Owning real estate is not only a proven strategy for building wealth, but it also allows you to reduce your income taxes.
Tax laws are complex. As your income goes up, so does the amount you must contribute to the government to fund their operations. Many people seek ways to keep more of their hard earned dollars, and owning real estate is one of the best strategies to do so. You can realize many of these tax benefits without utilizing a dedicated retirement account. However, with a self-directed IRA, you can leverage tax deferred income even further with your real estate investing.
Paying less in taxes is patriotic.
Some people believe that using the tax code lawfully to lower the amount a person pays in taxes is a bad thing. But in fact, it is the opposite. The government only has a few tools at their disposal to influence how its citizens deploy capital. When the government wants to direct capital into certain areas that benefits society as a whole, they frequently use the tax laws to motivate citizens to do so.
Housing is one of the key needs of all communities. Having safe, clean, and affordable places to live allows individuals and families to thrive. The government designs tax incentives to encourage the construction and ownership of housing on many different levels. One of the most popular tax incentives is the mortgage interest deduction allowed on a personal residence.
With commercial real estate, there are ways to structure an investment that maximize the incentives in the tax code that Congress has created to encourage that investment. Doing so is patriotic and helps fulfill the needs of the community that our lawmakers have identified.
Before we get started on the details: This article is not to be construed as tax or legal advice. The author is not a CPA, accountant, attorney, or tax professional, but rather a real estate investor who has learned the value of real estate investing, including the tax benefits. This is merely a layman’s understanding of how the tax code applies to real estate investments. Every individual’s tax situation is different and tax laws change periodically. Always seek the advice of your tax accountant or lawyer before making any investment or tax planning decisions.
Rental Real Estate
Income and losses incurred as a real estate investor are considered passive income (or losses) and the losses are treated differently than ordinary W-2 income. Any losses incurred in real estate investing can only offset income from other passive investing activities.
However, If you have an adjusted gross income of less than $150,000 as a married couple, you can deduct up to $25,000 of losses in rental real estate on your tax return. Though, if you earn more than that, you cannot use the deduction unless you qualify as a Real Estate Professional.
To qualify as a Real Estate Professional, there are two tests. The first test requires that you spend at least 50% of your working hours in your real estate investing business. The second requires that you spend at least 750 hours working in a real estate trade or business.
For most people who have a full-time job outside of real estate, meeting either of these tests would be difficult. For others, perhaps those that are self-employed or retired, it is certainly feasible that you meet the first test. The second test may prove a bit harder, and it is important to keep written documentation of your hours worked.
If you are eligible and qualify as a Real Estate Professional, all your real estate investing income and losses are treated as active income and losses. Any losses incurred in your rental real estate activities can offset your other active income.
Real Estate Syndications
Real estate syndications, where groups of people join together to buy commercial real estate, are commonly structured as limited liability companies (LLCs) and taxed as partnerships. The lead sponsor group assumes the role of general partner and investors become limited partners. The real estate syndication is considered a pass-through entity, and thus it is not subject to taxation. This means that income, expenses, gains, and losses that occur at the syndication level are transmitted to the general and limited partners.
The partners’ share of the income and expenses is passed through to the partners by the K-1, a tax form which separates items and reports them to be taxed accordingly.
Of course cash flow and taxable income are different. A passive investor may receive their pro rata share of the free cash flow generated by an investment each year, and at the same time participate in the depreciation discussed above, thereby having no tax obligation, and potentially offsetting other passive income with the losses passed down.
The lead syndicators are granted flexibility in how they allocate the various items, and this can be expressed in the real estate syndication operating agreement, reflecting the unique needs of the partners.
Depreciation
When a business purchases a large asset needed to produce the product or service that business delivers to its customers, the cost of that asset is not treated like a normal business expense such as payroll or supplies. The theory is that a large machine or building will last for many years, unlike office supplies or advertising, which are used by the business shortly after their purchase. So, the IRS has rules about how the cost of the large asset can be treated as an expense.
The cost of these large assets is depreciated based upon a schedule defined by the IRS for the type of asset. Basically, the purchase price is spread out over a specific number of years.
Commercial real estate is allowed to be expensed over 39 years. However, it is argued that the land never wears out, so only the value of the improvements that are on the land may be used in this manner, not the value of the land itself. So, if a business buys a warehouse, they must take the cost of the land out and then divide the value of the improvements by 39, to arrive at the amount which can be deducted each year as an expense by the business.
Residential property is treated similarly, yet over a shorter time period. The IRS has decided that residential buildings do not last as long as commercial buildings, so instead of 39 years, a property owner can depreciate the improvements of a residential structure over 27 ½ years. Why the half a year? Who knows, it must be evidence of the never ending wisdom of our federal government!
Example
Purchase an Apartment Building for $2,000,000
Land is worth $500,000 making the improvements valued at $1,500,000
Divide the value of the improvements by 27 ½ = $54,545 – Annual Depreciation
Annual depreciation is the portion of the cost of an asset which can be considered a business expense and deducted from the income generated by the business each year, thereby reducing taxable income.
Improvements are more than just the buildings. The value of the land is considered to be in its natural form. So, all the items that have been constructed, completed, or installed are considered an improvement. This can include the buildings themselves of course, but also the parking lots, signage, fences, gates, and even landscaping.
When a property is sold, the new owner does not inherit the depreciation schedule of the past owner. Each new owner gets to restart the depreciation and deduct the value of the assets over a new 27 ½ year period (or 39 years, for a non-residential building) beginning the year they purchase the property.
Major repairs and remodels of buildings cannot be expensed in the year they are made but must be treated similarly and are depreciated over time also.
Cost Segregation
Different components of the improvements to the property will deteriorate and wear out at different times. Flooring and appliances will not last as long as parking lots, which themselves do not last as long as plumbing or the foundation. The Tax code allows an owner to classify the various elements of a building and then depreciate some of them over shorter time periods. This process is called Cost Segregation.
The IRS requires that a study of the property be completed by an engineer or architect who analyzes the different segments of the building, classifying them based upon their expected life. This study then separates some of these components into shorter depreciation categories, such as 5 or 15 years, and the remainder stays in the 27 ½ or 39-year schedules.
By commissioning a Cost Segregation Study, a property owner can dramatically increase the amount of depreciation that may be claimed each year, thereby increasing the amount of income that can be offset, creating significant tax savings.
Example
Purchase an Apartment Building for $2,000,000
Land is worth $500,000 making the improvements valued at $1,500,000
Cost Segregation Study determines the improvements fall in the following depreciation categories:
5 Year Property – $210,000 – Divide by 5 = $42,000
15 Year Property – $75,000 – Divide by 15 = $5,000
27.5 Year Property – $1,215,000 – Divide by 27.5 = $44,182
Total Annual Depreciation for Years One through Five – $91,182
This example is assuming the Straight Line Depreciation method is used. Other methods, such as the Double Declining or Declining Method of calculating depreciation can accelerate the deduction and increase the tax savings even further.
Bonus Depreciation
In 2002 in an effort to stimulate the economy after the attack of 9-11, Congress introduced Bonus Depreciation. Our government wanted to encourage businesses and individuals to make capital expenditures by purchasing assets to grow businesses and provide more jobs. Bonus depreciation allows the cost of an asset to be recovered (depreciated) more quickly than the normal rules allow. In 2002 one could deduct 30% of the cost of an asset in the first year of service for assets put into service through September 11, 2004. Bonus Depreciation was renewed several times, culminating with the Tax Cuts and Jobs Act passed in 2017. This most recent version raised the amount of qualifying assets that can be depreciated in the first year of service to a maximum of 100%.
Under bonus depreciation, those portions of a commercial real estate building that have been categorized as 5- or 15-year assets, could be expensed completely in the first year of service, through 2022. Using our example above, if we apply bonus depreciation the calculation would look more like this:
Example
Purchase an Apartment Building for $2,000,000
Land is worth $500,000 making the improvements valued at $1,500,000
Cost Segregation Study determines the improvements fall in the following depreciation categories:
5 Year – $210,000 – Bonus Depreciation = $210,000
15 Year – $75,000 – Bonus Depreciation = $75,000
27.5 Year – 1,215,000 – Divide by 27.5 = $44,182
Total Annual Depreciation for Years One = $329,182
Total Annual Depreciation thereafter = $44,182
Under the current law, Bonus depreciation of 100% of the cost of qualifying assets is available for assets put into service up to the last day of 2022. After that the amount decreases by 20% each year until phasing out completely.
Effect of Depreciation
Income received from cash flow while the building is owned is taxed at ordinary income rates. This income may be offset by the depreciation discussed above. While you receive the actual cash, the non-cash depreciation deduction may be equal to or exceed the cash income you receive, thereby making that income essentially tax free. (Actually, tax deferred, there are requirements for recapture of depreciation when the asset is sold.) Should the depreciation exceed the income, it can be used to offset income from other passive investments.
Example
| Income (Expense) | Standard Depreciation | with Cost Segregation | with Bonus Depreciation | |
| Rent Income | $500,000 | |||
| Expenses | ($250,000) | |||
| Net Operating Income | $250,000 | |||
| Mortgage Interest | ($59,350) | |||
| Cash Flow | $190,650 | |||
| Depreciation | ($54,545) | ($91,182) | ($329,182) | |
| Taxable Income | $136,105 | $99,468 | ($138,532) | |
| Potential Tax Savings at 37% | $20,181 | $33,737 | $121,797* |
*(assumes passive activity loss offsets other passive income)
Capital Gains Tax Rate
When an investment property you own or have invested in with others is sold, you will receive your share of the equity in the property. This is calculated by taking the sales price of the property, less the costs of sale and less any outstanding loans on the property. Equity, however, is not the Capital Gain. Taxes are calculated on the Capital Gain, not on the equity you receive.
The Capital Gain is arrived at by taking the selling price of the property, less certain costs of sale, and deducting that from the Cost Basis of the property. The Cost Basis is the original purchase price of the property, including certain costs of purchase, plus capital improvements made to the property during the ownership period. The Cost Basis is then reduced by the amount of depreciation that was claimed each year during the hold period. The actual calculations are more complex, but this is basically what takes place.
Long Term Capital Gain tax rates are substantially lower than ordinary income tax rates. Congress wants to encourage investors to hold property for the long term, and to qualify for this lower tax rate, the property must be held for at least one year. This is usually not a problem for owners of real estate.
Depending upon the individual’s tax status, long term capital gains are taxed at 0%, 15% or 20%. Even at the highest rate that applies, for example, to married couples with AGI over $517,200 in 2022, it is substantially lower than the top tax brackets of 35% or 37% for ordinary income.
Recapture of Depreciation
When calculating the Capital Gains Tax, the amount claimed in depreciation is deducted from the Cost Basis, excluding those amounts from the favorable treatment. Since depreciation claimed during the hold period of the asset is used to offset ordinary income, the IRS requires that such depreciation be recaptured. However, again, in an effort to stimulate investment, the tax rate for such recaptured depreciation is capped at 25%. Accelerated depreciation made available by Cost Segregation Studies and/or Bonus Depreciation is recaptured and taxed at ordinary income rates.
The 25% recapture tax rate is likely still lower than an investor’s ordinary income tax rate, thus creating savings. Further, any delay in the payment of tax created by utilizing accelerated depreciation strategies allows the tax payment to be made with future dollars, which, especially lately, are cheaper than today’s dollars due to inflation.
IRS Section 1031 Like Kind Exchange
While the capital gains tax rate does reduce the tax liability upon the sale of a property, there is a way to pay zero taxes on the gain now, and instead defer those taxes into the future. The IRS allows investors the ability to “Exchange” their current property for another property, and when done properly, no tax is due at the time of sale. The term “1031” refers to the IRS Code, Section 1031 that describes the rule. The process is also frequently referred to as an “Exchange”, a “1031 Exchange”, or a “Starker Exchange”.
On its face, it means exchanging one property for another, yet in reality, by utilizing the services of a 1031 Exchange Facilitator, an investor is able to sell their current property to one party and purchase a replacement property from a different source. Through this technique, the cost basis of the old property is carried forward to the replacement property. It isn’t that the taxes are never due, they are just deferred until the replacement property is sold. This allows the investor to use the cash saved by deferring the tax and instead use those monies as additional equity (down payment) when buying the replacement property.
Debt can be used in addition to the proceeds from sale to purchase the new property, but the transaction must be structured so that no cash from the closing of the first property is received by the investor.
There are many technicalities that must be adhered to qualify, one of the most important being the timing. The replacement property must be identified in writing within 45 days, and the purchase must be completed within 180 days of the sale of the old property.
One creative strategy that some taxpayers use is called a “Reverse” exchange, where the replacement property is purchased before the current property is sold. This can apply to a situation where a desirable property is available before the investor is able to sell their existing property. Time periods apply here also, where the current property must be sold within 180 days of the purchase of the new property. To accomplish a reverse exchange, the taxpayer must have the financial wherewithal to fund the purchase of the new property without the benefit of the sale of current investment. Financing can be used in the purchase, but again, the investor cannot receive any cash generated from the sale of the first property and instead must put it all towards the new investment.
Participating in a real estate syndication as a passive investor utilizing a deferred exchange can be done, but only some sponsors will offer the option. It requires specific structuring of the ownership entities and entails more complexity for the General Partners.
Opportunity Zones
In 2017, President Trump signed the Tax Cuts and Jobs Act into law, which included a section designed to spur investment in the nation’s underprivileged communities. Investments in Opportunity Zones are eligible for preferential tax treatment. Specifically, if an investor reinvests a capital gain into a qualifying investment, the tax on that capital gain is deferred, similar to completing a 1031 exchange. Unlike a 1031 Exchange, the deferral of tax owed is for a limited time. The tax on the gain is deferred until the asset is sold, or December 31, 2026, whichever comes first. However, if the investor holds the asset for at least 5 years, there is a 10% exclusion of the deferred gain. If the investment was purchased prior to the end of 2019 and held for at least 7 years, the exclusion rises to 15%.
Perhaps more significantly, the gain and its corresponding tax on the Opportunity Zone investment itself can be eliminated completely. If the qualifying investment is held for 10 years, the basis in the investment is adjusted to fair market value on the date the investment is sold, thereby eliminating the capital gain on the qualifying investment entirely and extinguishing any capital gain tax liability for the investors.
Step Up for Heirs
The IRS grants the heirs of a person’s estate the right to increase, or “step-up”, the basis of inherited assets, avoiding capital gains taxes on the difference entirely. For example, if an investor owns an apartment building they paid $1,000,000 for and upon their death the market value is $2,000,000, the heirs will have a Cost Basis of $2,000,000 in the asset. At the point the heirs decide to sell the building, no taxes would be owed on the $1,000,000 increase in value that occurred prior to the original owner’s death. The heirs would only owe tax on the increase in value that occurred after they inherited the property. Of course, if the total value of the decedent’s estate was high enough to trigger estate taxation, those taxes would be owed at that time.
This article is not to be construed as tax or legal advice. The author is not a CPA, accountant, attorney, or tax professional, but rather a real estate investor who has learned the value of real estate investing including the tax benefits. This is merely a layman’s understanding of how the tax code applies to real estate investments. Every individual’s tax situation is different. Always seek the advice of your tax accountant or lawyer before making any investment or tax planning decisions.
References
Real Estate Professional Status
