Tax Implications of Passive Real Estate Investing
As is the case with all investment types, passive real estate investments have their own list of tax implications. Understanding these tax implications is paramount for any investor who wants to be sure that he or she is maximizing any available deductions while still operating within the legal parameters of federal and state tax laws. With different types of passive real estate investment options on the table, understanding the tax ramifications of each is important when creating an annual plan that should involve the taxes associated with your investment.
Real estate investment trusts, or REITs operate as a mutual fund that exclusively invests in real estate. Investors are drawn to REITs because of the true “hands-off” nature that they provide to investors who simply get to sit back and collect their share of the profits generated by the properties they have invested in.
Each year, REITs are required to provide investors with a 1099-DIV which breaks down the income that their investments have generated. In general, the profits that are generated through the REIT is passed from the trust itself to the investors. Because of this passing of profits, each individual investor is responsible for claiming his or her portion of the profits as ordinary taxable income. The amount that each investor will pay in taxes is decided by each investor’s marginal tax rate.
The trust is also responsible for informing each investor that their dividend is a capital gain or a capital loss when the trust sells a property that it has held ownership of for at least one year. It is also possible for a portion of the dividend to be listed as a “nontaxable return of capital.” If a REIT’s cash distributions exceed its earnings. It is important to note that these return of capital dividends are taxed later, so they are not truly tax exempt. If you receive a large enough return of capital and the cost basis drops to zero, any additional distributions are automatically taxed as a capital gain.
Real Estate Syndication
Real estate syndicate investing offers several tax benefits. Each investor in the real estate syndicate is allowed to claim depreciation of the subject property, property tax, mortgage interest, repairs and operating expenses as deductions on their annual tax return. It is important to note that the percentage of these deductions that you can legally claim on your taxes is directly proportionate to the amount that you have invested in the syndicate. Syndicate investors receive a K-1 form which is used to report their investment and income associated with the investment property.
Investors who choose to passively invest in real estate through a crowdfunding platform may be taxed differently based on whether they are accredited or non-accredited investors. Non-accredited investors typically have an easier time filing but turning a profit on your crowdfunded investment may put you in a position to be responsible for a hefty tax bill. Non-accredited investors typically invest in what is known as a “debt deal.” At its core, a debt deal allows the non-accredited investor to act as a lender to the people who are actually investing in the property. Since they don’t own any part of the property, they do not stand to reap any of the benefits associated with property ownership. The only income that non-accredited investors receive is the interest generated by their loan. Since their only income is interest, it will be taxed as regular income and they will receive a 1099-INT form from the IRS.
Conversely, the criteria that must be met to become an accredited investor is worth it when it comes time to settle your tax bill. Accredited investors receive a K-1 (1065) form from the IRS which documents the amount of income they received or lost based on their investment. The information provided on the K-1 is what accredited investors use in order to prepare their personal tax returns.
However, the income that is listed on the K-1 is not necessarily that amount of income that the investor may have at his or her disposal. Instead, the income reported on the K-1 is the income that was earned by the partnership, not necessarily the investor.
Privately Held Properties
You don’t have to go through a REIT, a syndicate or a crowdfunded partnership to be a passive real estate investor. If you are a passive investor who owns a rental property, you are legally allowed to deduct depreciation, operating expenses and other necessary expenditures from your annual tax return. The income that you earn is subject to being taxed at 0%, 15% or 25% depending on your personal tax bracket. However, you can use losses from the previous year to offset any capital gains from the current year.
Understanding the taxation system for passive real estate investors is a crucial aspect of successful investing. The best investors know how to offset significant gains with deductions when doing so is legal. Obviously, nothing is more important in the world of real estate investing than operating within the framework of the law. Knowing how to do that with your investment dividends can help you build a successful real estate portfolio. Remember to always consult a licensed CPA or a tax advisor before investing. Remember to always consult with your CPA or tax advisors prior to investing.