Transcript: ‘Tax-Smart Strategies for Syndicators’

Edited Transcript from the podcast episode ‘Tax-Smart Strategies for Syndicators’

With Special Guest Thomas Castelli

Originally Broadcast on May 19, 2022

Kim Lisa Taylor:

Hey, everybody. Welcome to Syndication Attorneys’ free monthly podcast, where we talk about topics of interest to real estate syndicators with the opportunity for live questions and answers at the end of the call. I’m attorney Kim Lisa Taylor. Before we get started, please note that all of our calls will be recorded and may be used for future promotion, posted on our website, or broadcast in a podcast available to the public. If you don’t wish to have your voice recorded, please schedule a one-on-one consultation instead of asking a question … or you can put your question in the chat and then we’ll just read it. Information discussed during this free podcast is of a general educational nature and should not be construed as legal advice.

Our podcast, in case any of you are not signed up for it, is “Raise Private Money Legally” and it’s available on 20 different podcast platforms. We have over 50 episodes right now. There’s a lot of great information on that. Today, our topic is “Tax-Smart Strategies for Syndicators” with Thomas Castelli from one of our favorite CPA firms, The Real Estate CPA. He’s helped a lot of clients of ours. I see Thomas and his partner Brandon at the same events that we go to. They know what they’re doing. They’ve really made this their niche, just like we’ve made syndication our niche, and it helps you to have a niche practice because I think they can give you the best guidance, because they see everything about all the different aspects of what you’re doing and they can help you like avoid pitfalls that other CPAs or other attorneys might not be aware of because they just don’t do the same volume in this space that we do. Thomas, thank you for joining. I’m so excited to talk to you today. Give us a little bit about your background. Tell us about your firm.

Thomas Castelli:

Absolutely. My name is Thomas Castelli. I’m a CPA. I’m also now a certified financial planner. I throw that in there, but just a little bit about me. I started in the real estate world probably like seven years ago. I kind of came in through the investment space. I went to a syndication three-day weekend where they taught me all about real estate syndication, and I invested as a limited partner in a handful of deals with someone who eventually became a mentor. We ended up syndicating an 82-unit apartment complex in Florida in 2017.

We exited during the pandemic. That was an exciting time. That’s kind of it on the investment side. At the firm, I’ve been a tax strategist for the last five years or so. I’ve worked with probably over a hundred investors on real estate tax strategies, how to reduce their taxes. Today, we have a really big budding syndication practice where we provide in-depth tax planning services, reviews of operating agreements to tax sections, as well as accounting services to our syndicates and funds. That’s really exciting.

Kim Lisa Taylor:

Well, that is very exciting. In fact, I’ll have you review our tax section. I like to have that reviewed periodically, just to make sure we’re keeping up with the law and also giving information that’s consistent between our favorite CPAs and our firm, right? Can you give us a brief overview of what kind of tax benefits there are for real estate investors?

Thomas Castelli:

Yeah, absolutely. Real estate is probably one of the most tax-advantaged asset classes out there in the tax code under current law. There’s a few things that happen when you invest in real estate, right? There’s going to be an expense called depreciation, and that’s going to come when you rent out a rental property. You’re going to depreciate part of its cost basis, which is effectively for all intents and purposes here, it’s purchase price over a number of years. Under current law, there’s something called 100% bonus depreciation that allows you to effectively accelerate anywhere between 20% to 30% on average of the property’s purchase price and deduct that as an expense in the first year.

The best part about depreciation, right, is that it’s a non-cash expense. What happens is, if you have a profit and loss statement, let’s just say, you visualize it real quick. You have rental income at the top, then you have all of your expenses, your hard expenses, things like advertising, repairs, maintenance, property management, fees, interest, all these expenses that leave your pocket, because these are actual money that leaves your bank account. But then this expense called depreciation is stuck in there, but there’s no cash effect to it. What ends up happening is it ends up creating this very large tax loss in the first year you invest in the property. This means that you’re not paying any taxes on your rental income.

That’s amazing, because rental income is typically taxed at your ordinary income tax rates, which can go up to 37% at the federal level. You have state taxes, of course, that you have to deal with if you’re in a state that has income tax. Then from there, once you have this loss, this loss can be used in a number of ways, depending on your circumstances. If you’re an active real estate investor, for example, like you are GP of a syndicate or a fund, you might be able to use these to offset income that you’re earning from other sources, like maybe you have a spouse who has a job, or maybe you have multiple businesses that you’re running.

If you can qualify as a real estate professional, which I think we’ll get into in a little bit, you can use these losses to offset the income that you have from other sources. That’s very powerful. If you’re not very active, these losses often get suspended and they could be used in the future to offset rental income that you have from your property or perhaps the gain on sale when you ultimately sell. That is one very big, powerful benefit of real estate. And then of course, there’s other exit strategies. You can use like a 1031 exchange, in some ways, qualified opportunity funds to defer or reduce the amount of taxes you pay when you sell a property, which all of this combined makes real estate a very, very lucrative asset class.

Kim Lisa Taylor:

We always get this question, right: Can depreciation be, I guess, disproportionately allocated amongst the members of the syndicate?

Thomas Castelli:

Yes. That’s known as special allocation and you can pretty much allocate it however you want. The partnership tax rules often allow you to do it however you want, but there’s going to be something called … It has to have substantial economic effect… To make a long story short, when you do specially allocate the depreciation, there might be a point in time where you have to claw that back later on if you have a negative capital account. There’s something called DRO. I’m not going to go into the specifics of it, but the bottom line is you can absolutely do that.

Just know that there might be some ramifications that you need to be aware of, that you want to speak to your accountant about, speak to your tax advisors about, prior to actually executing that. Just so you’re aware.

Kim Lisa Taylor:

I just had a conversation with a client who wanted to do … They didn’t want to pay their investors for four years on a specific project, and they wanted to take all the depreciation themselves, but they weren’t putting very much money in the deal. And that whole thing came up of, well, you can only take the losses, right, the depreciation up to the amount that you’ve invested. Once you get to a point where you get a negative capital account, then you have to allocate it to the other members.

Thomas Castelli:

Right, right. Now, there’s something… The good news is… Let me kind of break something down there real quick. There’s something called QNR, qualified nonrecourse financing, where if you’re responsible for the loan … If you’re a key principal and you’re signing on the loan, you’re going to be allocated basis in the partnership for the debt. If a general partner is basically signing on it, then what’s going to happen is they’re going to be allocated basis and they can take losses from the property despite not putting in a tremendous amount of capital. That’s good news for general partners and sponsors of deals. However, sometimes the limited partners, depending on how much they’re investing with you, might push back on that.

They might say, “Well, look, we’re putting up the capital. We’re taking the risk, and we should be allocated all of the losses.” I mean, that potentially happened, but yeah, it’s kind of just something to be aware of there.

Kim Lisa Taylor:

I actually need to have these clients call you because they were getting some different advice from their CPA who perhaps wasn’t as versed in this as you are. This is why you want to have the right CPA on your team, right? Because otherwise, you might get some advice… You might be leaving money on the table or not taking a benefit that would be available to you if you’re dealing with somebody who just does this part-time. It’s always good to have the expert.

All right. What are some tax strategies available for active real estate investors, such as GPs of real estate syndicates and funds?

Thomas Castelli:

Right. I think the biggest one that’s going to be available for general partners, people who are actively involved in real estate, is going to be the real estate professional status. What the real estate professional status allows you to do is to take losses from your rental activities against your active income from say a W-2 job perhaps or another active business that you might be running. This would include like acquisition fees and other fees that you may generate as a result of doing business. To kind of give some more context on that, all rental real estate activities are “passive” by default underneath the tax code that was put in place under the Tax Reform Act of 1986.

What that means is that your rental losses generated by this big depreciation expense I mentioned earlier generally cannot offset your active income. However, if you qualify as a real estate professional – and you can qualify by spending more than 750 hours in a real property trigger business and more than half your total working time, or your spouse can do that too –  then the losses from your rental activities become “non-passive” and can offset your active income, reducing the amount of tax that you pay from those sources of income.

Kim Lisa Taylor:

If you’re in this business, you almost have to kind of keep a track, like a time sheet of how much time you spend on this in case you ever had to justify that, right?

Thomas Castelli:

Yeah, absolutely. That’s the biggest thing about the real estate professional status: It’s the most litigated tax strategy in the tax code. There’s over 500 tax court cases on it. And believe it or not, one of the biggest reasons people often lose is their inability to substantiate their position because they don’t track their time. They don’t have an effective way to prove the amount of time that they spent in the business. The way we recommend it to our clients, the most bulletproof way that we’ve seen is a time log. You can use an Excel spreadsheet. You can use a time tracking application like Toggle, and there’s some other ones out there that can do that. That’s the most bona fide away.

Now, if you’re really in the real estate business full time, day in, day out, you live and breathe it and that’s really all you do, you could probably get away with using a calendar. But for the most part, you’re going to want to have some form of substantiation to back up your position. Because if you are ever audited, you’re going to want to have that readily available.

Kim Lisa Taylor:

I guess, you could also use like a Google Calendar and like block off time and say, “I only do this every week from 3:00 to 5:00 on Thursdays and 2:00 to 4:00 on Wednesdays,” or something and make sure that all those times add up. I guess, that could still be maybe pierced because there’s no actual evidence that you did it. You just had it blocked off. But at least it’s something right?

Thomas Castelli:

That’s an acceptable way to do it. If I could just throw in there real quick, the IRS may, in some cases, try to pull additional information to substantiate the fact that you actually did the work, including credit card statements, testimonials from other people. Just something to keep in mind there too.

Kim Lisa Taylor:

They could even look at your emails to see if you were sending emails during that time or look at your phone logs. Interesting stuff. All right. Real estate professional status is something you guys need to look into if you’re doing this more than 750 hours a year. What is that? That’s about a third of the time, right?

Thomas Castelli:

Yeah. I think it’s about 15 hours a week. Maybe. Let me see. Let’s see. It comes out to be roughly about 15 hours per week.

Kim Lisa Taylor:

15 hours a week. Right. If you’re spending that much, then you need to look in that so you get the tax benefits from it, and then you need to make sure you’re working with a CPA that understands it and actually allows you the deductions you’re entitled to take. Because that is the other problem is some CPAs that don’t understand things are just going to say, “Oh, well, we’re not going to do that because I don’t know how to defend it if the IRS were to challenge it.” They just won’t let you take it. You’ve got to make sure you’re working with someone that understands what benefits are available and helps you get all of them. All right. What about the tax benefits for passive investors? One other thing before we move on from the tax benefits for GPs.

This real estate professional status, is that going to help offset the tax on gain, or does it just help offset the tax on the active… I guess, there’s two ways that GPS or managers or syndicates earn money, right? You earn money in fees, which what I always tell people and you can tell me I’m wrong. I don’t mind being wrong. But I always tell people that you’re going to get taxed at ordinary income rates on all of your fees. Anything that is involved in actively managing that property, so that’s your acquisition fee, your asset management fee, loan guarantor fees, disposition fees, refinance fees, any of those fees that you’re going to take, you’re going to get taxed at ordinary income rates. Your rental income from cash flow, that’s also taxed at ordinary income rates, right?

Thomas Castelli:

Yes. Rental income is taxed at ordinary income rates.

Kim Lisa Taylor:

Okay. But that’s where this real estate professional status could come in is to help kind of offset some of that?

Thomas Castelli:

Right. If you have losses from rental real estate, it can offset your rental income or gain on the sale or rental property, regardless of whether or not you’re a real estate professional. But specifically on the active income side, the fees that you’re generating as a sponsor in order to use losses from your rental activities to offset that source of income, you do need to be a real estate professional.

Kim Lisa Taylor:

There you go. Otherwise, you’re stuck just paying ordinary income rates, which is going to cost you about another, what, 15%.

Thomas Castelli:

You’re going to pay self-employment tax on them too, which is 15.3%.

Kim Lisa Taylor:

That’s important. And then you can use the capital gains to offset your earnings on equity from sale, right?

Thomas Castelli:

Right. You can use losses from your rental properties or capital losses to offset capital gains on sale of the property.

Kim Lisa Taylor:

What is the difference between losses or capital losses?

Thomas Castelli:

Right. A rental loss is effectively a loss from a business activity. It’s just passive by default, unless you’re a real estate professional. Whereas a capital loss is a loss from a sale of a capital asset, such as stocks or real estate or other capital assets. Capital losses typically can only offset capital gains from other capital assets. If you have say, for example, you sell stock right now at a loss, you can use that loss to offset capital gains from the sale of your real estate and vice versa. That’s kind of the difference there.

Kim Lisa Taylor:

I think we’re kind of talking about the same thing, but I want to weave this terminology into the conversation. The term “carried interest.” Can you just kind of explain what that means for the audience?

Thomas Castelli:

Right, right. Carried interest is effectively the portion of the interest that your general partner or sponsor gets for doing the deal. In other words, it’s sweat equity. If you’re doing a deal that’s 80/20, where the investors get 80% and the sponsors get 20%, that 20% is going to be considered the carried interest. It’s the portion that they’re getting for putting the deal together and doing all of that without putting much capital into the deal. It’s a form of a profits interest. If we’re getting granular, a profits interest is usually granted to somebody without them putting capital up.

Kim Lisa Taylor:

We usually have our clients, when we’re setting up a syndicate, we go through a whole questionnaire with them and we ask them, how much of the company are you selling to your cash-paying investors and how much of it are you keeping for the management class? And then we always suggest that the management class does pay something for their interests. Very typically they’ll be keeping 20% or 30% of the ownership interest in the company as their carried interest, but we want them to pay something for that to establish a cost basis.

We usually just randomly pick a thousand dollars. So that later on, when there is gain on the property from the sale, then they can use that as their cost basis to determine what their capital gains were. Is that necessary? I mean, do they have to do that? What if they don’t do that? What if they don’t pay anything?

Thomas Castelli:

If they don’t pay… It sounds like if you’re putting some money in for the interest you’re establishing as a capital interest perhaps, and if it’s a capital interest, basically to your point, you would have a cost basis and it would help establish that. Now, if you don’t do that and you just have a profits interest, you’re not going to have any cost basis. Your cost basis is going to be zero. Now, that can be increased through the qualified nonrecourse financing if you do sell (and is) is a good way to get basis. But when you have a profits interest, there are some things just to be aware of under current law right now. Profits interest can be taxed as short-term capital gains if you do hold the property for less than three years.

That’s something that was implemented during the Tax Cuts and Jobs Act of 2017. Before that, if you had a carried interest and you held for longer than the year, when you sell, it’s taxed as a long-term capital gain, the long-term capital gains rate of 15% to 20%. But if you hold it for less than three years now, it could be taxed at the short-term capital gains rates, which are taxed at your normal rates up to 37%. That’s just something to keep in mind. Now, one thing that is good news for real estate investors as it relates to that is the Section 1231 Gain, which is the gain from the actual sale of real estate.

Typically, it’s still considered a long-term capital gain even if you do hold it for less than three years. The point is, it kind of is often a non-issue for real estate investors specifically, but just something to kind of keep in mind.

Kim Lisa Taylor:

What is that called again?

Thomas Castelli:

The Section 1231 Gain. That’s the gain from the sale of depreciable property.

Kim Lisa Taylor:

And that could apply if you held it for less than three years. Would it give you the same benefit that you would have if you’d held it for the three years and got the capital gains benefit?

Thomas Castelli:

Effectively, yes. Because basically that Section 1231 Gain is going to be taxed at your long-term rates, assuming you held it for longer than a year regardless. Really where the issue comes in is more for like hedge funds and private equity or buying and selling businesses. That’s where the bigger component is. But for real estate investors, most of your gain is likely going to come from Section 1231 Gains and you’re going to be able to take advantage of those long-term rates despite not holding it for three years.

Kim Lisa Taylor:

Okay, great. I’m taking a ton of notes here. I hope you guys are too, because I’m learning a lot. This is one of the reasons I have all these great guests on the show because I get educated. I hope it’s helpful for everyone. Next question is, what about passive investors who invest in syndicates and funds? What kind of tax benefits can they enjoy?

Thomas Castelli:

Yeah, that’s a good question. The biggest ability for passive investors is going to be the ability to suspend your passive losses and use them later on. The best way I can illustrate this is with an example. Let’s say you put $100,000 into a syndicate, right? Usually right now with 100% bonus depreciation in place, you’re going to get somewhere between like 80%, 90% of that back in losses for that first year. You put $100,000 in. You might get roughly $80,000 back in a loss. That means you’re not paying tax on your rental income because you have a loss. That loss can be used if you have passive income from other activities that year or gains.

You can use that loss against that. If not, if you don’t have any of that, they’re going to get suspended and carried forward. Now, they’re going to be unlocked and used to offset rental income in the future you have either from that syndicate you invested in or other rental properties you might have directly. If you don’t, if they’re not used, they’re going to be unlocked when the property is sold.

Kim Lisa Taylor:

Unlocked means no longer available?

Thomas Castelli:

I’m sorry. Unlocked means… They’re going to be… Say you have $80,000 of losses and you sell the syndicate down the line. You can use those losses to offset the gain on sale at that point in time. It’s going to reduce the amount of capital gains tax you’re going to pay at the time of sale.

Kim Lisa Taylor:

Hmm, okay.

Thomas Castelli:

Now, to kind of go a little step further with that, there is a strategy that a lot of people are using, I’ve used this myself, where you realize, okay, maybe the sponsor tells you that they’re going to sell the property and you realize you’re going to have a capital gain event coming up. You look at your tax return. You realize you’re not going to have enough suspended passive losses from previous years to offset the gain. What you can do is you can invest in another syndicate in the same year that the property is being sold, or you can go out and buy your own property. If you wanted to have a cost segregation study performed on it, increase its depreciation expense.

And then you can use that loss and that current year to offset the gain on sale from the property that’s being sold in that same year. This is kind of what makes real estate so powerful is there’s a lot of ways that you can… Sorry, a lot of strategies you can use to minimize, defer, or flat out, eliminate the taxes on the gain on sale as well. You can take that money, put it back into your pocket, reinvest it.

Kim Lisa Taylor:

Wow! Okay, that’s pretty powerful. I had no idea about that one. What about cost segregation? Is that advised?

Thomas Castelli:

Effectively what happens is when you buy a rental property either through a partnership like a syndicate or a fund, or you buy it yourself, if it’s a residential property, it’s going to be depreciated over 27 and a half years, which means that you’re going to recoup part of the purchase price over 27 and a half years. That’s quite a long time. But thanks to bonus depreciation, which you can do, you’ve run a cost segregation study and the cost segregation study itself is going to break down the various components of the building, things like carpet, appliances, cabinetry, decks, underground sewage systems, pools, etc., and to break all of these components down into their useful class lives.

Certain types of property are going to be classified as five-year property. Others are going to be classified as 15-year property. And then the remainder is going to be classified to the 27-and-a-half-year property. And that five- and 15-year property can be 100% bonus depreciated in the first year you acquire the property, meaning you can take that value and expense it in that first year, which is why cost segregation studies are powerful. The kind of give a quick example of it, let’s just say you bought a million dollar property, right? Now let’s say you cost segregate it and 20% to 30% of it is going to be allocated this five- and 15-year property. Let’s just take it right down the middle, 25%.

You’re going to have a $250,000 deduction in that first year that you acquired that property. Now that deduction is going to be on your P&L and it’s going to be added up with the rest of your expenses. You’re going to have your rental income. You’re going to take all of your expenses, including this $250,000 deduction, and you’re going to have a net number. Now, almost in all cases, it’s going to be a very large net loss in the first year. That’s all possible thanks to cost segregation, your ability to break out the components from their 27-and-a-half-year life into the five-, seven-, and 15-year lives.

Kim Lisa Taylor:

But isn’t there a point at which all that stuff gets recaptured?

Thomas Castelli:

Right. It is recaptured on sale. Depreciation is recaptured on sale, but there’s a few reasons why this all makes sense. The first one is the time value of money, right? If you were to pay the tax today, if you’re able to use the depreciation to offset taxes you would pay today, you could take that money and reinvest it. The example I always use is if you invested $100,000 at an 8% interest compounding for 10 years, you’re going to be left with $215,000 at the end of that period. You just made $115,000. Now, if you were to pay that money to the government, well, you never would’ve made that $115,000. Sure, you might have to recapture back … You might, and I’m going to get to that in a second, have to recapture that original $100,000 You didn’t pay the government. But guess what?

You made $115,000 out of it over this 10-year example here. But there’s a lot of ways to minimize the impact of depreciation recapture on sale. One of them is a 1031 exchange. If you do a 1031 exchange, you’re not paying depreciation recapture tax for the most part, in many cases. You can also use the strategy I just mentioned before where you sell a property, you’re going to have this big capital gain, including depreciation recapture, but you can buy another property or invest in another syndicate that’s going to generate losses. And that can be used to offset both the capital gain and depreciation recapture on the sale, further kicking it down the road.

Basically to kind of sum that up, between the time value of money and your ability to reduce or eliminate depreciation recapture tax, using certain strategies down the line, kind of make all this really make sense and why people do this.

Kim Lisa Taylor:

We’ve mentioned 1031 exchanges a couple of times, and I just want to point out that, first of all, there’s an article on our website called “The 1031 Dilemma.” It’s really a dilemma for syndicators because there are some ways that you can use it and there are some ways that you can’t use it. I recommend that everybody read that article at syndicationattorneys.com, go into the library and search in the articles for that. But the problem is that investors can’t 1031 exchange in and out of your syndicate, unless you’re buying properties in an opportunity zone that actually qualify for opportunity zone status, which is rare. If you’re a developer and you’re building properties in opportunity zones, then you can use this.

But if you’re not, then your investors can’t. The reason is because they’re selling real estate. If they own real estate now directly, they have direct title to it, they have to do a like-kind exchange and what they’re buying in your company and your syndicate is personal property interests in a company that’s going to own the real estate. It’s not a like-kind exchange. It’s specifically ineligible for 1031 exchange by individual investors. When you get ready to sell the property, and let’s say you have 10 investors with you on that property, and you’re getting ready to sell it, your syndicate can exchange its property for another property and keep those investors in the deal and keep them moving forward.

I think that’s a very powerful strategy. We’ve had several clients do that. It a little tricky because you’ve got to fall within the timing rules of finding that other property and getting it closed within a certain period of time, but it is possible to carry those investors forward into a new deal. If you have some investors that want out, the way that our other clients have done it is they carry them forward into the new deal and then they resyndicate the new deal. You’ve got the investors that stayed, but maybe you need to raise some more money to buy out the ones that want out. And then also because you’re maybe buying a bigger property, so you just do a new syndicate and you’re allowed to buy out those investors that didn’t want to stay in.

The other benefit of it is that our clients that have done this with their carried interest, you treat the first transaction as if the sale had actually occurred. You do your accounting as if the sale has occurred. If you’re a Class B member or a management class member and you’re getting a big chunk of the profits, you can either take that money and pay the tax on it, or you could convert that into a cash investment in the new deal. Convert it into cash, and then go ahead and reinvest it to buy Class A Interest in the new deal, and then you can still get your carry in the new deal. It can be pretty powerful for you as a syndicator and a way to build some ongoing wealth if you don’t need to cash out and get that money and use it right away for something else.

We’ve had several clients do it. It’s a little bit tricky. The odd part about it is that whatever you named the LLC that owned the previous property ends up buying a new property. There’s a little bit of a disconnect there. You can’t form a new entity for that. You’re just exchanging it. But it does work and you have to work with a 1031 accommodator that understands how that works in order to make it happen. But definitely we can help with that. Anything you want to add to any of those comments that I made?

Thomas Castelli:

No, I think you covered it quite well right there. 1031 exchange, definitely powerful. Hard to do with the syndicate, in some cases. But if you can pull it off, and I’ve seen it pulled off many times as well, it can be lucrative for both of you and your limited partners.

Kim Lisa Taylor:

Yeah, and usually what you’ll find is most people want to go forward, but you might get one or two that are like, “No, I’m ready to cash out. I don’t want to be in real estate anymore.” It does work. The other way to do it is to buy out those investors before you do the exchange. You just ask the other investors to step up and buy them out, and then you do the exchange. I think there’s a rule that certain percentage of the members have to be consistent before the exchange to after the exchange. That’s why we usually just do the buy-out after the exchange, because it then satisfies those rules. There are some other strategies that are more complicated called the “drop and swap” or “swap and drop.”

It’s where you actually are deeding the interest in the property out to your individual investors. Instead of having 10 investors in one company that owns the property, you now have 10 owners of the property. But it’s tricky because it all has to happen within a week or two of the sale. And then you’ve got to get all those people to sign off on all the sale documents, and then they could go out and exchange on their own. It is possible to do it. Technically you’re not supposed to, but the IRS has not enforced that in 20 years. Who knows when they might start? I’ve heard rumblings in the past where they wanted to do away with the 1031 exchange rules. Anything on that you’ve heard, Thomas?

Thomas Castelli:

Yeah. I mean, they mentioned this in every tax bill for the last few years, and it’s never really actually come to fruition. I spoke to 1031 exchange companies and leaders of 1031 exchange companies and they say that it gets threatened all the time. And then once people actually start to see the amount of income tax that that industry generates — the 1031 exchange industry, if you will, generates — the numbers tend to not make sense to eliminate it. That’s what I’ve heard. Right now, there’s nothing official attacking the 1031 exchange, but it is mentioned.

Kim Lisa Taylor:

And then I guess one other thing I want to say about 1031 since we’re on this topic is if you are doing a syndicate, the only reason to allow a 1031 exchanger into your deal is because they’re bringing a substantial amount of money that you can’t raise any other way or it’s your money. If it’s your 1031 exchange and you’re going to go and buy… The reason for that is because that 1031 investor that you’re trying to bring in to your syndicate actually has to be side by side with your syndicate as a tenant in common and they cannot come into your deal. Whatever portion of the equity they’re bringing, you’re giving them that portion of the property and you don’t get promote of it.

The only thing you can get is an asset management fee. There is a kind of a weird strategy that works if it’s a family member, but probably doesn’t work if it’s not, and that’s where you become the manager of their LLC that’s doing the 1031 exchange preferably before they do their exchange. You’d have to rewrite their operating agreement within their own LLC that would give you the promote. Most people that don’t know you very well are not going to allow you to do that because you’re like taking control of their company and it’s their money and they’re not going to do it. But if it’s your family member, then they might not care. But otherwise, you’re not getting to promote.

Just think about it. If you’re raising $2 million and then somebody wants to bring in a million dollars, you’re giving them 50% of the property, the profits are split at the property level. Your syndicate only gets its 50%. Your share of the earnings only come from the 50% that your syndicate owns. That’s what’s talked about in that article about “The 1031 Dilemma.” Take a look at it so you can understand that. Passive investors, let’s see, I think we’ve already talked about that. Maybe we didn’t. The passive investors can’t use the losses to offset their active income?

Thomas Castelli:

Yeah. There’s something that a lot of sponsors — and I don’t think they’re doing this intentionally, I think it’s just a misunderstanding of how things work — is they sometimes tell their limited partners, “Oh, you’re going to get these big losses from our syndicate and you’re going to be able to use it to offset your W-2 income,” is typically what’s being told. And that’s just not true. By the nature of being a passive investor, the way the tax rules work, long story short, is that that’s going to be a passive activity for you and the losses are also going to be passive.

That means they can offset your other passive income, other rental income, or other gains on sale from real estate, but it’s not going to be able to offset your W-2 or active income. Just want to kind of explicitly state that, because I know there’s a lot of confusion around that still to this day.

Kim Lisa Taylor:

Okay, that’s a really important point to know. I get clients or potential clients that contact us all the time and say, “Oh, well, this or that person has this tax question,” and what I say to them is they need to get their own tax advice. You should not be giving people tax advice or legal advice. You need to let people get their own advice. Or they’ll say, “Oh, well, I have an investor and they want to talk to you,” and it’s like we rarely, rarely, rarely want to do that because we represent you and not them and what we might tell you in private is contrary to what they want to do.

We might tell you, “Hey, you just can’t use that investor,” and we don’t want to be put in a position where we have to say that on the phone and harm a relationship that you might have. What about conferences, coaching seminars, and other events, are those tax-deductible for syndicators?

Thomas Castelli:

Yeah, so that’s a great question. If you do have an active business, and what I mean by that is you are currently syndicating deals, you have active irons in the fire, then the conferences, coaching, things of that nature are going to be tax-deductible for you. If you do not have those type of things, if you do not have an active business, you’re not doing any deals, then typically education is not going to be tax-deductible for you. It’s kind of clear under the tax code that it has to be… In many cases, it has to be used to improve or maintain a current skill or business that you’re a part of. If you’re not doing any deals and you’re kind of just kind of going to conferences and stuff like that, then that’s typically not going to be tax-deductible, unfortunately.

I’ll throw this in there too, because we get this question a lot from passive investors. When you’re a passive investor, a limited member, or a limited partner in a deal, you’re typically not considered to be in a business. You’re an investor. And because you’re not in a business, you’re not going to be able to deduct conferences and things of that nature. Generally speaking, this is something to kind of keep in mind.

Kim Lisa Taylor:

The best thing you can do is go out and buy a single-family property in your neighborhood, right? As a syndicator or as an active investor, and then you can go out and take all these conferences and courses about how to syndicate, right? And do it. I like that. What do sponsors and passive investors need to know about investing through their retirement accounts?

Thomas Castelli:

Right. Investing through self-directed IRA or solo 401(k) is a popular way to get into some of these syndicates and funds. Specifically for the passive investor, the person who’s going to be putting the money up, just note that if you’re using a self-directed IRA, that there’s going to be something… There’s something called the unrelated business income tax, also known as UBIT, that you may incur, depending on how the deal is structured. If you do use debt financing where the syndicate or the fund uses debt financing, there’s something called, this is a mouthful here, unrelated debt-financed income, also known as UDFI.

And that’s going to be, long story short, the income that’s attributable to the debt financing. A quick example, if you made $100 and you finance the property 75% with debt using the 75% LTV ratio, 75% of that income is going to be considered UDFI. UDFI above $1,000 when you’re investing through a self-directed IRA will be subject to the UBIT tax.

Kim Lisa Taylor:

What was that? What was that again?

Thomas Castelli:

UBIT is the unrelated business income tax. UDFI will generate UBIT. The first $1,000 of UDFI is going to be exempt from tax. But amounts above that $1,000 will be taxed at the trust tax rates. The trust tax rates are condensed, and they can go up to 37% after just $12,500 of income. It’s just something to keep in mind. I will add in there that for the most part, during the life of the deal, you’re not going to have to worry about UDFI in many cases or UBIT because the depreciation expenses and other expenses will typically shelter your income from… You have a loss, so you won’t have income basically is what I’m saying.

You won’t have to worry about that. But typically where we do see UDFI and UBIT come into play for passive investors is on the exit of the deal. And that’s going to require you to usually pay some taxes on that. You’re going to have to file Form 990-T. Now, sometimes the syndicator CPA will file the Form 990-T on your behalf. Other times they won’t. It’ll be your responsibility as the passive investor to get that 990-T filed. Just some things to be aware of there. In my experience, all this tax doesn’t usually eat into the returns more than a handful of a percent, like 2% or 3% maybe, but it’s just something to be aware of and that that filing component, that 990-T, is going to be necessary in many cases.

Kim Lisa Taylor:

It’s not insurmountable. It’s not a huge tax hit, but it is something to be aware of. You don’t want to be surprised and you don’t want to give your investors that are… If you’re the syndicator and you’ve got people who are investing through their IRA or 401(k), you don’t want to tell them you’re not going to get taxed. You want to tell them seek your own advice from your own custodian, from your own CPA. There could be some taxes that do apply to you, but it should be fairly minimal.

Thomas Castelli:

Right. Some syndicators do tell people they’re not going to pay tax on it, and that’s just not entirely, entirely true. One last thing I will add in there briefly is that if you do use a solo 401(k), in many cases, when you’re investing in real estate, you’re not going to be subject to UDFI because there’s a certain carve-out in that section of the tax code for 401(k)s for qualified plans; rather is kind of the broader way to look at it that exempt it from UDFI on real estate. That is something to also be aware of if you are eligible for a solo 401(k) and you do want to invest in real estate through a retirement account, that is typically going to be the preferred vehicle.

Kim Lisa Taylor:

I didn’t know that. I have one, so that’s good to know. All right. What’s coming? Are there any recent or new tax changes that are proposed that are going to affect our clients?

Thomas Castelli:

The good news is, is that the Biden tax bill that was being proposed late last year and even kind of into this year is dead. It’s over. In that tax bill, they were trying to attack the 1031 exchange. They were trying to attack the ability to invest in real estate through self-directed IRAs to begin with. Basically they would’ve forced you to remove the interest within two years, otherwise pay a penalty that was undefined. I know there’s a lot of syndicate groups out there pretty much lobbying Congress to ensure that that didn’t happen. And that was removed from further iterations of that bill, but effectively the entire bill has been killed. Just one other thing that was going to be big in there is they’re going to try to increase tax rates.

All of that’s dead for now. We’re not hearing too much about that. The biggest thing coming up for real estate investors though that they need to know, and this is both for active and passive investors, is that 100% bonus depreciation will be phasing out starting in 2023. Properties that are placed in service starting in 2023, so after 12/31/2022, will be eligible for 80% bonus depreciation. You’re not going to get 100% anymore after 2022. And then it’s going to phase out 20% each year through 2026 when it’s gone. … Each year it goes out 20%. … the point is by 2026, you’re going to have no bonus depreciation anymore.

Kim Lisa Taylor:

But there’s still depreciation, just not the bonus depreciation.

Thomas Castelli:

Right, right.

Kim Lisa Taylor:

Maybe talk about the difference between?

Thomas Castelli:

Yeah. When you’re just doing normal depreciation, a property’s going to be depreciated over 27 and a half years. 1/27 roughly every year, for 27 and a half years. When it comes to bonus depreciation, it allows you to rapidly accelerate the five- and 15-year property bonus depreciation. And that 100% allows you to completely deduct that entire amount in that first year you buy the property. When you have 80% bonus depreciation starting in 2023, you’re only going to be able to deduct 80% of that in the first year. The remainder is going to be depreciated over five or 15 years. The bonus depreciation, these big, large tax deductions that everybody’s been getting for the last five years since 2017, they’re going to start to phase out. It’s something that people just do need to be aware of.

Kim Lisa Taylor:

That’s going to go back to the cost seg, right? Where the cost aggregation is going to be less powerful.

Thomas Castelli:

Yeah, the cost aggregation study, that’s what’s going to break out the five- and 15-year property and that five- and 15-year property is what’s eligible for bonus depreciation. Effectively, cost segregation studies are going to become less powerful as these next few years kind of go on.

Kim Lisa Taylor:

All right. You have an upcoming event, and I would love you to talk about that because I think it’s an absolutely essential course for people who are syndicating and using other people’s money. It’s going to make you much more confident in what you’re talking about and what you’re doing. Tell us about your upcoming event.

Thomas Castelli:

We have a “Tax-Smart Bootcamp “we call it. It’s coming up June 6th, 2022. It’s a four-week boot camp where we go through the essential tax strategies in great detail with citations and everything that back it all up for real estate investors. I think it does benefit both active and passive investors. We do go through the real estate professional status in great detail. If you are looking to qualify and take advantage of that tax strategy, we do cover it. We also cover short-term rentals, which is a very, very popular tax strategy right now, because it allows you to take losses from your property, from your short-term rental against your active income without needing to be a real estate professional.

It’s a popular alternative. Not sure how much it’s going to help syndicators, but it is a very popular strategy that we do cover there. We also go through the basics of tax, so making sure you’re taking advantage of all the little stuff, paying your children through your business, deducting the right things, make sure you’re capturing all your deductions. Then we also go through exit strategies, including the 1031 exchange and the other strategies that are available and audit defense. To make sure that if you are ever audited, you do have all your ducks in a row. And then kind of maybe the best part about all of this is we have four weeks of live Q and A, so one hour per week, where you can come on.

I’ll be hosting these, so you can ask all your tax questions after going through the course. That’s been very helpful for a lot of people out there. I mean, that kind of in a nutshell is what we’re putting on. It’s a four-week course that’s going to teach you the basics of tax and give you guidance on some of the most lucrative strategies that there are out there right now.

Kim Lisa Taylor:

Is it a live class, like an hour a week? What’s the time commitment?

Thomas Castelli:

Right. Yeah, that’s a good question. It’s six hours of courses. They are pre-recorded and they are going to be released one module each week. Pretty much I think about two hours each week, give or take. They’re going to be available to watch at your convenience. But then the live Q and A sessions, they’re held live. They’re going to be held on Thursdays at 7:30 p.m. Eastern Time, and those will be live and recorded, and then distributed to the attendees after the fact.

Kim Lisa Taylor:

Very good. I love this program, and I think everybody should do it. In fact, I might send my husband. That’s fantastic. Thomas, this has just been amazing as always. If some of you do listen to our podcasts, you’ll see we’ve got some other podcasts that we’ve done in the past with Thomas. One on opportunity zones. I think we’ve covered a couple of other topics in the past, but it’s all well worth listening to and definitely these guys are a wealth of knowledge. Let’s go ahead and do a few questions. We will stop right at the top of the hour. Thomas, how would people reach out to you if they have some questions we’re not able to answer?

Thomas Castelli:

Right. If you want to reach out to us, the best way to get in contact with us will be the Tax Smart Investors Facebook group. You could just search for Tax Smart Investors on Facebook. You’ll be able to find us. We answer a lot of questions in there, or you can contact me. I’m on Twitter now @ThomasCastelli is another good way to get in contact with me specifically.

Kim Lisa Taylor:

Okay, great. If somebody wanted to become a client, how do they reach out to your firm?

Thomas Castelli:

You can go to therealestatecpa.com and you can click “to get started” button, and that will kind of take you to a form that you could fill out and we’ll get in contact with you, or you can just go to therealestatecpa.com/friends and you can just tell us that Kim referred you.

Kim Lisa Taylor:

That’s great. All right. And also, we sent out some notices for this in our newsletter. If you got our newsletter, then there’s a link directly for the program in that as well. Do you want to put the link in here? I guess I could put our link in there, right?

Thomas Castelli:

Yeah. The course, I see someone in the chat asked the price, the price is typically $1997. But if you use the code early, you can get it for $797. It is tax-deductible. If you already have a real estate business for anybody who’s wondering.

Kim Lisa Taylor:

Okay. I’m going to put the link here in the chat, so you guys can grab that. That takes you directly to the course. All right. Let’s get through as many questions as we can. Kumar asks, “Can you store depreciation and partnership LLC for future use?”

Thomas Castelli:

Can you store depreciation? Short answer to that question is yes, but only under certain circumstances. Long story short there, as a partner, you’re going to receive a K-1, and on the K-1 is going to be your share of income, losses, gains, etc., etc. Typically, the passive loss will not be stored by the partnership itself. It’ll be passed through to you, and then it’ll be reported on your Form 1040, which is your personal tax return. And then it will be suspended on your personal tax return for future use, assuming it’s not used in that same year that you get it.

Kim Lisa Taylor:

We’ve got another question. Thomas, do you work with clients in Texas? Tell us about that. Can you work with clients anywhere?

Thomas Castelli:

Yeah. We work with clients across all 50 states. We have clients in I think in all 50 states at this point. Texas and Florida, I see someone in the chat too, we have a lot of clients out of those two states too.

Kim Lisa Taylor:

Ted asks, “My understanding is that bonus depreciation is limited for syndications as they’re classified as a tax shelter.”

Thomas Castelli:

What was the first part of that again? I’m sorry.

Kim Lisa Taylor:

“My understanding is that bonus depreciation is limited for syndications as they are classified as a tax shelter.”

Thomas Castelli:

I think what he’s talking about is the business interest limitations, and most people and most syndicators will opt out of the business interest limitations and making bonus depreciation not … making it not restricted if they opt out. If they don’t opt out, it is restricted. But I don’t think I’ve ever seen anybody not opt out of that. Long story short, it can be, but most of the time it’s not going to be.

Kim Lisa Taylor:

Sean asks, “How does the recapture on the bonus depreciation figure in on the sale?”

Thomas Castelli:

Typically, when you take bonus depreciation, it will be recaptured as ordinary income and taxed at the ordinary income tax rates, but you can mitigate it. Kind of to give a quick overview of how that would look like, all right? Say you bought this million-dollar property. You take 100% bonus depreciation on $200,000. Now your cost basis is $800,000. Now say you turn around, sold the property for $1.2 million, where you’re going to have a total gain of $400,000. And of that, $200,000 will be considered depreciation capture and that would be taxed at your ordinary income tax rates, unless you use an exit strategy such as some of the stuff we discussed here today to mitigate that.

Kim Lisa Taylor:

Somebody asked in the chat, “Can you get a partial distribution and roll it over into a new syndicate?”

Thomas Castelli:

Partial asset…

Kim Lisa Taylor:

Partial distribution and roll over to a new syndicate.

Thomas Castelli:

Yes, but there’s no… You would still have to ultimately… There’s no tax benefits of doing it. It would just be you’re getting cash from one partnership, but you’re going to pay tax on that partnership. And then on that cash you got from the partnership per se, and then you’re going to go and invest it, there’s going to be … That’s just how it works. There’s no special benefits of doing that as far as I know.

Kim Lisa Taylor:

Someone else asked, “Can you do taxes in Florida?” We’ve answered that. Yes, all 50 states. Same as us. Everything we’re doing is under federal law. Thomas, they’re using federal tax law. We’re using federal law. We’re able to help clients in any state with that. Let’s see. “What are the cases one wouldn’t want to do cost segregation and bonus depreciation?”

Thomas Castelli:

When they would not want to do that. If you don’t want to … If you’re going to sell the property in a very short period of time, it might not make sense to do it. But other than that, I really can’t … In the world of syndication, most of the time you’re going to do it. I don’t have any ideas or any real good reasons why you would not want to do it. Other than if you sell the property after a very short period of time, you’re not going to really see the benefits of it. That’s pretty much the only one I have, unfortunately.

Kim Lisa Taylor:

All right. There are some questions that we just did not have time to get to. I apologize for that. Make sure you reach out to Thomas. And better yet, go to the Tax Smart Bootcamp and you’re going to get all your questions answered, and then you can get on the live Q and A with him. What is the cost for the course?

Thomas Castelli:

The course, if you go to the website right now, it’s going to be I think it’s actually $1,997. But if you use the code EARLY, capital E-A-R-L-Y, EARLY, it’s the word early, you’re going to get it for $797. That’s I think like 60% off. It is tax-deductible if you already have a business.

Kim Lisa Taylor:

I think I could safely argue that you’re going to easily learn tax strategies that are going to save you that much and much more if you attend. I would say definitely go through that. Hey, thank you everybody for showing up. I do want to tell you that if you want to reach out to Syndication Attorneys, you can do so at our website at syndicationattorneys.com. There’s a button there that says “schedule a consultation.” You’ll get a popup. You’ll get to choose from who you want to talk to, whether you want a free consult or a paid consult, depending on what your needs are. We’re trying to be flexible here and make sure we get everybody everything that they need.

We do have a pre-syndication retainer program for people who are not yet ready to syndicate. They don’t have a property under contract. They’re not ready to start a fund. This would give you up to two hours of one-on-one access to one of our attorneys, as well as it would give you access to our weekly masterminds. We have weekly syndication masterminds for clients only every Friday at noon Eastern Time.

We’d love to see you guys all as clients. If you want to reach out or if you want to reach out directly to someone who can help you with a pre-syndication retainer, you can reach out to anthony@syndicationattorneys.com, or you can click on that button on the website.

Thomas, thank you so much. This has been a wealth of information. We’re super happy to have you in our corner, and we look forward to seeing you at an event soon.

Thomas Castelli:

Yep. Thank you for having me. I appreciate it.

Kim Lisa Taylor:

All right. Thank you so much. Bye-bye.

Thomas Castelli:

Bye now.

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Are you ready to raise private capital?

At Syndication Attorneys LLC, we are committed to your success – book a consultation with one of our team members today!

About Syndication Attorneys

We are NOT your stereotypical law firm. We don’t believe in simply taking your money, handing you a stack of technical, often-incomprehensible legal documents and then bidding you good luck and good-bye. At Syndication Attorneys PLLC, we are committed to your success – not just with the project at hand, but your continuing success in business and investing. We are your long-term legal team.

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