Real estate investing is one of the most popular strategies for growing one’s wealth. Combined with the enticement of generating cash flow, and appreciation of the asset it opens a treasure chest of tax advantages that other investments can’t offer. Uncle Sam can become an investor’s best friend as there are many investment property tax benefits available. The trick, however, is understanding what’s available, and how to capitalize on it. Often investors strictly pay attention to the cap rate, of the property when deciding to purchase without considering the additional tax benefits that may be available.
DEPRECIATION, COST SEGREGATION & BONUS DEPRECIATION
Depreciation of real property is a key tax-saving strategy. Depreciation allows you to recover the cost of certain aspects of real property over time in the form of a tax deduction. The IRS defines depreciation as the process of recovering an asset’s acquisition cost up until the asset is recovered.
Real Estate depreciation is an important aspect of real estate management that allows for depreciation to be offset against the property’s income thus, reducing the tax due. It is commonly referred to as a “phantom expense” since no actual check is written or disbursement made to cover the expense.
Among other things, to qualify for depreciation, the property must be a property used for investment. If used personally & investment the depreciation will only be applicable to the portion of the property used for investment.
You can depreciate the cost associated with the initial purchase of the improvements on the property as well as improvements made to the property after the purchase. An improvement to the property can be defined as anything that increases the value or usefulness of the property, adapts the property to a new use, or restores the property to a better condition. The theory behind depreciation is the improvements on the property decline in value because of wear and use over time. The land itself does not qualify for depreciation.
Depreciation starts when a property is put in service, and you can continue to depreciate the property until you have depreciated your entire depreciable value in the property, or until you retire the property from service. A property is considered retired from service if you sell the property, abandon the property, or convert the property to personal use. Depreciation will reduce the property owner’s basis in the property and will be subject to recapture when the property is sold, unless the property owner enters into a 1031 exchange. However, even if the property owner does not enter into a 1031 exchange when the property is sold, capital gains tax rates are typically lower than ordinary income tax rates. In addition, the deferral during the ownership period has material benefits because of the time value of money.
The IRS allows residential rental property to be depreciated under straight line depreciation at a rate of 3.636 percent each year for 27.5 years. Commercial is depreciated at a rate of 2.564 percent per year for 39 years.
Cost Segregation is a commonly used strategic tax planning tool that allows property owners who have constructed, purchased, expanded, or remodeled any kind of real estate to accelerate depreciation deductions thus deferring federal and state income taxes, and increasing cash flow.
When a property is purchased, not only does it include a building structure, but it also includes all of its interior and exterior components. On average, 20% to 40% of those components fall into tax categories that can be categorized and written off much quicker than the building structure. A Cost Segregation study dissects the construction cost & purchase price of the property that would otherwise be depreciated over 27 ½ or 39 years under straight line depreciation. The primary goal of a Cost Segregation study is to identify all property-related costs that can be depreciated over 5, 7 and 15 years.
The IRS holds different timelines for how long a building component’s lifetime will be. Cost segregation studies in real estate can reclassify which IRS category a building component falls into. Investors can ‘accelerate’ the depreciation of a building’s components, and thus speed up the depreciation expense amount. As your expenses increase the more you can offset your taxable income.
These are generally broken down into 4 categories:
- Land: the land cannot be expensed
- Personal Property: renovations such as flooring, fixtures, electrical outlets, furniture which can be expensed over 5 or 7 years
- Exterior Improvements: renovations such as parking lots, fencing, etc can be expensed over 15 years.
- The building: is expensed over 27.5 or 39 years depending on the type of asset.
In most cases, engineering firms generally complete cost segregation studies, as studies involve a physical inspection of the real property as well as the re-classification of various physical aspects of a building.
Bonus Depreciation:
Bonus depreciation is a powerful tool for real estate investors, allowing them to frontload a significant part of the depreciation. Using bonus depreciation, you can take a huge tax deduction in the first year. Before the implementation of the JOBS Act, the IRS allowed real estate investors to claim up to 50% of their depreciation in the first year. Under the new laws, effective since 2018, you may take 100% bonus depreciation on qualified property both acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Full bonus depreciation is phased down by 20% each year for property placed in service after Dec. 31, 2022, and before Jan. 1, 2027.
| Under the law, qualified property is defined as tangible property with a recovery period of 20 years or less. |
Under the new law, the bonus depreciation rates are as follows:
Prior to 1986, a taxpayer could generally deduct losses in full against wages & passive income from rental activities regardless of his or her participation. This gave rise to significant numbers of tax shelters that allowed taxpayers to deduct losses against wages and investment income. The Tax Reform Act of 1986 added IRC § 469, which greatly limits the taxpayer’s ability to deduct losses from rental activity in which he or she does not materially participate against wages.
The IRS puts real estate investors into three categories for tax purposes.
- Passive Investor. This is the default. Rental income is generally considered passive income. A passive real estate investor can only deduct passive losses against passive income.
- Active Investor. This category allows you to deduct an additional $25,000 of your real estate losses against your ordinary income. But this deduction phases out when your Adjusted Gross Income (AGI) moves past $100,000 as a single individual or at $150,000 for a married couple filing jointly. Getting active investor status is easy. You just need to be involved in making decision about your real estate investment.
- The Real Estate Professional
Real Estate Professional Status
Real estate professional status is a powerful tax tool for high income W2 investors. It can help significantly bring down your tax exposure. If you are able to qualify as a real estate professional, you may be able to reduce your taxable income by writing off significant passive losses including depreciation from real estate activities.
For the most part, rental real estate is generally classified as a passive activity. Thus, depreciation, or other deductions on rental real estate assets typically can only be offset against passive income, even if you materially participated in the management, acquisition, repair, development, or other activities related to the rental real estate.
However, there is an exception to this general rule, if you qualify as a real estate professional, your rental real estate activities in which you materially participated may be classified as active activities. In this situation, depreciation, or other deductions on rental real estate can be offset against active income.
This can be especially favorable situation for high income W-2 income earners.
If the two spouses file a joint tax return, both spouses don’t have to qualify as real estate professionals to receive the benefits. Only one spouse must qualify to offset active gains with passive losses on a married-filing-jointly return. This is commonly done when one spouse is a high-income earner and the other works on real estate portfolio.
To qualify as a real estate professional, you must meet both below requirements:
- More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
*Generally, you are not allowed to count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer.
*You are considered an owner if you owned more than 5% of your employer’s outstanding stock, outstanding voting stock, or capital or profits interest.
* You do not need any specific qualifications or license to qualify for REPS. If you qualify on the criteria listed above, you are eligible to claim real estate professional status.
You can treat one or more rental activities, as a single activity if those activities form an appropriate economic unit for measuring gain, or loss under the passive activity rules. Grouping is important for several reasons. If you group two activities into one larger activity, you need only show material participation in the activity. But if the two activities are separate, you must show material participation in each one. Grouping can also be important in determining whether you meet the ownership requirement for actively participating in a rental real estate activity.
*A real property trade or business is a trade or business that does any of the following with real property.
- Real property development which is a trade or business, that includes the maintenance and improvement of raw land to make it suitable for subdivision, further development, or construction of residential or commercial buildings.
- Constructs or reconstructs it.
- Acquires it.
- Converts it.
- Rents or leases it.
- Operates or manages it.
- Brokers it.
Short Term Rental Tax Deductions Against Active Income, (Air BNB)
Short Term Rentals can be another exception to the general rule that rental income is passive income. Under certain circumstances, the rental activity can be characterized as a trade or business activity. To qualify the owner must materially participate in the running of the trade or business, and the average customer must use the rental for seven days, or less, or for thirty days or less if the owner provides significant personal services. The thought here is the activity is more like a trade or business, as opposed to simply engaging in passive rental activity. In this situation, depreciation, or other deductions on rental real estate can be offset against active income. Just like having real estate professional status this can be especially favorable situation for high income W-2 income earners. However, you will still need to show that you are materially participating in your short-term rentals. Because many of these activities have a management company and may not be near to the taxpayer’s residence, showing you materially participating may be difficult. However, if you self-manage these activities can be labor intensive and easy to qualify.
Below are the three most commonly used ways to qualify
- You participate in the activity for over 500 hours during the year
- Your activity substantially makes up all of the participation in that activity
- You participate in over 100 hours during the tax year, and your activity is not less than any other person’s
Material participation can include such tasks as staging, painting the property, managing the property, dealing with guests, repairs,cleaning, restocking ect,
If the taxpayer or family members spent more than 14 days at the property, or there are related people renting at less than fair rental value, losses generally are not allowed under the rules in IRC § 280A.
** It is extremely important that you document the activities that you performed during the year in a logbook in case your requested to prove the amount of time, and nature of the activities you performed during the year to qualify as a Real Estate Professional or take advantage of the Short-Term Rental Deduction as a business activity.
1031 Tax Deferred Exchange
A tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code, is a common way to defer paying capital gains tax on real estate that has appreciated. The taxable capital gain is generally due to the appreciation in value of the real estate being sold, and the amount of depreciation taken over a period of time on the property. When using a 1031 Exchange, the investor benefits from a tax deferral, allowing you to roll the capital gains tax you would have paid into the purchase of a new property.
Example:
The example below shows the breakdown of the tax benefit were an Exchanger sells an office building,(Relinquished Property) for $16,500.00, and buys a shopping center, (Replacement Property), for $20,000,000.00 and defers payment of capital gains tax of $2,275,000.00 that is rolled over into the replacement property.
TRADITIONAL SALE IRS 1031 EXCHANGE
Sale Price $16,500,000.00 $16,500,000.00
Basis $10,000,000.00 $10,000,000.00
Gain Realized $6,500,000.00 $0
Tax Due $2,275,000.00 $0
Funds available
to reinvest $14,225,000.00 $16,500,000.00
This simplified estimate of tax due is for illustrative purposes only, since the calculation of taxes involves many factors and your individual situation may require additional variables not included in this illustration, speak to your tax or legal advisors.
The general rules for a forward 1031 exchange require the following components:
*The relinquished & replacement property must be “like kind property”, held for investment.
*To completely defer the capital gains tax the replacement property should be of equal or greater value to the property sold.
*The Exchanger must obtain the same or greater debt on the replacement property. Debt may be replaced with additional cash, but cash equity cannot be replaced with additional debt. Additionally, the Exchanger may not receive cash or other benefits from the sale proceeds during the exchange.
* The vesting of the replacement property must match the vesting of the relinquished property, subject to some exceptions.
* The Exchanger must enter into an exchange agreement with a Qualified Intermediary, were the Exchanger assigns the Exchangers rights in the contract of sale to the Qualified Intermediary. Language allowing for the assignment of the contract to the Qualified Intermediary, must be included in the contract of sale.
* At closing the proceeds of the sale for the exchanged property sold are wired to the Qualified Intermediary, to hold in escrow until the replacement property is purchased.
* The Exchanger must identify a replacement property for the assets sold within 45 days of the date the Exchanger closed on the sale of the relinquished property. This is called the identification period.
* The Exchanger must acquire all replacement properties within the earlier of 180 days, after the sale of the relinquished property, or the tax filing deadline, including extensions, for the year of the sale of the relinquished Property.
* The time periods for the 45-day Identification Period and the 180-day Exchange Period are very strict and cannot be extended even if the 45th day or 180th day falls on a Saturday, Sunday or legal holiday. They may, however, be extended by up to 120 days if the Exchanger qualifies for a disaster extension under Rev. Proc. 2007-56.
* When the Exchanger enters into the contract of sale to purchase the replacement property the contract must have language allowing for the assignment of the contract to the Qualified Intermediary.
*At closing the Qualified Intermediary will wire the funds being held in escrow to the Sellers of the Replacement property being purchaser by the Exchanger.
Identification of Replacement Property must be done prior to the expiration of the Identification Period by one of the following methods:
- Complete the purchase of the Replacement Property within the Identification Period; or
- Identify the replacement property in a written document signed by the Exchanger and delivered prior to the end of the Identification Period (by midnight of the 45th day), to the Qualified Intermediary or other permissible party to the exchange that is not a “disqualified person” or agent of the Exchanger. Treas. Reg. §1.1031(k)-1(c). Delivery to the Exchanger’s attorney or broker would not qualify as these parties are agents of the Exchanger.
Requirements for a Proper Identification Notice:
- Must include a specific description of the Replacement Property
- Must be signed by the Exchanger
- The Identification Notice must include
a) the legal description,
b) a street address, or
c) a distinguishable name (i.e. “Chrysler Building”) - An identification of Replacement Property may be revoked prior to the end of the Identification Period. The revocation must be in writing, signed by the Exchanger and delivered to the same person to whom the original Identification Notice was sent. No changes or revocations may be made to the Identification Notice after the end of the Identification Period.
* You can identify multiple properties subject to certain restrictions:
- Three Property Rule: The Exchanger may identify as potential Replacement Property any three properties, without regard to their fair market value.
- 200% Rule: The Exchanger may identify as potential Replacement Property any number of properties, provided the aggregate fair market value (as of the end of the Identification Period) of all of the identified properties does not exceed 200% of the aggregate fair market value of all of the Relinquished Properties.
- 95% Exception: If the Exchanger identifies more potential Replacement Properties than allowed under either the Three Property or the 200% Rules, the Exchanger will be treated as if no Replacement Property was identified unless the Exchanger actually receives Replacement Property by the end of the Exchange Period worth at least 95% of the aggregate fair market value of all of the identified Replacement Properties. For this purpose, fair market value of the aggregate Replacement Property is determined as of the earlier of the date the property is received by the Exchanger or the last day of the Exchange Period.
**Common 1031 Tax Deferred Exchange Terms
Basis: The amount paid for real property , plus capital improvements, and decreased by depreciation.
Boot: The FMV of any non-qualified property received in an exchange. An exchanger who receives Boot in an exchange generally recognizes gain to the extent of the value of the boot received. Examples are Cash, debt relief not offset with new debt, property intended for personal use.
Replacement Property: The “new property” acquired by Exchanger.
Relinquished Property: The “old property” sold by Exchanger.
Exchange Period: The period during which the Exchanger must acquire Replacement Property in the exchange.
Exchanger or Taxpayer: The property owner seeking to defer capital gain, recapture or other income tax by utilizing a IRC §1031 exchange.
Identification Period: The period during which the Exchanger must identify Replacement Property in the exchange.
Like-Kind Property: Properties having the same or similar nature or character, regardless of differences in grade or quality. Generally, all real property located within the United States is considered to be “like-kind” to all other U.S. real property as long as the Exchanger’s intent is to hold the properties as an investment or for productive use in a trade or business.
Qualified Intermediary: The person or entity that facilitates the exchange for the Exchanger. To be a Qualified Intermediary, the exchange facilitator must meet certain criteria spelled out in Treas. Reg. 1.1031(k)-1(g)(4).
Exchange Accommodation Titleholder: The person or entity used to facilitate a “reverse” or “improvement” exchange The Exchange Accommodation Titleholder (EAT) will hold (park) title to either the Relinquished or the Replacement Property during the exchange.
Types of 1031 Exchanges
Forward Exchange: The most common form of exchange transaction in which the exchange begins with the sale of the Relinquished Property to a buyer and concludes with purchase of Replacement Property.
Reverse Exchange: An exchange involving an Exchange Accommodation Titleholder (EAT) when it is necessary for the Replacement Property to be acquired before the Relinquished Property can be sold to a Buyer, or when improvements must be made to the Replacement Property before it can be acquired by the Exchanger.
Improvement Exchange: An exchange in which improvements are made to the Replacement Property prior to acquisition by the Exchanger, either using exchange funds or funds lent by the Exchanger (or lender) to the Exchange Accommodation Titleholder.
William M Mason, Esq. is an attorney and founding partner of Mason and Mason PLLC. He has over 25-year experience, representing individuals, corporations, and lenders in the disposition, acquisition, and financing of residential and commercial real estate.
This article is not meant to be legal advice and should not be relied upon in making any financial decisions. It is a short summary of tax planning strategies and may not include all applicable requirements to your situation. Each individual’s situation varies, and it is recommended that you retain an attorney, or CPA to review your individual situation.
