The Mark Perlberg CPA Podcast
The Mark Perlberg CPA Podcast
EP 116 - Tax Benefits of Passive Real Estate Investing
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We explore the significant tax savings opportunities and incentives available through passive real estate investing. For high-income earners and busy professionals, understanding these tax advantages can transform wealth-building strategies while legally reducing tax burdens.
• Real estate investments create paper losses through depreciation that can exceed your initial investment amount
• Cost segregation studies accelerate depreciation, sometimes creating deductions 2-3 times your investment
• Real estate professional status combined with material participation allows losses to offset W-2 income
• Achieving material participation requires 500+ hours across grouped rental properties annually
• Without real estate professional status, losses still offset passive income from rentals and business interests
• Cash-out refinances provide tax-free cash distributions to investors
• Operational cash flow is often sheltered from taxes by depreciation deductions
• Property sales are taxed at favorable capital gains rates (0-20%) rather than ordinary income rates
• Continuous reinvestment creates a compounding tax advantage and wealth-building cycle
• Passive investing allows access to tax benefits without managing "tenants, toilets, and trash"
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If you are wondering what are the tax savings, opportunities and incentives for investing passively into real estate, this is going to be a great conversation for you. This is, in particular, going to apply to you if you're considering investing passively into a real estate fund or if you are raising capital and trying to attract other passive investors into your real estate. In this conversation, you are going to learn the loss treatment of investing in real estate and how that is treated and how those losses could potentially offset W-2 income or even business income. You're also going to learn about the tax treatment of the cash flow and the profit and the capital gains. At the end of this conversation, you're going to understand why the tax benefits may incentivize you to invest into passive real estate. You're also going to learn what this may mean for you as a passive real estate investor and how this fits into your overall tax and wealth building strategy. Now, before I jump into the materials, if any of this is interesting and you want to see how this pertains to you in particular and what other opportunities may be available for you for tax savings, go to prosperalcpacom slash apply. That's prosper with an L? Cpacom slash. Apply that's prosper with an L? Cpacom slash apply and we will prepare for you a free opportunity report sharing with you what may be available to you when you implement advanced tax reduction strategies. And if you're not ready yet, at least go to taxplanningchecklistcom to become acclimated and start thinking about what tax savings opportunities may apply to you by following a simple to follow tax planning checklist and mini course.
Speaker 1:Now let's get into the material. So the first thing you want to think about here when we talk about the tax treatment and the tax benefits of real estate, you can't ignore the fact that the biggest opportunity with real estate is that it's easy to create losses, and I talk about this all the time. It's easy to create losses because you have depreciation and that depreciation the writing off of the building and the real estate, the wear and tear of the building can be accelerated, and it almost always is when you have large funds and you're passively investing. It can be accelerated with the cost segregation study and what we see here is when you are investing passively into a large multifamily or self-storage or mobile home, you get a gigantic tax deduction from these investments. You see gigantic losses, especially with 100% bonus depreciation. You're going to see sometimes more than your investments, creating a tax deduction. So imagine you put in $100,000 and you get back to you on a K-1, a business loss of $150,000. I've seen more than that. I've seen business losses that were up to two and a half times what the investor put into the fund in certain scenarios. So obviously the ability to create losses sounds really fantastic, right? Well, hold on a second.
Speaker 1:There are all these rules and restrictions based on who can use these losses and, generally speaking, when you're investing in real estate, you cannot use these losses to offset your ordinary income. So before you jump up and start writing your checks to these syndicators because you're sick and tired of paying all these taxes out of your W-2 and you think that these losses are going to help, you may not be able to see these benefits of the losses right away, because one of the restrictions here is typically real estate losses are passive and what that means is they're only going to offset other sources of passive income, so that high W-2 or your ordinary business income, that's not passive income. So you're not going to be able to use your real estate losses, generally speaking, to offset your ordinary sources of income. However, there are some exceptions. You can have the real estate professional tax status to it than that, and some of you may have heard of the real estate professional tax status. What that means is either you or your spouse work more than 50% of your working hours in a real estate trader business and those hours equal 750 hours or more. There's more to it. You can check. We have a whole podcast and YouTube video dedicated specifically to that topic. Now this is really popular to get that real estate professional tax status by getting the wife or the husband to get that status and work full-time in real estate, and then the losses can offset the W-2 income that's being taxed very high or the high-income businesses that you own.
Speaker 1:Now, however, it gets a little tricky here because there's another element that also needs to be in place here for you to use these passive losses that you get when you invest into these large syndicated deals and you're a passive investor and they do the cost tag and the losses hit your 1040. You're going to need another variable, you're going to need another feature in place. So not only do you need the real estate professional tax status, you're also going to need what we call material participation, and essentially what material participation is is we have to look at the amount of time you put into your rental portfolio to say that you've put in enough time so you qualify to use these losses to offset your ordinary income. And there is a seven-pronged test and you only need one of these attributes to be true. But think about this You're investing passively in the real estate. You're not making any of the decisions at all. So how can we be real estate investors and use the losses from these passive investments to offset our ordinary income and our high W-2 income? Well, you get the real estate professional tax status right. Maybe someone is a real estate agent or whatever.
Speaker 1:To get the material participation, the easiest and the most likely and really the only way we see this when you're investing passively into real estate is you need to pass that 500 hour test. You need to say that you put in at least 500 hours into your real estate rentals and we need to do what is called a grouping election. So essentially, what we're going to do here is we are going to treat all your real estate rental investments the ones on your schedule lease as a sole proprietor, the one in any partnership you own, all the activity that you invest into all of your rentals are going to be looked at as one single rental for this material participation test. And if we can say that for your collection of rental properties you put in at least 500 hours, we can now say that you materially participate in all of your rentals, including that passive investment where you're investing in that syndicated deal, that multifamily, the self-storage, the mobile home, whatever it is where you're a limited partner. We can say that that is included in this group. This bucket of rental properties for that material participation test the 500, this bucket of rental properties for that material participation test, the 500 hours test is the only one that's going to really allow you to achieve that material participation test. Now, for some of you here who love short-term rentals and maybe you have that real estate professional tax status with the short-term rentals, unfortunately we're not going to be able to group your short-term rental activities with your long-term rentals and your passive syndicating investing. For that test we need 500 hours dedicated to your long-term rentals.
Speaker 1:Now let's move into some other features here. Okay, so we talked about all the features that have to be in place and all the variables for you to have the real estate professional tax status and material participation, and that's going to give you those non-passive losses. Those are the most desirable kind of losses because they'll offset any type of income. Not only can they offset your ordinary income or your W-2 income, they can also offset your capital gains income and your interest income, so pretty much any type of taxable income. You can use those non-passive losses when we have the real estate professional tax status and when we have material participation, to offset that income on your tax return income on your tax return. Now, some limitations we want to think about is the most amount of losses we can use to offset our non-business income. So that is, your W-2 income or your stock or your interest income is going to be to the amount of this, what we call excess business loss limitation. So the maximum amount of losses that you can take against your W-2 or your stocks or your interest is going to be $626,000 if you're married or $313,000 if you are single filers.
Speaker 1:Now, if you're a business owner, you can offset 100% of your business profits with the real estate losses. Now there are other ways that we could potentially use these losses. If you have profits from your short-term rentals, while we cannot group them, those profits are going to be passive and you can use the losses from your passive investments to offset potential profits from your short-term rentals. We know that short-term rentals can be extremely cashflow positive. Maybe you've already done your cost segregation studies. Now the revenues exceed all of your expenses, including depreciation. Those cost seg losses, the losses generated from those cost segs, are going to offset your profits from the short-term rentals. They're also going to offset the cash flow from your other real estate investments and this is going to come in handy for those of you who are maybe wholesalers, where the property doesn't have a lot of depreciation or if you had it for a long time, or just really strong cash flowing rentals. If you see that you're actually generating taxable income from them because you don't have enough depreciation to offset them, you're going to be able to use those losses from the passive investments to offset those profits.
Speaker 1:Now there's another opportunity here. You can use these losses to offset passive business income, and some of you who are full-time business owners owning multiple businesses, you may find that you have what we call a PIG, and we love PIGs. Pig stands for Passive Income Generator, so in certain circumstances we may be even able to create a spinoff entity where you actually fail that material participation test. Remember we talked about material participation. Now we want to fail it and actually be passive in certain business activities, so then it goes into that passive bucket and now we can use our rental losses to offset that passive income from our business activities. This is also possible when we see people who are serial entrepreneurs and they invest in a bunch of different projects. They install other people to run their different businesses. We may actually find that some of these businesses are actually passive activities and then we can use our rental. These businesses are actually passive activities and then we can use our rental losses to offset those passive activities.
Speaker 1:And I'll tell you what if you think this is possible, I'll say that the majority, not only of tax preparers but tax firm owners, have no understanding of this concept and likely don't even realize that this is a possibility. You're probably overpaying in taxes because you're now paying FICA taxes on those passive income streams as well. And, by the way, if you're looking to invest in other businesses so let's say, you know someone and you want to get in on their restaurant or other businesses there and you just received K-1s that also is likely going to be passive income where we can offset the profits with the losses from this real estate. And then, finally, another thing we want to think about here is when we have capital gains events from real estate any real estate that's long-term rentals, even if it's mobile home, self-storage, single family multifamily, mobile home, self-storage, single family multifamily the losses you get from this passive investment is going to offset those capital gains. So let's say I have a duplex right and I sell the duplex for a half a million dollars of profit and then I get a K-1 with a half a million dollars of loss created from the cost segregation study performed by the organizers of this syndication. Well, those losses are going to hit my 1040 and they are going to net against the capital gains from the disposition, from the sale of my other investments into real estate. So there are other ways we can use these losses. Now I probably just threw a lot of stuff out there.
Speaker 1:So here are the key things I want you to think about. You want to have real estate professional tax status and you want to materially participate in your collection of rentals to see the optimal amount of tax benefits from your passive real estate investments, because that's going to allow you to offset any sources of income. Now there are other ways to use those passive losses. As I described earlier, they can offset the passive income, the rental profits and the rental capital gains Still some value to these losses. And not to mention the fact, if we're cashflow positive, we're collecting cash, we're doing cash out refis, we're bringing money into our accounts and we're not paying taxes on these events. Some of these events are not even taxable events like the cash out refis. And also when we bring in the profits, it's offset by the depreciation. Even if we're cashflow positive, we likely will be producing a negative income statement and the losses when you don't use them. So let's say you don't have real estate professional tax status. If you're not using those losses, guess what? They're going to carry forward and they're going to offset the future profits in the real estate and other cap gains events.
Speaker 1:Now let's talk about profits. What's going to happen here when we have profit, profitable real estate here? So, like we described earlier, a lot of these passive investments a big part of the benefit you're going to see here is on. The exits is when you sell, and oftentimes we'll see capital gains events where you're doubling your investment over the course of five to six years. A lot of times you're putting money into these properties. They're undertreated and they really need a lot of improvement. And so the organizers of these syndicators and the GPs they'll fix it up. They'll put lots of your investment right back into the building. So you might not see a ton of cashflow because of all the improvements into the building and the renovations. And then eventually they're going to enhance the property and be able to raise rents and then sell it at a massive profit because they've put all of the proceeds, or a lot of it, into the renovations and the improvement of the asset. And when you sell things for a profit, you get that favorable capital gain event right.
Speaker 1:Capital gains are always going to be taxed more favorably than your ordinary income. Those brackets are going to be 0, 15, and 20%. If you don't have real estate professional tax status, you may be paying an additional 3.8% on those taxes. State taxes are likely going to be similar to what you were paying on ordinary income for state taxes. But even then you're going to be similar to what you were paying on ordinary income for state taxes. But even then you're going to have that favorable capital gains bracket. It doesn't go nearly as high as the ordinary income, which can be taxed as high as 37%. Additionally, this is passive income, so you're not going to be paying that dreaded FICA taxes on your real estate profits. So when you have ordinary income, you got to worry about paying your social security and Medicare taxes. That is not the case when you are investing passively into real estate.
Speaker 1:And again, remember that the capital gains can be offset by the losses. So if you continue to invest, you're likely going to do cash out refinances. If you continue to invest and grow your portfolio over time and you're going to get these cash distributions before the exit, so you'll have time to build up all your investments into these rentals you're likely going to find that you have enough losses to offset a lot or maybe all these capital gain events as long as you keep investing and acquiring losses for more cost sags. Now there is a depreciation recapture on the sale, so whatever deductions you've taken on the depreciation, they have to be pretty much given back to you, right? So for whatever the depreciation was on the regular building, that's going to be taxed at your marginal rate up to 25%. And then if you are recapturing the depreciation on whatever was that cost seg amount or just the write-off of the personal property involved in this real estate. Some of it may be taxed at your marginal rate, but what we're normally going to see for a lot of you real estate investors, if you're passive and you're not using those losses, you have enough losses or unused losses rolling forward, so you don't really see a tremendous challenge with the recapture. Now, if you are a real estate professional and you're able to use these losses and you don't have any unused losses, you might find that you're going to have to be a little more proactive here.
Speaker 1:So we have seen instances where people with real estate professional tax status invest into these syndicated deals. They get a massive deduction and it saves them hundreds of thousands of dollars in taxes. Well, that's spectacular, but they never think about what's going to happen on the exit. In five to six years have $100,000 in taxes. Well, in the future they're going to have profit and they're going to have the recapture of the tax. And guess what? Whatever that was let's say it was a $400,000 deduction from the cost segregation studies they created a massive loss in year one.
Speaker 1:Well, on the exit, that $400,000 deduction has to be recaptured and taxed as ordinary income. And if you don't plan for it. You can find yourself in a bit of a pickle here and we've seen this before especially because a lot of the syndicators are going to refinance these real estate investments and you're going to get cash distributions before the exit. Now that sounds fantastic, but what's going to happen here is that when you actually exit the property, you're going to be paying off a little more debt. But what's going to happen here is when you actually exit the property, you're going to be paying off a little more debt. So your proceeds may not be enough or may not reflect the actual amount of taxable income. We've seen instances where on the exit, you saw maybe $100,000 hit the client's account on the exit, but he has $200,000 of taxable income because he received some of his profit pretty much up front from those cash out refis.
Speaker 1:So if you have real estate professional tax status and you're using these losses, I probably scared you a little bit, but don't be scared because this is still a really good opportunity. You got to consider the time value of money and ideally what you're going to do here with your tax savings is you reinvest and you buy more real estate to get more depreciation and create more wealth, and you're typically going to see when you are proactive here, you can plan for these events. And also, as you acquire more and more real estate, you're just going to build this compounding wealth cycle by you create tax losses, you take your capital saved from tax losses and you reinvest into more real estate that gives you more and more tax losses, and you build this reserve of losses and use these losses over and over again to ensure that you are going to have a really strong ability to use these business losses to offset your other sources of income continually. And then, when the exits come, you've already acquired enough real estate to create enough losses to offset those exits. And even if you can't, there are some other capital gains strategies out there. But what you don't want to do is you don't want to be unaware of the situation. You want to be proactive and plan for these recapture events and make sure that you're aware of the tax treatment on these exits and you are properly planning to mitigate when that happens. Overall, it's still a fantastic win when you look at what this means for you from a long-term perspective building your wealth and reducing your taxes.
Speaker 1:Now some of you may be wondering well, what about a 1031? Can I 1031 as a passive investor? Well, theoretically yes, but we've seen 1031 exchanges very uncommon when you're investing passively because you have a group of investors and you can't 1031 in your own. Well, let me say this again you have this group of passive investors and to 1031, you have to exchange the real estate for another piece of real estate that's of equal or greater value. Now what's going to happen here is, let's say you have 20 people, how are we going to get them all to agree to redeploy their capital into another investment? A lot of these guys want to get paid out, so it's unlikely that you're all going to go in the same direction and want a 1031. So you're likely going to want to go in your individual directions and just get your distributions at the termination of this agreement, which is really just the exit of the property when you sell it at a profit. So 1031s are out of the question. Now you could do what's called a drop and swap, where you distribute the property to everyone and then they go their own directions with the 1031s. It's very cumbersome and it's unlikely that you'll want to do this in most of these passive investments, but if you're doing something smaller, that may be a possibility as well.
Speaker 1:Most of you are going to typically reinvest your proceeds into other real estate and lots of times you're going to see losses from your reinvestments of those proceeds. They're going to give you new losses, especially with 100% bonus depreciation, and those losses will offset the capital gains and the cycle starts all over again again, where we're acquiring wealth and the losses associated with those assets. Now I just threw a lot at you here on the profits and the loss treatments and obviously you can tell that when you invest in real estate, you have the opportunity to, at the very least, not pay taxes on your cash flow and your income, and sometimes you're going to be able to create losses, even with cash flow positive real estate to offset your ordinary income. Even with a recapture, you're buying time, you're building wealth and seeing highly advantageous tax treatment of your income and your profits. So what does this mean for you?
Speaker 1:So what does this mean for you? Well, as we said earlier, you may be able to use these losses, and those losses are going to these passive losses from the passive investments. You're still going to take part in the profitability of the investment. You're still going to see the tax advantages of the favorable capital gains rates. You're going to receive your share of the rent revenue and the cash out refis and they're not going to be taxed. The losses are going to carry forward and offset future and other current capital gains events. You're going to be building wealth and building equity and not dealing with ordinary day-to-day maintenance of the rental portfolio, the tenants, the toilets and the trash. And you get to participate in these profit generating activities managed by experts who probably know a lot more than you when you're investing passively, or maybe they want to do a lot more than you, so you could focus on the other things that are going to give you greater joy and greater profit and greater wealth outside of the investing. So there are many reasons why we may invest, so let's talk about what this means for you.
Speaker 1:If you need losses and we can get you that real estate professional tax status, or you're in a situation where you can use those passive losses, this is going to be a great strategy for you to build wealth and create immediate losses and tax savings. But if you can't create the tax savings, that's okay. If you want to win the tax game, this is what I recommend you do. You want to have a strong, proactive tax strategy. You may want to need other vehicles to drive down your taxes and that's why we work with our clients doing holistic tax planning. So we are looking for ways where we can create immediate tax savings.
Speaker 1:Sometimes the tax savings comes from the real estate and the losses, but other times we are creating tax savings from other vehicles to allow you to afford to buy more real estate, and that real estate is going to grow in a tax-advantaged manner because of the favorable treatment of the income. So we'll get guys who have high incomes. They don't have the real estate professional tax status, they can't use the losses. They probably would be horrible landlords because they're too busy in their other professions. So what do we do? We create tax losses from a variety of strategies. It may involve advanced charitable strategies, tax credit related strategies, other businesses that they can run while working that will create massive depreciation losses.
Speaker 1:There are so many other ways to look at this and spinoff entities and retirement account planning, qbi planning, et cetera, et cetera, et cetera.
Speaker 1:And when you are winning the tax game, now you have the ability to have more cash.
Speaker 1:What's a great place to park your cash so it doesn't get abused by the government, it's in real estate, and passive real estate investing can be a great way to go for that.
Speaker 1:So I hope you enjoyed this conversation and this gave you a little bit more clarity on what this may mean for you as a passive real estate investor, or what does this mean for your passive investors, who you are trying to gather up and encourage to invest into your funds. So now you know, you can share this information with them and how this is going to be one of the most tax advantaged ways to build your wealth. I've always said this that one of the most favorable ways to build your wealth in the eyes of the IRS. There's never going to be an industry that has looked on more favorably than real estate investing to save money on taxes and build your wealth. So I hope you found this helpful and, of course, if you want to learn more, you can always go to prosperalcpacom slash apply to see how these concepts may apply to you, or you can go to taxplanningchecklistcom for a free tax planning checklist and mini course. Have a great day.