Investors: How to Guesstimate Tax Losses You’ll Get from a Syndicate

Real estate syndications are on the rise and they are appealing because they offer great returns with the promise of no work.

For the uninitiated, a syndicate is a structure where a couple of people (the “sponsors”) will find a large real estate deal and raise money from investors to buy the real estate. This pooling of investor capital is called a syndicate.

Raising money for a syndicate is no easy task because investors are hard-pressed to part with their money. So sponsors highlight all the positives about their deal which is sure to include the tax benefits for the investors.

But how can you determine the tax benefits you’ll actually receive on your investment before you invest?

It’s an important question and one we are going to shed light on in today’s article.

Awesome Tax Benefits! Truth or Lie?

You’re inclined to put $100,000 of your hard-earned cash into a syndication. You’ve been following the sponsor group for years on social media and real estate forums and you feel they are genuine people. You talk to the sponsor and everything sounds great. They then mention that on top of the awesome returns, you’ll get tax benefits that are just a cherry on top.

You hesitate because you’re an avid reader of TaxSmartInvestors.

“What tax benefits are there?” you ask.

The sponsor explains they are getting a cost segregation study done and will pass significant tax losses back to investors.

You trust… but how do you verify?

By following three simple steps:

• Verify capital raised (or expected to be raised)
• Review the cost segregation estimate
• Review the operating agreement’s profit/loss allocation section

These steps will help you estimate the tax loss that you can expect to receive per dollar invested in the syndicate. You would then need to apply the passive loss rules to the investment to determine if you can actually claim the loss.

Verify Capital Raise Expectations

Every syndicate has a capital target that they are trying to raise. The raised capital will usually fund the downpayment and any initial reserves for capex and unexpected expenses as they stabilize the deal.

Knowing the total capital raised will be important when reviewing the operating agreement’s tax loss allocations. It will help you calculate the tax loss per dollar invested into the deal.

For example, an operating agreement may read “First, allocate 100% of losses to limited partners until their capital accounts reach $0. Then, allocate in X manner.”

If you know that $3MM will be raised, and we have a $3.2MM tax loss then we can re-work the above loss allocation statement so that it makes more sense to us:

“First, allocate $3MM of losses to limited partners at which point their capital account will be $0. Then, allocate the remainder $200k of losses in X manner.”

In this example, the investors are getting 100% of the losses until they have been allocated a loss amount equal to what they invested into the deal. If you put $100k into this deal, you should expect a $100k tax loss.

Review the Cost Segregation Estimate

A cost segregation study is the practice of allocating value between the land, the building, and the various components that make up the building. The purpose is to depreciate components over a faster time period than the overall building.

Logically, this makes sense. Carpet will deteriorate faster than the building structure will. So we should be able to depreciate carpet over a faster schedule.

Cost segregation companies always give an estimate of the tax benefits the study will provide the owner of rental real estate. Typically the syndicate will get this done during due diligence pre-purchase.

The estimate will show the real estate broken into five buckets:

• Land
• Building
• 15-year property
• 7-year property
• 5-year property

Currently, you can 100% bonus depreciate components with a useful life of less than 20 years when the components are placed into service.

This means that the 15-, 7-, and 5-year property can all be 100% expensed, via bonus depreciation, in year one.

On most multi-family cost segregation studies, we see 25-30% of the purchase price being allocated to 15-, 7-, and 5-year property which means 25-30% of the purchase price can be written off in year one.

Here’s where some math comes in.

Let’s assume you’re reviewing a syndicate that’s going to acquire a $10MM building. The cost seg estimate shows $3MM of 100% bonus depreciation.

Great!

But how do you calculate the actual tax loss?

By reviewing the offering documents provided to you by the syndicate and specifically the first year of operating income.

If the first year’s expected operating income is $300k and we have $3MM of bonus depreciation, we can deduce that the tax loss will be $2.7MM.

Review the Operating Agreement

Once we determine the tax loss for the deal, we have to know how to allocate the tax loss. That’s where reviewing the operating agreement comes into play.

When reviewing the operating agreement, you want to pay special attention to the Profit and Loss Allocation section and the Distribution section.

Here’s a real-life example of a profit and loss allocation section:

(1) Profits shall be allocated to the Members first to offset prior allocations of losses and then in proportion to the Percentage Interest; and

(2) Losses shall be allocated to the Members based on their Percentage Interest.

This tells you that any losses are allocated straight-up based on percentage interest. This also means the sponsor will be allocated losses (because they own a % of the deal) even though they may not have put money into the deal.

For example, assume the investors own 70% of the deal and the sponsor owns 30% of the deal. Based on the above allocations, the investors get 70% of the losses and the sponsor gets 30% of the losses.

If we continue our example of a $10MM building with a $3MM bonus depreciation from a cost seg and a first year operating income of $300k, then we have a $2.7MM tax loss that is allocated 70% to investors and 30% to sponsors.

This means a $1,890,000 tax loss is allocated to investors.

If the total capital raised from investors was $3MM (from step one above), then we can guesstimate that every dollar we invest into this deal will yield $0.63 in tax losses being allocated to an investor.

So if an investor invests $100,000, they can expect to see roughly $63,000 in tax losses.

Let’s look at another one:

(1) Profits shall be allocated to the Members first to offset prior allocations of losses, second 50/50 between investors and sponsor until investors receive IRR of 12%, and thereafter 30/70 between investors and sponsor; and

(2) Losses shall be allocated to the Members until their capital accounts reach $0, and then to Members with economic risk of loss.

This one’s a bit different.

First we have a waterfall approach to profit allocations which incentivizes the sponsor to outperform a 12% IRR because they will then get a much larger share of the profits over a 12% IRR.

Second, the losses are first being 100% allocated to investors until their combined capital accounts reach $0.

Continuing our $10MM building example…

We have a $2.7MM tax loss and the sponsor raised a combined $3MM. This means the entire $2.7MM will be allocated to members that put money into the deal.

Basically, for every dollar put into this deal you receive $0.90 back. So if you put $100k into the deal, you’d receive a $90k tax loss.

$2.7MM / $3MM = 90%. Pretty darn good.

There are other factors in operating agreements that can throw the profit/loss allocations out of whack so it’s really important that you review the ENTIRE operating agreement. Or pay your attorney/CPA to review it so that you truly understand what’s going on.

And once you determine your tax loss, the next step is figuring out whether or not you can actually claim it. You’ll need to check out future posts we have on IRC Sec. 469 – the passive activity loss rules.

Takeaways

Many sponsors of real estate syndications tout tax benefits as a reason to invest in their deal. Tax benefits generally means allocations of tax losses.

Importantly, you are able to guesstimate with reasonable accuracy what the tax loss allocation will be to you if you follow a few simple steps.

First, get the total amount expected to be raised from the sponsor. This is important so that you can determine the loss allocation on a per-dollar basis.

Second, ask to see the cost segregation study estimate or ask that the figures be passed on to you. Specifically, you’re looking for first-year bonus depreciation.

Third, review the operating agreement’s loss allocation section. How will tax losses be allocated between the members of the entity?

And that’s all there is to it!