So you are about ready to get things going to invest in a syndication. Now the only thing holding you back is how Uncle Sam will tax your investment.
Now I’m not a certified accountant and I encourage you to speak with your accountant regarding this (preferably one that knows about syndications).
Generally speaking, most syndications project a holding period of 5 years. Meaning you are committed to being invested in that deal for that timeframe. However, you will be receiving cash flow from your investment either monthly or quarterly throughout the hold period and once the asset sells you will receive your initial investment back plus a profit from the sale.
There are 2 types of tax buckets your proceeds from the syndication will fall under. First, the cash flow received through the hold period will fall under the “recapture tax” which is taxed at your ordinary tax bracket but capped at a maximum of 25%. If your ordinary tax income bracket is 39% then you will not pay more than 25% for recapture tax. It falls in this category because more than likely you will not pay any taxes on this cash flow received during the duration of the project because of depreciation, but will need to be paid at the end.
The second type of tax is “long term capital gains” on the profit you will make once the asset is sold. Capital gains are taxed at 0%, 15%, or 20%. For most people it is 15%. In 2022 the bracket for 15% is $41,675 up to $459,750 (filing single) or $83,350 to $517,200 (filing Jointly).
In summary, you are looking at paying somewhere between 25% for the cash flow received and 15% for the capital gains.
Let’s break this down into a deal:
- 5 year hold period
- 8% preferred return
- 2X Equity Multiple
Let’s say you invest $100,000
This means if everything goes exactly as projected you will then receive $8,000 a year in cash flow from year 1 through 5 and then in year 5 the asset will sell and you will receive your initial investment back plus a profit of $60,000.
If you add it up, you have a 2X multiple.
$100,000 (initial investment) + $40,000 (cash flow) + $60,000 (profit) = $200,000.
You will owe roughly 25% of $40,000 and 15% of $60,000.
Which, overall, is much less than if you had to pay ordinary income tax on the overall profit made.
Now you may be thinking why take the depreciation and avoid paying taxes on cash flow if we have to pay it back at the end anyways?
Two reasons we benefit from this. First, as I previously mentioned, recapture taxes are capped at a maximum of 25%. A lot of people can fall in the 39% bracket in taxes, if you were to receive the cash flow and not utilize this strategy you will be paying a high percentage on that cash flow.
Second, the taxes you would have paid in year 1 were instead paid in year 5 when the property was sold. Dollars in 5 years from now are worth less, so it is an indirect savings to you. To illustrate this further, paying 25% of $8,000 in today’s dollars 100 years from now is relatively less money than paying 25% of $8,000 today.
I hope this was helpful. As mentioned at the beginning I’m not a CPA and I don’t want this to be construed as any sort of financial advice. There are more details to consider in a real life scenario, but I’m simply using a straight forward cookie cutter deal to illustrate the 2 types of tax buckets income from syndications fall under.
If you have any questions regarding this article or you are interested in one of our offerings don’t hesitate to reach out to me.
Bernhardt Capital, LLC