Tax Considerations in Real Estate Investing
Taxation is one of the hottest topics for our investors. Not only are they concerned about how much they might have to pay, but they’re also concerned with the potential hassle that tax reporting can create. When making an investment in real estate, it’s important to have a tax plan in mind and a full understanding of your filing requirements and the potential cost.
A traditional one-off property investment, whether owned by yourself or through a syndicator/sponsor, can have a number of tax-related items to keep track of, though should be relatively straight forward. You will likely receive a federal K1 and the state equivalent for wherever the property is located. If the property happens to be in a state that doesn’t have personal income tax, then you may not even receive a state K1. However, just because some states don’t have personal income taxes doesn’t mean they don’t collect taxes. For example, gross receipts taxes not only collect a percentage of annual revenue or income, but they can also tax your sale proceeds. If you’ve invested in a deal through a sponsor, they’ve likely handled this at the entity level. There’s also the issue of taxable losses. Most investors we know cannot fully use these. Yes, they can be great if you have a sizable portfolio or sold an asset, and the losses can offset some or all of the gains. But, the losses keep piling up until a time when they’re eligible to be used.
Investing in a private real estate fund can reduce the number of federal K1s (you should receive just one for the portfolio), but it can exacerbate the number of state filings for the investor. Wherever that fund owns property, you’re probably going to receive a state K1 for that investment. That also means having to file personal tax returns in all of those states. When this happens, it’s best to hire a tax professional to navigate this for you and to keep track of your gains or losses. Nobody enjoys the cost of paying an accountant for each additional state filing, but it can be looked at as a cost of doing business and having access to the fund. A fund structure should actually be cheaper for the filer than being in multiple separate transactions. The same consideration regarding taxable losses applies here. The one caveat is that in a fund, it is more likely that taxable losses can be used given multiple properties and the potential to offset gains.
Our new Calvera Income and Growth Fund is structured to own property through a REIT subsidiary. One big benefit of this structure is it eliminates the state tax return for limited partners. This brings the hassle factor down considerably and is one of the key reasons we chose this structure. Investors will still receive a federal K1, and the REIT dividends received may even qualify for a 20% tax discount through 12/31/2025 for non-corporate limited partners. The REIT can generate taxable losses just like in other ownership forms, but those net operating losses are tracked at the REIT level, moving the tracking burden away from the individual investor. Lastly, if you’re worried about unrelated business taxable income (UBTI) because you want to invest through a retirement account, the REIT ownership structure minimizes this risk. All types of investing have different levels of hassle in regard to filing requirements and complexity of K1s. We believe the REIT structure is the best to minimize the hassle for investors.
The other big tax consideration involves how capital gains are treated. A 1031 like-kind exchange is available in many structures, provided investors consent to it. A 1031 exchange allows you to purchase a new property (with specific timing and other guidelines) and defer the tax until a later date. For example, let’s say an initial $200k investment generated $400k at sale, producing a $200k gain. If a 1031 exchange is elected, taxes are deferred and the total $400k of net sale proceeds (the $200k original investment plus $200k gain) can be reinvested in a new property. If the taxes were paid on the gain, perhaps only $300k ($200k original + $100k after tax) could be reinvested elsewhere. That loss of $100k has a big impact over time. The Calvera Income and Growth Fund is set up to do 1031 exchanges for all REIT-owned properties. This keeps your money working for you.
Lastly, an alternative to 1031 exchanges uses cost segregation studies to find assets subject to bonus depreciation. If enough bonus depreciation is found in a new property, it might generate enough taxable losses to offset the gain from the sale on another property. However, just like with a 1031 exchange, you must do this every time you sell or there will be a large tax bill due. Bonus depreciation was part of a tax law that is phasing out over time and is not as lucrative as it once was. The focus will return once again to 1031 exchanges.
Taxes are unavoidable, and if you have to pay taxes, chances are the investment made money. That’s a good thing. One of our objectives when formulating our new investment fund was to minimize and streamline the tax burden for our investors. We wanted to address some of the common themes in feedback we have received over the years from our investors who 1) do not like filing tax returns in multiple states, 2) do not like to pay capital gains tax and then turnaround and reinvest with Calvera (i.e., they lost investable capital), and 3) already know about 1031 exchanges and want to be able to use them in our investments. Over time we’ve found that everyone is unique and has different goals for their money. It’s never a bad idea to discuss this out in the open with your real estate and tax professional before deciding on a new investment.
Mr. Milovich is not a tax professional. He advises you to seek the opinion of a competent tax professional. Please see the FAQ section for additional information on taxes and the structure of the Calvera Income and Growth Fund.
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