157 Can An Investor Realize Pass-Through Tax Benefits In A Fund? | Hard Money Lenders

Home / Hard Money Lending / 157 Can An Investor Realize Pass-Through Tax Benefits In A Fund? | Hard Money Lenders

157 Can An Investor Realize Pass-Through Tax Benefits In A Fund? | Hard Money Lenders

Every Thursday at 1:00 PM Eastern, join the Carolina Capital team LIVE for the Passive Accredited Investor Show!

You can join Bill, Wendy & Jonathan, LIVE every Thursday at 1 PM Eastern as they discuss different topics in the Passive Accredited Real Estate Investor world.

This week Bill & Wendy will be answering this:

“Can an investor realize pass-through tax benefits in a fund?”

Timestamps:

0:01 – Introduction

0:53 – https://www.CarolinaHardMoney.com

1:20 – Wednesday with Wendy: https://calendly.com/wendysweet/wednesdays-with-wendy

3:04 – Can an investor realize pass-through tax benefits in a fund?

3:38 – What does passive investment mean?

23:02 – Does your fund generate depreciation?

Carolina Capital is a hard money lender serving the needs of the “Real Estate Investor” and the “Small Builder” borrower who is striving to build wealth and generate income for themselves and their families. We offer “hard money rehab loans” and “Ground up Construction Loans” for investors only in NC, SC, GA, VA and TN (some areas of FL, as well). North Carolina hard money lenders and South Carolina hard money lenders.

As part of our business practices, we also serve as consultants for investors guiding them to network with other investors and educating them in locating and structuring transactions. Rarely, if ever, will you find a hard money lender willing to invest in your success like Carolina Capital Management. North Carolina hard money lenders and South Carolina hard money lenders.

Listen to our Podcast: https://thealternativeinvestor.libsyn.com/

Subscribe: http://thealternativeinvestor.libsyn.com/rss

Visit our website: https://carolinahardmoney.com

YouTube Channel: https://www.youtube.com/channel/UCYzCFOvEt2n9TchgECLwpww/

Facebook: https://www.facebook.com/CarolinaHardMoney/

Bill Fairman

00:00:00

Hi, folks. Have you guys ever wondered if you can take tax benefits and pass them through being an investor in a passive investment?

Bill Fairman

00:02:29

All right. So we had Mike Zlotnick with Tempo Fund, Tempo Growth Fund and he’s also got another Tempo Fund. But anyway, BigMikeFund.com

Bill Fairman

00:03:04

Some of the things that we were discussing were the way to pass through tax benefits to the passive investors. Is it possible? And you know, I hate getting into the weeds with these things, but this is something that people need to understand. If you’re getting any type of a tax benefit that is passed through on a passive investment,

Jonathan Davis

00:03:30

And what does passive mean?

Bill Fairman

00:03:37

So, “passive” means you’re investing in something that is providing you an income that you have no control over, no management. You’re not swapping time for dollars.

Jonathan Davis

00:03:49

Yeah. Is there an hour limit as well? Like you have to show that you haven’t worked so many hours.

Bill Fairman

00:03:55

I’ll get to that in a minute.

Bill Fairman

00:03:56

But if you are actively employed, you can be actively self-employed with one industry and you’re getting income from that. That does not count as passive income. Only passive income from investments is going to count as passive income, which means in short that if you have, for example, a property that you’re depreciated, you’ve got stuff you’re writing off, you got values you’re writing down, all those are tax deductions, but it’s only against other passive income.

Jonathan Davis

00:04:38

So you can’t take deductions from active income and put it against passive.

Bill Fairman

00:04:44

Right.

Jonathan Davis

00:04:45

And vice versa.

Bill Fairman

00:04:46

Let’s say for example, you’re a dentist and you have active income from your dental practice.

Jonathan Davis

00:04:53

Okay, so it’s active income is typically W-2 income. I guess it could be 1099, too.

Bill Fairman

00:04:58

Or it can even be a K-1, but if it’s your business, that’s active income. However you get paid through your dental practice. And a lot of it sometimes depending on how the structure is set up, it could be just owner draws. That’s still an active income. But you’re invested in a syndication or there’s property ownership in it. And it is a – we’ll call it a value-add syndication. So this is going on for 5 or 6 or 7, 10 years.

Jonathan Davis

00:05:32

You’re buying it. You’re adding value in the first year or two. And then yeah, the sponsor is, and you’re participating,

Bill Fairman

00:05:39

Right? So you have cash in it. And over time they can pass through some of these write-offs if you’re getting depreciation right down in values because, and we’ll get to that in a minute, with some IRA stuff, too. As you’re trying to add value, you’re actually going to lose value during the process because when you buy it, you’re buying it and it’s got a value attached to it based on the current appraisal that is purchased. Then as you’re rehabbing or making this place a little bit better, you’re going to lose income. You’re going to because you’re paying more to bring it up to standards.

Jonathan Davis

00:06:21

So you’re talking about an income-producing property. So it went from producing X as a functioning place that needed repairs. Now, it is not functioning at all. It’s being repaired. So there’s work, there’s less income.

Bill Fairman

00:06:35

Or it could be that you haven’t lost any people, but now your expenses are higher than your income.

Jonathan Davis

00:06:41

So if it’s based off of an NOI and a cap rate, your value has gone down because your net operating income has plummeted because of your repairs.

Bill Fairman

00:06:49

Yeah. And in most cases you’re losing tenancy because you have to go in and repair places and they can’t operate while you’re repairing.

Jonathan Davis

00:06:55

Well, tell them how that’s a good thing.

Bill Fairman

00:06:57

It’s a good thing because you’re passing through these lower values. The one thing that comes to mind is if you have a traditional IRA and you invest a hundred thousand dollars into this fund, that’s the value of your investment. And two years later, they’ve had to write the value of that property down because it’s not getting as much income. That would be a great time to convert your traditional IRA to a Roth because you had to pay tax on the money from the traditional IRA because it was a tax deferred when you were putting the money aside.

Jonathan Davis

00:07:39

So let’s say it lost 20% value.

Bill Fairman

00:07:42

So now you’re only paying taxes on 80,000 instead of the hundred.

Jonathan Davis

00:07:46

And then in that Roth. So you’ve just paid taxes on that 80,000. And then when the income comes back up and let’s say the value goes above a hundred thousand, then that is all tax-free, correct?

Bill Fairman

00:08:02

Yeah, now it’s a Roth. So it’s tax-free from then on. So you’ve saved money on the conversion because you’re not paying taxes on as much money. And then at the same time, everything else you make in the investment is tax-free. 

Bill Fairman

00:08:23

This scenario only applies to somebody that is investing with an IRA-

Jonathan Davis

00:08:25

Into a value-add scenario, typically. Right?

Bill Fairman

00:08:29

Correct. The only way that’s going to help you is if the value goes down and if the value goes down and it’s not a value-add scenario, you’ve got issues.

Jonathan Davis

00:08:40

You don’t want to be in that.

Bill Fairman

00:08:42

Cause we knew in the value-add scenario, this is common. It happens almost every time. You’re going to get into a place where the value is actually less. And every year with your IRA, you’re required to turn in a fair market value for them, or at least your fund sponsor or fund manager is doing it for you.

Jonathan Davis

00:09:04

One of the easiest examples would be multi-family, right? You see a lot of syndications people investing in a multi-family. Someone buys a multi-family that’s, let’s say, it’s 50% occupied, but it needs all the units renovated. Well, they start kicking people out, you lose occupancy. So then, if you’re the sponsor of that project and you have self-directed IRA people in it, once you knock all those tenants out and start injecting capital into that project, you want to re-evaluate the value of that property, which will be less than what you purchased it for because the income’s less. And then, as you fill it, you do the repairs, you fill it back up, the income jumps back again. And hopefully these people have converted to a Roth with lower values and all their gains are realized, tax-free. That’s beautiful, Bill.

Bill Fairman

00:10:01

Here’s another scenario. And this is where you get your pass-through depreciation. So, let’s talk about a self-storage facility and you’re doing the same thing. You’re still getting a value-add of some sort because no one is going to, well, most people are not going to buy a fully-functioning, turnkey storage unit, unless you’re in a REIT.

Jonathan Davis

00:10:29

Well, a fully functioning, turnkey storage unit. What are those? Those are like trading at like a four cap with three cabins. You know, unless you’re in a hurry, you can’t afford it.  

Bill Fairman

00:10:38

When you’re in a private placement syndication type of thing. It’s always going to be about value-add, unless it’s just in a really high cap rate area. But that said, you can do what’s called “cost segregating.” And this is where you have, for example, you’re going to depreciate property over time. You’re able to go in and appreciate or depreciate items that wear out faster than other items. So you have these specialists that will come in and say, for example, the rolling doors. The rolling doors at the units are going to wear out a lot faster than, say, the concrete floors.

Jonathan Davis

00:11:23

Well, cause, what’s the typical depreciation schedule? Is it years? 35

Bill Fairman

00:11:27

I mean, you can speed them up and do, like, 20 years, but it’s a pretty long time.

Jonathan Davis

00:11:33

Yeah, so like, you can get like rolling doors. They have a life expectancy of 5 years.

Bill Fairman

00:11:37

Yeah, whatever the life expectancy or they, I think they call them a useful low, useful timeframe or whatever it’s called. Anyway, once it’s past that useful life expectancy, you can go ahead and depreciate that upfront. So you’re able to take the depreciation faster and it’s good for the project, but it’s also good for the investors because they can take those depreciation benefits and pass them through to the investor themselves. Here’s the problem. Again, if you don’t have passive income, it does you no good.

Jonathan Davis

00:12:19

So you get all of that, but you have no passive income to- So where do you get passive income from?

Bill Fairman

00:12:32

We always teach people and everyone should know this anyway, and you need to be diversified in anything that you’re doing. You can be very diversified in the real estate space. Notes, lending, they have zero-tax benefits, but there’s plenty of ways you can get passive income from those.

Jonathan Davis

00:12:54

And you said something, we talked about the hours before to be passive.

Bill Fairman

00:12:59

Yeah. I’ll get to that in a minute. 

Bill Fairman

00:13:04

So if you’re in the lending space, there are no tax benefits. So if you have a passive investment in lending, somehow, typically you’re going to get a K-1 and you’re going to pay tax on it. Now it used to be the only way you could overcome that is by having it in a tax-deferred or tax-exempt vehicle. Right?

Jonathan Davis

00:13:27

Correct.

Bill Fairman

00:13:28

Now back to the number of hours spent. In the Trump tax, I guess the new tax plan he had in 2017, they made some adjustments to lending and considering it an active income. And so they basically said that you may be subject to active income, even in a passive investment where you have no control, but they put a timeframe on it.

Bill Fairman

00:14:02

If you spend more than a hundred hours a year, it’s considered active income. If you spend 99 hours a year, it’s passive income. So those people who were taking their IRA personally and lending money out, make sure that you’re only spending 99 hours a year or less, or that’s gonna have a UBIT situation.

Jonathan Davis

00:14:30

What’s UBIT?

Bill Fairman

00:14:30

Unrelated business income tax. And that tax is at 45% of the profit.

Jonathan Davis

00:14:38

That’s pretty low.

Bill Fairman

00:14:41

But, again, I don’t want to get into the weeds with all this kind of stuff, but there’s other ways that you can offset that. And it’s the same kind of a tax that you would get if the fund had leverage on it, as well. And that’s for another time.

Jonathan Davis

00:14:55

So if you are in a fund that invests in real estate on the debt side. And you’re an equity member of that fund. You’re getting passive income from that fund?

Bill Fairman

00:15:08

Yeah, you’re getting passive income, whether you’re a debt member or an equity member.

Jonathan Davis

00:15:14

Okay. But if you’re a debt member, if you spend more than a hundred hours doing anything on reconciliation, it’s then active. 

Bill Fairman

00:15:21

Yeah. Well that would be the same on the equity side.

Bill Fairman

00:15:26

If you’re a passive investor, it’s highly unlikely that you’re spending more than two hours a year. It’s all investment. If you’re somebody that is actively investing their own IRA money to individuals, you could spend a lot more than a hundred hours a year, keeping up with your investment because it’s your investment. I know it’s not yours, technically, it is the IRA and it’s not the benefit of you, but you’re the one controlling it and you want to keep up with it. But if you’re the one doing the inspections and walking the properties and all that kind of stuff, when you’re lending this money, it could get up there. Just make sure you don’t spend more than 99 hours a year.

Jonathan Davis

00:16:15

Which is a great reason to buy notes with your self-directed IRA and not originate them.

Bill Fairman

00:16:21

Well, that’s true, too, but you still have due diligence that you have to do. Just make sure it’s quick. So I’ve kind of lost my place now, but so well when we get to the spreading of the wealth, so to speak, so to be able to offset your passive depreciation, if you are invested in, say, a syndication that holds real estate, and then you’re invested in some sort of a lending fund that has no tax benefits, you can at least take those tax benefits to offset the income that you’re getting in the passive lending fund. So one of the things that people worry about with a lending fund is that they only want to invest IRA money in it because there’s no tax benefits, but that’s not really true. If you have investments in other things that have tax benefits that are passed through passively, then you can use those tax benefits to offset the income that you’re getting on the cash that you have in these funds. I know we’re getting into the weeds in this, but it’s something that really needs to be said. You don’t always have to invest in a fund that doesn’t have tax breaks with an IRA with a tax-deferred or tax-exempt account.

Jonathan Davis

00:17:46

Is it like your mileage may vary? I mean, everyone has different scenarios, but if you have cash locked up and other things that have tax benefits, but you’re still sitting on some cash that you’d like to be invested passively, you could put that in there and they can offset each other.

Bill Fairman

00:18:02

The point here is that you need to be diversified in real estate holdings and as well as other means, which would be the lendings I had, owning notes, maybe even tax liens. All those things, there’s all kinds of avenues in the real estate side of things that you can still be very diversified and still be in the same space.

Jonathan Davis

00:18:25

What is it? What is it? 9 out of 10 millionaires got their wealth from real estate. Yeah.

Bill Fairman

00:18:31

Again, on a lending fund, they don’t own the assets unless there was an issue and they’re not going to own them long, but it’s still part of the real estate and the assets that the lender is lending upon are going to continue to go up in value. So it offsets your risk, gives you a good margin, and at the same time, it kind of offsets inflation issues. And there’s another thing, too. Inflation. How are we able to overcome inflation going forward? Well, one of those is to be in a fund that allows you to calm down your returns, correct? Because even though profits are typically going up in an inflationary, it depends on the industry obviously, but your profits should be going up and then rates that those companies are charging should be going up to offset that. Really the way to overcome inflation is by compounding overtime.

Jonathan Davis

00:19:33

I mean, it’s beautiful. You can take distributions in a fund that gives you 7 or 8% and you can take those quarterly or monthly distributions and make that cash. Then what do you do with it? You spend it, or you can compound that. And probably like a 10-year period, it’s going to be like 13 to 14%.

Bill Fairman

00:19:55

Yeah, you can have a low-single digits or low to mid-single digit return. I’m sorry, double digit returns with compounding. But you know, the same thing holds true with your investing in property holdings. You’re assuming that those property values will also go up over time. So you’ve got the benefit of the tax breaks through the property holding investments. Then you can pass those through to your lending passive returns. And then at the same time, the values of those property holdings are going to continue to rise in most cases. Again, we just went through a pandemic where certain property types were taboo and those values went down. But what happens when some people are disappointed, other people benefit. So now they’re taking those properties and redeveloping and something else. Now, if you were holding those properties, you’re the loser. But on the other side, you can benefit from somebody else losing. There’s always going to be winners and losers. You cannot control what you can’t control.

Jonathan Davis

00:21:02

And you will not always be a winner in real estate.

Bill Fairman

00:21:05

Yes. Most of the time you will, but not always. Okay. I’m sorry. I’m sure I confused most of you, but if you have any additional questions, we are happy to answer them. You got anything else you want to add?

Jonathan Davis

00:21:21

No, I think you did great, Bill. Yeah, I understand.

Bill Fairman

00:21:24

Numbers are boring. I’m sorry. I have to say that, but they are. But I love ’em. This is why you are dealmakers or deal architects. You have to think about these numbers and make sure that you’re benefiting the most you can from not paying.

Jonathan Davis

00:21:42

Because it’s not how much you make. It’s how much you keep. And by employing the best tax strategies, you keep more, which is what you want to do.

Bill Fairman

00:21:53

Absolutely. Folks, thank you so much for joining us on the Passive Accredited Investor Show. 

Jonathan Davis

00:22:11

I do have one question from Louise.

Jonathan Davis

00:23:01

Does your fund generate depreciation?

Bill Fairman

00:23:04

No, because our fund doesn’t hold any real estate. We just lend on real estate. So if you want depreciation, you have to own a property.

Jonathan Davis

00:23:18

Correct. So a syndication or into a fund that owns real estate.

Bill Fairman

00:23:24

But our point to this was, we wanted to make sure that if you’re going to invest in anything in particular because you think you’re going to have tax benefits and they do have tax benefits, but you can only utilize them if you have other passive income to offset those. That’s all. So if you’re a W-2 employee in a job and you have tax benefits or tax depreciation, any of that stuff from property holdings, and it’s in a passive nature, then it doesn’t do you any good.

Jonathan Davis

00:23:59

Exactly, you’d want to split your investment up between passive and active.

Bill Fairman

00:24:03

Now, if you own the property yourself and as part of your businesses, then you can certainly offset your active income with that. Does that make sense?

Jonathan Davis

00:24:12

And another question, can you give historical returns on your fund over the last three years?

Bill Fairman

00:24:16

I would love to in person, but because SEC rules, I can’t. If you’ll shoot me an email at Bill@CarolinaHardMoney.com, we can have a more private conversation about that. Okay, folks, have a wonderful day. By the way, we did have some breaking news, but nothing changed.

Jonathan Davis

00:24:36

The news is broken.

Bill Fairman

00:24:36

Unemployment actually did go up a little bit and it was kind of unexpected, but it’s all going to fluctuate and it’s all good. 

Recommended Posts
Contact Us

We're not around right now. But you can send us an email and we'll get back to you, asap.

Not readable? Change text. captcha txt