If you want to own real estate but do not want to be a landlord, then real estate crowdfunding may be for you. You will be able to participate in the cash flows and capital appreciation of the project, but will not have the responsibility of day to day management. It can be a win-win for both the crowdfunder and the investor.
But as this form of real estate investment gains traction, certain questions are being raised.
A real estate syndication is almost always taxed as a partnership and investors are typically classified as “passive” investors. This results from the investor not being actively involved in the management of the property. The sponsor (or syndicator) is the one who is providing the management expertise and is involved in the day to day operations of the property.
So what does it mean when you are a passive investor? Even though you may be getting a preferred return, you may still find that the investment is generating a tax loss as a result primarily of depreciation deductions. As a general rule, the deduction for a passive activity loss is limited in each tax year to income derived from a passive activity.
However, if the syndication is generating passive income it will be taxed at the taxpayer’s marginal tax rate. But remember that this income can also be used to offset passive losses. Many investors may have cumulative passive losses relating to rental real estate that have been carried forward for years. With a syndication generating passive income, this can allow the investor to “free up” these passive losses and use them to offset the income from the syndication. Interest and dividend income is not considered passive income, so for an investor with passive losses this form of investment can offer benefits that stock and bond investments will not.
So what do you do if you have passive losses that you are not able to offset against other income? If you find yourself with losses that you are currently unable to deduct as a result of passive loss limitations, there are a few strategies that you should consider.
Invest in rental real estate that generates passive income. Considering the low interest rate environment these days, you may decide to invest in rental real estate that you are sure will generate net income even after considering depreciation deductions.
Invest in income generating passive business activities. You could consider investing in an operating business that you have no material participation in. Assuming that the business operations generate taxable income that will be allocated to you, then you can use that income to offset the passive losses from the other activities.
Increase participation in loss activities. For a crowdfunding investment this may not be possible. But depending on the investor’s involvement in the activity, it may be possible to turn the passive activity into an active activity by increasing your hours of involvement so that you may meet the material participation rules. If you can accomplish this, you may be able to bypass the passive loss rules and fully deduct any losses in the current year.
Generate gains from the sale of other passive activities. Passive income will typically include gains from the sale of an interest in a passive activity or property that was used in a passive activity. The gain typically is not considered a passive activity if, at the time of disposition, the property was utilized in an activity that was not considered a passive activity in the year of sale.
Decrease your involvement in active income activities. You may have a business activity that you currently materially participate in that is generating active income. Accordingly, you could consider limiting your participation (or involvement) in this activity.
Understanding passive activity rules can be difficult. As you can see, there are a few ideas that you should consider if you have passive activity loss limitations. But these strategies can be complex, so make sure that you consult with a CPA or tax professional prior to implementing any of the strategies.
Tax and Legal Advice Disclaimer: AlphaFlow and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.