Investment rental property, whether houses, apartments, vacant land, commercial buildings, shopping centers or warehouses, offer big tax incentives for investors who understand the special but complex tax rules and regulations related to these investments.

Real Estate Professionals

The best breaks go to “real estate professionals,” defined as those who spend at least 750 hours per year, or more than 50% of their working hours, involved in real estate activities.

Full-time real estate brokers, realty sales agents, property managers, builders, contractors and leasing agents are eligible for virtually unlimited income tax deductions from their investment properties. However, the tax law clearly excludes real estate attorneys and mortgage brokers from qualifying for these unlimited investment property deductions.

 

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Real Estate Investors

Investors that do not meet the “real estate professional” test are limited to a maximum annual $25,000 realty investment property loss deduction against their ordinary taxable income from other sources, such as job salary.

If the nonprofessional investor’s annual adjusted income exceeds $100,000, the $25,000 loss deduction gradually phases out. At the $150,000 adjusted income level, the allowable tax loss deduction plummets to zero. The phase out is $1.00 for every dollar of earnings above adjusted gross income of $100,000.00 completely phased out by and AGI of $150,000.00.

Investment Tax Loss Suspended

Any phased out real estate investment tax loss is “suspended” for future use, such as at the time the property is sold at a profit. The unused suspended tax loss can be subtracted from the capital gain to lower the taxable profit. Suspended losses are also deductible against future net earnings related to the specific or sometimes pooled investment rental properties at such time that those properties have profits. The suspended losses are deductible dollar for dollar against profits at such time that those profits occur.

Unused suspended losses cannot be carried back to prior tax years to claim a refund. Suspended passive activity tax losses are available to offset profits from the sale of the property. Specific rules exist that allow the use of suspended property losses on an aggregate basis, rather than property by property. This is extremely important if the taxpayer owns several properties. This allows for planning in the sale of any given property and the sheltering of any possible gain when suspended losses exist in aggregate.

When planning a sale, the recapture of prior depreciation must be factored in when selling depreciable realty.

The Internal Revenue Code requires property investors to depreciate their investment properties, such as rental houses, apartments, warehouses, office buildings and shopping centers based upon Internal Revenue Code sections and regulations.
Depreciation is a “paper loss” required for estimated wear, tear and obsolescence. Land value is not depreciable. An allocation based upon objective data must be made between depreciable property components and land. Generally, lacking other objective evidence, the IRS will rely upon the local county assessor’s allocation between the land and improvements of any given property. While the assessor’s allocation may not be entirely accurate for any given property, lacking better information the IRS will generally use these allocations as the basis for which the property will depreciated.

Depreciation

Residential income property is depreciated over 27 1/2 years on a straight-line basis; commercial property over 39 years. Personal property, such as apartment appliances, is depreciated over shorter periods, typically five to 10 years. Even cars and trucks used in the investment operation can be depreciated over their useful lives.

An important point to consider is component depreciation when acquiring tangible equipment. First-year 100% deduction for up to $100,000 of business equipment purchased is available to property investors, a much looked over fact.

Because depreciation is a noncash expense deduction, it reduces taxable income from the investment property. Although the depreciation deduction often turns a positive-cash-flow property into a tax loss for income tax purposes, the result is the investor’s cash flow from rental income is said to be “tax sheltered.”

Given the locale of any given property the likelihood is that most investment properties appreciate in market value each year while on paper the “book value” is depreciating or declining annually. The result, the book value declines while the market value usually goes up creating potentially two types of gain upon sale, one being capital in nature which has very favorable tax treatment in that the lower Capital Gains Tax applies. The other type of gain is ordinary which is created by the depreciation. This ordinary depreciation must in most cases be recaptured on sale of the property.

Capital Gains

The federal capital gains tax rate is 15% for assets owned over 12 months. But the special 25% depreciation “recapture” tax rate remains unchanged. “Recapture” means part of the gain will be taxed when a property is sold.

For example, suppose you bought a small investment property for $300,000 and deducted $100,000 of depreciation during your ownership years. That means the book value (also called “adjusted cost basis”) declined to $200,000. Assume a sales price of $450,000. The capital gain is therefore $250,000 ($450,000 minus $200,000). Of that $250,000 capital gain, the $100,000 depreciation deducted will be “recaptured” and taxed at the 25% special federal tax rate. The $150,000 remainder of your capital gain will be taxed at the new 15% maximum tax rate.

Tax-Deferred Exchange

However, a way to avoid paying the 25% federal recapture tax is to make a tax-deferred exchange for another investment property, as allowed by Internal Revenue Code 1031. IRC 1031 allows for an exchange of “like kind” property assuming various criteria are met, the tax will be legally escaped. This is a highly complex transaction and must be planned well in advance.

For qualified real estate professionals who “materially participate” in managing their investment property, there is no limit to the allowable property-related deductions, which can be subtracted from other ordinary income.

If the criteria are met relating to the definition(s) of a real estate professional and material participation tests, deductions for operating losses are unlimited, at least to the extent that losses exist. The tax deductions are fully deductible, even if a professional manager is retained to operate your property for day-to-day operations, such as collecting rent, managing the properties, etc. However, you must make the major decisions, such as setting rent, approving major expenses and qualifying new tenants.

Real estate investments, for tax purposes, are said to be a “passive activity.”

Part-time realty investors who earn less than $100,000 annually can claim only up to $25,000 annual passive activity deductions from their other ordinary income.

To qualify, part-time investors must pass two tests:

 

  1. Own at least 10% of the investment property. The purpose of this rule is to eliminate small real estate limited partners from claiming loss deductions against their other ordinary income.
  2. A part-time investor must “materially participate” in property management decisions, as explained earlier. For example, if you own a vacation property that is in a “rental pool” when you are not using it, then that is not considered material participation because you do not approve each individual who uses your property. The contrary is true as well, if you make the decisions relating to your specific property, then you most probably will qualify as materially participating.

 

Peter Muffoletto is with Peter Muffoletto & Company and may be reached at 

(818) 346-2160, or you can visit us on the web at www.petemcpa.com.

 

To read more articles from the December 2021 Issue of the AOA Magazine, click here.