Hidden risks of tax benefits in syndications
On tax benefits and the often missed assumptions behind them
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Hidden risks of tax benefits in syndications
Many of you have asked about the pros and cons of tax benefits in syndications, and I decided to pair up with Roger after one of his posts because we both feel that this topic doesn’t get addressed enough. Roger posts a lot of great insights for free on Twitter and LinkedIn.
Our agenda for today:
Introduction
Why the promised tax benefits might not apply to you
An example of tax benefits gone wrong
“I’ll just 1031 to not pay the taxes … right?”
Why your GPs CPA matters
1) Introduction
Every LP investor in real estate will tell you the same reasons they prefer private syndications over REITs or the stock market: the tax benefits are amazing! For some other benefits of syndications, see 5 reasons to invest in real estate syndications.
While the tax benefits are truly great, they also carry a few assumptions that might not turn out as planned. Today we’ll discuss four separate risks related to tax benefits so that the below meme doesn’t have to be you! 😊
For starters, here are the three primary tax benefits of investing in a real estate syndication:
Accelerated Depreciation and Pass-through Losses - when a partnership uses investor capital and debt to buy a property, it can take accelerated depreciation on certain assets and that depreciation comes first to LP investors as K1 losses.
This is a good time for brief reminder: an LP has zero control over when a GP decides to perform a cost segregation study (i.e. they might not do it on time or never do it) or when a property is sold. Because both of these have tax implications to you as LP while being outside of your control, they’re important to think about when you’re tax planning.
Tax-free Distributions - when a property has been acquired, improved, and stabilized, typically the GP will refinance the loan and receive proceeds that are then distributed to you as an LP investor
This works from a tax perspective by way of “basis.” Meaning, the IRS will allow investors to receive distributions and not pay tax on them because they have basis either by: (1) their initial capital contribution, and / or (2) debt allocated to them. More on this later!
Further down, we will also discuss later why it’s better to think of these as “deferred” tax-free distributions, a risk many LPs don’t think about
Special Allocations - partnerships have a unique place in the tax code as the most flexible entity structure for determining which partners receive what allocations. Many rules exist as guardrails, but GPs love partnerships because they can receive a promote or carried interest at long-term capital gains rates instead of as a part of a fee - the same long-term capital gains rate enjoyed by LP investors. However, this special allocation can come back to bite LPs if the operating agreement isn’t worded adequately.