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The Tax Benefits of Passive Real Estate Investing

March 5, 2024.

The Tax Benefits of Passive Real Estate Investing

Passive real estate investing offers a potential long-term path to wealth. While investors focus on their day jobs and other financial pursuits, these investments can command solid returns – without an enormous commitment of time. But it’s important to recognize that, as passive​ investments, these opportunities come with unique tax considerations. As a result, we’ll use this article to outline the major tax implications of passive real estate investing.

Specifically, we’ll cover the following topics.

IRS Income Categories

Prior to discussing the tax implications of passive real estate investing, we need to provide an overview of how the IRS classifies different types of income. This income classification directly relates to the associated ​tax​ treatment.  According to the IRS, three types of income exist: active, portfolio, and passive.

Active income​: This includes all earned income (e.g. wages, tips, and active business participation). For self-employed individuals, business earnings also qualify as active income. Of note, in certain situations, real estate investment income also qualifies as active. We will discuss these exceptions in the next section.

Portfolio income​: Investment income such as capital gains, interest, and dividends qualify as portfolio income. And, investors can generally only offset portfolio gains with portfolio losses. However, it’s important to note that, while people refer to stocks and bonds as “passive” investments, the IRS treats this income separately from ​passive income.

Passive income​: The IRS states that this includes the income earned from rents, royalties, and limited partnership stakes. This income type proves particularly relevant to real estate investors. For most investors, real estate investment income qualifies as passive. This means that, in general, passive losses in real estate can only offset other ​passive​ income – not active or portfolio income.  Moving forward, we will use these terms to explain the tax implications of certain passive real estate investments.

IRS Real Estate Investor Tax Classification

In addition to classifying ​income​ types, the IRS also breaks down real estate investors into different categories. Each of these categories provides its own tax implications. As such, it’s important to understand exactly ​how​ the IRS will categorize an investor, because this will dictate the investor’s tax treatment.  According to the IRS, three types of real estate investors exist:

1) Real estate professional,

2) Active investor, and

3) Passive investor.

We’ll outline them below, from ​most​ to ​least advantageous from a tax perspective.

 

Real Estate Professional

This is a formal IRS tax classification. Simply working in the real estate industry does not mean someone qualifies as a real estate professional. Instead, individuals need to meet detailed criteria outlined by the IRS. However, as a real estate professional, investors receive tremendous tax benefits.

As stated above, the IRS typically treats real estate investment income as passive. This means that investors generally cannot use real estate losses to offset active income. As a real estate professional, the IRS categorizes real estate investment income as ​non​passive. This means that investors can use real estate investment losses to offset their active income – potentially leading to large tax savings.

 

Active Investor

Active real estate investors gain more tax benefits than passive investors, but not as many as real estate professionals. To qualify as an ​active​ investor, the IRS states that an individual must actively participate in a real estate investment.

Per IRS guidance, investors actively participate in real estate if they make management decisions in a ​significant and bona fide sense​. This could include decisions such as approving tenants, deciding lease terms, and approving property expenses.

Active investors potentially receive an exception to the above passive loss limitations. As stated, passive real estate losses can typically only offset other passive income. As an active investor, an individual may be able to deduct up to $25,000 in passive real estate losses from active income.

With a modified adjusted gross income (MAGI) ​less than​ $100,000, active investors can deduct up to $25,000 in passive real estate losses against active income. But above this MAGI, the deduction begins to get phased out, and with an MAGI ​greater than​ $150,000, the IRS does not allow any losses against active income.

 

Passive Investor

Passive real estate investors receive the least favorable tax treatment. They do not actively participate in their real estate investments, and they can only deduct passive losses against passive income. For example, a $15,000 loss on a rental property could offset $15,000 in passive income from another property. But, none of these losses could be used to offset wages or other active income.

Generally speaking, this is the classification that most people will receive with the passive real estate investment options. And, while this provides the least favorable real estate investor tax treatment, passive investing also provides the tremendous benefit of ​time​. Simply put, passive real estate investing allows investors to A) profit from real estate, while B) not committing their time and effort to the active management of that real estate.

 

Tax Implications REITS

Overview

Frequently, investors choose to begin their real estate journey with shares of a Real Estate Investment Trust, or REIT. Many of these entities are publicly traded, so they can be easily purchased and sold.

But, when investors purchase shares of a REIT, they purchase the ​company​ – not the underlying real estate. This provides the advantage of gaining investment exposure to real estate without needing to make any management-related decisions. Additionally, many REITs focus on a particular property niche (e.g. multi-family, office, industrial, etc.), providing investors further ability to diversify their portfolios.

Tax Implications

Among other requirements, REITs must pay out at least 90% of their taxable income as dividends to qualify as a REIT. This typically leads to higher dividend rates than most stocks and mutual funds. However, these dividends have unique tax treatments that investors need to understand. Of note, while investing in REITs may seem ​passive​, the IRS considers REIT dividends ​portfolio​ income. As such, these dividends will receive one of the following tax treatments, depending on their nature (as defined on the REIT’s annual 1099-DIV sent to shareholders):

Ordinary dividends​: The majority of dividend income will result from the REIT’s business operations. As a result, it qualifies as ordinary income to the investor and will be taxed at the investor’s marginal tax rate.

Capital gain dividends​: Some dividends will result from the sale of underlying REIT property. If held for more than a year, the dividend proceeds from these sales will qualify as capital gains. This means they will be taxed at the investor’s more advantageous capital gains tax rate of 0%, 15%, or 20%.

Nontaxable return of capital​: If a REIT’s distributions exceed its earnings, typically due to depreciation, it can provide investors a nontaxable return of capital. However, investors indirectly pay a tax on these distributions, as it reduces their tax basis. This means that, when they eventually sell their shares, they’ll face a larger capital gains tax bill.

 

Tax Implications: Real Estate Syndications

Overview

Real estate syndications offer an investment vehicle for multiple people to pool their capital for a real estate deal. And, these deals include two parties: the deal sponsor and the investors. The sponsor finds, underwrites, and manages the day-to-day operation of the deal, and the investors provide the capital for an equity stake.

For example, assume a deal requires $1,000,000 in up-front capital. The sponsor may personally contribute $100,000 and then raise $900,000 in funds from investors. From a legal perspective, these deals are either established as LLCs or limited partnerships. With an LLC, the deal sponsor acts as the managing member and the investors act as passive members. With a limited partnership, the sponsor is the general partner, while the investors gain limited partner stakes.

Syndications can be solid passive investment opportunities. They typically command higher returns than REITs, and they provide investors a ​direct​ ownership stake in the underlying property.

Tax Implications

Passive investment in real estate syndications provides two primary cash flows: rents and proceeds from property sales. With both, investors receive a pro rata share based on their ownership percentage. For example, a 5% limited partner will receive 5% of the property’s income ​and ​5% of its expenses.

Rental income/losses:​ Any rental income will be taxed at the investor’s ordinary income rate – the same as owning any rental property. And, this income qualifies as ​passive​. As such, any losses can only be used to offset ​other passive income​ (unless the investor qualifies as a real estate professional). Of note, limited partners typically do not play an active role in a syndication, meaning that they cannot claim the $25,000 of allowable passive activity losses available to active investors.

Property sale proceeds​: When a syndication sells its property, passive investors will be taxed on any gains from the sale at their capital gains rates (assuming the property has been held for longer than a year). Additionally, investors will need to pay a depreciation recapture tax of 25% on the difference between the property’s adjusted cost basis at sale and original tax basis.

 

Tax Implications: Private Lending

Overview

As the name suggests, private lending involves any non-traditional lender – typically an individual. For example, if someone has $250,000 in capital, he or she could choose to lend that money to real estate investors, collecting interest on the outstanding balance.

From a real estate perspective, private loans are typically used in a short-term context. For example, fix-and-flip investors often use private loans to buy and rehab a distressed property that wouldn’t qualify for traditional financing. Upon sale of the renovated property, these investors pay back the private money lender. Due to the short-term nature and rehab-related risk of these loans, private lenders typically charge much higher interest rates than traditional mortgages.

Tax Implications

As a ​lender,​ you take a position as a creditor on a property – not an owner. Therefore, you do not receive a portion of any of the property’s rental income or sale proceeds. Instead, the owner/borrower pays the private lender interest on the outstanding loan balance. The borrower’s interest ​expense​ represents interest ​income​ for the private lender. And, as with most interest income, this is taxed at the private lender’s ordinary income tax rate as ​portfolio​ income (despite the fact that private lending is generally considered a ​passive​ investment activity).

FINAL THOUGHTS

Passive real estate investing provides tremendous opportunities for building wealth – without massive commitments of time and energy. However, in addition to assessing potential returns, investors must also consider the tax implications of each one of these strategies. By balancing their desired returns, level of involvement, and tax burdens, investors can make the best choice for pursuing passive real estate investment opportunities.

 

 

Have Questions?  Contact Us!

 

 

References

High Peaks Capital. “Tax Implications of Passive Real Estate Investing” Tax Implications of Passive Real Estate Investing – High Peaks Capital March 5, 2024.

 

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