The Tax Implications of Real Estate Investments: Past, Present, and Future

9 min readMay 5, 2019

This learning series on Modern Commercial Real Estate Investing first appeared on the EquityMultiple blog. Please check in there for updates and additions to this series.

At EQUITYMULTIPLE, we’re careful to present all return projections net of any fees taken by us or the Sponsor or Lender who originated the investment. After all, returns don’t mean a thing unless you’re actually entitled to keep them. You cannot arrive at a true net return, however, without also considering the percentage Uncle Sam takes. This article takes a look at real estate taxes in the context of passive investments of the sort offered on EQUITYMULTIPLE. This article has been updated to consider changes brought about by the Tax Cuts & Jobs Act, which will impact income from real estate investment for the tax year 2018.

Note: EquityMuiltiple is not a registered tax advisor and therefore does not and will not offer tax advice of any nature.

A Brief Historical Perspective of Tax Law & Real Estate Investing:

The Tax Reform Act of 1986 (‘TRA 86’ or ‘The Second Reagan Tax Cut’) remains arguably the most profound reshuffling of U.S. tax code since the 1930’s. TRA 86 dramatically altered tax incentives for real estate investors by dramatically curtailing the tax sheltering available to passive real estate investors. The bill essentially created a demarcation between ‘passive’ and ‘active’ income — after the reform, passive real estate investors could no longer reduce the tax burden of their active income through “passing through” real estate losses. Many observers blamed the legislation for depressing commercial real estate property values and compromising incentives in real estate capital markets¹. In fact, new privately owned housing units starts declined 60% in the five years following the legislation, according to data provided by U.S. Department of Housing Development.

The income produced from EquityMultiple investments (which are typically made through an LLC) qualifies as passive income, as defined by the IRS: “earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not materially involved.” For income to be categorized as active, and thus the taxpayer must “materially participate” in the activity that generates the income.

TRA 86 reduced the favorable tax treatment of passive income real estate investments like those available on the EQUITYMULTIPLE platform. However, there are some silver linings here:

Costs or losses associated with passive income investments can still be deducted against income from other similar passive income investments
The ‘actively participating’ party — typically the GP or Sponsor — is still able to deduct cost against their income from investments like those you see on the EQUITYMULTIPLE platform. This means that post-tax returns are still treated favorably by the tax code, with EquityMultiple investors able to participate in the improved project-level returns.
Some of the costs associated with a passive real estate investment remain deductible against your overall income tax burden. (See below)
The Tax Cuts & Jobs Act — signed into law on December 22nd, 2017 — has ushered in a powerful new set of tax incentives for real estate investors. We’ll get to this in a bit.

Treatment of Passive Income

Investments on the EQUITYMULTIPLE platform (and on many investing platforms) are structured as “pass-through entities” (specifically, we establish a distinct LLC for each investment on the platform). Since the earnings from these pass-throughs is classified as passive, it is taxed separately from regular investment income(portfolio income). This has three implications:

Income from these investments is taxed at your ordinary marginal tax rate.
Any losses can be used to offset other passive (and only passive) income, thereby lowering your overall tax liability. Conversely, portfolio losses cannot offset passive gains/income, and vice versa.
Profits from passive activity is not subject to self-employment tax.

Passive Income Tax Deductions for Real Estate Investments

The good news is that while investments via EQUITYMULTIPLE and other such platforms are passive, you can still enjoy some of the real estate taxes benefit conferred upon the active real estate investor who sourced the investment (the GPor Sponsor), if deducted against other passive income from similar passive income investments.

Depreciation: Per the IRS, real estate investors are entitled to write off a portion of the property’s value against annual income based on a predetermined depreciation schedule. On an annual basis this would be the value of the property divided by its “useful life” — 27.5 years for a multifamily or other residential property, and 39 years for any other commercial asset.
Operating Expenses: Each expense item associated with owning a property, such as maintenance, property taxes and management fees, is deductible.
Net Operating Losses: If a property generates a negative NOI (a net operating loss), that figure can be used to offset other passive gains or income.
Interest: Interest paid on debt obligations is deductible. This expense will be listed on your K-1, and it further reduces your net tax burden.

Implications of the 2017 Tax Reform on Real Estate Investments (for 2018 and beyond)

The Tax Cuts and Jobs Act — signed into law on December 22nd, 2017 — cut taxes substantially for corporations and individuals. The long-term macroeconomic ramifications of the bill are a matter of debate, but the legislation undeniably carries major ramifications for how real estate investment income is taxes, and the tax incentives available to real estate investors and developers.

Here are some of the main takeaways for 2019 and beyond:

A New 20% Deduction for Pass-through Income

Members or owners of pass-through entities can now automatically deduct 20% of their taxable income earned from pass-through entities (“qualified business income”). Investments made through an LLC (such as those on the EQUITYMULTIPLE platform) qualify for this new tax benefit.

However, for individual filers this deduction begins to phase out above $157,500 of annual income, and is not available at all against taxable income greater than $207,500. Hence, this benefit may do little for accredited investors filing individually who qualify as accredited based on annual income of $200k or more.

For married couples filing jointly, the threshold is $315,000. So, for example, a couple who jointly earn $315,000 in taxable income — $250,000 through their day jobs and $65,000 in income earned via investments made through pass-through entities — could reduce their overall taxable income by $13,000 (20% of $65,000).

It may be a substantial boon to those who qualify as accredited based on net worth who currently earn less than $200k occupationally. An investor who has earned $150,000 in passive income through a pass-through entity in 2018 would be entitled to reduce their taxable income to $120,000.

As with all else covered in this article, the nuances depend on your specific tax situation and should be addressed with a licensed tax advisor. Even with new IRS guidance released in mid-2018, this deduction is subject to a complex set of rules and qualifications.

Opportunity Zones

The Investing in Opportunity Act — a bipartisan bill co-sponsored by Senators Tim Scott of South Carolina and Cory Booker of New Jersey among others — was passed as a ride-along bill with the Tax Cuts and Jobs Act, and drew little fanfare at the time. Over the course of 2018, the real estate investing community has awaken to the vast potential of the new tax incentives afforded in the bill.

Opportunity Zones are qualified census tracts, historically underinvested communities across the country, where investors can receive massive tax benefits for qualified investments — so called “Opportunity Funds”. The potential tax benefits of investing into Opportunity Funds are detailed in full on our Opportunity Zones Resource Page but, simply put, Opportunity Funds allow investors to roll over pre-existing capital gains (defined as gains on assets held for more than one year) and defer payment of taxes on the earlier of December 31, 2026 or the date which the investment in the Opportunity Zone Fund is sold. The basis is “stepped-up” by 10% if the investment is held for 5 years, and by 15% if held for 7 years. Profits realized on qualified Opportunity Funds held for 10+ years are wholly exempt from taxation.

As EquityMultiple CEO Charles Clinton put it, Opportunity Funds are “one of the most exciting developments for new real estate investors in decades.”

For the most part, real estate investment firms and platforms are still determining how to best structure and offer Opportunity Fund investments in light of guidance from the IRS and Treasury Department. EquityMultiple hopes to offer Opportunity Fund investments in the near future. You can track the latest Opportunity Zone updates and join our wait-list here.

Potential Impact on Demographic Trends Shifts

Americans are not fond of taxes — according to a 2018 GALLUP poll, 45% of Americans believe their taxes are too high². Some of the adverse impacts of the tax law may have sweeping impact on where people (particularly younger professional Americans) elect to reside and work. The tax reform bill had several key implications for how individual taxpayers calculate their tax burden:

Capping of state and local tax (SALT) deductions — Whereas previously taxpayers could deduct unlimited state and local property taxes from their taxable income, this deduction is now capped at $10,000.
Reduction of mortgage interest deduction — Single-family homeowners taking on a new mortgage on a primary or second home will now only be allowed to deduct the interest on debt up to a $750,000 principal balance, whereas the limit was $1 million previously.

Both of these changes will make it even more expensive to live in some of the higher-tax, more expensive states and counties in the country (like those found in coastal California, New Jersey, New York and Connecticut) and may make lower-tax areas and relatively-affordable urban centers — like those found in Texas — more appealing. While these incentives may not have a profound impact on their own, they may have a compounding effect with trends like the rise in remote work and accelerate the net migration of young and mid-career professionals out of expensive gateway cities and toward affordable, lower-tax alternatives like Tampa, Seattle and Denver

This will be worth monitoring as investors consider emerging secondary and tertiary markets. Such potential trends are always on our radar as the EquityMultiple Real Estate Team sources investment opportunities.

Changes in Potential Write-Offs

For commercial real estate property coming into service in 2018 and beyond, the maximum annual deduction for costs associated with real estate capital improvements is now $1 million (up from $510,000 for tax years beginning in 2017).

For real estate operators, eligible property includes improvements to an interior portion of a nonresidential building if the improvements are placed in service after the building (in other words, for value-add improvements). The TCJA also expands the definition of eligible property to include the expenditures for nonresidential buildings,

HVAC equipment
Roofing
Fire protection and alarm systems
Security systems

This should slightly improve after-tax return potential for value-add real estate investors and developers, which will ultimately filter down to investors who participate passively in value-add projects through a platform like EquityMultiple.

The Bottom Line: How Tax Law Will Impact Your Real Estate Investments

While the Tax Reform Bill of 1986 curtailed some of the tax advantages available to real estate investors, the Tax Cuts and Jobs Act of late 2017 has ushered in a number of new tax advantages for passive and active commercial real estate investors.

How your real estate investments are treated by tax code depends on the nature and extent of your investments, your location, and other specific aspects of your individual tax situation. Many of the fine points of new tax law (and impact on your portfolio) are esoteric and endlessly complex (if you don’t believe us, try reading through this memo from the IRS on new deductions available via pass-through entities).

Be sure to consult with your tax specialist, who will no doubt be working overtime in light of the new tax changes that will impact your 2018 filing. Note that EquityMultiple does not provide tax advice. We hope this overview has been helpful.