5 Things LP's Need to Know
We often have clients that are interested in investing in real estate funds or syndications as "limited partners". This can often be confusing for both first-time and seasoned investors.
In this Anomaly KB guide, we will focus on some of the core FAQs we receive and then talk about more of the strategic elements in a future article.
In this Anomaly KB guide, we will focus on some of the core FAQs we receive and then talk about more of the strategic elements in a future article.
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1What is depreciation and do limited partners receive it?
- Depreciation is an accounting and tax method that allows property owners to deduct the costs of purchasing and improving a property over its useful life. For residential real estate, the IRS generally allows this to be done over 27.5 years, while for commercial real estate, it's typically 39 years. This acts as a non-cash expense, thereby decreasing taxable income.
- Most times the GP or syndicators will perform cost segregation studies which allow you to receive a larger portion of depreciation (creating a loss) in year 1
- Most times the GP or syndicators will perform cost segregation studies which allow you to receive a larger portion of depreciation (creating a loss) in year 1
- Limited partners in a real estate syndication can benefit from their proportionate share of the depreciation on the property. The syndication's operating agreement and tax documents (like K-1s) will usually detail the allocation of this benefit among the partners.
- It is very important to understand HOW the syndication will allocate depreciation to you! There are often "games" played here so it is your right and responsibility as an LP to ask these questions upfront.
- Depreciation is an accounting and tax method that allows property owners to deduct the costs of purchasing and improving a property over its useful life. For residential real estate, the IRS generally allows this to be done over 27.5 years, while for commercial real estate, it's typically 39 years. This acts as a non-cash expense, thereby decreasing taxable income.
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2Are losses generated as a Limited Partner useless?
- No, losses aren't useless! This is a HUGE misconception. Losses, often driven by depreciation, can offset passive income that the limited partner might receive from the syndication or other passive sources such as rental real estate or LP business interests. If a limited partner doesn't have enough passive income 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.
- However, it's crucial to note that passive activity losses generally cannot be used to offset active income (like wages) except in specific situations or upon the sale of the property.
- No, losses aren't useless! This is a HUGE misconception. Losses, often driven by depreciation, can offset passive income that the limited partner might receive from the syndication or other passive sources such as rental real estate or LP business interests. If a limited partner doesn't have enough passive income 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.
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3Should I invest via an LLC or even a Trust? What about a self-directed IRA?
- LLC: Many investors choose to invest through an LLC (Limited Liability Company) because of the liability protection it can offer but as a limited partner, you are not exposed to much risk. Consult a lawyer but this is often not needed.
- Trust: Investing through a trust can be beneficial for estate planning purposes, ensuring that assets are managed and distributed according to your wishes. Do NOT invest through an Irrevocable Trust without consulting with a trust attorney and us!
- Self-Directed IRA: This 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 be tax-deferred or tax-free (in the case of a Roth IRA), but distributions may be subject to UBIT (Unrelated Business Income Tax) in certain situations.
- LLC: Many investors choose to invest through an LLC (Limited Liability Company) because of the liability protection it can offer but as a limited partner, you are not exposed to much risk. Consult a lawyer but this is often not needed.
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4Are my distributions taxable?
- Generally, distributions from a real estate syndication can consist of a return on capital (which is not taxable) and a return ofcapital (which may be taxable).
- Distributions in excess of your adjusted tax basis in the investment would be taxable but this is rare to due debt allocations.
- You may have taxable income in a given year BUT not distribution!
- The inverse is also true. You may have a distribution but not taxable income!
- It is extremely important to understand that your Distribution and Allocation of taxable income are NOT the same thing!
- Generally, distributions from a real estate syndication can consist of a return on capital (which is not taxable) and a return ofcapital (which may be taxable).
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5Can it offset my W2 income?Typically, losses from passive activities (like a real estate syndication for most investors) cannot offset W2 or other non-passive income. Even if you are a REP, this can be difficult.
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6EndMastering these FAQs should put you in a better position to invest as a limited partner. If you have questions on a particular deal, please let us know!
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