rather, by law, REITs must distribute 90% of their taxable income to shareholders in the form of dividends. And, these dividends are typically taxed at your ordinary income tax rate (i.e. your marginal tax rate) – not the more advantageous long-term capital gains rate.
These characteristics make REITs a solid choice for investors looking for reliable fixed income from tax-advantaged retirement accounts. But, for passive investors seeking the tax benefits of depreciation, REITs may not make sense.
Many people don’t have the time, money, or experience to take point on a commercial real estate deal. But, this shouldn’t prevent you from reaping the benefits of these investments. Passive real estate investing offers a solution. With this approach, investors contribute capital and generate returns on that investment – without actually needing to find and execute individual deals.
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 passive real estate investment opportunities.