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Tax Smart Real Estate Investors Podcast
MLRE: The Hidden Tax Problems Inside Real Estate Syndications
00:23:56
In this episode of the Major League Real Estate P…
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- [00:02]
A
Welcome to the Major League Real Estate Podcast. A podcast for large scale real estate portfolios. My name is Nathan Sosa and I'm your host. Together with my co host, Tom Castelli, we talk about tax and legal strategies and we bring on operators of large portfolios for in depth discussions on how they grow their business and this tax strategies behind what they do. We hope you enjoy. Welcome to another episode of the Major League Real Estate podcast, of course, joined here by Tom. And let's do actually a temp check, Tom. And that's what I'll say is I basically ordered this like this running sweater last week and I was like, man, I'm not going to get to wear it because it's the summertime now. So I'll just wear it in the fall. Like it was like super percent off because it dropped into 40 degrees last week. So I actually got some good, good use out of it. Tom, what's temp check where you're at?
- [00:49]
B
It's definitely getting to the summer heat here in Miami. It's 84 degrees right now with a high of 87, a low of 79. So yeah, I was out this weekend and it was like, it was 88 degrees, it was hot. It's so it's hot here in Miami right now.
- [01:03]
A
Okay. Yeah, so we're getting in the summertime, right? It's going to be fun stuff and everyone loves summertime, so we'll do that. But point of today's episode is kind of just like describe in our opinion of what happens when you mix CPAs with syndicators. And what I mean is like basically how do they work with each other? How do they create a long term partnership of how CPAs integrate with you, right? What a good CPA, good advisory CPA integrates with you because look, there's a lot of times people just go get their tax prep done and that's like they should get their tax fins done and their K1's out. I totally get it. That is the hardest part at this moment. Right. For you guys. But there's a lot of times where you could have integrated someone a little bit better, where you could have used them as your bench. Right. A lot of people do this already through attorneys a lot of times, right, Tom? They integrate their attorneys. But how can they integrate a CPA also be on their bench in a more effective manner?
- [01:52]
B
Yeah. So CPAs are not just about preparing tax returns. Right. There's more to it than just that. And I think a lot of syndicators, they think it's just about the K1s and we need to get the K1s out. And that's a very important part of what CPAs do. So I'm not discounting that by any means, but there's a lot more that goes into it beyond getting the K1s out the door. Right?
- [02:11]
A
Real estate syndication tax is confusing to you? Well, that's why hopefully you listen to the podcast today. Also you should go to our website www.the realestatecpa.com and you'll be able to get access to the Ultimate Guide to Real Estate Syndicators and Sponsors which breaks down everything from a preferred returns, depreciation strategies. Whether you're a GP or an lp, Avoid costing mistakes and maximize your returns. Download the complete guide free and get the taxpayer you need to succeed.
- [02:38]
B
When you're doing a syndication, there's very complex tax related issues that you might be facing. Whether it's special allocations of depreciation within the operating agreement or other special allocations you might be doing. Or it is determining whether or not you want to go into a deal offering a 1031 exchange option down the line for your investors. Or maybe you're trying to take in money as a tenant in common alongside your syndication. There's all these different types of tax elements that impact your syndicate or fund and you need a cpa. You can not only of course file the tax returns, it's very important again, but help you navigate these waters and help make sure that you're setting everything up for success and that you're navigating things as the deal goes on.
- [03:21]
A
100%, right? Tom, that's like we're meant to be part of your bench, right? Like you've got a team that you are somewhat quarterbacking and then you want us to own the tax piece of it, the tax and the accounting piece. Because the highest cost that your fund is going to ever have or your investors will have are taxes.
- [03:38]
B
Right?
- [03:38]
A
You as a GP and then you're also your LPs. And so you try and figure out solutions to reduce that cost of taxes. And that's where the CPAs come in. So what can the CPAs do? How can they help with that? Well, one thing they can do is preformation. They can help you with the entity and operating agreements. Right. And Tom, how does, what does that exactly mean actually? And then we can help out with that type of stuff.
- [04:00]
B
So the first thing is entity structuring, right? There's a few different types of entity structures out there for syndicates and funds. But, you know, they're all relatively common, right. You typically want to make sure that it's going to be a partnership. Right? That's first and foremost. That's what's most common. There are some, and we talked about this on a recent episode, some limited use cases where using an S Corporation or C Corporation could make sense in certain aspects of that entity structure. For example, C Corporation could be a blocker entity for your foreign investors who might be subject to certain U.S. taxes. Right? That might make sense. But generally speaking, you want to make sure you have your CPA looped in on your entity structure to make sure that's all set up well from a tax perspective, and you're not doing anything that might cause unanticipated consequences for you or your investors. The other part of it is the operating agreement. Of course, the operating agreement is like, kind of like the governing document of that partnership. And what's in that operating agreement is how that partnership should legally be operating. And within that operating agreement, there's a tax section to that operating agreement. Now, what a lot of attorneys do, and attorneys are really good at making things compliant from an asset protection standpoint and making sure you're covered from a liability standpoint. But when it comes to taxes, not all securities attorneys are going to go in there and update the tax language to reflect the outcomes that you and your other sponsors or your partners perhaps want to do for the deal as it relates to you and your LPs. One of the main ones being special allocations, a big one. Right. So you want to allocate depreciation, for example, in a way that's not in accordance to the ownership percentage. Right? So typically in a partnership, if you own 50% and somebody else owns 50% or 20 or 2% each, whatever the case may be in the syndicator fund or less, whatever the numbers are, that's typically how the profit, the deductions, the credits, everything is allocated along those lines. But within a partnership, you can allocate that stuff differently. And that's all kind of outlined in the operating agreement. I can't tell you how many times I speak to somebody and they're like, oh, this is what we're doing on the tax side for this syndicate. I'm like, okay, sounds reasonable. Pull up the operating agreement. And it's just not at all what's actually happening. So it's really important that that operating agreement at the tax sections actually reflect the outcomes that you want to drive.
- [06:13]
A
You're totally right, Tom. And that's like, like I said, like, I think a lot of times people think, oh, well, my attorney should be able to write this. And they can, they can do. Attorneys do basically everything in the operating agreement, right? And they're pretty good at doing everything in the operating agreement. The only thing that we think that they need help on is a tax section, right? And also a tax attorney. A tax section is really, really important to do everything Tom just mentioned, right? And figuring out, well, what happens when you get to X, y and z point, right? Well, does liquidation follow what is happening in contribution? Right. And like there's so many categories to consider there. And also factoring in, like you mentioned, do you want to do a 1031, do you want to have that optionality, right. That needs to be in the operating agreement and also needs to be let to your investors know. And so those are questions that not all tax attorneys ask because they're not involved in that type of stuff. So just FYI there. And in our last episode we had the syndication attorneys on and they talked about the differences between 506B and 506C and why does that matter, etc. What's important there? And hey, it's getting accredited investor letters, K1 distributions, right? How can you can actually fundraise? It's important because a good CPA will help you own that outcome and have a conversation with you about, hey, what are you doing? Right? How are you doing this? How are you structuring this? And if you've not considered considered it, or you are considering it, but it's also just a good reminder to have someone that knows that type of information with you, right? Then you also, you get into really complicated issues. If you have foreign investors jumping in with you, right. That gets really complex really fast. And so you need someone that helps you understand. Sometimes you gotta have withholding when you take distributions out. Sometimes you have to send special 1042 S's right. And send those out to people. There's just a lot unknown holes, Tom, that I think that a lot of times the syndicators don't realize that they may or may not be stepping into. They need someone that can actually be on their bench from that perspective.
- [07:54]
B
Yeah. Yeah. At the end of the day, I think things are more complex and nuanced in accounting and tax than I think a lot of people realize on the surface. But I think in today's day and age, with between social media and AI and just general, the fact that not everybody's accountants, that there's a lot of things that go on that just people don't quite realize. And you do need somebody who's experienced, especially when you're dealing with other people's money. And you're going to be a steward of other people's capital. You want to make sure you have the right people on your team. And having a CPA who has experience in syndicates and funds not only for the tax return, but for these other elements that we're talking about here, it cannot be underestimated. And when it comes to bookkeeping, I'll say this, being an accountant at an lp, having talked to as many syndicators as I do, when I hear the amount of syndicators that don't have their accounting under control is alarming to say the least. As an lp. Can't tell you how many times I get on a call with somebody, they have no bookkeeping system, right? So all in some spreadsheets that they update once a year, once a quarter. And I'm like, your steward is somebody else's money and you don't have a professional bookkeeping solution in place or an accounting solution or other times someone has like an office VA that they hire like a VA from wherever. An office manager with no accounting background doing the bookkeeping for a major syndicate with sometimes millions, if not tens of millions of dollars raised is just insane to me. It's like another one of those underappreciated things that accountants can do for you and is keeping good books and records that's the foundation of any business. And if you're raising money and taking other people's capital, it's your duty to have that type of professional system in place. And again, I can't. I get why people do it, right? When you're just starting out in the syndicator fund, you want to try to manage expenses, right? But at some point, you know, again, if you're raising money from people and taking other people's money, having an accounting system is a non negotiable. Like if I ever found as an LP that you had no accounting system and everything, anything went wrong, I'll be trying to see if there any way illegally I could sue you for negligence. Because it's just that, that's what it is, it's negligence. So making the big deal, because it is a big deal. Okay, it is. So that's another element of something to consider where a CPA can help you.
- [10:09]
A
Dom, I totally agree with you. Right. Like I think actually it's like funny is that you talk to people like oh yeah, I'M running off a spreadsheet. Like, that's like $5 million you got right there that's running off a spreadsheet. And then you go, yeah, well, we made this one entity, then we rolled into this other entity and like, oh, okay, well, that's like two tax returns. And they go, oh, well, can't you just make it one? And the answer is no, we really actually can't. If you want us to do this legally and correctly. Right. And then talk about legal stuff. Right? And you want to avoid that. And so this FYI, there are things we have to do from a legal law perspective. I totally agree with Tom. That is an incredibly important part and might be the most important piece to be considering on the front end. And so the next thing to think about is, like, how does the CPA jump into the capital raising closing? Right? And what I'll say there is, like, honestly, we don't do a whole lot because we can't help you do the pitch. Now, what we can provide is comfort on the pitch, right? If you're promising a certain bonus depreciation number, we can be on there and say, hey, that's a pretty good estimate, right? We can review that information. Say, that's pretty good estimate. Or we say, hey, the timing of that should be changed. Maybe you should do that in year two, not in year one. And here's why. Right? That's when we can step in to have a conversation. Right? If you need a cost segregation study, we can get you covered from that perspective, too. Also, just talking about if you're having someone that's like trying to bring in property or trying to bring in not dollars, but property, what does that look like? Right? That is all part of the capital raising closing piece that I think is really important. And then of course, the most important part. We've kind of talked about this already, but on the raise, what is the actual acquisition structure look like? How are you getting money in? Are you using tenants in common under a partnership? How are we doing? Potential drop and swaps or debt, even an option on the table? I think there's a lot of questions that people need to be asking, Tom, that I don't think people ask enough in a capital raise perspective either.
- [11:57]
B
Yeah, no, there's definitely a lot of options that are out there for you. And like, if you're going to be bringing in money from a tick structure. So one of your. One of your investors did a 1031 exchange on a property they own, and now they're going to be trying to bring that money in with you alongside your syndicate, there's an entire revenue proclamation, I believe it's Rev Proc 2002-22 that deals with that, that if you're not aware of all the nuances on how to structure that, you could be running into some issues. So that's why it's best to get somebody in here to help review all your options up front. Because a lot of times things can be really easily. Oh, and I don't say really easily, but it's easier to do things the right way on the front end than to try to fix things in the back end or implement things later on when they would have been better off, considered and, and moved through in the beginning.
- [12:41]
A
Nope, I totally agree with that, Tom. Like, it's just like, like, look, what is having the C, having the CPA with the GP in this instance, why does that matter? It just like creates more context, right? So you have another person who is knowledgeable in a space, maybe you're super knowledgeable in tax, if you've done your research, done what you need to do, that's awesome. But it's always good to have one more person look at the situation and actually ask if it's correct or not, right? I'm sure in today's day and age you're using a lot of AI for this type of stuff, which I'm an AI person too. But it's always good to make sure that the CPA can sign off on what the AI is saying and telling you what it's actually prepared and be like, hey, there's actually a mistake in this, right? FYI, having the human set of eyes on something that's auto generated. So just FYI there. And then when we get to the operation side, right, what happens there? So how we normally think about how that works is basically what are you doing, right? What are you doing throughout the year? Are we tracking your basis? Are we talking about, hey, is that like what happens when you do the refinance, right? What does that look like? What are some pitfalls that exist when it comes to doing a refinance? Proceeds disguise sales, et cetera. What happens if you have mid year transfers, Tom? What happens if that happens?
- [13:46]
B
That's what they bring us in for, 100%, right?
- [13:49]
A
I totally agree. And then also state filings, right? That's a massive piece of the puzzle. If you're having multi state investors and you're having multi state properties too that a lot of people don't think about. Like this difference between composite Filings, non resident filings, how should this income be apportioned? It's all incredibly applicable and it just needs to be thought about on the front end or being considered on the front end when we go to do tax return prep, which I think we'd like. That's another thing we should talk about here too, Tom, is like what happens in the K1 season, as we like to call it.
- [14:17]
B
K1 season is the time where your partnership tax return is completed by your CPA and then your K1s, which is the document that's sent out to all your limited partners and you yourself too, as a general partner, receive your K1s that are reported on, on your individual tax returns. So that all takes place during tax filing. Right. Right now, a lot of people, a lot of syndicators always want to try to get that out by 315. And I understand the rationale behind that. You want to get the K1s to your investors so they can file it by 415. But we would typically encourage you not to be in so hasty in doing that and trying to rush to get that all done. Because if mistakes are made, information's missing, things are done prematurely, and your investors receive their K1s, and then you have to go back and make revisions on those K1s at some later point, it could be an issue. So that's what happens during the filing, right? You're getting your tax return filed and the K1s are going out to your investors.
- [15:11]
A
No, you're totally right. And that's like, probably everybody thinks what? Like this is like one of the last parts that we're talking about here, right? That's not the only place that, see, like most GPs and syndicators think, oh, this is where you plug in, right? This is where the GP actually, this is where the CPA plugs is right here. And yes, absolutely. But that's not the whole piece of the puzzle. There's a whole lot on top. And before that, I think super valuable to consider here. And so I think it's just like, like you mentioned, Tom, it's super important to communicate that extensions are fine and they're normal and they're okay. And like, we should all just take a deep breath and realize our homework's not due on time, right? Like that basically they're like, hey, we actually can file an extension with the teacher to. Before we file our homework, actually. And so we're going to do is ask. And there's a whole easy process to ask to get that done. And realizing Especially in year one of a new project, a new fund, even a new, like spv, whatever winds up being that it's good to be able to have a little bit extra time to do that type of stuff. Why? Because that's how we make sure we get everything taken care of, right? If we find out that someone actually switched their ownership or changed their address, right? A couple of days for the deadline, easy, we can make that fixed because we have the extension and process. We have that communication in there, right? The GP is communicating with us on all that type of stuff. So that means we're on top of the ball here. So just FYI, everybody, this is definitely where CPAs plug in the most, but it's where we can also provide the most value and provide some feedback for you and your teams. And like, what all that looks like ultimately. Now we're talking like this is a longer year down the road. What happens on Exit? Right? Well, Tom, what happens on Exit? What should we be considered? What, like what I'll say first is how we built this on the front end is actually how we get to this point here at the end, right? This actually the most. It's like basically everything we do on the front end is the most important part, right.
- [16:53]
B
Sometimes you got to. You know, while not everything is predictable in a syndication, maybe the timing of the exit is not always predictable because of market conditions and things like that. You can begin with the end in mind, right? If you. If you know that you're going to probably want to do a 1031 exchange to bring your investors along into the next deal, it's best to get that set up in the beginning so that you can navigate that much more seamlessly when you get to the exit itself. Right. If you're going to be doing an installment sale, I don't really see it too often within syndications, but there are some things considerations there. Then there's depreciation, recapture, right? You want to make sure that you understand how that works and how it's going to impact your investors. And then final K1s, right? Maybe this is the most important thing here because final K1s, you have to zero out the capital counts. There has to be the dissolution. If there are DROs or there are certain ways the money needs to flow based on your operating agreement and how you allocated certain expenses and things like that up front. All that is going to be important upon the exit.
- [17:54]
A
No, I totally agree, Tom, that like the beginning and the end are some of the most important parts, right? Not saying the middle is not. There's a lot that happens in the middle, but, like, the end is also incredibly crucial on how you figure out where income is allocated, who receives what gain. If you're doing a 1031, how is that being reported and what are we doing there from an exit strategy perspective? There's so much to think about there. So I guess, Tom, the final question is, if you're listening to this conversation, how do you pick the right cpa? A lot of times people are not sure how to ask for professional services. I feel like, how do you investigate that? What have you seen on your end? And how would you as well, let's say you're an lp, you've also been a GP at times. How would you interview, make sure that the CPA is right for the job?
- [18:37]
B
Yeah. First I would start my search with CPAs that are actually in the syndication space and have experience with syndicates and funds. If you're listening to this podcast, you're listening to people who do. So that's. That's kind of the first rung. Then I, when I would go through my due diligence process, I'd be asking questions like, do you work with syndicates and funds like me? Right. That's one of the first thing I ask. If you're interviewing CPA and they tell you, no, we don't work with a lot of syndicates or funds like you, that's a red flag. I don't say it's a red flag, but they're telling you they don't have that much experience dealing with this type of thing. Right. Then I'd also ask them, okay, well, how often do you file partnership tax returns? If they tell you that they don't file many partnership tax returns, they do mostly individual tax returns. Well, now you know that maybe that's not a good fit because again, everything in a syndicated fund is based around usually partnerships. And the partnership tax law is extremely complex and more nuanced than, I think, what a lot of people would appreciate. So you want to make sure that somebody has experience with partnership tax returns. Right. Then you probably want to ask, well, how often do you review operating agreements on behalf of your clients? How familiar are you with special allocations? Have you ever helped Anybody do a 1031 exchange? What is your experience getting K1s out to investors? These are all questions that are going to be important to understand. Does this CPA firm that you're evaluating, do they have experience working with syndicates and funds? Right. Chances are you don't want to work With a CPA firm that has no experience working with syndicates and funds, you. You probably don't want to be their guinea pig. Again, we're going back to the fact that you are steward of other people's capital, right? You. It's not just your capital that you're. You're risking, right, Yourself, it's now other people's money. And you want to make sure you have the right team on board with you to play the game. And I'm not going to go hire a divorce attorney, right, to draft my syndication documents. You shouldn't probably hire a generalist CPA or CPA who specialize in manufacturing or small, just general, small business to help draft, you know, help you review your documents and send out your K1s, right? You want people who have experience doing the thing that you're doing so that they can help you and plug in in the right way. So that's the questions I'd be asking to try to gauge does this firm that you're talking to, do they have experience in this area and will they be a good addition to the team for this specific part that, that you need, which is, you know, when you're dealing with CPAs, accounting and tax.
- [20:55]
A
I 100% agree, Tom. And I, honestly, we didn't even get into the fund accounting piece of it, right? We want to focus on tax, but I think that's like asking like, hey, have you done fund accounting? Have you worked with someone? Like, like, what have you done? Because, like, that's. Honestly, it's a whole different beast when it comes to an accounting space, right? Just because some person says, yeah, I do bookkeeping and I do accounting, doesn't actually mean that they have done your size, your level before. So it's just, FYI, like, I think it's good to have a team who can help you with that piece on that conversation. I think that's really good pointers, Tom. And like, how. What they should look for, how to do that interview process and pick the right service ultimately. Tom, anything else you'd like to add today?
- [21:32]
B
No. I mean, I think at the bottom line, the reason why you did this episode today is because there's a lot of people who come to us looking for help with syndicates and funds, and a lot of times don't truly see kind of where CPA fits in. It's not just about getting the K1s out. And again, like I said at the top of the episode, getting the K1s out, filing the partnership tax returns critical to any syndicator Fund, do not get me wrong, but all these other elements that you may not even be aware that go on. Now if you're tuning into the show, the good news is we have on the MRE podcast and Major League Real Estate Podcast a whole backlog of episodes where we go through in depth. Whether, you know, it was me or Nate or Nate, Matt, whoever the case may be, going through all these different syndicate and fund issues that you may face as a syndicate fund to help educate you on what could be coming up the pipeline beyond just filing that K1. So again, CPAs is not just about filing K1s right. There's much more to it than that and that's why we did this episode today. So if you are a syndicate or fund out there, whether you're just getting started with your first indication, you're already in the middle of syndicates and funds and maybe your CPA isn't cutting the dice for you or, you know, you want to see what else is out there, see what you can do for improvement. We'd love to have a conversation with you to see how we can help. You can fill out the link in the show notes to request a discovery call and we'd love to have a conversation to see how we can help you and your syndicate and fund take it to the next level or get off the ground if you're just launching. So that's all I got for today, Nate.
- [22:57]
A
Awesome. Now Tom, I appreciate it. It's good stuff. Like I said. Again, just click the link in the show notes below. Email Tom or I, nathan.sosa@hallcpa.com or thomas.castelli@hallcpa, llc.com this has been another episode of the Major League Real Estate Podcast. Thanks for listening to the Major League Real Estate Podcast. There are three ways you can connect with us. If you're interested in getting email updates on upcoming shows, go to ww.therealestatecpa.com and subscribe there. If you'd like to explore a tax and accounting relationship with our CPA firm, you can go to www.therealestate cpa.commlre and fill out a web form to get started. And if you'd like to connect with Matt or I on social media, you can find us on LinkedIn or Twitter. Just search Nathan Sosa, CPA Matt Hamilton, CPA and shoot us a request. We'd love to connect. See you guys next time.