Whether you’re investing in a REIT, a publicly-traded stock through a broker or online service, or investing in a private real estate offering like those found on contemporary real estate crowdfunding platforms, it is important to take into account net fees. Return projections don’t mean much without looking at the bottom line, net figure. When comparing net returns of potential investments, it’s critical to also look at the relative tax implications; after all, your net, take-home yield from any investment is impacted by how taxed the investment is. This article takes a brief look at the tax implications of private real estate investments. While we hope this is useful, keep in mind that your tax advisor will always be able to provide the most valuable input on the tax implications of your investment activity.
A Brief History Review:
Up until the Reagan Administration’s tax reform bill of 1986, investors were accustomed to using real estate investment for sheltering passive income to reduce overall income tax burden. After the reform, investors could no longer reduce the tax burden of their active income through “passing through” real estate losses. This landmark policy change has had a lasting impact on how real estate investments are taxed, including private, passive investments like those offered on the EQUITYMULTIPLE platform. The IRS defines passive income as “earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not materially involved.” Thus, under the post-reform tax law, investors can only deduct normal expenses due to operation of the properties invested in. That said, investors in private placement real estate offerings may still enjoy a number of tax benefits, as discussed below.
Considerations for “Passive Income” Real Estate Investment
Real estate and equity crowdfunding portals (like EQUITYMULTIPLE for example) are structured as “pass-through entities” – as is typical, we create a distinct LLC for each investment on the platform, to which all of our investors are party. Since the earnings from these pass-throughs is classified as passive, it is taxed separately from regular investment income (which is often referred to as portfolio income). The impacts are threefold:
- Profits from passive activity is not subject to self-employment tax.
- Income from these investments is taxed at your ordinary marginal tax rate.
- Any losses can be used to offset other passive (and only passive) income, thereby lowering your overall tax liability. Conversely, portfolio losses cannot offset passive gains/income, and vice versa.
Tax Deductions
From a tax perspective, platform-based passive real estate investing provides the best of both worlds: while you are not saddled with the hassle of daily management, and do not assume nearly the same level of risk as the managing (active) party, you can still enjoy some of the same tax benefits as the active real estate investor who sourced the investment (the GP or Sponsor).
- Net Operating Losses: If a property generates a negative NOI(a net operating loss), 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, and it further reduces your net tax burden.
- 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.
Conclusion
At a high level, real estate investing provides a greater and broader set of benefits than investing in stocks or bonds, regardless of whether you are actively owning and managing property, or simply investing passively. Again, though, every portfolio’s tax burden is unique, and you should consult your tax advisor regarding the impact of any particular investment, real estate or otherwise. There may be other aspects of your personal tax situation to consider with respect to such investments, e.g. marital status, your employment income, or the state you reside in, just to name a few.
Note: EquityMuiltiple is not a registered tax advisor and therefore does not and will not offer tax advice of any nature.
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