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So you're considering an investment as a Limited Partner (LP) in a real estate syndication. Before you invest, there's a number of factors to consider, including taxes. In this article, we'll discuss the tax implications you need to be aware of as a Limited Partner (LP).
As a preface, syndications are generally taxed as partnerships, and partnerships are not taxed at the partnership level. Instead, each partner receives their share of income/losses on Form K-1, which is filed on their individual tax return.
Cash Flow and Sales Proceeds
Unlike General Partners (GPs), because you aren't actively participating in the syndication, you don't receive fees. Instead, you simply invest and collect your returns, which are in the form of cash flow and sales proceeds. And they are taxed much in the same way as the GPs.
Your gain from the sale of the property will be considered a capital gain taxed at 15-20%, plus the Net Investment Income Tax (NIIT) of 3.8%, if applicable. And you will also pay depreciation recapture tax (up to 25%) on the portion of your gain generated from accumulated appreciation.
Your share of rental income/losses is treated as they would in any other rental property. If you have net income it will be taxed at ordinary income rates. If you have a net loss, it can be used to offset passive income from other properties. Otherwise, it will be suspended and carried forward into the future, even if you're a real estate professional for tax purposes. (Real estate professionals must actively participate to deduct passive losses against ordinary income.)
Some LPs choose to invest in syndications using their self-directed IRA (SDIRA). And if the syndication uses debt financing then the SDIRA investor may be subject to the Unrelated Business Income Tax (UBIT).
UBIT is generated by Unrelated Debt Financed Income (UDFI), which is the portion of income attributable to debt financing. Here's an oversimplified example, if the building uses 75% debt financing and generates $10,000 in cash flow, $7,500 of it will be considered UDFI and subject to UBIT.
The first $1,000 of UDFI is exempt from UBIT. But the amount above $1,000 is taxed at the trust rates which max out at 37% after just $12,501 of UDFI.
That said, for most investors, UBIT won't be significant enough to materially affect returns. Its just something to consider before making an investment.
Note: 401(k)s are not subject to UBIT on rental income, even if the property uses leverage.
Let's say you invest $100,000 in a syndication for a 10% limited partner stake. This allows you to collect 10% of the cash flow and sales proceeds when the property is sold. And we'll assume you're in the 32% tax bracket.
In the first few years of the investment, a loss is produced for tax purposes. Since you're a limited partner these losses can help you offset the income from other passive activities. But if you don't have any passive income, these losses will be suspended and carried forward until years when you have passive income or the investment is sold.
Should the investment show net income, it will be taxed as ordinary income (32%), plus the 3.8% NIIT, if applicable.
Over the five years you hold investment, it appreciates from $4.8 million to $6.2 million and accumulates $698,182 in depreciation. This produces a total gain of $2,098,182. Of this gain, $698,182 is subject to depreciation recapture and the remaining $1.4 million is considered a long-term capital gain.
Because you have a 10% stake in the property, your share of this gain is $209,818. $69,818 (10% x $698,182) is subject to depreciation recapture and the remaining $140,000 is considered a long-term capital gain. You will pay $17,455 (25% x $69,818) in depreciation recapture tax and $21,000 (15% x $140,000) in long-term capital gains tax. Also, if your AGI is above $200,00 if sing;e or $250,000 if married, you're going to pay an additional $15,946 in NIIT.
Timing of Investments
We are believers that investment decisions should be based on the fundamentals first and foremost, and not solely for their tax benefits.
However, there are ways you can time your investments for tax efficiency. One of the more popular strategies is to invest in a syndication that will pursue a cost segregation study in the same year another investment is sold at a gain. The cost segregation will increase the depreciation expense causing a loss. This loss will then offset the gain from the sale of the other investment.
Let's look at a quick example, one of your syndication investments sells this year and you recognize a gain of $209,818. However, you invest in another syndication that passes through a loss of $20,000. You also have $40,000 in suspended losses from prior years. This combined $60,000 in losses will reduce your gain to $149,818, saving you $9,000 in tax.
The Bottom Line
As a Limited Partner (LP) it is important to understand the tax implications of your investments. That way you can take the necessary steps to mitigate these taxes where possible.
Before you do your next syndication, ask your CPA what the tax implications will be for your specific circumstances. And what planning opportunities are available to help reduce the amount of taxes you’ll have to pay.