Real Estate Fund Pros & Cons: Let’s Talk Tax Advantages

by | Jan 21, 2024

Calling all C-level execs and pros in tech. Investing in a real estate fund as a limited partner is your key to unlocking passive income without sacrificing your most precious commodity: time. 

This hands-off investment path grants partners significant tax benefits they can enjoy today, all while investing in a long-term and lucrative tomorrow. It is low-risk, low-commitment, and professionally-managed, ultimately allowing you to enjoy the fruits of investing without having to roll your sleeves up too high as a partner. 

Of course, a real estate fund comes with a list of pros and cons to consider, just like any other investment venture. However, what sets this opportunity apart from the rest when it comes to reward outweighing risk is this: even its potential negatives can be tweaked for your benefit. 

What is a real estate fund?

A real estate fund is a way for limited partners to pool their resources and purchase larger, higher-potential real estate properties under a general partner’s guidance and expertise. 

Out of all the real estate investment opportunities on the market, a fund is the most democratic. It offers investors a way into real estate projects that might have been otherwise out of reach for them, all while gaining access to professional expertise that informs lucrative, smarter decisions for the whole team. 

General versus limited partnership

While the general partner acts as the driving force of the fund—identifying and vetting potential opportunities, developing investment plans, negotiating with sellers, and managing daily property operations—the limited partners simply provide capital and collect cash flow and equity gains.

This is where professionals looking to gain capital without sacrificing free time find their sweet spot. Limited partner real estate fund investment lets you experience the benefits of property ownership with none of the challenges that come with active management. Now, you’re free to focus on you and your family while your money works quietly in the background—and you can enjoy a number of timely tax benefits in the meantime. 

The tax benefits of real estate funds

Being able to invest without frequent stress and hard deadlines is enticing enough on its own, but to further sweeten the deal, real estate funds also offer an extended number of benefits that pertain specifically to tax returns and deductions. 

  • Depreciation deductions

This accounting practice allows the cost of a tangible asset—in this case, property—to be allocated throughout the course of its “useful life.” The IRS defines this as 27.5 years for residential properties, which means you can claim a depreciation deduction against your taxable income on an annual basis. 

So, what does that mean for a real estate fund’s LPs?

While a cash-flowing property might appear to be losing money each year from a tax perspective, that loss can still be carried into future years, reducing tax liability and enhancing net returns in the meantime. 

  • Accelerated depreciation deductions through cost segregation

This strategy requires the fund to conduct a detailed analysis of the property. Your general partner will check for any components that could potentially depreciate over a shorter time period (about a 5-15-year window), which in turn helps you earn greater tax savings in the earlier years of ownership. 

Why? The present value of tax deductions is higher when they occur sooner, which means property owners can maximize those increased deductions to offset their taxable income and improve overall cash flow. 

This benefit can also offset other passive income gains, like stocks or other investments. As a result, LPs won’t have to pay capital gains taxes, and current losses are carried forward indefinitely to offset future passive income gains.

  • Mortgage interest deductions

This is one of the biggest recognized perks among real estate fund LPs. Any interest paid on the fund’s property mortgage loan can be deducted from your taxable income, which means less tax liability and increased efficiency for your return. 

  • Capital gains tax advantages

When a fund’s property is sold, the profits are subject to a capital gains tax. But here’s the loophole: if the property is held for over a year, the gains are classified as “long-term” and taxed at a lower rate than “ordinary” income. That lowered rate means higher returns just got that much easier for you to access. 

  • Cash-out refinancing

Cash-out refinancing is pretty common among investment funds. The strategy involves borrowing against the asset’s increased value, which then releases tax-free equity. These accessed funds are considered loans rather than income, meaning they won’t be subject to tax. 

  • 1031 Exchanges

The 1031 Exchange system allows LPs to defer their capital gains taxes indefinitely. This is accomplished by reinvestment: taking the proceeds from the sale of one property into the purchase of a very similar, “like-kind” property. 

  • Self-directed IRAs and other tax-advantaged accounts

Finally, if you invest in a real estate fund as an LP through a self-directed IRA or similar tax-advantaged retirement account, you might be eligible for even more tax benefits. These types of accounts offer tax-deferred or tax-free growth, so you’ll be able to maximize your investment’s return over time.

Weighing real estate fund pros and cons

Investing in anything comes with a number of potential negatives, like liquidity, high management fees, interest rate sensitivity, and the constant risk of market fluctuations.  Real estate funds are no different. However, it’s important to develop a sharp eye when taking this investment route, because what initially looks like a con might actually be something you can use to your advantage down the line. Interested in learning more about how a real estate fund can bring you tax benefits today while stacking money for your tomorrow? Contact us today to begin connecting with the future you and your loved ones deserve.
Brenda Jones

Get In Touch With Us

We value open communication and are committed to providing you with the information and guidance you need.