The ink is drying on the check you just wrote to your retirement account, to maximize your deductions for last years tax bill.
Now, where will you invest that money? Often investors are encouraged to invest Self Directed retirement accounts into syndications, as a way to benefit from real estate without all the work.
However, one of the benefits to investing in real estate is the tax write offs, which may be limited if an investor places retirement account assets in real estate.
Understanding Depreciation in Real Estate
Depreciation allows property owners to account for the wear and tear on an asset over time. The IRS permits real estate investors to depreciate residential rental properties over 27.5 years and commercial properties over 39 years. This deduction can offset rental income, reducing the taxable income of the investor. (Multifamily 5+ units is depreciated over 27.5 years, even though it is considered ‘Commercial’ for loan purposes.)
In a real estate syndication, depreciation is distributed among the investors based on their ownership interest or as outlined in the operating agreement. Typically, depreciation on the property is allocated based on the cash investment of the deal. However, there are other methods to allocation.
Methods of Allocating Depreciation
Depreciation is typically allocated to investors in a syndication in the following ways:
1. Pro-Rata Share Allocation
Most real estate syndications allocate depreciation based on the investor’s percentage of ownership in the entity. For example, if an investor owns 10% of a syndication, they receive 10% of the depreciation deductions. This method ensures an equitable distribution of tax benefits in proportion to the investment made.
2. Preferred Return vs. Common Equity Structure
Some syndications have a tiered investment structure where preferred investors receive priority returns, while common equity investors participate in residual profits. In such cases, the depreciation may be weighted differently to favor certain investors who have contributed more capital or taken on greater risk.
3. Special Allocations in the Operating Agreement
The operating agreement of a syndication can specify customized depreciation allocations. For instance, the general partner (GP) may receive a different proportion of depreciation deductions compared to limited partners (LPs).
- Special allocations must be written into the operating agreement and have ‘substantial economic effect’ by rule under Section 704(b) of the Internal Revenue Code. Special allocations are subject to IRS scrutiny.
- While syndication structures can be designed with different classes of partners or special allocations, these arrangements are subject to complex tax rules. It’s essential that any such allocations are supported by actual economic arrangements, not just for tax purposes.
- Under this type of structure, depreciation can be specially allocated. As controlling partners, you may incentivize investors to join your business by passing depreciation-related tax deductions on to them. In oil and gas investments, sometimes 100% of the depletion and credits bypass the general partners who actually manage the business and go straight to investors. This can be in the best interest of all parties involved: investors may benefit more from deducting losses, and startups may benefit more from leveraging the special tax allocations to bring in more capital.
Effects on Self-Directed IRAs
A self-directed IRA is an IRA where you have more control over the investments and can include alternative investments like real estate syndications.
However, there are stringent rules to follow, and any returns generated would generally be tax-deferred or tax-free (in the case of a Roth IRA), but distributions may be subject to UBIT & UDFI (Unrelated Business Income Tax & Unrelated Debt-Financed Income) in certain situations.
- Solo 401ks are generally not subject to UBIT & UDFI, and are a great solution for self employed individuals who qualify for them.
Are losses generated as a Limited Partner useless for your IRA Investment?
No, losses aren’t useless! Losses, often driven by depreciation, can offset passive income that the limited partner might receive from the syndication on the portion that may be subject to UBIT/UDFI. If a limited partner doesn’t have enough passive income in the IRA in a particular year to utilize all of the passive losses, those losses can be carried forward to offset future passive income OR the eventual gain on the sale, for the portion that would be subject to UBIT/UDFI.
- In many situations, even where a property is cash-flowing, the IRA will not be subject to UBIT because the property expenses and depreciation will offset UBIT income, and the K-1, which the IRA receives, has a tax loss.
Conclusion
Depreciation allocation is a key component of the tax advantages associated with real estate syndications. Investors should carefully review the syndication’s structure, operating agreement, and potential tax strategies to maximize their benefits.
Investors placing retirement funds in syndications should seek advice from their trusted tax advisor on how the investment will be taxed.
By understanding how depreciation is allocated, investors can enhance their after-tax returns and make more informed decisions in real estate syndications when investing inside or outside retirement funds.
Many investors we work with appreciate the full spectrum view we help provide to maximize their returns in ways they had not expected. Call us to deepen your investing strategy in unique ways.
Sources
–https://www.irs.gov/pub/irs-pdf/i8990.pdf
DISCLAIMER: This email is not intended to be legal or accounting advice. Each investor should seek guidance from the CPA and attorney.
