Tax Considerations for the Passive Real Estate Investor
Understanding tax liability is key to evaluating the net take-home return potential of any investment. Real estate investments are treated differently by the U.S. tax code than stocks, bonds, or other investment vehicles. This article takes a look at the specific nuances of taxation on passive real estate investments of the sort offered on EquityMultiple.
Note: EquityMultiple is not a registered tax advisor and therefore does not and will not offer tax advice of any nature.
Passive Income & Real Estate Investments
When investing in private real estate transactions—like those offered on the EquityMultiple platform—you are technically not investing directly in the property, but rather purchasing membership interest in a Special Purpose Vehicle (SPV) established specifically for the investment. For EquityMultiple investments, this is almost always a Limited Liability Corporation (LLC). The income produced from EquityMultiple investments and attributable to the SPV qualifies as passive income as defined by the IRS, “earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not materially involved.”
The U.S. Tax Code maintains a number of benefits for passive real estate investors:
- Costs or losses associated with passive income investments can still be deducted against income from other similar passive income investments. This can extend to non-real estate investments, so long as they are also passive and made through an SPV.
- The ‘actively participating’ party—typically the General Partner (GP) or Sponsor—is able to deduct cost against their income from investments like those you see on the EquityMultiple platform. In some cases, passive EquityMultiple investors are able to share in the benefit of this sheltering through passive investments made on the platform.
- Some of the costs associated with a passive real estate investment remain deductible against your overall income tax burden.
- The Tax Cuts & Jobs Act—signed into law on December 22nd, 2017—has ushered in a powerful new set of tax incentives for real estate investors. We’ll get to this in a bit.
Treatment of Passive Income
Investments on the EquityMultiple platform, and on many investing platforms, are structured as “pass-through entities”. Specifically, we establish a distinct LLC for each investment offering. Since the earnings from these pass-throughs are classified as passive, it is taxed separately from regular investment income (portfolio income). This has three implications:
- Income from these investments is taxed at your ordinary marginal tax rate.
- Any losses can be used to offset other passive income and only passive income, thereby lowering your overall tax liability. Portfolio losses cannot offset passive gains/income or vice versa.
- Profits from passive activity are not subject to self-employment tax.
Passive Income Tax Deductions for Real Estate Investments
There are several specific components of losses that may accrue to a real estate investment in a given year and hence be reflected on your tax documents as a passive investor:
- Depreciation: Per the IRS, real estate investors are entitled to write off a portion of the property’s value against annual income based on a predetermined depreciation schedule. On an annual basis this would be the value of the property divided by its “useful life” – 27.5 years for a multifamily or other residential property, and 39 years for any other commercial asset.
- Operating Expenses: Each expense item associated with owning a property, such as maintenance, property taxes and management fees, is deductible.
- Net Operating Losses: If a property generates a negative Net Operating Loss (NOI), that figure can be used to offset other passive gains or income.
- Interest: Interest paid on debt obligations is deductible. This expense will be listed on your K-1, further reducing your net tax burden.
In general, passive real estate investments that are made through an SPV and accrue income activity in any given year, positive or negative, will necessitate a Schedule K-1 for passive (LP) investors. This is the case in the vast majority of EquityMultiple investments.
To better understand K-1s and other mechanics of EquityMultiple’s tax filing protocols, please refer to our FAQs on the topic.
Implications of the 2017 Tax Reform on Real Estate Investments
The Tax Cuts and Jobs Act (TCJA)—signed into law on December 22nd, 2017—cut taxes substantially for corporations and individuals. The long-term macroeconomic consequences of the bill are a matter of debate, but the legislation undeniably carries major ramifications for how real estate investment income is taxed and the tax incentives available to real estate investors and developers.
While both investors and tax advisers may have gotten acquainted with these changes last year, here are some of the main takeaways:
A New 20% Deduction for Pass-through Income
Members or owners of pass-through entities can now automatically deduct 20% of their taxable income earned from pass-through entities (“qualified business income”). Investments made through an LLC (such as those on the EquityMultiple platform) qualify for this new tax benefit.
For individual filers, however, this deduction begins to phase out above $157,500 of annual income and is not available at all against taxable income greater than $207,500. Hence, this benefit may do little for accredited investors filing individually who qualify as accredited based on annual income of $200k or more.
For married couples filing jointly, the threshold is $315,000. So, for example, a couple who jointly earn $315,000 in taxable income—$250,000 through their day jobs and $65,000 in income earned via investments made through pass-through entities—could reduce their overall taxable income by $13,000 (20% of $65,000).
It may be a substantial boon to those who qualify as accredited based on net worth who currently earn less than $200k occupationally. For example, a retired investor who has earned $150,000 in passive income through a pass-through entity in a given tax year would be entitled to reduce their taxable income by $30,000 (20% of $150,000) to $120,000.
As with all else covered in this article, the nuances depend on your specific tax situation and should be addressed with a licensed tax advisor. Even with new IRS guidance released in mid-2018, this deduction is subject to a complex set of rules and qualifications.
The Investing in Opportunity Act—a bipartisan bill co-sponsored by Senators Tim Scott of South Carolina and Cory Booker of New Jersey among others—was passed as a ride-along bill with the Tax Cuts and Jobs Act, and drew little fanfare at the time. Over the past two years, and the course of several rounds of clarifying rules issued by the Treasury Department, the real estate investing community has awakened to the vast potential of these new tax incentives and Qualified Opportunity Zone (QOZ) investment volume has increased substantially.
Opportunity Zones are qualified census tracts—typically historically underinvested communities across the country—where investors can receive massive tax benefits for qualified investments. A qualified investment in a QOZ may otherwise be called an “Opportunity Fund”. The potential tax benefits of investing into Opportunity Funds are detailed in full on our Opportunity Zones Resource Page but, simply put, Opportunity Funds allow investors to roll-over pre-existing capital gains (defined as gains on assets held for more than one year) and defer payment of taxes on December 31, 2026 or the date which the investment in the Opportunity Zone Fund is sold (whichever comes first). The basis is “stepped-up” by 10% if the investment is held for 5 years, by 15% if held for 7 years, and profits realized on qualified Opportunity Funds held for 10+ years are wholly exempt from taxation.
As EquityMultiple CEO Charles Clinton puts it, Opportunity Funds are “one of the most exciting developments for new real estate investors in decades.”
Changes in Potential Write-Offs
For commercial real estate property coming into service in 2018 and beyond, the maximum annual deduction for costs associated with real estate capital improvements is now $1 million, up from $510,000 for tax years beginning in 2017.
For real estate operators, eligible property includes improvements to an interior portion of a nonresidential building if the improvements are placed in service after the initial construction phase and once the building is fully operational (in other words, for value-add improvements). The TCJA also expands the definition of eligible property to include the following expenditures for nonresidential buildings:
- HVAC equipment
- Fire protection and alarm systems
- Security systems
This should slightly improve after-tax return potential for value-add real estate investors and developers, which will ultimately filter down to investors who participate passively in value-add projects through a platform like EquityMultiple.
The Bottom Line: How Tax Law Will Impact Your Real Estate Investments
How your real estate investments are treated by tax code depends on the nature and extent of your investments, your location, and other specific aspects of your individual tax situation. Many of the fine points of new tax law and their impact on your portfolio are esoteric and endlessly complex—if you don’t believe us, try reading through this memo from the IRS on new deductions available via pass-through entities.
While we hope this article has been informative, it bears repeating that EquityMultiple does not provide tax advice. We encourage you to work closely with your advisor early in each calendar year as you prepare to file taxes.
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