Real estate is a popular investment, and there are many potential tax benefits to owning it. Want to get all the tax benefits you could be entitled to? Of course you do! So learn about some of the more popular benefits, and pitfalls, in my real estate tax-benefit checklist below. (Thanks to my partner Brian Lovett, CPA, JD, for his help compiling this checklist.)
Entity selection. The choice of the entity that owns your investment real estate is very significant. Real estate should generally be owned by an unincorporated entity such as a partnership or LLC. This permits the pass-through of gains and losses to the owners…a step-up in basis if real estate is inherited and the ability to take depreciation deductions on the stepped-up amount…and the possibility of a donation of the real estate to a charity without having to be taxed on the appreciated value while getting a full deduction for the entire value. Mortgage debt can be used to establish basis, allowing greater losses to pass through to the owners. The property can also obtain mortgages based on the appreciated value, and the proceeds can be distributed to the owners tax-free. A single owner can establish an LLC and does not have to file a separate tax return to report the activities. There are special situations when real estate should be owned in a corporation, but these will not be covered here.
Real estate professional status. Real estate professional status would allow you to avoid the net investment income tax. In addition, losses incurred by real estate professionals are available to offset other ordinary income. To qualify, you must be primarily engaged in managing real estate and in other enumerated real estate activities. There are strict rules to be followed, but substantial tax benefits can be realized.
Annual operating losses. Deductibility of real estate operating losses is limited on the individual return of the owner(s) based on their other passive income and their adjusted gross income. If they don’t have real estate professional status, amounts not deductible can be carried forward to offset future income or to offset an eventual gain on the sale of the property. Note that some states do not permit this offset, so you need to check the rules of your state. If you own multiple properties, then real estate rental losses can offset income so those with active acquisition or development programs can use the losses on the new properties to shelter the income from their mature properties.
Mortgage interest. If properly elected, mortgage interest on rental real estate is deductible in full on the return or schedule that reports the transactions. In exchange for this deduction, there are special depreciation calculations that must be done.
Using Section 1031. This part of the tax code permits the deferral of tax on sale at a gain if like-kind replacement property is acquired in exchange for the property sold. The tax is deferred until the replacement property is sold. With a continuous series of Section 1031 exchanges, tax can be deferred for very long periods, and if the property is still owned at the owner’s death, the basis will be stepped up totally, eliminating capital gains tax.
Installment sale. When a seller of real estate defers receipt of a portion of the price, tax on the portion of the gain attributed to a deferred payment can be deferred until receipt of the deferred payment. With long-term mortgages or notes, this can draw out the tax payment over many years. Interest payments received on the unpaid principal would be taxable. If the entire purchase price were paid at closing, the after-tax cash available for reinvestment would be lower, potentially reducing the annual investment income below that which could be achieved via an installment sale. The risk of default on an installment note should be considered.
Additional depreciation on inherited partnership interests–Section 754. When interests in a partnership holding real estate are inherited or acquired via purchase, Section 754 permits additional depreciation based on the excess of the inherited value or amount paid over the basis of the property on the books of the entity. This is not permitted for acquisitions of corporations that own real estate.
Cost segregation study. This is an engineering-based analysis done when a property is acquired. The cost segregation study allocates the purchase price among various components that are entitled to shorter depreciable lives. For example, the acquisition price allocated to seven-year property would be depreciated over seven years, much quicker than the 39-year recovery period for the building property. Further, under the recently enacted Tax Cuts and Jobs Act of 2017, assets with a recovery period of 20 years or less may be eligible for additional first-year bonus depreciation. A cost segregation study is typically performed when a property is acquired, but it can be done retroactively in subsequent years. If it’s not performed in the year of acquisition, a taxpayer is required to file a change in accounting method to catch up the depreciation that was under-deducted. It can also be done for property previously acquired to allocate basis to an asset that the buyer wasn’t aware they were acquiring, such as when they are asked to sell “air rights” to their property.
Step-up upon death. When partnership interests in an entity that holds property are inherited, that partnership is valued based on the value of the property at the date of death. As a result, the value of the interest is increased, or stepped-up, to the date-of-death value with no capital gains tax on that increase. In addition, by making an election under Section 754 (discussed previously), you can take depreciation on the stepped-up amount. It is important to note that if a partnership interest has negative basis, perhaps because of prior depreciation deductions or withdrawals of mortgage refinancing proceeds, the step-up procedure would wipe out any tax on the negative basis.
Retirement account ownership. IRA and other retirement account ownership of real estate is permitted. Generally, any income would not be taxable to the plan. However, to the extent the property was acquired with a mortgage, income in the retirement account attributable to the debt-financed property would be taxed as unrelated business income. When this is done, there can be no self-dealing where the IRA or retirement account owner uses the property. The ins and outs of holding real estate in a retirement account are many and are pretty complex—I’ll help you through them in a future post.
Not every owner of investment real estate could or should use every strategy described above. But if you use this rundown as a starting point to understand the many tax benefits of owning real estate, you’ll be ahead of many people in getting correctly positioned. Be aware that the tax rules are very technical and in some cases very narrow and specific. Make sure you check with a knowledgeable tax advisor before proceeding with any of these issues—and to determine whether you are maximizing tax benefits.