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  • Passive vs active real estate investment

    I know that if I buy a property to rent out I'll be able to deduct mortgage interest and also depreciation on my tax return. However, if instead I invest in a syndication or REIT, how would mortgage interest deduction and depreciation work? Will I lose those 2 benefits by investing passively?

  • #2
    A REIT has none of the tax benefits. You don’t get any depreciation deductions.

    A syndication is more like direct ownership, but with 2 caveats. The benefit with a syndication is the depreciation deductions pass through to you with K1’s, but the first caveat is a disproportionate share of the profits flow to the general partners, not to you as one of the limited partners. The second caveat is the sale of the real estate generally comes in about five years. You have no control over timing the sale, and you have no control over the tax consequences of the sale, and no ability to do a 1031 exchange to defer depreciation recapture and capital gains taxes.

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    • #3
      So if you want the tax benefits and are willing to put in the work to find, purchase, and manage a property, stick to direct investment. If you are most interested in the passive nature of a syndication--someone else find it, works out the purchase, and manages the asset AND you are willing to pay the sponsor, accept sale when it occurs out of your control--investing in a syndication could be better. Whether you think the sponsor ultimately gets fair or unfair compensation for their work and risk, remember they are still doing work and taking on risk (upfront costs, sometimes recourse on a loan), that you would need to do yourself to invest directly.

      White.Beard.Doc, you are a big proponent of direct management. Have you written any articles on balancing practicing medicine with direct RE investing? If not, that seems like something that could be really valuable to a lot of members here.

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      • #4
        Yes I concur. Can someone who is doing direct management of real estate start a solo 401k? Seems like you might find a way to add more tax shelter space if this is possible and you are a full time W-2 worker.

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        • #5
          Originally posted by Jack_Sparrow View Post
          Yes I concur. Can someone who is doing direct management of real estate start a solo 401k? Seems like you might find a way to add more tax shelter space if this is possible and you are a full time W-2 worker.
          When you do direct real estate investment, typically as a successful RE investor you will generate nice monthly positive cash flow. However, you will also generate large phantom paper losses in the form of depreciation deductions. So as far as your annual income tax return, you have to look at this differently. While your direct real estate investments will be generating that cash income, from a tax perspective you are generating phantom losses. So there is no RE income showing on your tax return to shelter, as all of the RE income is already sheltered.

          I pay very high income taxes on my medical income. But on my real estate income, we have a six figure annual positive cash flow coming in that is completely tax free. Our strategy for 2021 is to transition our real estate business from passive to active. My spouse will be considered a real estate professional (known as REPS) in 2021 as she is spending enough time doing real estate business activities to qualify. So our 2021 real estate income, which from a tax perspective is considered a loss due to both straight line and bonus depreciation, will be able to shelter a lot of my active medical income for the first time. In the past, the real estate depreciation only sheltered the real estate income, but that will no longer be the case in 2021.

          Investing in real estate is a side job, yes, but the tax advantages are so beneficial that we find it to be worthwhile. My spouse will generate a six figure amount in cash flow rental income, all tax free, and an additional six figure amount in income tax savings resulting from the real estate activities sheltering some of my medical income.

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          • #6
            Originally posted by White.Beard.Doc View Post

            When you do direct real estate investment, typically as a successful RE investor you will generate nice monthly positive cash flow. However, you will also generate large phantom paper losses in the form of depreciation deductions. So as far as your annual income tax return, you have to look at this differently. While your direct real estate investments will be generating that cash income, from a tax perspective you are generating phantom losses. So there is no RE income showing on your tax return to shelter, as all of the RE income is already sheltered.

            I pay very high income taxes on my medical income. But on my real estate income, we have a six figure annual positive cash flow coming in that is completely tax free. Our strategy for 2021 is to transition our real estate business from passive to active. My spouse will be considered a real estate professional (known as REPS) in 2021 as she is spending enough time doing real estate business activities to qualify. So our 2021 real estate income, which from a tax perspective is considered a loss due to both straight line and bonus depreciation, will be able to shelter a lot of my active medical income for the first time. In the past, the real estate depreciation only sheltered the real estate income, but that will no longer be the case in 2021.

            Investing in real estate is a side job, yes, but the tax advantages are so beneficial that we find it to be worthwhile. My spouse will generate a six figure amount in cash flow rental income, all tax free, and an additional six figure amount in income tax savings resulting from the real estate activities sheltering some of my medical income.
            WBD - always appreciate your responses, especially regarding real estate. I am reading the Corey Faucett real estate book now. Any recommended resources with advice on getting started with direct RE investing?

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            • #7
              Originally posted by SEC Doc View Post

              WBD - always appreciate your responses, especially regarding real estate. I am reading the Corey Faucett real estate book now. Any recommended resources with advice on getting started with direct RE investing?
              Leti and Kenji run the SemiRetired MD website. They are a successful 2 physician couple that focuses on real estate investing for docs. They have a blog and a forum specifically for docs to share notes on direct real estate investing.
              Last edited by White.Beard.Doc; 04-29-2021, 03:53 AM.

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              • #8
                Originally posted by Jack_Sparrow View Post
                Yes I concur. Can someone who is doing direct management of real estate start a solo 401k? Seems like you might find a way to add more tax shelter space if this is possible and you are a full time W-2 worker.
                I actually think this doesn’t work independent of WBD’s point about bonus depreciation (which may end 2026 anyway). Real estate income is passive and cannot be used as earned income to fund IRAs, 401ks, etc. one could form a management company, but then there are all the SE taxes and paperwork.

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                • #9
                  Out of curiosity, can someone provide some rough numbers on how much in income sheltering a real estate investment can provide? I feel fortunate to be a solo private practitioner, and generating an amazing income, which I know I should feel blessed to pay taxes on 😉, but if there is a large amount of additional sheltering feasible with RE investments, I'm all about figuring it out.

                  Is there a rule of thumb for size of real estate investment correlated to amount of sheltering feasible?

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                  • #10
                    Originally posted by DoogieHowser View Post
                    Is there a rule of thumb for size of real estate investment correlated to amount of sheltering feasible?
                    Through 12/31/22 there is bonus depreciation on real estate. We are generating 25% of RE investment value in 1st year bonus depreciation. I.e. a 200k down payment on a 1M property in year 1 generates a 250k write off in bonus depreciation. But you have to be aware of active vs passive income classification depending on your personal tax circumstances or you may end up with suspended losses.

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                    • #11
                      I don't do real estate investing so I certainly don't understand the taxe.

                      That said, a question:

                      outside of this direct ownership of real estate, depreciation is considered a real business expense. Yet here, and on other threads about individual ownership of real estate, it is treated as a free tax deduction, rather than as a true expense that is deductible, just as any other legitimate business expense would be

                      Does the IRS permit depreciation deductions at a unreasonably high rates? Higher than the true rate at which properties deteriorate? Is that why depreciation is treated as free?
                      If that is the explanation, then wouldn't this free part reflect only a component of the total depreciation? Clearly there is SOME depreciation going on even if the IRS let's investors overstate it?

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                      • #12
                        Originally posted by afan View Post
                        I don't do real estate investing so I certainly don't understand the taxe.

                        That said, a question:

                        outside of this direct ownership of real estate, depreciation is considered a real business expense. Yet here, and on other threads about individual ownership of real estate, it is treated as a free tax deduction, rather than as a true expense that is deductible, just as any other legitimate business expense would be

                        Does the IRS permit depreciation deductions at a unreasonably high rates? Higher than the true rate at which properties deteriorate? Is that why depreciation is treated as free?
                        If that is the explanation, then wouldn't this free part reflect only a component of the total depreciation? Clearly there is SOME depreciation going on even if the IRS let's investors overstate it?
                        Depreciation of real estate should be somewhat of a misnomer (not exactly the right word, but I cannot think of a better one). That is because real estate should appreciate in value, not depreciate. The result is that, should you hold for many years and sell, you have to recapture the depreciation in the sense of the asset you are selling has a very low basis compared to the proceeds. However, the top recapture rate is 25%, which is still less than many doctors’ marginal tax rates.

                        In addition, you can do a 1031 exchange and defer the tax bill. The result is that the new property you exchanged to has a much lower basis than the value of the property. Should you continue doing this until death, your heirs will get a stepped-up basis. In my mind, that is the only real “freebie” with real estate. The rest is pretty much timing and having an eye for choosing undervalued properties.

                        I have yet to run into a RE investor who fairly calculates the ROI of income+appreciation totals in all properties over time less all expenses (including the value of their personal time) from purchase to sale in order to compare an ROI to the long-term returns of the a well-diversified equity fund portfolio that requires very little time. The stepped-up basis is also applicable to investment portfolios, of course, so not an issue. I believe there surely are some who come out ahead (and, of course, not including the side hustle income, like RE podcasts and classes) but not many. But that’s just my belief based on logic and free-market principles.

                        Some ppl have a passion for it, such as White.Beard.Doc and a few of our clients. Those who don’t and ask me if they should due to FOMO, I give them my personal opinion (which does include personal experience).
                        Last edited by jfoxcpacfp; 07-05-2021, 07:03 AM. Reason: Correct pronoun
                        Our passion is protecting clients and others from predatory advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

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                        • #13
                          I'll be the naysayer and outlier here. I'd never, ever, invest in direct-ownership investment real estate. I invest extensively in passive, get tax benefits especially the first few years with negative K-1's, and don't have to worry about when to sell, whether to repair or replace the roof, what to do when tenants move out, etc. My job is medicine; don't want another. With due respect to those like the "Semi-retired MD's" etc, I think it's arguable they very simply chose the wrong career. They should have been RE investors only - why spend all the time and effort with the medicine thing if that's not the primary goal?

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                          • #14
                            Originally posted by ScopeMonkey View Post
                            My job is medicine; don't want another. With due respect to those like the "Semi-retired MD's" etc, I think it's arguable they very simply chose the wrong career. They should have been RE investors only - why spend all the time and effort with the medicine thing if that's not the primary goal?
                            Yes, my primary job is medicine. And I spent years of my life learning my craft and decades giving back to my patients, with over 100k patients cared for over a long career.

                            While I have done the usual relatively passive thing on the investment side, the tax deferred retirement accounts, I also did some other types of investing. I started 3 successful health care related businesses while I continued to practice medicine. And I have invested in real estate for a long time. When I was a PGY3 resident, I bought my first investment property.

                            For many years, my medical practice was so busy that I limited my real estate investing activities to a few hours a month. Nevertheless, a relatively small initial investment grew to a 7 figure amount over the years. Leverage and inflation worked that magic. Yes, my tax deferred accounts also grew to a 7 figure amount, but the real estate offered diversification and tax benefits of a different type.

                            I think WCI says it well. We have our primary job, medicine, but if we want to have a comfortable financial life, whether that is the ability to handle life's emergencies if and when they arise, or the freedom to continue working, or not, or the freedom to retire comfortably at the appropriate time, then it is worthwhile to pay attention to our second job, learning to manage investing and the other financial aspects of life.

                            Real estate investing is not for everyone, but it is a viable alternative for those who choose to pursue it. I will add a 7 figure amount of growth to my net worth this year through my RE related investments. And I will continue to see patients part time as a senior physician who is not yet ready to hang up the stethoscope. At this point, the RE investing has become a pretty big hobby for me. I greatly enjoy it. To each his own. Live and let live.

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                            • #15
                              If I look deep down why I did vested in RE, it has to do with parental influences/culture and greed. That being said, our rent is usually always a touch under market rate.

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