How I Started Investing in Multifamily Syndications, Part 3: Tax Implications
Learn alongside first-time investor Jeff Hamann as he hits a tax roadblock on investing in his first multifamily syndication.
Taxes can be complicated. That's what I've always heard, anyway. Still, here I am, nearly 40 years old, and just about every year I've been able to just file my 1040 and be done with it in a matter of an hour or two, tops.
Sure, living abroad does complicate my tax filings a little bit, but just to the tune of some extra costs and another supplemental form.
I figured investing in a syndication would have some tax ramifications, but I wasn't too worried, given the tax incentives present within the multifamily sector.
Unfortunately, taxes are the precise reason I decided not to pull the trigger on my first investment. At least, not when I wrote this in 2023.
Quick Recap: How to Navigate an OM
Last time, I took a long look at offering memorandums and what they're great (and not great) at when assessing a syndication investment opportunity.
It's not directly related to this episode, but it's a great primer if you're starting to look at actual investments. The short version, though? Don't rely solely on an OM to get the info you need. Your own due diligence is essential.
Let's Talk Taxes
Tax benefits are a big advantage for many multifamily investors. Why? Well, let's look at some of the (potential) deductions for a passive investor:
- Depreciation deductions can reduce your taxable income.
- Pass-through deductions can mean a lower individual tax liability.
- Capital gains tax rates are typically lower than income tax rates.
- 1031 exchanges can defer any cap gains taxes to begin with.
- Cash flows are generally taxed as ordinary income.
- Mortgage interest deductions mean you can often deduct interest payments.
- Property tax deductions can reduce your taxable income.
- If I reside outside the U.S., does this complicate things?
- What should I expect from the syndicator in terms of documents?
- Will I really need a tax advisor to file my taxes, or can I go it alone?
Truly, there's a lot more to expand upon here. I won't pretend to be an expert on taxes, though, so I'm keeping it brief.
My Investment Situation
So, let's get back to talking about my situation.
A good friend of mine works as a syndicator, and I'd asked him early on in my search if he had a tax advisor he'd recommend I speak with. Thankfully, his business partner is actually a CPA who specializes in real estate investment (especially with syndications!), so I was off to a good start.
I booked a call with this guy — and we had a quick Zoom call a week or so later.
I had a list of questions I was ready to ask him. Such as:
The Investment I'd Selected
I also should mention a bit about the actual investment I'd decided to pursue. Now, because OMs are generally given under a confidentiality agreement, I can't really disclose any specific details — but I'll try to paint a general picture of the deal.
First, unlike many or most syndications, this wasn't for common equity in a property. Instead, it was for preferred equity in a property the syndicator already owned. Basically, they were looking to do some heavy renovation work to drive appreciation and higher rents in a high-growth market, and this capital was their way of doing just that.
I knew the market very well, and the property checked out — both from what the OM gave me, and from my deep analysis of the property and sales comps on my own. Plus, the asset had a huge equity cushion, so I was confident I was getting my full return, even if for some reason the property took a major valuation hit.
What Went Wrong
So, I had my call with the CPA. He was incredibly helpful with all the questions I had, plus in just walking me through how taxes work.
In short: My tax situation actually isn't made any more complicated by living outside the U.S. (phew), I should probably go with a proper accountant at least initially (okay), and the syndicator will need to give me a K-1 to show my income every year, starting with tax year 2023.
Wait, I said. 2023? But I wouldn't get any actual cash flow from the property until the first quarter of 2024.
He told me that didn't actually matter — the document is necessary for every tax year in which I'm invested in the asset. Yep, even if I don't earn any return during that year.
This is what derailed this specific investment for me. The syndication was raising capital through the end of 2023. If I invested before December 31, however, my tax filing costs would have gone from nil to a few hundred dollars — and I wouldn't really have sufficient incoming revenue from the investment (in 2023) to justify that. Basically just a couple weeks' worth at the end of December.
Honestly, it wasn't a huge deal breaker, but I figured: Why complicate my life (and increase my costs) for no reason?
If a deal doesn't tick all the boxes for me, there's no need to bend myself backwards to make it happen. Sometimes walking away is just the best choice, especially when I'm now getting a lot more deals in front of me. It's a good lesson to learn, really.
The syndicator was understanding, and they mentioned they'd have a similar deal to put in front of me come early 2024. Count me interested — but I'm also examining a few other investments in the meantime.
What's Coming in Part 4?
This all kind of went sideways from where I'd imagined it going when I started writing this series, so it's hard to know exactly where the next episode will take me.
Tentatively, I'm imagining a piece focused on identifying a good syndicator. Assessing a property is one thing, but the syndicator is also a critical element of the investment. I'd much rather have a good investment team with a bad asset than a bad investment team with a great property.