The tax benefits of real estate investing are attractive, but until recently many investors had difficulty participating in commercial real estate syndications that could fully take advantage of those tax benefits. Now, however, the advent of real estate crowdfunding sites like Realty Mogul has enabled smaller (though still accredited) investors to participate in real estate projects in ways that bring those tax advantages directly to investors.
The tax benefits of direct real estate ownership are substantial and not generally available to investors in real estate investment trusts (REITs), who do not receive all the tax attributes associated with the actual ownership of real estate. Real estate investments made through a limited partnership (LP) orlimited liability company (LLC) structure can be more attractive than REITs for several reasons, but at least some of the appeal lies in the inability of REITs to fully take advantage of the various tax shelter benefits available through the LP or LLC structure.
Depreciation. The primary tax feature of equity real estate investing is the role of the depreciationdeduction, which has long played a major part in the popularity of real estate direct participation programs involving LPs or LLCs. This is because well-located and well-maintained real property often has a useful life longer than the depreciation recovery periods allowed by law. The depreciation deductions thus effectively create a tax shelter for a property that likely still has a useful life following the investment period. More accurately, the deductions create a tax deferral, since the tax basis of the property is reduced by the amount of the depreciation deductions, increasing the gain (or decreasing the loss) recognized at the time of sale. It should be noted that some or all of this additional gain may be recaptured in the form of ordinary income, as opposed to capital gain.
A particular advantage of the depreciation rules is that the basis for depreciation write-offs is the full cost of the asset. Rarely is real estate purchased for all cash; usually, the major portion of its cost is financed through a mortgage loan or other type of debt financing. The owner, however, gets a full depreciation deduction whether or not he pays all cash for the property, and whether or not he makes any sort of personal guarantee on a financing loan. The reasoning for not limiting the depreciation deduction to an owner’s equity stake is that eventually the owner will have to amortize the debt obligation to complete his investment in the property. In practice, however, mortgages usually amortize at a slow pace during the early years of ownership, and many investments are limited to 5-10 year hold periods. Generally, then, even when depreciation deductions are compared with loan repayments, the deductions may generate more current tax savings than the outlays allocated to principal repayment on the loan.
Loan Interest. A further major tax benefit is the deductibility by the real estate operating entity of mortgage interest expense to shelter the current income from that property. Rental properties purchased using mortgage or other financing can have the associated interest expense deducted from the rental income of that property for purposes of calculating the operating entity’s taxable income.
Investors in a real estate LP or LLC usually hope that the pass-through entity will have sufficient depreciation, interest expense, and other deductions to shelter the cash flow from the property and keep that distribution of cash nontaxable (or at least tax-deferred). These shelters can permit the entity’s partners (or members) to receive a return similar to a tax-exempt bond – only real estate returns have historically been substantially higher. Investors may ultimately have to have some of this tax benefit “recaptured” upon a sale or other disposition of the property, but in the meantime they have substantially tax-free use of the distributed cash.
Investors also often hope that the LLC will generate excess deductions and thus net operating losses (NOLs) to offset income they have earned from other passive investments. To fully utilize these, investors must take into account the “passive loss rules” (which generally provide that losses generated by an activity characterized as a passive activity can only shelter income from other activities characterized as passive activities, and cannot offset non-passive income) and the “at risk” rules (which generally limit an investor’s ability to utilize losses generated by an activity in a given year to the amount for which the investor is considered “at risk” with respect to such activity) in evaluating the current tax savings to be recognized from a real estate investment. If the depreciation deduction, interest expense and other items result in a net loss, such losses are subject to those passive loss rules.
Along with existing cash flow and the potential for appreciation in a property, then, equity real estate investments made through pass-through vehicles like LLCs can take full advantage of the depreciation and interest expense deductions that are some of the most valuable characteristics of direct real estate investing. These tax benefits are substantial and not generally available to investors in REITs.