Real estate investing affords certain tax benefits when it involves the direct ownership of a property. For example, investors are able to deduct the value of mortgage interest as well as certain expenses associated with leasing the property, such as maintenance or repairs.
For investors whose real estate holdings are limited to a real estate investment trust, these tax advantages generally do not apply. Fortunately, real estate crowdfunding has made it possible for investors to reap the tax rewards of owning real estate through equity investments.
How Crowdfunded Real Estate Equity Investments Work
Real estate crowdfunding is divided into two distinct areas. The first centers on debt instruments, which involve an investment in the mortgage loan associated with a particular property. Equity investing, on the other hand, permits investors to invest in shares of a private commercial or residential property. In exchange, they receive a percentage of the rental income generated by the property.
Many real estate crowdfunding platforms establish a separate limited liability company (LLC) or limited partnership (LP) for each equity investment they offer. The LLC or LP holds an interest in the entity that owns the title to the property. When you invest in real estate equity, you effectively own shares of the corresponding limited liability company or limited partnership. This works to your advantage because it creates a pass-through entity for tax purposes.
Equity Investments and Depreciation
Property owners have the ability to deduct depreciation value on their taxes, which is an estimate of the amount of wear and tear incurred from year to year. The deduction is designed to allow owners to recover some of the expense of maintaining the property. The full cost of the property is used as the basis for calculating depreciation, rather than the amount of equity the owner has. This allows for the amortization of the mortgage loan over the investment holding period.
With equity real estate investments, the depreciation is calculated by the LLC or LP, rather than the individual investors who hold equity shares in the property. Because of the way equity investments are structured, the value of the depreciation deduction is able to be passed on to the investors for tax reporting purposes.
The depreciation deduction, along with deductions for other expenses associated with the property, can be used to offset any taxable income it generates. From an investor standpoint, the net result may be a lower tax bill or a deferral of tax liability until the property is sold.
Deductibility of Loan Interest
In addition to depreciation, the mortgage loan interest is another deductible expense associated with real estate investments. The amount of loan interest paid on an annual basis is subtracted from the amount of rental income received for the year to determine the property owner’s taxable income.
Once again, the value of this deduction is passed through an equity investment’s LLC or LP to its members or partners. When combined with the depreciation deduction, the write-off for mortgage loan interest can minimize the taxation of cash distributions to investors. This serves to increase the overall return investors realize from the property while lessening their tax burden.
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Capital Gains Taxation
Another beneficial aspect of real estate equity investments centers on how they’re taxed in terms of capital gains. Real estate crowdfunding is largely a buy-and-hold proposition and with equity investments, the holding period may last from two to 10 years. With that being said, the long-term capital gains rate would apply for any earnings realized upon the sale of the property.
The current long-term capital gains rates range from 0 percent to 20 percent, based on your tax bracket. By comparison, short-term gains are taxed at your regular income tax rate. That could make a substantial difference in the size of your tax bill if you’re a high-income earner.
Passive Income Rules
Investor income generated by real estate equity investments held in syndication through an LLC or limited partnership is generally considered passive for tax reporting. Income from passive activity can be used to offset losses from other passive investments.
When an equity investment results in the investor receiving passive income, it’s typically taxed at their marginal tax rate. If an investor is carrying forward passive losses from previous years stemming from other real estate investments, those can be applied towards any tax liability in connection with the passive income created by equity investment.
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Income that is earned passively is also exempt from self-employment tax, which would normally apply to real estate ventures that you take an active role in. For example, if flipping houses is your primary form of income, any profits you realize would be subject to both ordinary income tax and self-employment tax. By investing passively through equity deals instead, you’re able to avoid the additional self-employment tax entirely.
Equity investments are an enticing alternative for investors who want to add real estate holdings to their portfolio but are unable to purchase a property directly. Each investor’s tax situation is different and it’s always prudent to consult an accountant or tax expert when evaluating tax consequences. Understanding which tax rules apply to real estate equity investments is an important step for investors who want to fully capitalize on their economic benefits.
Author Bio: Nav Athwal is the Founder and CEO of RealtyShares, a curated online marketplace for real estate investing. His platform connects individual and institutional investors to private U.S. real estate investments, raising $300 million across more than 550 deals in 35 states. Prior to founding RealtyShares, Nav was a real estate and land use attorney in San Francisco, representing developers, fund managers, nonprofits, and public and private REITs on some of the largest US real estate and renewable energy projects. Nav holds a B.S. in Electrical Engineering from UC Davis and a J.D. from UC Berkeley Law School where he was Class Valedictorian.