Real estate is widely known as a tax-advantaged investment. However, we will often see individuals purchase and sell real estate, assuming they will receive the benefits. Yet, these real estate investors often miss out on some of the most material tax savings for real estate. This article covers five of the most significant tax advantages of real estate that can minimize (or eliminate) your tax liability.
1. Leverage 1031 exchanges to defer tax liabilities.
If you follow certain requirements under IRC Section 1031, then you can defer tax on the gain from your real estate investment. We have seen individuals that are aware of this tax benefit, but when it comes to selling their real estate, they did not execute the transaction properly to avoid the gain. Then, once they have not met the requirements of the code section, they are left with unintended tax consequences and taxable income that could have been deferred (or eliminated entirely, when combined with tax benefit #2).
Before selling your real estate, you should engage with a qualified intermediary to handle the transaction as well as a CPA experienced in 1031 exchange reporting so that you can ensure you’re taking all necessary steps to receive the maximum tax benefit.
2. The step-up basis loophole can help eliminate capital gains taxes.
Some of the most experienced real estate investors combine benefit #1 with this benefit to never pay tax on any gains from their real estate investments.
Step up basis is an automatic tax benefit that occurs upon inheriting an asset. The inheritance of an asset (rather than the gifting) provides for an increase in the value at which an asset is essentially considered to have been purchased, eliminating the taxable gains as of the date of death.
For example, your father purchased an investment property for $10,000 over 10 years ago that is now worth $100,000. He has three options on trying to transfer the value to you, but only one option that is tax optimal:
- Sell the property and gift you all the remaining cash (unfavorable)
• Tax impact: Immediate taxable gains of $90,000 on sale by father
- Gift you the property (unfavorable)
• Tax impact: Taxable gains to you upon the future sale of property (cost basis of $10,000 is transferred from father to you, so $90,000 gain will still occur when you sell the property)
- Take a loan against the property, use the cash for retirement, and then leave the property to you in his will (eliminates tax)
• Tax impact: No taxable gain on the $90,000. Ever.
The strategy from option #3 allows the person who purchased the property to enjoy the value of the property while living (from borrowing against the property) while tax-efficiently transferring the remaining value to another person. When combined with 1031 exchanges during the life of the person who purchased the property, there is no reason with this method to ever pay capital gains tax on any real estate investments. If you are above the estate tax threshold, currently about $22M for a married couple, then there are estate tax considerations in this situation.
3. Group investment properties to qualify as an active real estate activity.
If you’re a real estate professional, as defined by IRC section 469(c)(7)(B), then you may also benefit from grouping your real estate rental activities to utilize the losses against other active income. When you group the rental real estate activities, you only have to meet the material participation threshold for the properties combined rather than for each individual property. When you meet the material participation threshold, then you can consider the activity active rather than passive and use the active losses to offset other active income.
To qualify as a real estate professional under the Internal Revenue Code, the requirements are:
(i) more than one-half of the personal services performed in trades or businesses by the
taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and
(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. Real property trade or business is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
4. Use cost segregation to accelerate depreciation.
A cost segregation allows you to accelerate depreciation on real property. Real property is usually 27.5- or 39-year property, depending on whether it is residential or commercial. A cost segregation essentially breaks down the value of the real property into tangible property with a shorter useful life. Since bonus depreciation currently allows for 100% of the deduction in the first year for property with a 15-year life or less, real property with a cost segregation performed can result in a substantial and immediate tax benefit to offset other income.
It is often important that this tax benefit is combined with tax benefit #3 if the real property is for rentals. The loss can offset other active income, rather than being limited to passive income, if there is no substantial passive income on your tax return.
5. Avoid ordinary income recapture tax.
When you depreciate real estate under IRC Section 1250, which applies to real property, the ordinary income recapture is $0 if you hold the asset for over a year. This is a substantial tax benefit compared to all other tangible personal property (e.g., equipment), which are taxed at ordinary income rates upon sale up to the amount of the original purchase price or basis.
When considering this tax benefit in the context of benefit #4, if you know you will be reselling the real estate sooner than later, you likely will want to avoid doing a cost segregation since it will convert tax code Section 1250 property to Section 1245 property in order to accelerate the depreciation, which will increase your tax upon the sale.
CONSULT WITH AN EXPERIENCED TAX PROFESSIONAL
At DiLucci, our experienced team of tax professionals is here to help you with your real estate investing and tax strategy.
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- Individual and business accounting
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