Real Estate Right Now is a video series covering the latest real estate trends and opportunities and how you can make the most of them. This episode discusses the difference between passive and non-passive income, and why it matters.

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When it comes to a real estate investment, the income generated can be defined as either passive or non-passive. 

Passive income refers to income earned from any business activity where the investor does not materially participate in its creation. When a real estate investor invests in a real estate property, but has no substantial, hands-on, active participation in generating its income, that income is defined as ‘passive.’ Passive income comes from money that was invested in a property and was left to generate revenue; the earnings are regarded similarly to earnings from interest, dividends, royalties and bonds, though the tax rates differ. 

On the flip side, when an investor materially participates in the day-to-day activities of managing a property – for example, collecting rents, managing tenants, advertising and maintenance – the income he generates is defined as ‘non-passive.’ Some other examples of non-passive income include wages, earnings from active stock trading and earnings from business activity.   

Why is the difference between passive and non-passive income relevant?

Because the way your income is categorized impacts how it will be taxed. 

Generally, the IRS does not allow a taxpayer to offset passive losses against non-passive income. Passive activity loss rules preclude a real estate owner from deducting losses generated from passive income (i.e. rental income) from non-passive income (i.e. business income).  

However, when it comes to taxes, there are always some exceptions to the rule. 

If a taxpayer qualifies as a real estate professional, as defined by IRC Sec. 469, the passive activity loss rules do not apply. The investor, or ‘real estate professional,’ can use the losses from real estate activities (like rentals) to offset ordinary and non-passive income.  

In another caveat, if a taxpayer owns a piece of real estate and uses it for his own business (i.e. it is “owner occupied”), then real estate loss (passive) can offset the business’ ordinary income (non-passive).  

The takeaway? It is essential for a real estate owner to correctly define his income as passive or non-passive in order to enjoy the greatest ROI. 

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.

Real Estate Right Now is a video series covering the latest real estate trends and opportunities and how you can make the most of them. This episode discusses a tax-friendly way to maximize your charitable donations – by donating appreciated property.

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Donating appreciated property to a charitable organization that you care about is not only a do-good, feel-good undertaking; it also offers valuable tax benefits. When you sell a  real estate property and donate the proceeds, your earnings are subject to capital gains tax. If instead, you donate that same property, you are free from capital gains taxes and the charity gets a higher-value donation. It’s a win-win.

A second benefit is realized when a real estate owner donates appreciated property held longer than one year. Appreciated long-term assets – such as stocks, bonds, mutual funds, or other personal assets like real estate that have appreciated in value – qualifies the donor for a federal income tax charitable deduction. Generally, this deduction is for the full fair market value of the property (or up to 30% of the donor’s adjusted gross income). If the property is held for less than a year, an owner can still benefit by deducting the basis of the property. Since the calculation is based on fair market value, it is highly recommended to get a qualified appraisal on the property so that the donor can substantiate its value if challenged.

What happens if the property is mortgaged? That debt is taken into account when calculating the deduction. The donation of the property is divided into two parts. The portion of the fair market value representing the mortgage is treated as a sale, and the equity portion is treated as a donation. The adjusted basis of the property will be prorated between the portion that is ‘sold’ and the portion that is ‘donated.’ The calculations are often complex, so don’t try this at home! Consult with an experienced tax advisor when donating a mortgaged property for the most accurate computation of your tax benefits.

The double benefits of donating appreciated property – a fair market value deduction and avoidance of the capital gains tax – makes donating to causes you care about both a generous and tax-efficient way to support a charity.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.

Real Estate Right Now is a video series covering the latest real estate trends and opportunities and how you can make the most of them. This episode discusses the difference between holders and developers, and why it makes a difference.

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An identity crisis in the real estate industry can make for costly tax obligations.  The real estate industry is diverse and there are many roles to play – investor, agent, broker, developer.  Each has its own tax ramifications. Before embarking on the purchase of a property, a buyer needs to ask himself some important questions in order to understand what role he is assuming. What is his business? Is he purchasing a property to hold and profit from as an asset? Is he purchasing a property to develop for sale?

Let’s start with some definitions. A real estate developer is someone who buys land and builds a real estate property on it or buys and improves an existing property. His intent in purchasing is to sell the property for a profit. A developer profits by creating real estate.

A holder or investor purchases a property with a long term intent. He intends to hold the property, rent it out and accrue revenues from it. A holder profits by possessing real estate.

Whether a purchaser defines himself as a holder or a developer is critical because the tax treatment of real estate holders provides certain benefits that are unavailable to developers.

A real estate holder may purchase a property, rent it out, collect income, and when he sells the property, his profit is taxed as a capital gain, as long as he’s held it for more than a year. That means that instead of being subject to the ordinary tax rate he had been paying on his rental income, his income from the sale will be subject to a lower, long term capital gains rate of 15%-20%. Holders are allowed to take advantage of a Section 1031 like-kind exchange to defer the recognition of their gains or losses that would otherwise be recognized at the time of a sale.

Because a holder may be challenged to prove that his intentions were to hold and utilize a property for the long term, it is advisable that he keep good records to support his status. Lease and rental agreements, advertising and listing information, and research efforts should be documented and saved in case his position is challenged by tax authorities after the sale of the property.

For a real estate developer, it’s a whole different picture. A developer is taxed like someone who is running a business that buys and sells real estate inventory. A real estate dealer, or developer, is defined as “an individual who is engaged in the business of selling real estate to customers for gain and profit.” Under this definition, a developer’s income, earned by the sale of his property, would be taxed as an ordinary gain, and taxed at the higher ordinary income rate of up to 37%. He may also be subject to self-employment taxes up to 15.3% (subject to OASDI limitations) as well as city taxes. Developers also cannot depreciate property held as inventory or use a Section 1031 like-kind exchange to defer income recognition. However, they may take advantage of their real estate selling expenses by taking them as ordinary business expenses and deducting unlimited ordinary losses.

Under the IRS Code, each individual property purchased is assessed independently, so one’s status as ‘holder’ or ‘developer’ is not absolute. A real estate entrepreneur may own a portfolio of rental properties which makes him a holder, and may simultaneously purchase and sell other properties, making him a developer as well. His tax status will depend on his intent for that individual property at the time of purchase.

Before purchasing, the savvy investor must be cognizant of his goals and make sure to structure his purchase properly at inception in order to avoid any tax surprises. Consult with your financial advisor regarding newly acquired or potential real estate assets.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.

Real Estate Right Now is a video series covering the latest real estate trends and opportunities and how you can make the most of them. Part one of our mini-series on real estate investment through syndication focused on the use of a clause called a ‘waterfall provision.’ We’ll continue with part 2 of our series, which discusses syndication and carried interest.

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A real estate syndicate is an organization, or combination of investors, who pool together capital to invest in real estate.  The syndicate shares in the investment’s profits, even though it does not invest any of its own capital. When it realizes a profit, that profit  is called a ‘carried interest’ or a ‘promote.’ The carried interest serves as compensation to the syndicator for the risk it assumes during the development of the project and the efforts made prior to its sale.

If a property has been held for more than a year before it’s sold, the carried interest has traditionally been treated as a long term capital gain. This is important because Uncle Sam recognizes a carried interest as a return on investment. So, it’s taxed at a lower capital gains rate than is ordinary income.

However, the IRS later extended that holding period from more than one year to more than three years. Does this paralyze a syndicator for three years, disallowing favorable tax benefits on an earlier sale? Apparently not. On January 13, 2021, the IRS posted final Treasury Regulations for Section 1061 of the Internal Revenue Code. Section 1061 extended the 1-year holding period required for long-term capital gains treatment to a 3-year period for entities termed, “applicable partnership interests” (APIs).

Section 1061(c)(1) defines the term “applicable partnership interest” as “any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.”

There’s an interesting – and potentially profitable – caveat built into the IRS’ definition. Section 1061 rules inadvertently include a favorable exception for real estate investors. After careful review of the updated code, practitioners realized that this new restriction omitted interests resulting from certain services.  These services include investing and disposing of real estate held for rental or investment. In our scenario, the syndicate provides these real estate investment services for the investors. This means that a syndicator’s profits at the time a property is sold are the result of an allowable service that,  if held for one year, can be treated as a long term capital gain. It is free of the three year holding period requirement and subject to advantageous capital gains tax rates.

Here’s the bottom line: A syndicators’ profits at the time a property is sold will be treated as long term capital gain, free of the three year holding period requirement, and subject to advantageous capital gains tax rates.

Speak to your professional advisor about investing through syndication to build wealth.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.