Tax Strategies for Real Estate Investors: How to Reduce Your Taxes and Maximize Returns With Thomas Castelli and Justin Shore

Tim Lyons 00:03
Welcome to another episode of the Passive Income Brothers Podcast. My name is Tim Lyons, and today I’m joined by two absolute rockstars, one of whom is my brother Greg. How are you doing today, buddy?

Greg Lyons 00:12
Tim, fantastic does not even begin to describe it! Coming off a tax webinar, and I am fired up, baby!

Tim Lyons 00:21
I love to hear it! You know, it’s not every day that I’m able to hear my brother say that he’s fired up for a tax webinar because only a few short years ago that would have never come out of his mouth.

Greg Lyons 00:31
It would have been the opposite. It would have the opposite absolute sleep. 

Tim Lyons 00:35
Absolutely, kicking and screaming. The other Rockstar we have today is our other partner here at Cityside Capital, Paul Dircks. How’s it going, Paul?

Paul Dircks 00:42
I’m doing well. And you know, this webinar was great. As one of our mentors, Tom Wheelwright, says, “If you want to change your tax, change your facts.” That’s what this webinar was full of—full of facts. It’s good stuff. It is as exciting as taxes can be.

Tim Lyons 01:02
So, we’re gonna jump into this webinar for you here on the podcast for this week’s episode. But I really want you to get a notebook out, pull the car over, get the notebook out, get the pencil sharpener, because we’re going to cover a lot of topics that limited partners often ask Greg, Paul, and me when we hop on our intro call or talk to our current investors. Questions like how does the K-1 work? How does depreciation and losses and income benefit me? What are those tax benefits that we hear about in the 101 books, webinars, and other podcasts? So, this is going to be a masterclass for the LP or limited partner, also known as a passive investor, but also for real estate investors in general. Whether you’re an active investor owning your own single families or small Maltese, or if you’re investing with us here at Cityside Capital in private placements like multifamily, self-storage, industrial, triple net leases, and other private equity investments, there are ways to strategize with a CPA that understands your facts and can help you change the facts to save on your tax. Without further ado, I’m going to jump into the webinar for tax strategies for limited partner real estate investors. Alright, guys, listen, it’s 1:02, I feel like if everybody else wants to sign on, they’ll sign in. But I want to welcome everybody to our first-ever webinar. Thomas and Justin, this is our first time, so go easy on us. But it’s a great day to have a conversation surrounding the tax strategies that limited partners, aka passive investors, should really learn about, and what the strategy is, what’s the roadmap, what does it mean to be an LP, how do taxes affect you as an LP versus being an active investor? These are all questions that Greg, Paul, and I get on a daily basis. People want to know about, well, how does it work? I’ve read the books, I’ve read the 101 books, they say tax benefits, cash flow, appreciation, depreciation, recapture, IRAs, all these things. And really, this is going to center all of us today for investors, as well as whoever’s watching this, if you’re a sponsor, because this is really top of mind for a lot of folks. So, with that being said, here are some of the topics that we want to cover today. And I’ll just run through them, and then Thomas and/or Justin, we can feel free to start from the top, and we can just go down these topics. The idea today is to be maybe 30 to 45 minutes or so, and then we have some time at the end for a little question and answer. So, to the attendees, if you do have a question that you would like Justin or Thomas to answer, just put it into the Q&A box. I’m going to nominate Greg to be the Q&A guy to monitor some of that stuff, let us know as they come in, or at the end of the seminar. But really, the topics we want to cover today are: Who is the real estate CPA firm? Why is it important to have a CPA on your team? I’m always famous on our podcast talking about building out your team. If you broke your ankle, Justin, Thomas, you wouldn’t go see a pediatrician or a neurosurgeon, right? But they both have MD next to their name. The same thing goes for CPAs. When you’re building out your team, if you’re a busy W2 employee, if you’re a small business owner, if you’re a real estate investor, you need to have that team built out. The next thing we want to talk about is the different buckets of income, the three buckets of income, how they’re taxed, and why it’s important to know that as an LP. Then with the tax experience, I think we’ll spend the bulk amount of time today on the tax experience of the limited partner. What is a K-1? How is depreciation allocated? Why does it even matter? What is depreciation? I keep hearing that word. How can I use it in my strategy? We’re also going to talk about some strategies and tips for LPs, and maybe what they can get tripped up on, some of the things to watch out for. And then really, some updates. There’s a lot of information right now about what an accredited investor is. Are they going to change the criteria for accredited investors? What does it even mean to be accredited, non-accredited, sophisticated? And what does that mean as far as 506B’s and 506C offerings? Also, bonus depreciation. There’s a bill going through Congress. Who knows if it’s going to get passed? Hopefully, it does. But what does that mean? So, with that being said, Thomas, do you want to just introduce yourself and your firm to our webinar?

Thomas Castelli 05:59
Yeah, absolutely. So my name is Thomas Castelli, CPA, and Certified Financial Planner, and I’m with Full CPA. We’re an accounting firm that works with real estate investors of pretty much all sizes, from as little as one rental property all the way up through syndicates and funds that are buying commercial properties, big multifamily, the whole nine. So we’re fortunate we get to see a lot. And really, what we do for our clients is a handful of things. The first thing we do is take a look at what they currently have going on in their situation and where they’re looking to go over the next handful of years in terms of investments, business income streams, and then really work with them to come up with a plan on how they can reduce their taxes. This is critically important because there are a lot of CPAs out there, a lot of tax professionals who will simply only prepare your tax return. The problem with that is your tax return is really just a report card of the activities, the income, the deductions, the credits, and all that good stuff from the prior year. And when it comes time to filing your tax returns in the first quarter of any given year, for example, 2024, a lot of the things that you could do, you’re not going to be able to do anymore because the time has already passed. So really, setting yourself up proactively to reduce taxes is tremendous. So we, of course, do tax planning, then we do tax preparation. So we actually file tax returns for you, as well as outsourced accounting services to get your bookkeeping in order, which is actually critically important not only to your tax situation but also for making sound financial decisions that can impact the returns you’re getting from a portfolio. So that, in a nutshell, is a little bit about what we do.

Tim Lyons 07:43
Love that. You know, I really want to hammer that home. Your tax return at the end of the day is a report card of the activities that preceded in the previous year. It’s not something you just check the box on. I mean, that’s what I did for a long time until I realized that I can align myself with the IRS tax code as a W2 employee. I mean, everyone knows that by now I’m a New York City firefighter, right? That’s a W2 job, not a lot of write-offs when you’re doing that. But as you become a real estate investor, even as a W2 employee, there are certain things that you can do to align yourself with the IRS tax code, specifically the passive activity rules. So I love that you mentioned that. And really, it’s about building a strategy before you get into the game or as you’re getting into the game, so that when you bring your report card to your CPA, hopefully they’re a real estate-focused CPA and they know how to use all the tools in the toolbox. Now you can really capitalize on those types of strategies. So thank you for pointing that out, Thomas. Justin, even though your name tag says Thomas Castelli the second, could you kind of give us a little bit of your background and what your role is over at the firm? And then we’ll have Paul and Greg introduce themselves, and we’ll get into the topics.

Justin Shore 08:54
Yeah, yeah, absolutely. Contrary to the tag on the screen, we’re not related. So I’m the advisory manager at the firm. I oversee our team of advisors who are dedicated to working with clients on a day-in, day-out basis. A lot of what I do is continued research and expansion, digging deeper. We’re always keeping a close eye on the tax code because, as I’m sure many of the listeners are aware, it’s constantly changing. Real estate, especially, has a lot of granular subtleties in it. So it’s something that we like to be continually immersed in so we can provide that expert-level experience that a generalist tax professional probably won’t be able to.

Tim Lyons 09:49
I do love that, and that’s why we’re here, right? Because as a W2 employee or a 1099 or a business owner, we don’t have the time to understand the voluminous amount of tax writings, case law, precedents, and changes and updates, right? So we need to have that team. That’s really why we’re here today. So thanks for having that. Welcome, Justin. Paul, take it away, baby.

Paul Dircks 10:16
Just real quick, Paul Dircks here from Cityside Capital, of course, happy to be here. I’ve been a client of the Real Estate CPA for several years. And, you know, I can attest to the professionalism and diligence that they provide as a real estate investor and as a client. One or two things to call out from my experience with them, which has been consistently positive, is that they don’t just focus on real estate. So if you’re a business owner or have other complexities in your tax picture, they can handle those too. And that was really comforting to me, coming from the W2 world, then as an active real estate investor, and now as a real estate investor. I felt very comfortable working with them versus a traditional tax preparer because of what they can see and the tools they have to work with, especially with the complexities that arise in real estate investing. Additionally, they embrace new technologies and ways of streamlining information sharing, making it a lot easier to work with them compared to traditional firms. 

What makes this event so exciting is that Cityside Capital is all about providing access to passive income investment opportunities. Usually, the question is what or why or how, but today, it’s about who can help you access, take advantage of, and utilize those opportunities in the way that works best for your portfolio and your life. So it’s exciting to join professionals like Thomas and Justin, who can help you execute on the plan you’ve outlined for yourself when you make the decision to pursue and invest in passive income opportunities. Thomas, Justin, thanks for being here, and Greg, over to you. 

Tim Lyons 12:25
Well, I just want to jump in real quick, Paul. I’m sorry. I just want to let you know, giving them a ringing endorsement because you are a client, and I can attest to Paul’s due diligence process. Okay. Paul does not let anything just skate by him. So there’s a big due diligence process. So when it’s great to have that ringing endorsement. But, Greg, the one and only, the rockstar, my co-host of the Passive Income Brothers podcast, and the other partner here at Cityside Capital, take it away.

Greg Lyons 12:55
Yeah, hi, I’m Greg Lyons, co-founder of Cityside Capital. And I’m really excited today about learning everything Justin and Thomas have to share because four years ago, when we founded Cityside Capital, it was to solve a problem. And that problem was how do I get into real estate with not enough time, right? Tim and I found a way, and now with Paul, we’re continually doing different deals in real estate. But the big overarching part of our whole real estate strategy is taxes. How do we mitigate taxes? How do we defer taxes and all the different tips and tricks there are to really maximize the money you make and be able to keep year in and year out? So I’m really happy to have Thomas and Justin here. Let’s get started.

Tim Lyons 13:49
Of that, you know, for everybody listening, if you haven’t read a book called “Tax-Free Wealth” by Tom Wheelwright, it’s got to be one of the shortlist reads for you, right now. Like, order it on Amazon. It’ll be here in two days. But one of the first things he says in that book is, “We’ll work till about April or May each year just to satisfy our tax liabilities, right?” Taxes are one of our biggest expenses, yet we spend more time planning our family vacations and trips than we do planning our taxes, right? So if you kind of use that as a lens to look through, saying, “Look, how do I minimize expenses?” This is how we do it. So we kind of covered, you know, who you guys are, why we should have somebody who’s really focused on where we want to be. Let’s kind of jump into the different buckets of income, right? There are three buckets of income, and the one that we want to concentrate on today is our passive income bucket. So let’s just define that, guys, and then we can go into how that relates to a real estate investor.

Thomas Castelli 14:57
Yeah, absolutely. So to start off, it’s important to understand where this all came from. Before the Tax Reform Act in 1986, there was no such thing as passive income or non-passive income or portfolio income. To my knowledge, there was just one big bucket. But then what happened was there were a lot of high-income earners, like doctors and attorneys, who would buy rental properties, not do much work, and be able to take these big losses, thanks to depreciation, against their active income from a W-2 job and the business they were running, and even their stock dividends and gains from stock sales. Basically, that was very controversial. So they patched it with section 469, which said that all income is going to fall into one of these two buckets: either passive income or non-passive income.

Non-passive income is income from activities you’re actively involved in, such as a W-2 job, an active business you might be running, and even portfolio income like stocks, bonds, dividends, and gains from those types of assets. Although they might be passive in reality, you click a few buttons to buy stock, they’re actually in the non-passive bucket. And that’s very explicitly written in the tax code; there’s not much room for interpretation there. So that’s in the non-passive bucket.

Now, we have the passive bucket. The passive bucket includes all rental real estate by default. So all rental real estate is typically going to be passive. It also includes businesses that you own but aren’t actively involved in, or perhaps you’ve invested in as a limited partner and you’re not actively involved or materially participating, as it’s technically termed. That’s going to be in the passive bucket.

The issue with the passive bucket, or the “issue” with the passive bucket, is that losses from passive investments, such as rental real estate, which often have large passive losses that are non-cash, cannot offset your non-passive income. That’s how it works and why section 469 under the Tax Reform Act of 1986 was put into place. So you have your passive bucket, which includes your rental real estate, and you have your non-passive bucket, which includes your W-2 income, your active business income, and your portfolio income. And the passive losses can offset non-passive income. That’s kind of in a nutshell, the framework, the frame of mind we’re coming from.

Tim Lyons 17:33
So, really, I’m going to drive that home, right? Because, you know, before I really got into this, you know, space, guys, you know, I was a firefighter and an ER nurse, right? I got a W-2 from each of those jobs. And that was just one source of income, right? Well, there were two sources of income, but I treated everything the same. I didn’t realize that there was passive and non-passive income, portfolio income, and how they would be taxed differently, right? And now we’re starting to get the ball rolling here, where we’re in the passive bucket, and we’re going to have passive losses that can potentially offset your passive income. And as Thomas, you know, said, all real estate activities, you know, whether you’re Thomas, feel free to correct me at any time, I may, because I am not a CPA, but any real estate activity, right? So, if you have a single-family rental, if you have a syndication that you’re a part of, multifamily, industrial, self-storage, you know, what have you, as long as you’re an investor in one of those things, it falls into the passive income bucket. And now that we’ve defined that, let’s talk about ways to mitigate some of that income.

Thomas Castelli 18:41
Right, right. So really, what it comes down to is I’ll go from the ticket from the passive side, right? As a passive investor, and this includes being a limited partner in city kids and funds, the biggest play here is that the losses generated from rental real estate are going to shield your rental income from tax. And this is important because let’s say you have a job or you’re running a business, well, those are taxed at federal income tax rates up to 37%. And in many cases, you have state taxes, perhaps local taxes if you live in a city like New York, and then you’re going to have FICA taxes, perhaps self-employment taxes, and this can easily add up if you’re a high-income earner, where you’re going to be paying 40 to 50% of your earned income (your W-2 or active business income) in taxes, and we see this happen all the time. So, that is a pain right now. When it comes to rental real estate, rental real estate is also taxed up to 37% at the federal level, but thanks to depreciation, we’re actually sheltering this source of income from tax. So, you might be generating positive cash flow from our rental real estate investment, but you’re telling the IRS you owe us money. Now, on top of that, there’s usually a loss, so not only are you making money, but there’s this loss. Now, how does this loss work for the passive investors? This loss will help you offset your other passive income in that year. Now, if you don’t have any other passive income or gains, for example, from the sale of real estate in that year, they will be suspended and carried forward into future years when you do have passive income or gains from the sale of property. So, these losses can still help you even as a passive investor. So, as a passive investor, the name of the game is, “Do I have enough passive losses to offset my passive income and gains?” Now, on the non-passive side, you can actually turn passive losses into non-passive by qualifying as a real estate professional. Now, to qualify as a real estate professional, you have to work more than 750 hours in a real property trader business in which you own at least 5% of. For the most part, if you’re going to have a W-2 from that job and more than half of your total working time, that’s what trips a lot of people up. It’s challenging to hit those requirements unless you are legitimately working almost full time in real estate. But that’s when you could turn those losses non-passive and help them offset your W-2 or active business income; otherwise, they will be in that passive bucket, you know.

Tim Lyons 21:04
And that’s really important because a lot of people will either hear it on a podcast or read about it in a book, something about real estate professional status, and they go, “Right, that’s going to be me, right?” So they think, “I’m going to be an orthopedic surgeon, I’m going to make a good living, and then I’m just going to buy some rentals and shield all my income.” Well, maybe before 1986, that might have worked, but after 1986, they really tightened the screws on that one. So we could probably spend a whole webinar just on real estate professional status, what we call REPS, right? But there are certain criteria, and you guys are really good at defining that criteria and helping folks determine if they qualify for real estate professional status. And if they don’t, how can they strategize? Does their spouse work? If not, maybe their spouse can qualify. How much do they own of each property, be it a beach syndicate or whatever it might be? It’s not a hard “no” all the time, but there are ways to strategize and say, “Let’s listen, let’s strategize. Can I get my spouse involved? Can I get involved? How do we do this, right?” And then, now you have something. You have a goal set, and now you can go get that goal. Because the value of earning that real estate professional status, Thomas, maybe you can spend 30 seconds on what exactly that means for you and give a quick example with some round numbers. And as everybody knows here, I’m terrible at public math. So back to you.

Thomas Castelli 22:28
Yeah, so let’s just say, for example, you bought a $500,000 property, right? At a high level, usually within that $500,000 property, a portion is allocated to land, and land is not depreciated. Let’s assume that’s 20% for the sake of this example, which means $400,000 is allocated to the building. Now, the building is going to be depreciated over a period of either 27 and a half years for residential or 39 years for commercial property. However, there’s something called bonus depreciation. Bonus depreciation allows for a significant acceleration of depreciation for property with a class life of 20 years or less. When you buy a building, it’s not just the walls; you also have things like carpeting, appliances, fixtures, and land improvements such as pools and decks. Typically, 20% to 30% of that building can be allocated to this 20-year property or less, which can then provide significant benefits. Let’s walk through the example. So, you have $400,000 in your building, and let’s say 25% of it is eligible for bonus depreciation, which amounts to $100,000. Now, in 2024, under current law (which may be subject to updates), bonus depreciation is 60%. This means that the $100,000 would result in a depreciation deduction of $60,000. It’s important to remember that depreciation is a non-cash expense and only exists on paper. So, having a $60,000 depreciation expense on a $500,000 property would generate a sizable loss of $60,000 (let’s keep things simple). Now, if you’re in the 24% tax bracket, this could potentially save you $14,400 in taxes. If you’re in the 37% tax bracket, the highest federal tax bracket, you could be looking at tax savings of around $22,200. This is why this is powerful, and it’s just an example based on a $500,000 property. If you were to buy a million-dollar property, these numbers would double. So, this is just an illustration of how this works at a high level.

Tim Lyons 24:47
So you know, just to drive that point home. You know, this is why people do real estate investing. It’s one of the reasons why it’s one of the benefits of real estate investing, whether it’s active or passive, right? Because if you can significantly lower your tax liabilities in a legal and, you know, winded way, like why wouldn’t you, right? And the biggest thing is the reason why is because $1 today, as we all know, in this high inflation kind of period that we just went through or are going through, $1 today is worth more than $1 tomorrow, more than $1 in five years or 10 years, right? So if you can save that money today, reinvest it in today’s dollars, you know, nominally today, you can see how that can exponentially build your wealth over time. So I hope I was eloquent in saying how that works. But it’s really powerful stuff, you know, real estate professional status. But let’s really focus, if we can attain real estate professional status. So we can take these write-offs and put them, you know, the depreciation, the bonus depreciation, if we can’t take that and put that against our active income. Let’s really focus on the LP experience here. And specifically, we have a ton of investors on this webinar from Cityside Capital who’ve already invested with us. So they’ve been in, you know, I’m looking at the list here. They’ve been in multifamily, they’ve been in self-storage, some of them have been in industrial syndications where they might have done $50,000 or $100,000, or million dollars, and at the end of the year, they get a document called a K-1. So that can confuse a lot of people, Thomas, and Justin, you know, what do I do with this K-1? Or, you know, maybe my CPA is not familiar with how to read the K-1? What’s the most important part of that? Right? And how does it apply to me as an LP?

Justin Shore 26:34
Yeah, absolutely, I can jump in there and explain that one. So the way I always explain K-1s, especially to new investors, is kind of like a W-2 on steroids. On your W-2, you see that there are a whole bunch of different boxes with different figures dictating how the income is going to be taxed, or how much tax was taken out. With your K-1, there are typically quite a bit more boxes, usually around 19 or 20, outlining all the different types of income you’re receiving from that syndication or partnership investment. Now, when we’re talking about rental real estate, typically the first big number you’re looking for is in box two. That’ll have your net income or loss from rental real estate activities. And what that’s effectively showing you is your share of the income or loss generated that year from the partnership. So if, for example, you own 5% of that syndication, then effectively, you’ll see 5% of that income or loss allocated to you in box two. Now, the other interesting thing with this, and like we’re talking about this idea of paper losses or tax losses, is what Tom was alluding to before with real estate in general. You can be positively cash flowing while still showing these tax losses. And this is where you’ll actually see a separate box on your K-1 reporting how much distributions you took during the year. What a lot of investors get thrown off by, especially the first time, is that the share of income or loss showing in box two is almost never going to match the distribution amount you took during the year. Because frankly, you could be showing a $25,000 loss in that net rental real estate box, but maybe you received $7,000 of distributions. And that discrepancy there is the benefit we’re talking about, that delta or difference between the fact that you could actually be receiving cash flow from this investment while a tax loss is being reported to you on that K-1.

Tim Lyons 28:50
And that’s a great point, right? Because a lot of investors that we deal with at Cityside Capital, they’re into multiple deals, multiple different years, right? So maybe that first year, you know, K-1 has a sizable, quote unquote, “paper loss” from the depreciation that’s allocated to the LP or the limited partner on that first year K-1, and then years two through six or something like that, it’s a much smaller amount of loss reported. But whatever you can’t use in that one taxable year, correct me if I’m wrong, guys, but you can suspend and carry forward to the following year. How does that work?

Justin Shore 29:26
Yeah, exactly. So, to give an easy example: Let’s say you made a $50,000 investment in the syndication. In the first year, thanks to the cost segregation and bonus depreciation that the partnership took, they end up sending you the K-1, which reports $40,000 of losses in the net rental income or loss box. Now, you could also be receiving distributions in that year, which, even though they may both be reported, are fairly independent from one another. So, what that means is, if you’re passive—again, not qualifying as a real estate professional or jumping through some other hoops— we’re just talking about passive losses here. What you would end up showing on your personal tax return is a $40,000 passive loss that has to be suspended and carried forward.

Now, let’s jump forward to year number two when the syndication is fully operational and generating some income. The partnership is still going to continue taking some depreciation and shielding some of that taxable income. But, for this example, let’s say in the second year, the partnership reports to you that you have $5,000 of taxable income from the syndication. What’s going to happen is that the $40,000 loss carryforward is going to absorb or consume all of that $5,000 of taxable income. Now, you’re left with a $35,000 passive loss carryforward at the end of the second year. Keep in mind that during that second year, you again may have received distributions because the cash flow could still be positive.

Paul Dircks 31:10
Yeah, Justin, if I could jump in real quick here with that. If an investor invests in a syndication in year one, and then in year two, like you said, that syndication is ramping up, if that same investor invests in a new syndication in year two, they could receive a new depreciation shield in that year. Correct. And those depreciation shields could, in effect, grow together and create an even larger shield, almost like a snowball rolling downhill. Is that the correct way to think about this going forward?

Justin Shore 31:44
Absolutely. Sometimes I’ll describe that as a ladder, layering additional losses each year with new investments. The beauty of this, as Tom outlined in the beginning when talking about the two different buckets of income, is that with passive losses, we can use them to offset passive income. So what can be exceptionally helpful is if you’re making additional investments each year and generating new losses, especially thanks to things like bonus depreciation. In the new year, these passive losses effectively get aggregated on your personal return, although they’re tracked separately. This means your passive loss carryforward number can slowly increase as well. 

You can have the losses from a new syndication investment this year offsetting the passive income that maybe an investment you made four years ago is now producing a lot more taxable income. You don’t necessarily have to have them come from the same partnerships even.

Paul Dircks 32:52
Got it. Very helpful. I mean, with a lot of our syndications, we don’t necessarily know when there could be a capital transaction in the years to come as well. So you’re planning this. I think of it almost as planting the seeds to offset what we hope will be a successful execution of one or more syndication plans over those future years.

Justin Shore 33:12
Absolutely, it’s a tremendous safety net to have, for sure.

Tim Lyons 33:18
You know, one of the things we talk about all the time with Paul, Greg, and our investors is something that we affectionately termed the conveyor belt theory on stacking investments up, right? So, if I can just go over that real quick, guys, you know, we learned it from Gino Barbara, one of our mentors here for Greg and me. And he really talks about the conveyor belts as, you know, look, if you’re just getting started in the syndication space, or passive investing, or even active investing, if you have what’s called a $50,000 investment once a year, right? So when you put $50,000 into a syndication, and you get the cash flow, the depreciation, the K-1, and that kind of moves down. 

Then, in year two, you put another $50,000 in, making another investment and another deal, you get your K-1, you get your depreciation, you get all your stuff, right? And then that slides down; it goes on and on. So, generally speaking, a lot of these deals are maybe three to six years, let’s call it five years, right? So if you do that $50,000 a year for five years, now you have $250,000 deployed onto this conveyor belt. 

As year six comes around, that first one you put on the conveyor belt will drop off; maybe it’ll sell, right? So now you’ll get your original $50,000 back, right? And then you’ll get, you know, hopefully some appreciation on top of that. But now there’s something called depreciation recapture, which I want maybe Thomas and Justin or Justin to kind of talk about depreciation recapture because that’s always a big question from our LPs. How does that work? What does it look like? 

But now you can take that first one that fell off in year six and just say you doubled your money—I’m using really rough math here, right?—but just say you doubled your money, right? So your $50,000 became $100,000. Now you put $100,000 on the conveyor belt in year six. And then now you can see year two drops off and sells. Now you put that back on year seven. So now you can really see with $250,000 deployed over five years, now you can start stacking that money on top of each other in years seven through ten and recycling that money. So, I hope that made sense, Greg. You know, my public math was kind of simple, but you know, hopefully it was effective. But let me throw it to Thomas.

Greg Lyons 35:35
Yeah, let’s go say hello to Thomas. And Justin, just to say, how does that work with a taxable event when a syndication does sell? And maybe you want to reinvest that money again?

Thomas Castelli 35:49
Yeah, absolutely. So when you sell a syndication, typically what’s going to happen is there’s going to be a gain on the property. Now, that gain is usually going to be from appreciation, which is the increase in value of the property from the time you bought it to the time you sold it. That’s typically considered a capital gain and taxed at capital gains rates, usually 15 to 20%, depending on your tax bracket, if the property was held for longer than a year. 

Additionally, there will be a gain from depreciation, which is the amount of depreciation you’ve taken over the time you’ve owned the property. Part of this depreciation recapture is taxed at your ordinary income tax rates, which can be up to 37%, and another part is taxed at rates up to 25%. This is typically from recapture related to the building itself or straight-line depreciation over 27.5 or 39 years.

As an investor, you’re typically exposed to both of these tax events. So how can you mitigate this as a limited partner? Well, you’ll want to take a look at your Form 8582 on your tax return, Form 1040. This is where your passive activity losses from prior years are reported. If you have enough losses on Form 8582 to offset or wipe out the gain and depreciation recapture from the upcoming investment being sold, then you don’t necessarily have to do much. 

However, if you do not have enough losses, you can invest in a syndicate or fund that utilizes Cost Segregation studies and bonus depreciation, as most do. These properties can generate current losses or losses in the same year that you’re selling the property, which can help offset the gain on sale from the property, including recapture. So, in a nutshell, that’s how it works.

Tim Lyons 38:25
You know, that just really brought something up to me because we’ve had the opportunity to sell deals. Well, we sold one before we became licensed capital raisers when we did a joint venture. And we thought about doing a 1031 exchange for us and our investors. We ended up not doing it. But one of the options as an LP is if the operator or the sponsor that you’re working with, who’s selling the property, might have another deal in their pipeline where they can offer you the opportunity to perform a 1031 exchange with that passive investment that you started out with. So you would sell the first one you were part of, say, five years later that was selling. But hey, now they have a brand new property, and they might offer you the opportunity to 1031 exchange your original capital and whatever appreciation that you had. Now you can do a tax deferral strategy called a 1031 exchange.

Another thing, just real quick, is a lot of people can get really hung up on 1031 exchanges. There are timelines, you have to identify properties within a certain amount of time, and you need to close within a certain amount of time. I would love for these guys to jump in on that. It can be stressful, and then suddenly you’re backing yourself into a property that maybe you don’t love and an area that you don’t love. That’s where hanging out or not hanging out, calling Cityside Capital, we can maybe have something in our pipeline that we can connect you to with a tenant in common agreement or a DST or some kind of vehicle like that. Also, your CPA might have a lead on maybe one of their other clients might have something going on. So building your team to have these resources, to have these conversations can be super powerful.

Finally, there’s something called the lazy 1031, which Thomas just laid out, right? If you sell a property and you’re facing a capital gain, you might be able to take that capital gain and shield some of that tax liability by doing another investment in the same taxable year and using the losses from that new investment to offset the one that sold. Thomas, how did I do? And can you clean up anything that needs to be cleaned up?

Thomas Castelli 40:43
No, that was great. That was good. Two thumbs up. Awesome.

Tim Lyons 40:47
So we actually had an investor, several investors do 1031 exchanges with properties that they sold, and they did what’s called the lazy 1031. Right? We’ve had them do regular 1031s and the lazy 1031. The lazy 1031 was really in conjunction with their CPAs, and their CPA was instrumental in helping us and the investor make the decision to invest because they showed, ‘Hey, look, here’s a sensitivity table. If you did a 1031 exchange, here’s the income, the proceeds you’d walk away with, here’s your tax liability, bonus, whatever it might be, right? And here’s the income and the proceeds you’d walk away with in scenario two if you did the lazy 1031. Take your head, right? But also invest that money into a new deal.’ And Greg, I don’t think it was the Delta, but it was only a couple of $1,000. It wasn’t really that big of a deal. And it was easier for the investor. They said, ‘Listen, I don’t want to have to go through the whole rigmarole of doing the identification process and the Qualified Intermediary. It’s all a great strategy, don’t get me wrong, but there are ways that you can do a 1031 without going through it.

Justin Shore 41:59
Yeah, absolutely. I’ll kind of supplement that, too. That’s a conversation that we have extensively with our clients on a regular basis. Because, you know, there are a lot of things that we can do with real estate. It may be something that costs you a little bit of money, sure, whether it’s having conservation studies done or paying a Qualified Intermediary to handle your funds in a 1031 or something like that. But then there’s also that, like, what you kind of mentioned there is the stress factor, right? The identification periods are relatively slim, and there are a lot of different options and rules for those on how much you can identify and things like that, too. But, you know, there’s a potential that temporary ones can fail. So we consult with clients regularly, ‘Hey, my temporary one blew up, what do I do now?’ So, like I said, looking at the options there for, hey, what if I do the lazy 1031 exchange? Is it going to take a huge amount of stress off my shoulders? And figuring out, you know, do you have those options? Or what if there is a cost to it? How much more in taxes am I going to pay? Or is it going to be really, really close where there’s a Delta of like 1%? Then yeah, that’s worth relieving myself of all that stress.

Tim Lyons 43:08
Love it. So we have a couple of questions in the chat. I want to start off with the first one. Basically, they’re asking if they have a couple of single-family rentals, and they’ve never done a cost segregation study, they just learned what a cost segregation study was today. Can they go back and amend any taxes? Can they go back, you know, if they’ve owned the house for I don’t know how many years they have owned the house for? But can they go back and do a cost study? Can they go back and amend taxes? And you know, how would you maybe talk to a client about doing this type of thing?

Justin Shore 43:42
Yeah, that’s a good question. Well, we see that very often. Cost segregation studies, surprisingly, are not recommended by investors, tax preparers a lot. Again, this is one of those things where if you’re not immersed in real estate all day, it might be something that wasn’t really on your radar. So we have a lot of new clients that will come in and say like, ‘I just heard about this three months ago, six months ago, but I’ve been investing in properties for five years or 10 years.’ And another one that we even hear every once in a while is that regardless of whether they’ve heard of cost segregation studies, some tax professionals will recommend not claiming depreciation at all, even straight-line depreciation. We’ve seen that before. And the mechanism we can use to fix that is similar for both of those situations. So it is possible to claim bonus depreciation in a subsequent year. I won’t go into all the nitty-gritty details, but there’s a pretty hairy calculation that goes into doing it. And also, one of the other key cutoff factors is it has to be properties that you acquired after September 27, 2017. It’s like an oddly specific date, but that’s when the Tax Cuts and Jobs Act technically went into effect. So that’s essentially our cutoff date. But that means if you bought a property even in 2019 or 2018 and you’re just now hearing about this on this podcast, you could potentially go back and do what we would call a retroactive cost segregation study to catch up on that bonus depreciation that you missed.

Tim Lyons 45:15
So just to stack on top of that, their previous year’s tax returns can be amended then and they could be facing a potential check from the government because they’re doing today what they could have been doing over the last couple of years.

Justin Shore 45:33
Right, right, potentially. And the beauty of it is you may not necessarily have to amend the tax returns. It’s possible to actually do that for it. We’re recording this in the spring of 2024. So you could be doing this on your 2023 tax return.

Tim Lyons 45:46
Cool. The next question we have in the chat looks like it has to do with the UBIT taxes. And if they’re investing through an IRA, so people who have a self-directed IRA or a solo 401(k) – well, the solo 401(k) is a little different. But let’s stick to the self-directed IRA. Many of our investors use that as a vehicle to invest in our deals and other opportunities out there. So, can they – you know, they will get a K-1, I believe, as well. How does that affect somebody who invested in that vehicle?

Thomas Castelli 46:23
Yeah, so when it comes to IRAs, as many of us, I’m sure, know, one of the benefits of investing in an IRA is not only can you potentially get a tax deduction today, depending on the type of IRA, your income brackets, etc., you can get a deduction today, but also your investments grow tax-free within the IRA account until you start withdrawing them in retirement, which is currently 59 and a half in most cases. The problem is, when you start to put rental real estate into an IRA that is financed with debt, you start to incur something called the UBIT tax. So there’s something called the Unrelated Debt Financed Income (UDFI). And most rental real estate, whether it’s through a syndicate or through a direct purchase, is going to be financed partially with debt. And within the IRA, when you do this, you’re exposing yourself to the UDFI income, which then triggers the UBIT tax. Basically, long story short, you might have a tax due typically when you sell the property, because there’s going to be a portion of this which is considered this UDFI, which is subject to this tax. So you might have some minor exposure; in my experience, it’s not really impacted people’s investments all too much, maybe by a point or two. It might knock down your return by a point or two when it comes to this UBIT tax. But it’s certainly something to be aware of when you’re investing in self-directed IRA accounts.

Tim Lyons 48:01
Greg, did you have another Q&A question come in the chat? You’re muted, buddy.

Greg Lyons 48:09
We actually had another couple of questions come over. One’s a pretty good in-depth one that I think we’ll email to you guys afterwards and connect you with the investor, because it’s a really great question. But another question that came through from Gary was, when you invest in a syndication, you don’t usually have to invest in your backyard, right? You can invest anywhere in the country, in good markets and stuff like that. But that may be an out-of-state investment. Do you have to file taxes in each state you do a syndication? And I think that was a really good question for some of the newer LPs out there. So

Thomas Castelli 48:51
So yeah, so the answer to that question is, it depends. So I’ll give a quick answer, and I think Justin might jump in to complete it. But basically, what happens is when you invest in a property out of state, you’re going to now be doing business with that state. And depending on that state’s rules and laws, you may or may not have to file a tax return in that state. Most states have laws where if you have a loss, you don’t need to file an estimate, meaning it’s not a technical requirement. However, when you do have the losses, it typically makes sense to, generally speaking, file a tax return in that state to carry those losses forward. Because what happens is when you go and sell that property in that state, you will eventually have to pay capital gains tax, typically in some way, shape, or form to that state, and those losses you accumulated throughout those years, while you maybe didn’t have to technically file a return, could be useful for you in mitigating those losses later on down the line. Now, that depends on cost-benefit sometimes, whether or not it’s actually worth it to carry those losses forward. In other cases, it may be. In some states, you don’t need to always file the returns to carry those losses forward, or in other state cases, you may need to file a return regardless. And it’s just depending on state-to-state. So that’s kind of how that works. The short answer to that question is, do you need to file in every state that you do business with? Then, it depends, just like anything else.

Justin Shore 50:22
Yeah, yeah, I would say, like I said, like most states, if you’re in a loss situation, you’ll probably be able to avoid the filing requirement. But at some point, when you start to have those states in year two, year three, or four, you start to generate a little bit of taxable income there, is when you’re going to have that, and like Tom said, you want the law of passive losses to be at least established or recorded there to be taken. And I would say, you know, when it comes to just business in general, you typically have to pay taxes in the state where it’s being generated, with real estate, it’s being generated where the property is located. So it’s always going to be like where that actual property is sitting. And what I think is very confusing for investors going into multiple states is really understanding how exactly that works, because, well, for example, California, I’ll pick on them being a really high-tax state. A lot of our clients will ask, like, okay, so should I make investments in Florida and Texas, because those are two good examples of no-income tax states. So I think it’s important to understand a little bit how this works when you have your domicile, like your residence in one state, but you’re investing in another. So let’s say you have like $15,000 of taxable income that came from one or multiple syndications that are in another state. Now in California, a really common tax rate there is about 9.3%, is where a lot of people fall. So if you’re California, tax on that would be $1,395, almost $1,400. Right? But like we said before, the state where the property is located is going to want to tax on that as well. So let’s say this property was in like Arizona, which has a particularly low tax rate, about 2.5%. On the $15,000 of income, Arizona would want to collect about $375. So what you kind of see there on your state returns is taxes being paid to Arizona, and then California calculating its tax on the same income, which sounds like double taxation. Now, what’s going to happen with most states, if that’s your home state, is they’re going to charge you whatever that tax is on taxable income, but then they’re typically going to give you a credit for the amount of taxes that you paid to another state. So a lot of people hear that and think, like, why don’t they just not want to just let the other state collect it then? And the answer is because if your state has a much higher tax rate, they basically want to be able to collect the difference there. So yeah, it looks like you’re being taxed twice. But it’s really just like your home state, if you’re in a higher bracket, is kind of catching up the difference.

Tim Lyons 53:05
Greg, I’m really happy to answer that question because we get that a lot, right? Because we have investors in almost all 50 states, and they want to know, you know, how does it affect me? And honestly, we hand them off to the CPAs and say, ‘This is a great question for the CPA,’ because, look, if this was easy, everybody would do it. But it’s not, right? That’s why you need to build out your team and have a competent CPA that understands not only your situation, but also the rules and the regs for real estate. Paul, I think you had a question come in to you.

Paul Dircks 53:37
Oh, yeah, and one thing to piggyback off of as well, you know, when we talk about passive income investments, right, in syndications, the nature of that investment is that we, as the investor, do a lot of due diligence upfront, you do all the work, all the vetting, and then you invest. And it’s a passive investment. In a certain sense, it’s almost like that as well, at least a little bit on the tax side. I think we should really convey it and bring home the point that you do the work to surround yourself with the team. And then also, there’s a handful of things that as limited partners, we can do that make it a little bit easier to execute on the tax part of this. One thing for me that comes to mind is as a passive investor, receiving K-1s. A lot of K-1s don’t show up in my inbox till March or April, and in some cases, correct me if I’m wrong, guys, but I think a lot of sponsors may have until September, September 15, if my memory serves, to even deliver a K-1. So as a limited partner, I’m incentivized, and I think you guys would agree with this, to file an extension when you file your taxes. You know, I think about how I used to be when I was filing my taxes when I only worked a W-2 before I was an investor. I just wanted to file them, get them done, and maybe get $1,000 back from the IRS. Now, at this point, I’m perfectly fine to delay filing my taxes, get all my forms, give them to my CPA team that knows what to do with them, and then realize any sorts of benefits and understand the tax picture later on down the road. So hopefully, I got that right, guys, I just wanted to ask, though, to piggyback on that point, are there any other things that you recommend limited partners do to kind of understand what’s expected of them, kind of best practices? And then maybe secondly, as limited partners, we do due diligence on different investors, different sponsors out there. Are there any things that you’ve seen from some of those that you’ve worked with, either positively or negatively, that you would encourage us as limited partners to look for when we’re vetting a sponsor or to think about as it relates to taxes and understanding what may actually come from the investments that we’re looking to make?

Thomas Castelli 55:51
Yeah, those are great questions. I think some of the biggest things to look out for as a limited partner are going to be, kind of first and foremost from a tax perspective, is just to understand that you will probably have to extend your tax return. Now, we’ve already touched on this already, but filing your tax return beyond the 4/15 deadline is customary in this space. The reality of the situation is, all of your GPs are not going to get you their tax returns and your K-1s before that date. It just, I’ve been doing this for 10 years now, and it’s never happened that well, never once has everybody got it. It’s usually just kind of prepare yourself for that. That’s perfectly okay to extend your tax return, by the way, there’s nothing wrong with that people do it routinely, I’ve been doing it for 10 years at least. So that’s the first thing just to kind of brace yourself for as you enter this world. Another thing is, you’re definitely going to want to make sure that you’re monitoring your Form 8582 on your individual tax return. That’s, again, where your passive losses will be stored, for lack of a better word, and you want to make sure it’s carried forward year to year. Believe it or not, there’s a lot of situations we’ve seen where CPAs or tax professionals in general fail to bring that form forward every year for their clients. And it can lead to potentially losing some of your passive losses to, you know, the ether, if you will. So that’s something to keep an eye out on. As far as other things, it’s really when you’re really want to sit down and review the tax section of that operating agreement and sit down to understand what you’re getting yourself into, because there’s something called a special allocation. And general partners and sponsors can use special allocations to allocate that depreciation, income expenses, so on and so forth in various different ways, which may vary from ownership interest. So that’s just something you want to keep an eye out on, make sure you’re taking a look at that, and you’re understanding how that’s going to impact you moving forward.

Tim Lyons 57:49
Well, guys, we are coming up on the hour. We’ve been at this for almost 58 minutes, and I gotta tell you, I’m just getting warmed up. But unfortunately, everybody has to get back to their day. But we probably have a bunch of questions out there in our viewers’ minds that they’re going to come up with today, they’re going to come up with tomorrow, or on the replay. And I want to encourage everybody that this is the time to really dive in and build out your team, right? Whether it’s here at Cityside Capital to find out different opportunities that might be available to you, or building out your CPA team by connecting with people like Thomas and Justin over at The Real Estate CPA. Because, you know, even if you think you have a guy or you got a girl and they’ve been doing your taxes, they did your dad’s taxes, and they did Uncle Hank’s taxes, you know, that person may not know all the intricacies and you could be leaving some resources or money on the table. Not only that, really kind of getting with somebody on your team that can help you hammer out a strategy, a game plan, a playbook, a goal, if you will. A lot of people are working remote, they want to retire earlier, they want to do all these different things, but they don’t have a strategy. So CPAs can certainly be a team member to help you accomplish those goals. Fortunately, we have a special website you can go to if you want to hop on a call and have a consultation with Thomas, Justin, or somebody on their team to run some things past them. You know, here’s my situation, here’s what I’m looking to do. Should I even go with somebody like you or you know, you know, just, oh, there’s so many different options. So you can go to www.therealestatecpa.com/cityside. Cityside is spelled C-I-T-Y-S-I-D-E. So therealestatecpa.com/cityside and you can sign up for a consultation on that webpage. There’s also some free downloads that you can sign up for. Also, Thomas has a great podcast or two of these days. It’s hard to keep up with you, Thomas, but it’s the Tax-Smart REI Podcast. And are you still doing The Real Estate CPA guys?

Thomas Castelli 1:00:02
Yeah. So the Real Estate CPA Podcast is actually the same podcast, we just renamed it. So that’s where it is today.

Tim Lyons 1:00:10
This is all going to go to you guys in your emails after this webinar concludes. So I really wanted to give a special thanks to Thomas and Justin for coming on, sharing your knowledge, sharing your time with us, and really being a part of this tribe, because people, we are in the business of supporting each other, networking with each other, building out our teams. We always say that you’re the average of the five people you spend the most amount of time with, right? And if you are surrounding yourself with high performers, tax professionals, attorneys, you know, it’s just where you need to be. So also, we are happy to support you guys here at Cityside Capital. We have a lot of exciting and diverse upcoming offerings coming through our pipeline as well. If you would like to see those opportunities, you have to hop on a call with us first. You can head on over to citysidecap.com. And there’s a button right there to set up a call, or you can send one of us an email. It’s either Tim, Greg, or Paul at citysidecap.com. And finally, we have a brand new phone number that you can call us at, it’s 844-289-1075. And you can contact Greg, Paul, or me. With that, guys, I want to thank you for your time, Thomas, Justin, Greg, and all the webinar participants. If you have any questions that come up after this webinar, please feel free to email each of us, we can get in contact with Thomas or Justin and get you an answer to your questions. So Thomas, Justin, thank you so much.

Justin Shore 1:01:45
Thanks for having us. Thanks, guys. Bye now.