One of the major benefits of real estate investing is how it is treated under the tax code. When you invest in a real estate syndication, you are essentially purchasing shares of an LLC (or similar entity) that owns the underlying asset.
Most real estate syndications are structured as pass-through entities, meaning the tax benefits of ownership, including depreciation and cost segregation, are passed through to investors.
This page explains how taxes and depreciation typically work in passive real estate investments and what investors should understand when evaluating opportunities.
Taxes play a significant role in how much of an investment's return an investor actually keeps. Unlike many traditional investments, real estate offers unique tax characteristics that can improve after-tax outcomes over time.
Understanding these basics helps investors evaluate opportunities more realistically and avoid surprises at tax time.
Income from passive real estate investments is generally classified as passive income for tax purposes. This income is reported on a Schedule K-1, which details each investor's share of income, expenses, and deductions.
Depending on the structure and performance of the investment, taxable income may be lower than the actual cash distributed due to depreciation and other non-cash expenses.
Depreciation is a non-cash expense that allows investors to deduct the cost of a property over a set period of time, even if the property is increasing in value. Depreciation is one of the most powerful wealth building tools used by real estate investors.
For passive investors, depreciation can help offset taxable income generated by the investment, potentially reducing current tax liability.
**Disclaimer: This depends on your individual tax situation. Please consult your CPA.
In many real estate investments, depreciation deductions may reduce or eliminate taxable income in the early years of a project. This can result in investors receiving cash distributions while reporting little or no taxable income.
Each year, you would receive a schedule K-1 showing your income and losses for the syndication you invested in. In many cases, due to cost segregation and accelerated depreciation, the paper losses can be extremely high, especially in year 1.
This means that you could show a paper loss, even while you continue to collect ongoing passive income.
Cost segregation is a tax strategy that accelerates depreciation by identifying components of a property that can be depreciated over short timeframes. Think depreciation, but amplified.
Cost segregation acknowledges the fact that not every component in the property is created the same. For example, the toaster at your home has a much shorter life expectancy than the roof
In a cost segregation study, a qualified engineer itemizes the individual components that make up a property, including things like windows, roofs, mechanicals, and the wiring.
Some items can be depreciated on a shorter timeline, 5, 7, or 15 years, instead of the standard 27.5 years. This can greatly increase the depreciation benefits in the beginning years.
When a property is sold, investors may owe taxes related to capital gains and depreciation recapture. The amount depends on holding period, sale price, and individual tax circumstances
Some investors may explore strategies to defer taxes, but these should be reviewed carefully with a tax advisor.
What passive investors should understand at exit:
Passive real estate investments are typically taxed as pass-through entities, meaning income, expenses, and deductions flow directly to investors. Each investor receives a Schedule K-1 showing their share of taxable income or loss for the year. Due to depreciation and other non-cash expenses, the taxable income reported may be lower than the actual cash distributions received. Each investor should consult with their CPA to verify how investing in real estate syndications will affect their own unique situation.
Depreciation allows real estate investors to deduct the cost of a property over time, even if the property is increasing in value. For passive investors, these depreciation deductions can help offset taxable income generated by the investment, potentially reducing current tax liability. In many cases, investors may receive cash distributions while reporting little or no taxable income due to depreciation and cost segregation.
When a property is sold, investors may owe taxes related to capital gains and depreciation recapture. The exact tax impact depends on factors such as the holding period, sale price, and an investor’s individual tax situation. Because tax outcomes vary, investors should review how potential exit-related taxes with their CPA or tax advisor before investing.
We designed this free 7-day email course to show you exactly how to get started passively investing in real estate development opportunities and how you can start building generational wealth for your family.
Justin Goodin is the founder of Goodin Development, a multifamily development firm in Indianapolis, Indiana. He graduated from the prestigious Kelley School of Business with a degree in Finance and used to work at a bank as a multifamily underwriter, before founding his own company.
Justin created Goodin Development to help busy families build wealth with real estate investing without the day-to-day responsibilities of being a landlord.
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