In this article, we dive a bit deeper into some faulty preconceived notions that many newer investors hold about real estate syndications and reveal time-tested truths about these unique investment vehicles.

MISCONCEPTION #2: Syndications Are Tax Friendly

Real estate—specifically, investments in syndications—are considered tax-friendly assets. What exactly does that mean? When considering a syndication, you’ll find that operators use buzzwords like “tax efficiency,” “pass-through depreciation,” and “tax deferral.” In reality, investing in syndications requires considerable proper due diligence and tax planning if you want to take advantage of all those buzzwords that have become clichés in this space. Prior to investing in any potential deal, you should discuss your options with your accountant, who can explain everything from whether or not to purchase the investment in a retirement account (which is done easily and often these days), to how to invest in a way in which passive gains will be offset by passive losses in a non-retirement account.

Understanding the Schedule K

When you invest in a syndication, the tax form that is provided to you at the end of the year by your operator is called the Schedule K. The form is usually prepared by the CPA and summarizes your portion of the profits and losses received from the legal structure that owns the property.

Operators are often willing to send you a sample Schedule K of a previous deal so you can show your accountant for estimation purposes instead of waiting until you’re already invested to talk to your accountant. Keep in mind that your current accountant may not have enough real estate experience to properly answer your questions. This is where networking with other investors is critical. While it’s considered taboo to talk about how much money you make with your current network, talking about tax planning with other real estate investors is welcomed. Weird, I know!

A pro tip:

You can tell a lot about an operator by the professionals that they work with. A CPA plays an important role on that team and is independent and usually unbiased because of their professional reputation. As part of due diligence, you can always reach out to the accountant and see what you can find out. Before doing so, you should let the operator know as a matter of professional transparency and courtesy.

On a related note, most operators do a great job of expediting Schedule Ks for their investors, but if they are late, you’ll need to file a tax extension. Keep in mind, it’s not the operator that processes the Schedule K; it’s their accountant. Being late once for a good reason is fine, but if the same operator is late with the Schedule K year after year and consistently blames it on their CPA but does nothing to change their CPA, that is not ok. This will largely depend on the mentality of the operator and their investor groups. Most real estate investors file extensions by default regardless, so it’s no big deal. Newer investors, however, may have never filed an extension in their lives before and don’t plan on starting now. Just know where you are on the spectrum.

Fair warning: If you invest in more than a few deals, you will most likely need to file an extension. This is just the cost of investing in syndications.

What Kind of Taxes Will I Pay During the Holding Period?

A holding period lasts from the time of the acquisition to the time of disposition of the asset.

During the holding period, any distributions made to a limited partner are usually very tax friendly due to the enormous depreciation an apartment building creates annually. There is also a term called cost segregationthat supercharges the depreciation an investor sees on their Schedule K.

In simple terms, the investor may have received their share of the distributions, but the investor document may show a negative number because the depreciation share for the investor was greater than the distribution received. However, taxes on those distributions are only deferred until the property sells, at which time, you may need to pay them. The key is to plan ahead with the understanding that these gains are not tax free indefinitely.

Referring back to the sample Schedule K you may have received, it’s important to find out if the sample provided included cost segregation. You can usually tell because it will show losses that are significantly higher than a deal that doesn’t use cost segregation. For a rough rule of thumb, deals that we have invested in averaged about a 10% loss in the first year without cost segregation and around 50% when cost segregation is involved. Also, just because the last deal had a cost segregation study done doesn’t mean the operators in the next deal will have it done. You’ll want to ensure you’re making apples-to-apples comparisons.

There is also constant chatter from the government that cost segregation rules may need to be updated or eliminated altogether. That’s important to track, even as a limited investor. To be certain, this chatter usually ratches up during elections and dies down after, given that a large number of politicians are also real estate investors (no surprise there!).

How Will a Schedule K Affect My Taxes?

This is far and away the biggest misconception out there, especially for newer investors.

Just because your Schedule K shows a negative number doesn’t mean you can apply those losses to offset your other income.

The general rule of thumb is that, as an investor in a real estate syndication, you are considered a passive investor and passive losses only can offset other passive income. Otherwise, the losses keep rolling over until you can use them. The exception is if you are a designated a “real estate professional”, which will allow you to use those losses. One extremely powerful strategy that has emerged as of late is for a couple to have one high-earning W2 employee, while the other is a full-time real estate professional. This allows the passive losses to offset the active income from the W2. Keep in mind that tax rules change every year, and what worked last year won’t necessarily work this year.

This highlights the importance of talking to your CPA. Before investing, make sure you understand how passive losses work and what the net effect of investing in that syndication will do to your financial picture. Otherwise, when it comes time to file your taxes, you could be caught blindsided.

The Best Piece of Advice I Received

In talking to multiple real estate CPAs, they all say mostly the same thing: Investing in syndications is not magic, contrary to some operators’ statements.

All it does is kick the “tax can” down the road. With proper planning, you may be able to keep kicking that can down the road even until death, but make no mistake—it’s not as simple as it’s made to look by some operators.

If you liked this article and wish to continue on your path in learning about alternative investments, please make sure to check out my other educational articles as well as my book, The Alternative Investment Almanac: Expert Insights on Building Personal Wealth in Non-Traditional Ways. 

Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.