America is an amazing country built on the cornerstones of individual freedom and capitalism infused with a spirit of innovation and entrepreneurship.
Like it or hate it, the odds are stacked in favor of risk-takers, entrepreneurs and capitalists. The tax code, in particular, provides multiple incentives and benefits to encourage entrepreneurship and investment.
Unfortunately for clock punchers, the tax code is stacked against you. Entrepreneurs, on the other hand, are offered a multitude of incentives to invest in anything from technology, infrastructure, and energy to commercial real estate and everything in between.
So while clock punchers can pay up to a maximum federal tax rate of 37%, entrepreneurs generating passive income from private investment funds pay the maximum capital gains rate of 20% on both profit distributions and long-term growth.
Tax Benefits of Passive Investments
Let’s compare the tax liability between a partner in a law firm and an investor in a private investment fund.
Both make the same $525,000 income per year, but while the lawyer’s income is categorized as earned income, the investor’s is considered passive income.
The investor will pay less in taxes because passive investments like private investment funds are typically set up as partnerships (LPs or LLCs) designed to maximize tax benefits for its partners. Passive profits distributed to the partners are taxed at the individual levels at the capital gains rate.
For purposes of this exercise, we’ll assume the top capital gains rate of 20% for the investor.
Here are their relative tax liabilities:
Lawyer: $194,200.00 ($525,000 x 37%)
Investor: $105,000.00 ($525,000 x 20%)
So, while the lawyer and investor both make the same amount of income, the lawyer pays a whopping $89,200.00 more in taxes.
The reasoning for the favorable tax treatment of passive investors is that it’s in the overall economy’s best interests if entrepreneurs are incentivized to create businesses, innovations, and opportunities, which will, in turn, provide jobs for multiple clock punchers who will pad the IRS coffers.
An additional tax benefit for private fund investors is the exemption from paying FICA (social security & medicare) payroll taxes.
That’s an extra savings of 7.65% per year or $40,162.50 in our example.
Taking FICA into consideration, the investor is $129,362.50 less in taxes per year compared to the lawyer.
Gains from the eventual sale or redemption the investor’s partnership interest will also be taxed at the long-term capital gains rate.
Tax Benefits of Private Real Estate Offerings
Passive investments in private real estate offerings offer an additional layer of tax benefits. Some of the most common real estate-related deductions include:
- Depreciation (Accelerated)
- Mortgage Interest
- Property Tax
- Operating Expenses
- Repairs
In a private real estate investment fund, these deductions are distributed to their partners on a pro-rata basis and reported on each partner’s annual K-1.
Deductions considered passive losses can be used to offset passive income, while any other deductions can be used to offset ordinary income to reduce tax liability.
Here’s a rundown of the significant real estate tax benefits:
Regular Depreciation – Regular depreciation deductions allow investors a business deduction for the cost of items that have a “shelf life” like a building. The typical depreciable period is 27.5 years.
For example, if the cost basis of a multi-family property (the structure only and not including the land or improvements) is valued at $1,000,000, the annual depreciation deduction allowed over 27.5 years would be approximately $36,400.
In a passive investment, this depreciation would be distributed pro-rata to all the partners. The practical effect of depreciation deductions is that a passive investor will pay little to no taxes on their periodic profit distributions.
Cost Segregation – Cost segregation is a tax strategy that dissects construction costs from the purchase price of the property that would otherwise be depreciated over 27.5 years. Cost segregation is typically conducted by an engineering company and reported on a cost segregation study.
The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7, and 15 years as opposed to 27.5 years for the building. This accelerated depreciation allows greater deductions in the earlier years of the life of an asset.
Bonus Depreciation – One of the significant changes from the Tax Reform Act was the bonus depreciation provision, where businesses can take 100% bonus depreciation on a qualified property purchased after September 27th, 2017.
SDIRAs – Because Self-Directed IRAs (SDIRAs) allow for investments in alternative assets, investments in private commercial real estate funds are ideal for taking advantage of additional tax benefits from investing in private real estate funds through an SDIRA.
Consider the benefits of investing with a Self-Directed Roth IRA. With a Self-Directed Roth IRA, if you are under the age of 50, you can contribute up to $6,000 per year into an IRA and an additional $1,000 if you are 50 or older.
Because you contribute to a Self-Directed Roth IRA with post-tax dollars, your investments will grow tax-free.
1031 Exchanges – A 1031 exchange doesn’t typically come to mind when considering private real estate investment funds. Still, there are options for passive investors to take advantage of this tax benefit that allows a swap of like-kind commercial property to defer the capital gains.
Although most private real estate funds are not set up for qualified 1031 exchanges from an investor’s personal property, this same investor could do a qualified 1031 exchange flipping his interest in one private real estate fund to another real estate fund under the same sponsor.
Qualified Opportunity Zones – As part of the recent Tax Reform and to encourage private investment in distressed communities, the government has instituted significant tax breaks for investors who invest in Qualified Opportunity Zones.
By investing in an Opportunity Fund, an investor can:
- Defer taxes on the original capital gain until the end of 2026.
- Reduce up to 15% of the tax bill on the original capital gains if remain invested in the Fund for at least seven years.
- Eliminate the tax on any appreciation (new capital gains) on the original investment after the 10-year mark in the Opportunity Fund.
The government wants your help in stimulating the economy.
It particularly wants you to invest in private real estate investment funds where the tax benefits are generous and numerous.
Mike
