Table Of Contents
In this episode, Brandon Hall and Thomas Castelli discuss strategies limited partners can use to minimize taxes, estimate the tax benefits of an investment, and interpret operating agreements.
This episode is sponsored by our free Tax Smart Investors Facebook Group.
Full Transcript:
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.
Thomas Castelli 0:00
You're now listening to the real estate CPA podcast.
Brandon Hall 0:05
Your source for all things real estate, accounting and tax. Here we reveal our secrets that can save you 1000s in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors and current clients on what strategies they use to grow their business, and how they steer clear of Uncle Sam.
Thomas Castelli 0:30
Everybody, welcome back to episode two of the syndication series, where we're gonna be talking about tax strategies for passive investors commonly referred to as limited partners in syndications and we're gonna kick it right off. So, the core strategy for passive investors is going to be understanding the passive activity rules, which we did discuss in an earlier episode, and basically being able to so the core strategy for passive investors in real estate syndications is understanding the passive activity rules which we have discussed in a prior episode. But just to kind of give you a quick recap, passive losses can only offset passive income. And if you're a limited partner, or you're a passive investor, as they would say, in a syndication, by default, you are going to be considered it is by default, excuse me, you can be considered a passive activity. So that means you can use your passive losses from other passive activities to offset the income or gains from your interest in the real estate syndication because it is a passive activity.
Brandon Hall 1:39
Yeah, two buckets of characterization apply to every single dollar that you earn under section under Section 469. And those two buckets are passive and non passive. So every dollar that you earn will fall into one of those two buckets. And even if you have like friends that are not investing in rental real estate, the same rules still apply to them, even though they don't know it, right. There are two buckets that apply to every single dollar that you earn. And it's either passive or it's non passive. And so as Tom was saying, passive losses can only offset passive income because you're trapped in that passive bucket. And a lot of real estate investors want to move those rental losses out of the passive bucket and into the non passive bucket. But it's not always like you don't always have to, it's not always a bad thing to have losses in the passive bucket because you can have passive stakes in businesses. You know, I know that we're talking about LPs and syndicates, but you could also be an LP in a hair salon. It's my favorite example, you put $100,000 into your local hair salon to help them expand into a new shop. They give you $10,000 a year in cash flow. But $10,000 a year is passive because you're not materially participating. You're not making management decisions. That passive income can be offset by your LP syndication, passive losses, your rental losses, because it's all in the passive bucket. And I go into detail on how this all works on one of our tech smart daily episodes number 49. You can go to YouTube, you can type in tech smart real estate investors, and you'll find our YouTube channel, hit the tax Mark daily episodes and go to episode number 49. And I walk you through exactly how this works. Because there's a lot of confusion out there are a lot of CPAs that say, Oh, your passive income from one business can't be offset by your rental losses and it's hogwash. If they would just review form 8582, they would see that it's hogwash. And so on that episode, Episode 49 of the tax Mark daily, I walk you through form 8582. It's a really good episode really clarifying in everybody has this form in their tax returns? Well, most real estate investors have this form in their tax return. And it's the number one form that you should know above and beyond Schedule II above and beyond form 1040, you should know form 8582. So go watch that episode. But the big takeaway is that your passive losses can offset other sources of passive income. And so you can build your LP strategy around this. I mean look at Rich Dad, Poor Dad, right, the famous book that most real estate investors read to get into this. It's all about creating cash flow that is tax free or tax deferred. And this is a great real life way that you can do this. I mean, if you have that hair salon investment, that's net new $10,000 a year and then you go and you place a $100,000 syndication investment in real estate, you're gonna be passed back and $80,000 tax loss. Well, now you get eight years, right $10,000 times eight, eight years of your hair salon income tax free until you got to start paying tax on it because you have this $80,000 Suspended passive loss from this LP investment. So really important to understand that, you know, this episode we're going to talk about the ins and outs of the LP investment, what to look out for looking at the operating agreement, K ones that type of thing, but from a strategic perspective to you know, you can pair this up really nicely with passive investments that actually generate positive taxable income?
Thomas Castelli 5:03
No, absolutely, absolutely, that is definitely one thing that you can do. Now, if you're investing as an LP in rental real estate, most or majority of the opportunities out there are focused on a strategy called Value Add and evaluate strategy. Usually in the first two to three years, there's going to be heavy renovations on that property. And there's going to be some turbulence, if you will, in the amount of rental income that you are going to be able to receive, meaning the rental income is usually going to be lower. So when you combine that with all the expenses that are going to be incurred during that period, there's usually going to be a loss. In addition to that, in the first year, most indicators, they're going to go ahead most sponsors, they're going to go ahead and do a cost segregation study on the property, which is going to accelerate the depreciation expense via 100% bonus depreciation. And in most deals we're seeing these days somewhere between 50 or 70%. In some cases, more of your initial investment can be given back to you in that first year as a rental loss. And that rental loss as we've been discussing, as a limited partner will be passive and you could find that rental loss on page one of your Schedule K one is going to be in box two, and then box two, there'll be a little negative number, maybe it's in parentheses, depending on the software that is used to prepare that return. And that's going to be your passive loss for that year. And again, in most indications that first year, you're going to have a passive loss. If you don't have any current income, current rental income or passive income from other activities in that year, that loss that you have will be suspended, and that suspended loss will carry forward to the next year. And if you don't have any passive income in that year, it will continue to carry forward indefinitely. Until eventually, when that syndication is sold. Hopefully, you're going to have a gain on the sale. That's an occasion that is the goal. That's where a large part of the investment return comes from in syndications is from that end sale, and in that year, you're going to have a capital gain. And those losses can be unlocked to offset that capital gain. You can also invest in syndicates within that same year to generate more losses to help you offset the capital gain from the sale of that or liquidation of that syndicate. So they're kind of Long Story Short here, it becomes a game of monitoring, like Brennan said on form 8582, your suspended passive losses each year to know do I have enough suspended losses to offset potential large gain from the sale of one of my syndicates? Or do I need to go out and invest in more passive activities such as another limited partnership interest in another Syndicate, or maybe you buy a property yourself and you do a cost segregation study yourself or you go and invest in a another type of business that has probably heavy fixed assets that are going to be able to create large losses in that first year, in order to help you offset that gain.
Brandon Hall 8:05
Great primer. Now let's start talking a little bit more in detail about the fundamentals of how this actually works. So if I'm a limited partner, and I'm going to put $100,000 into a syndication, I need to be aware of a few things. First, the Syndicate is going to tell me that they're going to offer great tax benefits. Now, what are those tax benefits? Really, what it is, is exactly what Tom just said, the Syndicate is going to do a cost segregation study. And you as a limited partner are going to be allocated losses that the cost segregation study creates, because the cost segregation study is going to create 100% bonus depreciation or increased depreciation, which will create a tax loss because the expenses will be more than the rental income, it doesn't mean that there's an actual net operating loss though it's just a tax loss. Right? It's the classic example of I can be cash flowing $3,000 a year, but my depreciation is $3,500 a year. So I have a $500 tax loss, but $3,000 actually hit my pocket. Same thing with syndications just at a much larger scale. So you put $100,000 in, you're gonna get allocated tax losses as a limited partner. Now, the question is, though, so again, every syndicator likes to tell people there are tax benefits. And it's tax efficient. And they're not wrong, because it is tax efficient to own real estate and there are tax benefits. But the question is, specifically, what tax benefits are you going to receive as a limited partner? The only way to know that is to go to the operating agreement. You want to go to the profit and loss sections of the operating agreement, and you want to go to the distribution section of the operating agreement. You need to read those sections very carefully. potentially even with your CPA, we actually provide this service for some of our clients depending on what sort of subscription plan they have with us. So you want to look at that operating agreement. You want to read it. You want to make sure that you understand how losses and help profits are going to be allocated to the investors. Now typically, there's some sort of waterfall you know, the first 10% of profits is allocated to these people. And then after that it's allocated split between x and y, or A and B class, and yada, yada, yada and down the chain. But the big question is, in the years that the entity has losses, who gets the losses, because those losses can be allocated relatively freely, relatively freely. And the reason that they can be allocated relatively freely is that everybody has basis in the partnership, whether or not I put money in so I can syndicate this deal, right, I can sponsor the deal, I can put $0 into the deal. But I can still have basis to take losses, thanks to the debt. The debt piece is called qualified non recourse debt, and that qualified non recourse debt. Typically, it's allocated based on economic interest. So everybody gets a little piece of the qualified non recourse debt. Qualified non recourse debt, even though it's non recourse, it gives you a basis at risk basis in the partnership to take deductions. Now, what does that mean? That means that my sponsor, if I'm, if I'm a limited partner in the deal, the sponsor could put $0 in but still have basis to take losses. So I've got to read the operating agreement very carefully to understand who is being allocated losses. Now, typically, losses are first allocated to the limited partners to the extent of their capital contributions. And then losses are allocated pro rata, or they're allocated to the general partners. But it's not it doesn't have to be that way. So you've got to read the operating agreement, because it could be that losses are allocated 5050 between Class A and Class B, which means that the general partner even though they put $0 into the deal, when we do a cost segregation study on a $10 million building, the general partner is getting a $1.5 million loss allocated to them, even though they put $0 into the deal. And they probably have basis, thanks to that qualified non recourse financing, to take the loss. So as a limited partner, you have to read that operating agreement, you have to know how are losses being allocated between the gap in between the LP, because everybody can talk about tax benefits, but the operating agreement tells you the truth about those tax benefits. And if you're looking at those operating agreements, you're like, I have no idea what I'm looking at, you gotta call your CPA or call somebody up that understands partnership, tax law, I feel like I'm pretty good at partnership, tax law, but we have a woman in the firm Kailyn, who is amazing at partnership tax, blows me out of the water. And so like things that I say on this podcast, I'm always like, I should go get that cross check with Kailyn. It's complex stuff, probably the most complex piece of the entire tax code, partnership tax law. So make sure that you get with CPAs that understand how it works. So they can advise you appropriately. And so there's no surprises at the end of the year, because the worst thing is to put $100,000 into a deal, expecting an $80,000 tax loss to be allocated to you, then you get 20. And that's not fun, because then that just blew up whatever other strategies you were implementing on the side, irrespective of that Limited Partnership deal. So be careful. Read that operating agreement, check out those loss allocations, check out the profit allocations, check out those distribution sections, make sure that you understand exactly what's going on. And also make sure that you understand that words matter. Words matter, just because the operating agreement says one thing, if they have to define it, so make sure to check out those definitions. Two words are extremely important than legal agreements.
Thomas Castelli 13:39
Absolutely. We actually did a series with Kailyn. Not too long ago called The OA series, there's three episodes, you go ahead and check those out if you want to learn more about operating agreements, but kind of just follow along with what Brandon was saying. So most syndicators, they're aware that this the passive losses are something that their limited partners, their investors, aka like pretty much what their clients are looking for. So they will set up allocations that are favorable to their investors. However, however, there are some cases where the general partners do want those losses for one reason or another. And they can skew that via the average agreement, as Brandon was saying. So you have to take a look at what the sponsor is telling you. And then you want to go ahead and get that verified by a CPA or tax attorney to make sure that is being done that is being done correctly. So that is something that we could absolutely do for you. So if you are a limited partner, you could learn more about that by checking out the OA episode, or going to our website, putting your name into the become a client page, and we could have a conversation on if that's something we could help you with.
Brandon Hall 14:42
Yeah, and we're gonna run a whole content series on this as well deep dive at Tech smart investors.com. So if you're a subscriber to tech smart investors.com You will see that and you'll get some really solid education. I promise you if you are investing as a limited partner, you need this education. It's not something that you You can approach lightly because these operating agreements, they're the law, they are how your partnership is going to operate. And you need to understand how that's going to work. And if you don't understand how it's going to work, you need to seek outside help and assistance before you go and place your cash. In quick comment, you know, if a general partner let's say, a general partner, and I allocate 100% of the losses to me, but doesn't necessarily make me a bad general partner, right? It just like allocating losses to the GP is not a bad thing, I want to make that very clear, it's not a bad thing, it might be against your interest as a limited partner investor. Like if I put $100,000 into the deal, and I'm taking the capital risk, I probably want that losses allocated me first, right? That's the best interest for me. But it's not necessarily a bad thing. If the GP gets allocated losses, it's just that they need to make that obvious to you, right. So it is a bad thing, if the GP touts all the tax benefits that you're going to receive, and Oh, you guys are gonna be great. And you guys get all the tax benefits, and we're not getting any tax benefits. And then you read the operating agreement, it says that they are getting tax benefits, they're getting a loss allocation, before the LP, so that that's where the issues are, but it's not a bad thing. As long as everybody's transparent, like all deals are structured differently. And that's totally okay. So let's talk a little bit about how you can estimate the loss allocation that you're going to receive when you put money into a deal. And it's a really simple calculation, you can definitely get crazy with it. But I always like to think about it in a very simplistic manner. So first, we have to assume that we're going to use a relatively standard operating agreement, and that operating agreement is going to allocate losses to the limited partnership interests until their capital contributions are reduced to $0. Now, what exactly does that mean? Well, if I put $100,000 into a deal, my capital contribution is $100,000. And I can be allocated losses until my capital account reaches $0. And then if I'm allocated any qualified non recourse debt, I can actually go below $0. So a lot of people think you can't go below $0 capital account, which is true, except if you're involved in a real estate partnership, because you have qualified non recourse debt allocations and those debt allocations give me basis to continue to take the deductions, even if my capital accounts $0. So I can drop below zero, and go negative and continue to be allocated losses that typically it's not going to happen with a limited partnership interest. So we kind of go back to a couple steps back, we look at that operating agreement, it says we're going to allocate losses 100%, the limited partnership group, always think of it as a group until their capital account balances equals zero. And then we're going to do you know these other things. So, if we are buying a $10 million deal, you can ask the sponsor, how much money you raised? We're raising $3 million 20% downpayment, 25%, downpayment plus a CapEx budget $3 million. So we're buying a $10 million deal. We're raising $3 million. Cool. So that's one one piece of the puzzle, right? And what does that solve for us? Well, that tells us the total limited partner capital account balance, if 100 People are collectively putting $3 million into this deal, than we know that $3 million is the total capital account balance. So if we go back to that operating agreement, it says we're going to allocate losses to the limited partners until their total capital account balance equals zero. Now we know that there's at least $3 million dollars of loss allocations that need to occur before the GPS gonna get anything. Right. So quick recap, just in case, this is going way over your head, we put $100,000 into this deal. But I'm trying to figure out what my personal loss allocation is going to be at the end of the year. So I have to look at the operating agreement. And the operating agreement says we're going to allocate losses to the limited partners first, until their capital accounts reach zero. So now I have to know what the total limited partner capital accounts going to be. So that I can understand who's going to get lost allocations, right. So I know that we're buying a $10 million deal. I go to the sponsors, how much money you guys raising from limited partners, I'm raising $3 million. So now I know that $3 million is the total limited partner capital account pool. So then I go into the sponsors and I say, Have you gotten a cost segregation study, analysis performed? Typically, they're gonna say, yes, they typically do this during due diligence. What is the bonus depreciation? What does that look like? They tell you it's $2.7 million.
Great. Now, what I like to do in this situation is assume that that is also going to be the tax loss. And I know that it's not one to one, you know, like don't don't go flame me like Brandon, you're just making high level, you know, summary assumptions that makes zero sense look, it's immaterial. Otherwise, you're gonna have some rents, you're gonna have capex, you're gonna have repairs, you're gonna have maintenance that first year that you're operating an asset, you're going to run at relatively close to break even from a tax perspective. And then we're going to add on top of that, this cost segregation, bonus depreciation. So if we have $2.7 million of bonus depreciation, coming from this cost segregation study on this $10 million apartment complex, then we know that we're going to get a $2.7 million tax loss. But the operating agreement says we allocate first the LPS until their capital accounts read $0. Well, the LPS capital account is $3 million. So we are, we are reducing the LPS capital account down to $300,000 $3 million minus the $2.7 million tax loss that's been allocated to them. But what that tells you as an investor is two things one, the entire tax loss 100% of that tax loss is being allocated to LPs, because the $2.7 million tax loss is less than the entire aggregate LP capital account of $3 million, so the entire capital that was raised. So 100% of that tax loss is allocated to LPs, which means that you get a slice of that, you get a slice of the 100% of the tax loss. It also tells you though, how much you can expect to be allocated on a pro rata basis. And you don't even have to get into the percentage interest or anything like that. You don't have to worry about any of that right now. Because what do we have here? We have a $2.7 million tax loss compared to a $3 million capital account. Right? What is that, that's 90%. So if I put $100,000 in, I can expect to receive a $90,000 tax loss from this syndication. That's what I'm getting at. So you can relatively easily see it's not going to be 100% pinpoint accurate, by any means. It might be 80,000 might be 85,000. But you can see on your $100,000 investment or your a $50,000 investment or whatever you can see by going through this exercise of let me look at the operating agreement, how are they allocating losses 100% of the LP Great, now I have to know what the LP capital account is $3 million dollars. Great. Now I need to know what the estimated tax loss is going to be thanks to that bonus depreciation $2.7 million. Great. Now I know that the estimated tax loss is 90% of the capital account, my capital accounts $100,000. Because I put $100,000 into the deal, I'm going to get a $90,000 tax loss allocated to me. So if you get a $20,000 tax loss allocated to you, you have problems, either you did not read the operating agreement correctly, the cost segregation study was abysmal. Or the operating group has a bad tax repair. It's one of those three things typically. So that that's how you can kind of expect and then you can go and take that information. And you can you can strategize outside of that, right? Well, if I know that I'm going to get roughly a $90,000 tax loss, then I also know that I can go and sell the single family home that I've been holding on to it because it's got $110,000 gain, and now I've only got a net 20k spread roughly that I'm going to pay tax on. That's how you do it. Extremely, extremely important to estimate that upfront, but it's a relatively simple exercise. I know it sounds big and scary, but you do it one time. And you realize, oh, wow, all I have to do is ask like three questions. And I can estimate this relatively accurately. And if you want like a visual and a walkthrough on it a really deep dive on it. Again, we're making that available to people that are subscribers at Tech smart. investors.com.
Thomas Castelli 23:52
Absolutely. And you know, one of the things that why this becomes so important estimate, you know, is if you're exiting a deal, right, if you know that the sponsor comes down and says, Hey, look, we're going to be selling this property this year, right? Or the intended sales this year, you know, you're gonna have a capital gain coming down the pipeline. And if you go and you look at that form 8582. And you realize, oh, you know, I don't have that many passive losses, or that that much passive losses already, then you might need to go ahead and make an investment. Or you may choose to make an investment in another limited partnership, another syndicate to get passive losses, and you're going to want to have a relatively close idea of how much losses you can get at least in a ballpark figure to see if it's going to be enough to offset that capital gain and the sponsors should be able to help you determine what that capital gain is or they should have an idea of what what that gain is going to be when it is sold. So if you can kind of play around and estimate a little bit of how much passive losses you're going to need to offset the gain so you can at least come close to hitting that number. You know one of the biggest problems we have in the CPA industry is people, the CPAs are too busy preparing tax returns to ever really provide any planning on how their clients can minimize their taxes, which is often costing their clients a lot of money. And so
Brandon Hall 25:12
I'm and I've worked with over 1000 real estate investors on tax planning over the past six years, we've saved them millions of dollars in taxes. And the reality is, is that tax planning, especially one on one is really expensive. It's not in the budget for all real estate investors. But real estate investors are near and dear to automatize heart, we're real estate investors, our parents are real estate investors, we want to help every single real estate investor out there. So we created tax smart investors.com, there's three subscription tiers, you can get a content subscription tier that gives you access to gated content, and we write it in a way that you can digest it. But there's also citations that you can go to your own tax payer and say, Wait a second, this is how it's actually supposed to be. And here's the citation. On that content subscription, you also get access to a weekly tax strategy newsletter. On top of that, we also have a subscription that gives you access to our insiders Facebook group, which just allows closer access to Tom and I and our team of CPAs. You can schedule paid calls with us. And you can get access to our monthly workshops. Through that subscription tier and those monthly workshops. We're doing tax planning, financial planning, we're going over accounting strategies and how to automate your systems. And then we have a top tier
Thomas Castelli 26:20
and that top tier, that's really where you get access to us and our team of experienced real estate tax planners. And you could do that through two calls, we'll take a look at your situation and determine what strategies you can use to minimize your taxes based on where you are, where you're looking to go. And in addition to that, what a lot of our clients have loved over the years is the ability to send emails where you could send in your question, and we'll get back to you with an answer within 48 hours. And you should definitely check that out. If you're sending questions to your CPA and they're taking weeks to get back to you if they ever get back to you. Or they're not providing with any planning, we can take a look at your situation and determine what can be done to help you save on taxes. Right. So
Brandon Hall 26:57
So then you start paring that becomes part of the strategy is it's an acquisition strategy. It's a timing strategy, it's a being in touch with your sponsor on an ongoing basis strategy. You know, like if I if I invested in sponsorship, and I get a $90,000 tax loss allocated to me on my 100k investment, let's say that I like strategically plan, I'm able to use my $90,000 tax loss to offset rental gains or offset business income or whatever. But I don't carry it forward, it's not going to be suspend because I use the entire thing. Well, let's say three years from now, the syndication liquidates and on that liquidation, I'm allocated, you know, an extra 50k of gain or something. So, in very simplistic terms, my total capital account should be my 100k. Investment, plus my 50k of gains. So 150k, right. But the problem is, is that I was allocated $90,000 of tax loss. So really, my capital account is $10,000. And if I'm being cashed out at 150k, I've got $140,000 of gain, and I might not receive a cash distribution, that equals that, I might, I'm gonna have to pay tax on that it might be a little painful. So you also have to recognize that if I'm able to claim these losses up front, when I make these syndication investments, like if I can use that $90,000 Today, at some point, I'm gonna have to pay the tax, because at some point, the investments that I'm in are going to liquidate, and my basis is going to be very low, which means that my gain is going to be very high, by using $90,000 loss on 100k. Investment. My investment basis is now $10,000. So if that thing liquidates at 150, I've got a big gain $140,000 that I've got to pay tax on, there's gonna be depreciation recapture tax in there, that's allocated to me, there's going to be capital gain tax in there as well, that's allocated to me. So I've got a, you've got to be careful in the timing. And you've got to just understand that, you know, I'm taking the tax benefit today. And it's a good thing to take the tax benefit today, a lot of people say, Well, I don't even know, I just want my losses to be suspended. Now you don't know you don't time value of money theory, a gallon of milk today is worth $3 a gallon of milk next year is worth $3 In one sense. So I want to invest my money. Now I want to capture all the benefits now. invest the money now, so that I can buy the milk next year, rather than just having that $3 sitting in my checking account. Because $3 a day in my checking account buys me a gallon of milk, but next year, that same $3 will not buy me that milk. So I want to I want to capture those tax benefits today. I want to use those losses today. But I just have to understand that at some point, and we have to pay a chunk of that back.
Thomas Castelli 29:44
Absolutely. So circling back on all of this as a limited partner. Your losses from the syndication, whether it be real estate or whether it be a business are always going to be passive because by definition, you're not materially participating in The activity, right. So when you have rental losses, like we've been discussing, the rental losses are going to show up in box two of your k one, those losses are passive, its passive for two reasons. The first reason is that you are not materially participating in that activity. And unless you're a real estate professional, we'll get into it a bit. But it's passive because you're not materially participating in that activity. Same thing with a business like Brennan's hair salon, or any other businesses that you might invest in. Even though those losses, they're not going to show up in box two, because they're usually not rental losses, those are business losses, they'll show up in box one. And those losses are also passive, because you are not materially participating in the activity, because you're a passive investor. Again, you're, you're looking at a bunch of opportunities, and you're making a decision to invest. So the time you spend looking into these activities and making a decision to invest are investor level activities, and they don't count as material participation, material participation counts when you're actively involved in the day to day operations of a business. And as a limited partner, you're delegating effectively, that responsibility to the sponsors and the team sponsors hire to operate that business, right. So when you get a loss in box two, it is going to be passive. And this goes for ATM machines. Indications This goes for the hair salon for a fitness center. I love fitness centers, I always use fitness centers as an example. This goes for the restaurant, this goes for a laundromat, this goes for any activity that you're investing in passively, those losses are going to be passive to you as a limited partner, regardless of what the sponsor tells you. Okay, right now, our
Brandon Hall 31:40
list of what the sponsor tells you, regardless of what the sponsor tells you, this is a point that I want to emphasize because we see a lot of mistakes made by CPAs. Made by tax pros, they get the k one from the client, and they will see box one income or loss box one is ordinary business income or loss, right? Well, that doesn't automatically mean that it's non passive. Because when I invest in my hair salon, I'm going to get $10,000 of positive income that shows up in box one. And it's gonna say ordinary business income. But I didn't participate at all. I didn't do anything. All I did was put up 100k. So they could expand. That is passive income for me. It's not non passive. A lot of CPAs make the mistake. A lot of preparers make the mistake and a lot of DIY folks, do your DIY, your tax turns on TurboTax. h&r block, we've seen people make the mistake thinking, Oh, well, if it's not rentals, then it's non passive. And I just put that on my 1040. And I'm good to go. And all you've done is you've just shot yourself in the foot because my $10,000 passive income from my hair salon being even though it's inbox one, even though it says ordinary business income, that's passive income baby. And I can use my syndication losses to offset that passive income. So I'm doing the Rich Dad Poor Dad thing, I'm creating all these income streams, where I don't pay tax on the positive income that's coming into me. But I do pay tax if I have a bad CPA, or if I don't quite understand it really important to understand that the sponsor can tell you whatever the sponsor wants to Oh, yeah, you're gonna be able to you, we've seen it all the time, especially with the ATM stuff, oh, you'll be able to use the losses. No, you won't. It's passive. Its passive, the passive losses for you they just because you're investing in an ATM in the case business loss, it doesn't mean that it's non passive, what you have to do is you have to look at your individual participation in the activity. If you did not participate in the activity, it's passive, always. And that's for businesses and rental real estate.
Thomas Castelli 33:40
Yes, with the exception of oil and gas, but that's a story for another time. Now, oil and gas. Now, there is working interest specifically in oil and gas. Now, there's one thing that we do want to touch on today, and that is when you're limited partnerships, losses can be non passive. And there's one instance when that can occur. And that's not going to be true if you're truly a passive investor. But if you are a real estate professional, and you have a rental portfolio that you manage directly, so maybe you have 10 duplexes that you self manage with you and your spouse and your real estate professional right when you could do is you can group all your rental activities together. When you have a limited partnership interest in a rental activity. Then when you group all your rental activities together, generally that LP interest or that limited partnership midges will be grouped in with your rental activities making those losses non passive. Now that's really the only exception when you're going to see a limited partnership interest in a syndicate be turned on passive so this is something keep in mind.
Brandon Hall 34:44
The grouping election is founded reg section one 469 dash nine G and one caveat to making that election is that when you group in a limited partnership interest into your rental activities because again, the grouping election treats all you interest in rental real estate as one. So if you don't make the grouping election, and you have 10 rental activities, then you have to materially participate in each rental activity separately to make it non passive. And you've got those seven material participation tests that you can adhere to. But when you make this grouping election, the nine G election that I just mentioned, then you treat all of your rental interests as one all of your rental real estate activities as one for the purposes of material participation. But when you group in a limited partnership interest, you have to meet certain material participation tests, there's three, but the one that you can count on meeting conservatively, is the 500 hour test. So when you group in a limited partnership interest, you can't use the substantially all tests, you can't use 100 hours more than anyone else, you should really should be aiming for 500 hours at that point. And all that means is that if I have my own local rental portfolio, I qualify as a real estate professional, I materially participate in my own local rental portfolio, but I materially participate hitting 500 hours, 500 hours of rental management, then I can make that nine G election and group in my limited partnership interest.
Thomas Castelli 36:11
Yep. So you have to have a direct rental portfolio at the end of the day, and you have to be spending at least 500 hours of material participation on that rental portfolio specifically, in addition to the other real estate professional requirements. And we're not going to go into that today. Just wanted to make you aware that that is the one time the one exception where these limited partnership and the losses from these limited partnership interests can become non passive, again, with the exception of working interest in oil gas. But now let's shift our attention to some of the other exit strategies that are available to real estate investors and whether or not they apply to limited partners in syndicates. And the first one is a 1031 exchange, right? I get this all the time, a client will email me the syndicate that I'm involved with, they're going to be sold this year, can I utilize a 1031 exchange? And the answer to that question is it depends. One case when you could use it is when this sponsor says you know, we're going to 1031 exchange this property into another property as a sponsorship group. And you can go along with them. Usually sponsors who do this will let you know up front, hey, look, we'll look to do a 1031 exchange on this asset. And usually limited partners sign on and are on board for that type of opportunity. And the reason why this is important to understand is because in order to do a tender exchange, the same entity that owns the relinquished property, also known as a property that's being sold, needs to also own the new property or the replacement property. So in order for that to occur, the partnership that you're investing in as a limited partner needs to be the same partnership that takes title to this other property to the new property and the 1031 exchange. So in order for that to occur, the entire partnership needs to do it. And you could sometimes sell your interests out and get out in those cases. But that's what's going to take
Brandon Hall 38:00
in a real quick note on that. That's the that's the same taxpayer rule. That's what Tom's getting at here. So like, like, if you want to boil this down on an individual level, let's say that you through a single member LLC, own $100,000 single family home, and then you 1031 exchange that into a $500,000.10 Plex or something I don't know where you would get a $500,000.10 Plex in the United States today. But you know, just assume that you can do that. Because you personally are the taxpayer because a single member LLC does not exist for federal tax purposes, it's a disregarded entity, you can take title to the replacement property, or your single member LLC can take title to the replacement property, or a new single member LLC can take title to the replacement property, or a pass through trust can take title to the replacement property. The point is, is that the taxpayer has to remain the same. And in this example that I'm using, when you have a disregarded entity, you are the taxpayer. And so it doesn't matter what disregarded into you that ultimately takes title to the new property, because at the end of the day, you are still the taxpayer. But when you're in a partnership, the partnership is the taxpayer, the partnership has to be the next one. So the partnership has to be on that replacement property. And that's what Tom was explaining. So when you are in a partnership, you cannot take your partnership interest and go and 1031 that does something else, because now you're changing out of a partnership and into something personally. And well. First, you can't exchange partnership interest anyway. But second, you would be running afoul of the same taxpayer rule because the partnership is the taxpayer, not you individually on that property.
Thomas Castelli 39:41
So in most cases, bottom line is unless the entire partnership or the sponsors initiating the 1031 exchange on their end, and you're going to come along into the next property as part of the same partnership that you originally invested in. You're not going to be able to do a 1031 exchange at the individual level as a limited partner and that could be in negative for in some cases, when some people want to go ahead and defer their taxes using a 1031 exchange, that's something you generally can't do as limited partner, at least at the individual level, something to keep in mind. Now, there are other strategies that can be utilized outside of just using the passive losses. And that is a qualified Opportunity Fund, which we went through in our last series exit strategy. So we're not going to recap that there. But that is something that you can use as a limited partner, you can defer the section 1231 gains into a qualified opportunity fund with your individual interest. So that is possible to do just something to keep in mind and you can go ahead and learn more about that on our last series, the exit strategy series.
Brandon Hall 40:44
Man, that's kind of a meaty meaty episode, huh? Yeah, you know better buddy all these limited partners thought they were gonna listen to an easy 60 minutes or so I think we just went 60 minute episode on investing in limited partnerships but or investing in syndications. But man, that was a we had everything we had operating agreements k one, so yeah, all that
Thomas Castelli 41:03
gets. Yeah, you know, and if they want deep dives, anybody wants deep dives in a this stuff they want to you want to visualize it, see how it could work for yourself, you know, you can go ahead and subscribe to the tech smart investors.com. We will be putting out articles that go deep into this stuff with visualizations of how this works. And in addition, we will be doing workshops that do cover these topics in greater detail, where there will generally be a q&a component to those where you can actually ask some of your questions and maybe we can help you out and facilitate some of those conversations in that row.
Brandon Hall 41:37
Thanks for listening to today's show. If you enjoyed the show, please find us on iTunes and leave us a review. You can also email us at contact at the real estate CPA comm with any feedback or topic suggestions, we are always taking on new clients and with the new tax laws in play. You really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs. To become a client navigate to our client page at the real estate cpa.com and fill out a webform with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.
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