Investing in real estate is one of the most beneficial modes for generating wealth and is known to be the best performing asset in modern times. Owning real estate creates opportunities to generate cash flow, create avenues for effective wealth building and transferring and, provide for estate planning advantages. In utilizing tax deductions, tax incentives and strategic tax planning, real estate owners create opportunities to achieve financial goals. There are many benefits for investors however, understanding these benefits can be confusing and become quite overwhelming. Tax laws are constantly changing and property owners must stay on top of these complex rules to achieve the greatest benefits.
CREATING CASH FLOW:
If your desire to own real estate is driven by creating cash flow, there are several factors that will need to be considered in order to maximize tax benefits and, ultimately, financial gain. Initial intent of the property will determine what tax breaks and possible tax deferral methods are available to the investor. In turn, the investor may also be concerned with asset protection and choose to place the real estate in a legally structured business entity. Most real estate investors opt for a limited liability company or a limited partnership type entity. These are typically the best choices to increase asset protection from creditors or lawsuits, limiting the amount of liability and risk associated with owning real estate property and running a real estate investment business. However, choosing to hold the property in one of these business structures will require the entity to file tax returns. If a property owner chooses to hold the property outright and in an income producing capacity, all income and expense associated with the property would be reported on the owner’s individual tax return. However, it is suggested that a CPA and/or attorney be consulted for advisement on which entity is most appropriate for the investor’s own personal circumstances.
For most real estate owners, the intent of using the property as investment or rental, for instance, will classify the property as a capital asset, giving rise to capital gains or losses when disposed of, in most circumstances. For investors who sell or flip real estate as part of their business or are deemed real estate dealers, the real estate would be classified as inventory and income associated with selling will give rise to ordinary income. Real estate that is considered inventory has different tax implications as opposed to real estate that is considered a capital asset, held as investment or rental property. It may be advantageous either way, depending on the real estate investor’s individual circumstance.
Real estate that is held for rental, vacation, commercial or investment, classified as a capital asset will be taxed at the favorable capital gains rates, the highest being 20% unlike the highest bracket of 37% for ordinary income. While there is no real benefit for holding the property short term, defined as less than 1 year, properties held long term, for over one year, will reap these beneficial rates.
In creating a source of cash flow from real estate holdings, the biggest boon to achieving financial goals is a result of available deductions to offset any income generated from the property. Deductions such as property taxes, mortgage interest, repairs, along with any ordinary and necessary expenses for managing, operating and maintaining the property, including advertising, utilities and insurance may be used as a deduction against current year income. The Tax Cuts and Job Act also created a deduction allowing for profitable businesses, including rentals that earn qualified business income (QBI) to pass along a benefit to investors of a deduction of up to 20% of the net business income.
One point to keep in mind when planning for increased cash flow or loss is that any income earned from real estate holdings by an owner that is not considered a real estate professional and who does not actively participate in the business activity is classified as passive income. Losses generated from these passive real estate activities can only be offset by other passive income. However, in some instances up to $25,000 in passive losses in rental real estate can be deducted each year to offset non passive income.
Of the available deductions associated with holding real estate, one of the biggest tax benefits comes from the ability to claim a depreciation expense deduction. The concept of depreciation allows the investor to recover the cost of income producing property as yearly, tax deductions for the wearing down of assets. Simplified, a depreciation expense is calculated using the property’s cost basis, useful life expectancy over a determined depreciable method for specified asset classes. Land is not depreciable but buildings and building components are. In fact, significant tax benefits can be found by utilizing more favorable depreciation schedules by seeking out and conducting cost segregation studies to identify fundamental building components and classifying accordingly, to separate from real property, in order to create a more beneficial depreciation deduction. It is even possible at times, to have depreciation expense categorized as a net loss on property regardless of if the property has current year positive cash flow. A property’s life depends on the type of property, for instance, for residential rental property, the property can be depreciated over 27.5 years or, if commercial property, depreciated over 39 years. At the end of the property’s depreciable life, the property’s value for tax purposes would be zero as, the investor in previous years would have realized the depreciable loss in annual increments.
One might think that owning a property at the end of the property’s useful life and having a zero-tax basis, may be problematic if the opportunity or the want to sell may present itself. In theory, taxes would be owed on the difference between the sales price and the depreciated value. For tax purposes, this is known as depreciation recapture whereas, gains to the extent of depreciation claimed are treated as ordinary income. Many look at the concept of depreciation as a form of income deferral, that is, an expense deduction which ultimately defers tax on current year income until the property is sold. If property is not fully depreciated when sold, the property’s gain on sale will be partially taxed as ordinary income and partially taxed at the more favorable, capital gain rates. Some real estate owners may see a benefit in selling and paying taxes on the gain by buying new properties that can potentially generate higher returns and offset tax burdens while other property owners may only see tax burdens upon sale. Fortunately, there are avenues to relieve the tax burdens of property sale dispositions.
One avenue is found in the Internal Revenue Code Section 1031 which provides for a like kind exchange of real property held either for investment or trade or business use. These exchanges allow for property owners to exchange one real estate investment for another of equal or greater value. The property owner must find and identify a replacement property for the original within 45 days and complete the exchange of property within 6 months. If the transaction is handled properly, the property owner will not be required to recognize a gain or loss and will avoid paying any taxes on the current disposition of the original property until the replacement property is sold at a later date, deferring taxes indefinitely on the sale.
A second potential avenue of deferral of tax on the gain resulting from property sales was introduced as a tax incentive in 2018 as part of the Tax Cuts and Jobs Act. This incentive, created to encourage development and growth in specific designated distressed areas called, Qualified Opportunity Zones, give investors the ability to defer gain, temporarily or permanently if they elect to invest all capital gains earned from a sale of property into an opportunity zone fund. The deferral benefit is based on how many years the investor commits to the investment, ultimately qualifying for additional tax breaks, including a permanent tax exemption on all gains realized on any opportunity zone investments.
Although, creating an annual cash flow from owning or investing in a real estate type business, along with all the possible tax incentives associated with it, is very appealing to some, many people wish to own real estate property for personal use. Whether residential home ownership or vacation home ownership, home ownership builds wealth over time and is historically an overall good financial decision. There are also tax incentives to residential home ownership such as a mortgage interest tax deduction. For many people, interest payments made on residential mortgages, especially early in the mortgage, are one of the largest deductions that are taken on tax returns. Property taxes on a personal residence and a vacation home are also deductible for income tax purposes. Besides the tax incentives, the largest financial returns come from appreciation in the property which will be tax free to the owner due to IRS exclusions up to $250,000 per person or $500,000 for a married couple if ownership and use tests are met when the property is sold.
ASSET AND ESTATE PLANNING WITH REAL ESTATE PROPERTY:
There are a number of tools that can be used by the real estate owner to fully realize the benefits associated with property ownership. Regardless of tax deferrals on capital gains, taxes must be paid at some point. When an individual owns real estate, property can be held until death which at that point will be transferred to heirs at a stepped-up value and can potentially escape any tax on gains. Estate planning tools can also be utilized by transferring real estate property into partnership or LLCs in order to take advantage of discounting. There are additional asset planning and wealth transferring opportunities when owning real estate when appreciation of real property is anticipated if the owner holds the real estate in a Roth IRA or a Grantor Retained Annuity Trust, for instance. Being aware and proactively planning for asset appreciation can greatly increase the likelihood of reaching financial goals.
As a real estate owner, keep in mind that many of the benefits of owning real estate are tax deductions and incentives. Tax laws are constantly changing and property owners must stay on top of these complex rules to achieve the greatest benefits to maximize their financial goals.
Cathy Sciera is a tax Manager at CDH, P.C. She has more than two decades of accounting experience. She received her Bachelor of Business Administration in Finance at Loyola University Chicago, and her Master of Science in Taxation at Golden Gate University.