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Tax Benefits of Real Estate Investment Properties – IRS Rules Explained
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Renting versus buying can be a difficult choice. Still, according to The Wall Street Journal, almost two-thirds of American households own homes. Many more own rental properties or second vacation homes. By contrast, a Gallup Poll found that only one-half of Americans own stocks.
Home equity is the foundation of personal wealth in the United States, representing about two-thirds of net worth for most American households, per Bloomberg. The expansion of home ownership has been stimulated by government programs and tax advantages to incentivize the purchase of houses. According to a study in Social Forces, home ownership leads to “a stronger economy, better schools, and an invested, proactive citizenry.” Homeowners have higher voting rates and are more involved in civic organizations.
Owning real estate has some unique financial advantages. For example, homeowners can deduct their mortgage interest, mortgage insurance premiums, and property taxes from ordinary income. Also, proceeds from the sale of a house are treated as capital gains for taxes – up to $250,000 of the gain can be excluded from income for a single taxpayer or $500,000 for a couple filing a joint return.
Real Estate as an Investment
Owning an investment property is significantly different than owning the property in which one lives. While investors share many common risks – illiquidity, lack of transparency, political and economic uncertainty – each investment property is unique, varying by use, location, improvement, and permanence. Each investment can be subject to a bewildering collection of tax rules, all of which affect the net return on investment.
Andy Heller, co-author of “Buy Even Lower: The Regular People’s Guide to Real Estate Riches,” notes that most people pay too much for their properties: “The profit is locked in immediately once the investor buys the property. Due to mistakes in analysis, the investor pays too much and then is surprised when he doesn’t make any money.”
- Thorough Planning. Too many people fall in love with a property without a strategy to make profits.
- Realistic Expectations. Buying, owning and selling real estate is not an easy way to riches. Eric Tyson, co-author of “Real Estate Investing for Dummies,” notes that you have to be smart, willing to work, and cognizant of your personal risk tolerance.
- Detailed Due Diligence. In efforts to close deals before competitors, many buyers fail to adequately check the history, conditions, and limitations of a potential property purchase, ending with surprisingly expensive rehabilitation costs.
- Competent and Experienced Advisors. Successful real investors invariably have a team of consultants to assist them in finding, analyzing, purchasing, financing, managing, and selling their properties.
Types of Real Estate Properties
- Undeveloped Real Estate. Investors acquire raw land for a variety of purposes including farms and ranches, natural resource exploitation such as harvesting timber or mining coal, subdivision and lot sales, or future development. The price of raw land depends upon its highest possible use, whether agricultural or the site of an office building. Proximity to urban areas and approved zoning purposes often determine the value of the property.
- Residential Properties. Real estate is commonly used for residential purposes, whether single-family homes or multi-family properties including apartments and condominiums. These properties – ranging from a single duplex to developments with hundreds of rental units – require constant maintenance and active management to maintain occupancy and increase value.
- Commercial Properties. This segment includes office buildings, retail properties such as grocery stores and shops, and industrial properties including warehouses and manufacturing plants. Commercial real estate requires active management due to competition, physical maintenance, constant tenant turnover, and the variety and complexity of lease terms. Property owners regularly contend with legal, zoning, and environmental issues.
- Unimproved. Unimproved properties are raw land that has not been changed by human action, i.e., without any buildings, structures, roads, artificial ponds or lakes upon it. Since land is considered to have an infinite useful life, it cannot be depreciated for tax purposes. However, depletion deductions may be available if natural resources such as timber, oil, and other minerals are taken from the property.
- Improved Property. Improved properties are land that has been altered by the addition of buildings and man-made structures, residential or commercial. While the land cannot be depreciated, costs of improvements may be recaptured over their useful life. In many cases, accelerated depreciation of the real assets is allowed.
Real Estate Tax Rules and Regulations
Owning a real estate investment property can provide significant tax benefits to the owner if properly organized and managed. The general rules of thumb applying to tax treatment of investment real estate are:
- Costs associated with the property acquisition (title charges, recording fees) are added to the cost basis of the property and depreciated
- Costs related to financing a property (lender fees, mortgage application fees) are amortized over the life of the loan
- Costs incurred as a result of operating the property (taxes, insurance, utilities) are deductible as current expenses
However, the tax rules are complex, and their application depends on the type of property, as well as the tax classification of its owner. In other words, one investor may be able to shelter other income from taxes while another cannot.
As a consequence, sophisticated real estate owners frequently use a combination of legal entities – trusts, C corporations, Sub-Chapter S elections, and limited liability companies (LLCs) – to buy, manage, and sell their real estate assets. The owners typically engage in subsequent complex transactions between the entities to minimize legal and financial liability or maximize their personal tax benefits.
Each strategy is created to accommodate the particular circumstances of the owner(s), the property’s intended use, the addition of significant improvements, the holding period of the asset, and the ultimate impact of the strategy upon non-related income and tax liability.
The taxpayer may be required to justify a tax position to the IRS. As a consequence, obtaining professional accounting and legal advice is always warranted, if not essential, before proceeding with the implementation of a tax reduction strategy.
The Issue of Passive Income
According to the IRS, passive income is income that is the result of a rental activity or a business in which the taxpayer does not materially participate. Losses from passive income can only be offset against passive gains – the loss cannot be used to reduce the taxpayer’s ordinary income and subsequent tax burden.
Since most improved real estate ventures generate taxable losses in the early years of ownership due to the use of accelerated depreciation, an inability to offset such losses with ordinary income is a disadvantage for many property owners.
Real Estate Investor Definitions
- Real Estate Investor. A real estate investor is an entity (individual or legal organization) that purchases a property with the intent of holding the property and producing a capital gain. Income and losses for a taxpayer classified as a real estate investor are considered “passive” and cannot be used to offset ordinary income from other sources. There is one exception: Investors with a modified adjusted gross income (MAGI) of less than $100,000 and who actively participate in rental activities of a property can offset ordinary income under a special $25,000 allowance under IRC Section 469 (Form 8582). Passive losses more than passive income and the special allowance can be carried forward until extinguished. Also, real estate investors are entitled to capital gains treatment at the sale of their property.
- Real Estate Dealer. A real estate investor is characterized as a dealer if his intent is to purchase real estate for sale, rather than investment – in other words, buying and selling real estate in numerous frequent or continuous (such as selling lots in development) transactions. The major advantage of being a dealer is that income and losses are considered ordinary and can offset other income. At the same time, property classified as dealer-owned cannot use capital gains treatment, installment sale treatment (Publication 537) or like-kind exchanges (IRC Code Section 1031). Also, income received as a real estate dealer is subject to self-employment tax.
- Real Estate Professional. Real estate investors may qualify as a real estate professional if they spend at least 750 hours each year in the real estate business and more than one-half of their working hours are spent performing specific real estate activities. A qualified real estate activity is any development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or sale of real estate. If you have a full-time job unrelated to real estate, you are unlikely to qualify for the classification. Also, proper records-keeping including a log of your hours is critical as the IRS is likely to challenge your use of the classification. Real estate professionals are taxed similarly to real estate investors except that they can deduct 100% of passive losses from ordinary income. While a real estate professional’s rental income is specifically excluded from self-employment taxes paid by a real estate dealer, their income is subject to the 3.8% surtax on net investment income included in the Health Care and Education Reconciliation Act of 2010.
- Real Estate Developer. A person or entity who remodels or constructs a property is considered a real estate developer by the IRS. A developer must capitalize all of the costs or development of the property. Including direct costs such as interest on loans, taxes, and construction expenses as well as indirect costs like administration, management and the ongoing costs of running the business. No deductions are available for tax purposes until the property is either put into service or sold. The primary disadvantage of the developer classification is the inability to offset expenses when incurred under the Uniform Capitalization Rules.
When determining the classification of a real estate owner, the IRS looks at his initial intent when purchasing the property as well as the amount of his time spent on real estate and his stated business purpose. While the determination is often subjective, a classification has significant tax impact upon the taxpayer.
The issue is further complicated since the designation can vary from property to property. In effect, a real estate owner might be considered as a real estate investor for one property and a real estate dealer for another. As a consequence, real estate owners often use a variety of legal entities to acquire, develop, and hold properties to gain the maximum tax advantage.
Additional Real Estate Tax Considerations
Depreciation is the process of recovering the cost of an asset over its useful life. While land, having an infinite life, is not depreciable, nonresidential real estate buildings and improvements have a useful life of 39 years, and residential rental property a life of 27.5 years according to IRS Publication 946.
Depending upon the property class, real estate owners can use either straight-line or an accelerated method of depreciation. The first method provides a consistent amount of deductible each year over the life of the property (the cost of the improvements divided by the useful life in years, i.e., $3,500,000 cost/39 years = $89,744 depreciation each year). Accelerated depreciation generates the greatest depreciation costs in early years and declines after that.
Investors often separate the various components of a structure for tax purposes due to their different useful lives. For example, leasehold improvements – those accommodations made for a particular renter – can be depreciated over a 15-year period or less while office furniture and fixtures have a life of 7 years. By segregating the assets, depreciation is maximized, generating a taxable or “paper” loss.
Section 179 of the IRS Code allows the purchase of certain qualifying equipment (such as air conditioning or heating units) to be expensed up to a limit of $500,000 in the year of acquisition. The qualifying equipment ranges from business vehicles and furniture to computer hardware and software necessary to carry on the business. Also, Congress provides for bonus depreciation in some years above the 179 limits, currently at $2 million.
Capital Gains and Losses
When sold, personal or investment assets are subject to a capital gains tax. The gain or loss on an asset is determined by the difference between the “basis” price – the purchase price including adjustments, such as depreciation, as defined in IRS Publication 551 – and the net sales price. Profits or losses are considered short-term if held for less than one year or long-term if the holding period is greater than one year.
Properties owned by real estate developers must include all costs – direct and indirect – in the basis calculation until the property is put into use or sold. The primary disadvantage of the developer classification is the inability to offset expenses when incurred under the Uniform Capitalization Rules. Income from the sale of properties owned by real estate dealers are considered ordinary income and are not eligible for capital gains treatment.
Short-term capital gains offset short-term capital losses while long-term capital gains offset long-term capital losses. The remaining short-term loss or gain is matched with the remaining long-term loss or gain. If the net result is a long-term capital gain, one-half of the gain is tax-free and one-half is subject to the taxpayer’s ordinary income tax rate. Since the maximum tax rate is 39.60%, a long-term capital gain will be taxed at a maximum up to 19.8%. Short-term gains are taxed at the taxpayer’s ordinary rate.
A maximum of $3,000 of long- and short-term losses can be deducted from ordinary income in a single year, with the remaining loss carried forward. Tax filers use Schedule D of Form 1040 to report capital gains and losses.
Taxes on the profits from the sale of properties owned by real estate investors can be deferred if reported as an installment sale under the rules of Topic 705 – Installment Sales. This treatment is especially advantageous for short-term capital gains as the profit and tax liability is spread over several years. Each payment consists of portions of tax-free return of capital, interest, and a capital gain.
Real estate investors can also use IRS Section 1031 to postpone taxes on any gains if they trade their property for a similar property in a like-kind exchange. The basis in the new property remains the same as the basis in the old property, thereby keeping the possible future gain intact. However, the basis of the old property is also transferred to the new property to calculate depreciation.
Real estate dealers are subject to self-employment taxes and reporting, while real estate professionals may be liable for the surtax on net investment income. As a consequence, real estate professional and their advisors use a variety of strategies to defer or escape such taxes. For example, rental income that flows through to an investor from an S corporation is excluded as self-employment income and not subject to self-employment tax.
Business income that is not subject to self-employment tax is subject to the tax on net investment income with one big exception: Income that is considered non-passive under code section 469 is not subject to net investment income tax. According to Forbes, this means that the income from rental real estate, including gain on disposition, might be exempt from the 3.8% tax in the case of real estate professionals.
Andrew Carnegie, a Scottish immigrant in the mid-1800s, built a fortune in the steel industry and became one of the country’s greatest philanthropists. (He is credited with opening 2,800 public libraries in towns across America.)
Even with his success as an industrialist, Carnegie recognized the investment value of real estate: “90% of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined. The wise young man or wage earner of today invests his money in real estate.”
Since Carnegie’s observation, the attractiveness of real estate as an investment remains unblemished. Barbara Corcoran, a well-known American businesswoman and a frequent participant on ABC’s Shark Tank, claims, “A funny thing happens in real estate. When it comes back [after a recession], it comes back up like gangbusters.”
While the tax treatment of real estate investments is often confusing, investors can use tax strategies to reduce risk and improve returns. Retaining competent tax advisors and tracking changes in the rules and regulations will pay dividends far beyond their costs.
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