#51: Tax Benefits of Investing in a Syndication

Foreign. Welcome to the Passive Income MD Podcast where we talk about creating your ideal life through multiple streams of income. I'm your host, Peter Kim. If you enjoy hearing about this stuff, make sure to hit subscribe so I can bring it to you every week. Now let's get on with the show. Hey everyone, hope you've had a great week. April 15th passed recently and for many of you, you know what that means. It's tax time. Now, that might be what comes to mind in a normal year. This year's been a little bit different as the deadline's been pushed off to May. But there's no doubt that when that date came, something, you know, crossed your mind about paying taxes, how much you pay, how do you pay less and that sort of thing. And honestly, that's one of the biggest drivers, if not the biggest driver, for physicians to often get into real estate investing. We don't often have tax benefits or shelters as much as, you know, some of these other business folks might have. And so investing real estate allows us to capture a lot of that. So I'm sure it's been top of mind for many of you. It always is for me. Around this time, we're gonna get into five tax benefits of investing in a syndication. But before we do that, I just wanna remind you, and I have to remind you that this weekend actually is when we launch an open enrollment for, for our signature course, Passive Real Estate Academy. And for those who have no idea what that is, basically it's a four week online course where we teach you to confidently invest in real estate without being a landlord. What that means is that we help you understand how to do the proper due diligence so you can make great investment decisions and avoid mistakes when it comes to investing in syndications and funds. If you're interested at all, join the waitlist, because we are offering a waitlist discount. But if you missed that, there's still an opportunity. To join, go to www.passiverealestateacademy.com, www.passiverealestateAcademy.com and that should be easy to find. But let's get into our episode. So there's no doubt as a physician, every year tax season comes around. It's painful. It reminds you just how much you're paying in taxes, you know, and taxes aren't necessarily a bad thing. It's part of our duty as a citizen. And, you know, the rules are the rules. At the same time, there are also ways to maximize or minimize, I say even a better word to minimize the amount of taxes you pay in a legal way. And you know, oftentimes these are incentives that the government gives to investors and business owners because they know on the backside giving those incentives will result, at least they think so, in some other benefits down the road, whether it's in, you know, creating employment or creating taxes in some other way that they know that the having these incentives really helps people to make decisions one way or another. And that's really all it is. The tax code is a series of incentives, incentives by the government. And that's what I see anyways, when I think of taxes. And to be honest with you, tax season was never a fun thing for me. I mean, it still isn't in so many ways. But to be honest with you, because of real estate investing, it has absolutely changed my perspective on income taxes and ultimately strategy behind it. And so I've really been thinking about how am I gonna invest my capital in a way that is extremely tax efficient? I mean, to be honest with you, if you're, it's, it's good that you make a high salary, you make a good income, but if a good majority of that is going to taxes year to year, it's hard to store some of that away and create that passive income that you want, right? It's actually taxed at a very high point. So tax efficiency is absolutely important. And I found that that investing in passive and these private real estate opportunities offers a good amount of tax advantages. I mean, also when you invest in, you know, by owning your own direct rentals, there are a good amount of taxes, you know, tax benefits, as we've talked about before. But honestly, you get a lot of those same benefits, not every single one, but a lot of the same benefits in investing in syndications and funds. So I'm going to be talking about five of those things today. And the first thing I want to talk about is something called depreciation. So you might have heard me talking about this quite a bit. It's a huge deduction. Now, what is depreciation? It's when the IRS allows you to deduct the cost of business items that have a shelf life, such as the building itself. Now, what that basically means is that this building, when you purchase a rental property, normally it has a value at least the actual building apart from the land. Everything that's within the building as well has a shelf life. And, and you know, that life in terms of residential property is 27 and a half. For commercial properties, it's 39 years. And what the government allows you to do, typically is each year you deduct that precise amount from the total value of whatever you purchase. I'll give you an example of that. So if you had a rental property and you bought a building and it's valued at 500,000, then what you. I mean, talking about the value of the building itself apart from the land and everything in it. So if you divide that by 27 and a half years, that's about $18,000 each year you can deduct $18,000 as a depreciation expense again for 27 and a half years. And the IRS allows you to do that. Now, there is something called bonus appreciation. This is something that is a limited thing. It came about in the Tax Cut and jobs act of 2017. It changed some rules around depreciation and it allowed you to and businesses to accelerate the timeline of depreciation and take it much earlier in the lifespan of a property. So what it allows you to do, and let's say you own these rental properties, you can depreciate and deduct significantly a significant amount early on and squash it into the first couple years of when you own that property. So I would say if it's like a rough amount, people always will ask me what that amount is. I'd say like you're almost able to deduct about 25% of the purchase price of the actual building of the property in the very first year. That's just a rough amount. So, for example, if you bought a property that was $4 million, let's just say investors can deduct $1 million in the first year alone. And that's huge for your K1, huge for your taxes. And this is a major thing for you to understand. Now what happens is when you invest in a syndication as a limited partner, as a owner, you know, you're a smaller owner and you're, like I said, you're a limited partner, but you're still an owner in that property. Now you can benefit from the deduction as well, benefit from the appreciation. Now, this is something you should definitely ask whoever you're working with. But the way I've seen almost every syndicator and sponsor that I've worked with is they pass that depreciation 100% down to you as an owner, as an investor. So what happens is, I've seen is when I make an investment of, you know, whether it's $50,000 or a hundred thousand dollars, whatever it might be, into an apartment syndication, my expectation is that I will receive a good portion of that amount in that first year as a deduction. Now where that shows up is in your K1. Now the K1 is what you receive and as like a statement that talks about your ownership stake and your involvement in it. And so what ends up happening is that your first year, second year, third year, fourth year, fourth year because of depreciation in particular, you end up having a significantly negative, significant negative number, as I'd say, your net returns for that year. And so what happens is that, let's say on pa, let's say in reality, you know, you receive distributions, you receive, you receive those quarterly dividends, those quarterly paychecks. The funny thing is, on paper, according to the irs, you've actually lost a significant amount. And so what happens, you're able to take that cash flow, you can either spend it, you can go ahead, invest it elsewhere. The thing is, honestly, it's all being tax protected by that huge negative depreciation, K1, that shows that negative number. And so it's really nice. So it allows for tax protected gains, especially early on in the life of the investment. So that's one, that's appreciation. Number two is something called capital gains. As you know, capital gains are, it's just basically the profits from selling an asset. So this is counted as income and it's going to be taxed. However, the tax rate is different than it is for the rate of traditional income. For example, the tax brackets, you know, it changes like with each, you know, presidential term and obviously depending on the party and that sort of thing. But the 2020 income tax brackets, you know, you can go anywhere from 10% to somewhere around 37% at the top. And many of you know this because it affects physicians significantly with our higher salaries and without our ability to actually take a lot of significant deductions and drop brackets. And so I can go from 10 to 37%. Now, if you compare this to the brackets for long term capital gains, right, the long term capital gains, which is what you're going to be paying on a lot of these syndications because you've held that investment for at least longer than a year, the long term capital gains rate is somewhere between either 0, 15 to 20%. And so what ends up happening is that the income that you receive from this real estate investment, especially when it goes and it sells, let's say this investment sells and you get a good amount of income, it's considered long term capital gains. And it's taxed at the maximum 20%. Now that's a pretty far cry from either 35 or 37% that you might have to pay on your day job income. And if you compound those gains, I say over time it becomes even more significant. So again, this is another way that investing in real estate is far more efficient than you creating income from your day job as a physician. And in the past, I don't know, I've written a blog post, you might want to check it out, that not all income is created equal. You know, certain dollars and certain types of income are honestly taxed significantly different. And it's important to know that. And it's an amazing benefit of, of investing in passive real estate. Okay, number three, in terms of the tax benefit, it's refinancing. Now, many of you own your own properties, your own homes. You know that refinancing is a great way to pull money out. That's one way to do it. Pull money out of a current asset like a property, and then take that money and then you can do whatever we want with it. And this works great when your property has appreciated in value. So what I mean by this, let's say you bought a property for $500,000. You've renovated the property, higher rents, higher operating income, the market also improves and now the property is worth a million dollars. Now there's a way that the bank allows you to do is to do some sort of something called a cash out refinance. You're able to pull out significant amount of that initial, you know, the value of that property. For example, let's say this time you decide to pull out $500,000, right? I mean, that was your initial investment, let's say, and you're able to take that and you're able to put that towards the purchase of another building or whatever you want. You can spend it whatever you want. Now that is actually a tax free process that allows you to take that cash, utilize it to grow your streams of passive income without paying more in taxes. Now, at the end of the day, once your property is sold, then all that comes true, right? And then all that gets accounted for. But during the refinance and because of that, that's tax free money that you can pull out. Now, when you invest in a syndication, many of these operators, syndicates, will do that exact same, the exact thing where, let's say I will tell you, for example, my very first property that I invested in a syndication, I invest in a syndication and I invested, my very first one was $25,000. And in about a year and a half the property had increased in Value quite a bit. They did a refinance and honestly they returned half of my capital back immediately in 18 months. So I received somewhere about $13,000 back. Now that $13,000 that refinance and because of all the other tax deductions, honestly that was tax free kind of returns. And it came back to me and I was able to throw that into another investment. And that is something you don't have to pay taxes on. Again, it becomes really powerful when you begin to compound these things. So that's benefit number three. Number four is something called a mortgage interest deduction. I think that's pretty straightforward. You all know that when you own a property, there is a deduction on the mortgage interest. Now this amount has changed in terms of the ceiling for how much you can deduct. But the majority of payments when you pay for a loan and the quote unquote mortgage, a lot of it goes towards interest of loans. Now these payments can be deducted. And so again, this all goes into play when you are calculating your ownership stake. And when you get that great K1 at the end of the year for investing in real estate, that is a deduction that can work absolutely in your favor. And this adds up over time. Now, number five, losses carried over to future gains or can offset current income. Now let me say this one again. The losses, okay, can be carried like each year to offset future gains or honestly, it can offset current income. Now your physician income. Now I'm going to talk about this. This one can get a little bit complicated, but let's spend a little bit of time here. So as I mentioned, because of these deductions, especially something called depreciation and different, you know, mortgage interest deduction, all of these kind of things, you might Show a negative K1 or negative number on your K1. Now these losses get carried over year after year after year. You're showing a net loss even though you're receiving distributions along the way. Maybe refis happen, you start receiving money back. Again, those in that situation, as long as you remain a K1 with that's negative, you're not paying taxes on that. So I mean, it's great you're receiving all these things tax free at this point. You've probably got losses that you're carrying over. Now what happens is that, you know, most people ask and have got asked this quite a bit, can those losses offset your doctor income? Now unfortunately, the IRS designates this income and losses associated with your rental properties as quote unquote passive income. Now that's different from Your active day job. And those two things are absolutely separate because back in the day, people used to take advantage of this, invest in real estate, get those deductions, offset their doctor income. They made a stop to that, created that wall between active and passive investing. There's an exception to this where you can actually use some of these passive losses to offset your active income. Now I have to just do a quick disclaimer here. I am not a cpa and so you should be talking to your CPA or real estate tax professional before actually trying to implement some of these. But I'm just passing on what my CPA has done with me and told me as well too. Now, if you are a real estate professional, and you've probably heard this, it's called reps real estate professional status. And this is something that the IRS designates that you are a real estate professional because you, you spend more than 50% of your time on real estate related activities that's active. And also there's an hours requirement, something like 750 hours that you have to put in per year. But if you qualify for these things, and maybe many people do who work part time as a physician, many people who have a spouse or a partner who is able to demonstrate real estate professional status, and when you file jointly, you able to take benefits of that, they'll take these losses that they're gaining from their real estate syndications, from these passive investments and they're able to offset their active income from it. And so that can be hugely beneficial to know that, hey, I am investing in real estate, but I'm offsetting some of the taxes or something I would have paid towards the taxes on the active side, towards that. And again, this can be a powerful, have a powerful compounding effect over time. That is one of the greatest benefits of real estate professional status and investing in some of these passive real estate investments as well. Now that is one of the strategies that we talk about, I mean, in our course as well, Passive Real Estate Academy, we talk about how to invest in passive real estate, especially for those who can have real estate professional status and how to offset some of your active income. Now if you don't have real estate professional status, it continues to offset any gains that you have on the passive side. You know, in future years, perhaps you have other deals, other syndications that you've invested in that are now exiting, meaning that they're selling and you get a nice capital gains on top of that. Now that's still considered on the passive side. Now if you have losses stacked up from other investments, passive real estate investments, then those things tend to offset kind of deferring those taxes down the road. Again, hopefully I'm being clear on that. But you can stack losses to to offset your gains and that can be a powerful way of continuing to defer taxes down the road for you to continue to get income that is tax free that you can use to either spend, live off of, have that cash flow, or to throw into future investments and have that compound over time. Now all of these deductions and benefits that I mentioned can result in amazing, amazingly huge gains as an investor. Again, if you are just steady with your investments and these things tend to compound over time, it's pretty clear how these things can result in significant gains. Now for someone like you or me, that's the busy professional who where our time is limited and our time is extremely, I'd say valuable. You know, the last thing we want to do oftentimes is create another job. And so for many people that passive real estate investing is just fits the bill where it's a tax efficient structure that doesn't require any additional time, energy, effort, expertise to get that passive cash flow. In that previous episode I talked about how to leverage passive real estate investing to really achieve your goals. So take a listen to that if you haven't, but just know that when it comes to taxes, passive real estate investing, you can get the majority of the benefits of investing in real estate with minimal amounts of time and and effort. And I love talking about this, so hope that was helpful. Like I said, I never enjoyed taxes before, but now that I know that there are smart ways to deal with taxes and make it work in your favor, it's helped change my perspective around this time of the year. So anyways everyone, thank you for listening. Have a great week and take care. Enjoy the show. 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