How Tax Efficient Are Real Estate Private Placements?

Depreciation deductions are no free lunch. Understand their benefits and surprises.

You know you are a true LP investor if you need to wait until September to finish your personal tax return. I don’t say this to gloat.

A Glimpse Into the Tax Side

Today you will have a glimpse into the tax perspective of my private investment portfolio. In this context we will discuss the tax efficiency of private placements regarding time and cost.

I began investing into private placements (one-off deals and funds) in 2017. At the time I was a seasoned investor in public markets across various asset classes but I was just learning about crowdfunding and private placements.

Over the last 7 years I have invested in more than 50 private placements including real estate private equity, real estate debt, secured notes, buyout private equity, private credit and specialty finance. By type of tax form (1099 or K-1), below is a chart displaying the composition of my last 50 private investments.

As you can see above, I chose the K-1 structure as the majority of my investments compared to the 1099 structure. I had intentionally invested this way for the tax benefits. For purposes of this article, I will focus exclusively on the “real estate equity” and “private equity” bars since debt and credit are treated differently and do not benefit from the depreciation like equity does.

NOTE: While some of our readers may be considered Real Estate Professionals (REPs) for tax purposes, this article will address taxes from the perspective of a traditional passive real estate investor.

Sponsors can benefit from this article by enhancing their own understanding through the eyes of their traditional retail investor base. For LPs who are also REPs, there is also an open debate as to whether truly passive RE investments can be classified as active income for REPs.

Let’s start off with a high level view of the tax treatment relating to real estate equity investments.

Understanding Tax Treatment

Several factors affect the degree of tax efficiency in a real estate investment. A few of the most important factors include:

• Property Type: Depreciation is one of the greatest tax benefits available to private real estate investors. The type of real estate property can dramatically affect how much depreciation deduction is available by time and magnitude. For instance, residential rental properties can provide higher early depreciation due to their shorter depreciation recovery period in addition to the cost segregation of shorter-lived building components. On the other hand, office buildings may provide less accelerated depreciation benefits due to longer useful lives on the building and fewer cost segregation opportunities.

• Entity Structure: There are typically two different entity structures for real estate investment.

  • Pass-through entities: multi-member LLCs or Limited Partnerships where more tax-deferred benefits exist. The entities typically issue K-1s.

  • Real Estate Investment Trusts (REITs): Distributions are commonly taxed as ordinary income although through 2025 (at least) taxpayers can deduct up to 20% of qualified REIT dividends. These entities issue 1099s. As mentioned below, REITs do provide a certain level of depreciation benefit too.

• Characterization of Income: Generally, income/losses can be characterized as ordinary or capital gains/losses, each of which result in different treatment depending upon the taxpayer’s individual situation and tax return. Certain items such as depreciation recapture can be taxed at their own special rates.

The Closest Thing To A Free Lunch In Real Estate

Depreciation Deductions

Depreciation deductions are the most commonly noted tax benefit of real estate private placements. The passage of the Tax Cuts and Jobs Act (TCJA), passed in December 2017, also had a significant impact on real estate investments in recent years allowing additional tax benefits from bonus depreciation with a cost segregation study. However, the government may let this additional benefit continue to phase out if a bill like TRAFA does not pass.

There are a few caveats to the powerful tax benefit of depreciation:

1. The depreciation deduction benefit is temporary as it will eventually be recaptured upon sale of the property in the future. Additionally, recapture (and related arbitrage) can be disadvantageous if the original deduction is in a lower tax bracket. This can occur for middle-aged folks too.

2. The deduction benefit is front-weighted in early years and later years result in (sometimes unexpectedly) higher amounts of taxable passive income with the potential to create a cash crunch in later years. This can compel investors to engage in what I call “perpetual deferral” in an effort to optimize their taxable income. I will discuss later why it may be important to understand any unforeseen consequences to this approach.

3. Passive Activity Loss regulations exist in the IRS Code that limit how much passive loss an investor can deduct against taxable income. Real Estate Professionals (REPs), as defined by the IRS, can better utilize these losses to offset their active income but it can prove more difficult for more traditional passive investors.

4. Don’t let the tail wag the dog: Finding new deals with relatively high depreciation deductions (the tail) can increase tax efficiency but doing so with quality deals and attractive returns (the dog) can be challenging.

Regarding #1 above, some exits can surprise LPs in recent years with CRE prices transacting lower. It is possible for an LP to have an exit selling at cost but see a large tax bill. This would be due to the recapture of deprecation deductions from cost segregation - the interest-free IRS loan being called back. It can take some LPs by surprise who don’t understand this.

While depreciation may not be a free lunch, it certainly appears to represent no-interest lunch money (deferred tax) which the IRS does not ask for until years later. While pass-through entities (K-1s) tend to provide a 100% pass-through of depreciation, even some REITs can provide investors with up to 60-90% of the depreciation benefits through classifying distributions as a Return of Capital, according to JP Morgan Asset Management.

Perpetual Deferral: Strategic Approach or Cautionary Cash Crunch

Following up on the caveats to depreciation listed above, an investor may adopt the strategy to invest in new real estate opportunities each year with high initial depreciation to offset income from existing investments thereby reducing, or eliminating, his/her near-term taxable income.

This strategy requires the commitment of either of two particular actions in most or all tax years:

1. Invest in a new real estate syndication/fund with sufficient first-year depreciation to offset the desired amount of taxable income.

2. Continuously acquire additional properties without selling others, which requires additional capital investment. Sale of any existing interests will trigger larger taxable income via depreciation recapture. Taxes eventually catch up to us. It is an interest-free loan, NOT a permanent savings, but as the months and years pass by it is easy to lose sight of this and become surprised.

Of course, in private equity deals the investor does not have the ability to choose when the exit occurs. Additional exits in particular tax years can require further new investment to offset taxable income.

As you can see, this strategy can become a slippery slope. I advise LPs not to let this become a primary strategy for capital allocation.

I personally experienced this effect as I approached the end of my 2023 tax year. I felt the temptation to let the tail wag the dog. While I did not adopt the aforementioned strategy I did experience a large increase in my taxable income for 2023 due to the fact that I could not find any worthwhile real estate opportunities to offset my passive taxable income, which grew larger due to the front-loaded depreciation deducted in previous years.

I was faced with the decision in December 2023, leading into the new year, whether to subscribe to a new triple net lease (NNN) private RE fund. The fund was forecasting depreciation deductions in Year 1 of approximately 60% of my would-be capital contribution.

Ultimately I decided to take the tax bite rather than invest for the sake of tax savings alone. However, it is quite the cycle of emotions to ride larger tax loss carryovers and suddenly face the need to cut a check to the IRS for a large tax bill. So you see, cash forecasting is critical for Accredited Investors too, not only businesses. Just as important, disciplined capital allocation must always trump tax efficiency. Rule Number 1 is to preserve capital.

To tie up this section, some readers may have thought to use a 1031 exchange to defer their capital gains but unfortunately this is only permitted for direct ownership of real estate. This can help the REPs for properties which they actually manage. However, the IRS considers partnership interests (e.g., LP interests) as personal property and these cannot be exchanged for an interest in real property.

Likely the best strategy is to focus on longer term capital appreciation rather than which opportunity produces more front-loaded depreciation deductions. And pair this with a responsible and proactive cash management program.

Navigating Multi-State K-1s: Is it Worth the Time and Fees?

Tax strategy is a very important component of an investor’s overall asset allocation plan. Unfortunately, as Congress continues to further complicate the tax code, this component can be a beast to fully understand. Nothing can be further from the truth when it comes to state income taxation of real estate investing.

The 1099 funds (e.g., REITs) make tax life simple for passive real estate investors, but for the extra tax efficiency boost of pass-through vehicles (e.g., K-1s) the increased tax complexity cannot be overlooked. Each state is truly its own animal. High burdens of time on the tax preparer, and consequently increased preparation fees to the investor, are only scratching the surface here. Based on my surveys of accredited investors in buyout private equity and real estate funds, I have heard of tax preparation fees from $1,500 to as high as $10,000 for investors with very large numbers of multi-state K-1s.

I prepare my own taxes but I have received quotes ranging from $4,200 up to $7,500 for my individual return which includes about 30 K-1 forms. I used two different CPA firms in 2017 and 2018 but mistakes were more common than I had expected.

Even if an investor, such as a CPA like myself, is knowledgeable enough to prepare one’s own return, the opportunity cost in the time required to prepare it can make one question the pursuit of private real estate investing in K-1 funds.

I have spent an inordinate amount of time preparing my individual returns with about 34 K-1s from existing investments on average per year. These holdings will gradually roll off my portfolio over the next several years. I have made the decision to only invest in K-1 vehicles if they are in tax-free states going forward due to the underestimated complexity when I committed to these K-1 vehicles.

In addition to high fees or time for K-1 tax prep, there is the potential for unexpected tax liabilities or inefficiencies due to:

• Residing in a low income tax state but investing in a higher income tax state

• Requirements for non-residents to file state tax returns for any income sourced in that state

• Incorrect preparation of your tax return by the preparer (yes it happens more often than you would think - on the sponsor side and the investor side). Most preparers, including CPAs, are not experienced in the nuances of most other states outside their home state. One can go with a national firm but the cost will be much more expensive and they likely only take much wealthier clients like family offices.

• Management fees are often not deductible and this effectively produces phantom taxable income for the investor. Unlike accelerated depreciation, this negative is indeed permanent. The structure of the entity matters in this case. I have seen sponsors with very similar multifamily funds by geography - one will pass through non-deductible management fees and the other will structure it in a way that nets out these fees within rental income (at the property level) making it deductible. Effectively, a 1% non-deductible annual management fee for an LP earning an 10% economic IRR will be taxed at an 11% IRR.

Alternatives

Adopting new criteria to investing in private RE vehicles leaves me with a few options.

1. Consider a 1099 vehicle. There are no multi-state K-1s to deal with in a 1099 vehicle even in a fund structure providing more diversification. The tradeoff is less upfront depreciation deductions, but a large portion of this benefit is retained. Unfortunately, many sponsors do not offer a 1099 vehicle.

2. One-off (single asset) RE deals where there is no blind risk as in a K-1 fund. For instance, I know ahead of time that my investment is exists solely in a Texas multifamily property as opposed to the chance that capital is scattered across 13 other non-resident taxable states. Of course, single asset deals can make diversification more difficult, but with a blind fund you can receive K-1s in several states. My largest multi-state K-1 covers 13 states. This is not a badge of honor. The prevailing trend I see is sponsors migrating to fund models once they achieve sufficient AUM.

3. Higher Check Sizes. If you want to invest in a blind K-1 fund with potential multi-state exposure because it is appealing then you may want to consider investing with a higher check size over fewer funds as this will limit some of the tax complexity and cost. It is much less work (or tax pro cost) to have 5 complex multi-state K-1s instead of 10 of them. Of course, you will sacrifice some diversification in this approach.

Based on my experience, the tax preparation complexity increases proportionally with the number of K-1s an investor receives. The various investments create a web of interrelationships across and within states.

Disclaimer: This article is not tax advice. Please consult your tax advisor for guidance as each investor has their own unique financial circumstances.

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-Kris

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