In prior articles we mentioned the tax advantages of investing in real estate. Tom Wheelwright’s most recent book The Win-Win Wealth Strategy does a great job explaining why the government has created such incentives and how they benefit not only the real estate investor and the community, but also the government itself. In today’s quick snippet we will scratch the surface of a few of those tax advantages. As usual, we would emphasize that it is best to and that you should always consult with your CPA on any additional strategies and if/how any of the ones noted herein can apply to you. Let’s dive in.
Depreciation is a non-cash expense. The underlying premise is that the building loses its book value over time due to natural wear and tear. We know this is really not the case (as the property’s market value, especially when held long term, usually increases over time). Each time a property is sold, the new owner restarts the clock on such depreciation. However, this non-cash expense can reduce the net income generated by such property and thereby reduce its taxable income.
A commercial property is usually depreciated over a 39-year straight-line period. A residential property (multifamily is included in such definition for tax purposes) depreciates over a 27.5-year straight line period.
The tax code also allows an owner to accelerate the depreciation and record it in year 1 of owning the property by performing a cost segregation study. Such study is conducted by property engineers and tax professionals who detail each component of a building. Such component may be on a different depreciation schedule, i.e. some components may be depreciated over 5 years vs. 27.5 years. This process in essence allows one to accelerate the depreciation on average. 2022 is the last tax year during which one can claim 100% bonus depreciation. Starting in 2023 it will phase down to 80%, then 60% in 2024 and so forth until it reverts to the historical rate of 20% (unless the tax code is changed again).
When (bonus) depreciation is taken, it can create paper losses. Such passive losses can be used to offset other passive income. This can potentially offset a big portion of your taxable income if you or your spouse qualify as a real estate professional (see below). If you earn $250K or above, your passive losses can only offset other passive income (e.g. passive losses from a cost segregation on a new deal in Year 1, can offset passive income on another deal that is now in Year 2 or 3). In addition, even if you have no other passive income to offset, you do not lose such passive losses. These losses are accumulated and can later be applied against the gain on sale of the asset.
Depreciation serves as a tax deferral strategy. Deferral vs. savings is a more accurate way to describe it, as it is usually recaptured at the time of sale (irrespective of whether you claimed it or not). Accelerating depreciation effectively allows you to use the tax savings today (time value of money) to invest in other cash flowing assets today.
2. 1031 Exchange.
1031 is a section within the IRS code that allows one to exchange one property for another (of equal or greater value) and thereby defer the tax on the gain from the sale. One can 1031 exchange properties indefinitely, until one passes away, at which point title would transfer to one’s successor at a market (vs. cost) basis minimizing the successor’s tax liability. The replacement property must be identified within 45 days from and the exchange must close within 180 days from when the relinquished property closes the sale.
1031 may not make sense in all scenarios. For example, if you have meaningful passive losses accumulated over time, they may be sufficient to offset most of the capital gain, making the cost and time of a 1031 exchange not as attractive.
If you decide to proceed with a 1031 exchange, you must engage a qualified intermediary to manage the exchange and before you take any action, as always you should consult with your CPA to determine the optimal strategy for your individual situation.
3. Real Estate Professional Status (REPS).
A REP spends: (i) more than 750 hours per year on a real estate business (e.g. an active investor would qualify as one but an admin working in a title company would likely not) and (ii) more than 50% of the time on a real estate business. The 50% rule makes it difficult for a full time W2 earner to qualify as a REP as it is generally very difficult to prove that you work more than 40 hours a week on the real estate business in addition to your full time job. You must track your hours and be able to clearly document what you did and when, in the event of an audit. The benefit of being able to qualify as REPS is overall reduction in your tax bracket to as low as 15% (vs. 35%).
4. Cash Out Refinance Tax Free Income.
When you refinance a property, such cash out refinance income is usually tax free as the source of that income is debt (you are leveraging your property even more). Debt is not considered earned or investment income for tax purposes. This is one of the powers of real estate – when you own an asset you can keep refinancing every few years and utilize the cash out income to invest in more income producing assets.
5. Rental Income And Capital Gains Tax.
As rental income is not earned W2 income, it is not subject to Social Security and Medicare tax. In addition, while short term capital gains (e.g. flips) are taxed as ordinary earned income (and therefore would fall in the various ordinary income tax brackets), if you hold a property long term (more than a year), the gains on sale are considered long term capital gains and as such, taxed at a lower income tax rate (15-20%, depending on your tax bracket).
6. Homestead Exemption.
When you sell your personal residence, you have the ability to exclude capital gains of up to $500K (if married) or $250K (if single), if you lived in that home for two of the past five years. For example, for a home you purchased at $250K when you were single and sold at $500K a few years later when you start a family, that $250K gain will be tax free.
The above strategies are just a few ways to reduce or defer one’s taxes and designed to stimulate investment in real estate. As noted previously, it is always best to consult with your CPA to explore additional paths that may be more applicable to your individual situation and goals.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.