The Tax Advantages of Residential Real Estate Investing
As you consider how real estate investing may help you to reduce or defer your income taxes, please consult your legal and tax advisors about your own situation. Tax advice should be customized. (The comments provided here do not constitute specific legal or tax advice.)
The United States income tax laws and regulations contain provisions that are beneficial to real estate investors. The most important and common aspects of these rules are as follows:
1. The Potential for Non-cash Losses to Offset Ordinary Income
For investors with adjusted gross incomes (AGI) of up to $150,000, operating losses from real estate caused by favorable depreciation rules may allow a full or partial deduction of up to $25,000 in real estate losses annually against ordinary income. This benefit phases out as AGI levels exceed $100,000 annually. This is one scenario where it may be possible to have cash flow positive real estate investment results, while also potentially reduce ordinary income taxes. Your specific result will depend on the annual facts pertinent to your income sources and portfolio.
For high income investors, real estate non-cash losses may be required to be suspended and deferred until the time of a taxable sale of the real estate investment. This is a feature of the IRS Code’s passive activity rules. However, this should be understood as favorable tax treatment since the investor may receive positive cash flows while paying no income tax (due to the depreciation deductions). The deferred real estate income treatment is similar to the deferral of taxation on cash returns within an IRA; however, in this case the investor may both receive and spend cash without paying current income taxes. Compare this to dividends and interest paid by most other investments (i.e. stocks and bonds), which are taxable to the extent of the cash received by the investor.
If you actively work in real estate businesses, you might qualify as a Real Estate Professional (REP). REPs must work actively at least 750 hours per year in real estate businesses, and more in real estate than in any other business, among other requirements. For such investors, they may offset real estate losses against ordinary income when calculating their tax liability, regardless of how large their AGI is in the year. The REP test must be met each year to qualify for this benefit, but only one spouse needs to qualify.
2. Favorable Depreciation Rules
Real estate investors in residential housing may deduct the costs of housing assets, except for the cost of land, over 27.5 years, or a shorter life. Buildings are depreciated over 27.5 years. Short-life equipment may be deducted over 5 years, while other types of real estate asset components have other depreciable lives. To maximize depreciation deductions (and tax deferrals or reductions), investors may perform a cost segregation study to identify the component assets of each investment.
3. Tax Rate Benefits
When an investment in residential property ultimately is sold, investors are generally taxed at a capital gains tax rate for the portion of the gain that exceeds their original cost. Additionally, the depreciation which was taken during the life of an asset is generally taxed on sale at a tax rate (28%) between ordinary tax rates and the capital gain tax rates. Deferred real estate losses are recognized at the time of the sale and serve to reduce these taxable gains.
4. Other Tax Deferral or non-Recognition Benefits
Real estate investors who sell properties, but who also meet complex like-kind exchange rules under Section 1031 of the Internal Revenue Code, may defer recognition of all or portions of their gains. This means that investors can redeploy profits into larger, or more profitable, investments while not paying taxes on the intermediary transactions. The successful completion of these transactions requires competent transaction facilitators, intermediaries and professional advice. The “tax basis” of the old property is transferred to the new property so the gain on the exchange sale is deferred into the future.
This exchange strategy is limited to structures where a fund does the 1031 Exchange or ownership structures where the investor has direct title in the asset. A limited partner or LLC member cannot trade the proceeds from a sales distribution from a real estate partnership or LLC under these rules.
Real estate properties may be refinanced in “cash out” transactions with no recognition of tax on the cash proceeds since a refinance is not a “sale” event under the Internal Revenue Code. Second mortgages used to finance real estate investments create tax deductible interest expense (as long as the aggregate proceeds are $100,000 or less).
Investors who leave their heirs real estate may permanently create non-recognition of inherent gains in the properties because the tax basis is “stepped-up” to fair value at the time of death. Furthermore, the heirs can depreciate the real estate assets based on the stepped-up basis.
Investing in real estate ventures through LLCs and limited partnerships presents gifting and estate tax benefits. Unlike stocks, when an investor gives an LLC interest of a real estate investment to a family member, an investor will likely be able to reduce the value of the gift by about 30% for gift and estate tax rules. The value is discounted under the theory that the investor has limited control over the LLC interest under IRS rules.
Gains from the sale of a taxpayer’s primary personal residence are excluded from capital gains taxation of up to $500,000 for married couples and $250,000 for single individuals if the taxpayer has lived in the home for two of the last five years. In addition, should the gains from the sale of a taxpayer’s primary residence be greater than those exclusions, the taxpayer may also invest that portion through a 1031 exchange. (See http://www.investopedia.com/articles/tax/08/real-estate-reduce-tax.asp).
The investor’s home may be a strong engine of personal wealth creation in markets where home prices are appreciating since such non-taxable gains may be invested in another home or into other investments.
5. Business Tax Deductions
Real estate investors may create favorable business structures to facilitate liability protection while creating tax-advantaged reporting structures. These business structures include partnerships, C and S corporations and LLCs. (Note: it is not recommended to hold real estate investments in corporations.)
As a part of these activities, real estate investors may create business enterprises and conduct business in a way that seeks to maximize available tax deductions. Yes, investing in real estate may be structured as a business! Just a few of the types of ordinary and necessary business deductions that may be available include the home office deduction, employing a spouse or children, meals and entertainment, vehicle deductions, travel expenses, office expenses, small capital improvement deductions and telephone expenses. Following the IRS rules for deductibility of each type of cost can result in increasing business deductions while offsetting some otherwise personal expenses. In addition, using the appropriate tax structure may reduce the marginal tax rates paid on the investor’s income.
6. Other Tax Points
Real estate investing income is generally not subject to self-employment tax (FICA and Medicare) unless you are conducting an “active” real estate business. Active real estate businesses include activities such as real estate sales and brokerages, flipping houses, real estate construction and development, renting hotel space or short-term trading of properties. Consideration should be given in some of these activities to takes steps to avoid the “active” business label.