The pullback in real estate prices in many areas of the US might offer buying opportunities for careful investors.

What’s more, tax advantages may make a good real estate investment even better. The following simplified example can illustrate some of these tax breaks…

TAX-FREE CASH FLOW

John Smith buys a small apartment building near his home for $1 million. He makes a $200,000 down payment and borrows the remaining $800,000 at 7%. The loan calls for interest-only payments.

Counting the cash flow: Assume that the building’s operating income this year is $80,000. That’s the excess of rental income from tenants over John’s expenses for utilities, insurance, repairs, etc.

John pays $56,000 interest on the loan — 7% of $800,000. Therefore, his cash flow from the building is $24,000. That is the $80,000 from operations minus the $56,000 he pays in loan interest.

Tax break: John also is entitled to take depreciation deductions. The actual amount will depend on the allocation between land and building as well as the allocation within the building to furnishings, fixtures, etc.

Assume, for this example, that John is entitled to $40,000 worth of depreciation on his $1 million apartment building.

Result: John now has a $16,000 net loss from this investment, for tax purposes. His operating income is $80,000, but he deducts a total of $96,000 for interest and depreciation.

With a net loss from the deal, John owes no income tax on his rental income. He pockets $24,000.

Caution: This $24,000 is not totally tax free. His cost basis in the property is reduced by his $40,000 depreciation deduction. When he sells the property, this basis reduction will either increase the tax he owes or decrease his reported capital loss.

DEDUCTING LOSSES

Although the above example is simplified, it is true that real estate investors in a successful venture can collect untaxed cash flow. Can they go one step further, and deduct a net loss from ordinary income that year?

Key: The tax treatment is subject to the “passive activity loss” rules that generally apply to investment property. For most taxpayers, passive losses up to $25,000 per year can be deducted.

Required: To take a $25,000 loss, your adjusted gross income (AGI) must be under $100,000.

If your AGI is more than $100,000, that $25,000 maximum deductible loss phases out. By $150,000 in AGI, no such deduction is permitted.

Example: John Smith’s AGI this year is $135,000. He is 70% through the $100,000 to $150,000 phaseout range. Thus, he can take only 30% ($7,500) of the $25,000 maximum deduction.

Result: John not only has $24,000 in untaxed cash flow, as described above — he also has a $7,500 loss that he can deduct from his ordinary income this year.

Above, it was shown that John’s reported loss from the deal was $16,000 this year. If he deducts $7,500, what happens to the other $8,500?

Going forward: That $8,500 can be carried forward indefinitely to future years when it can be deducted against passive activity income.

Any passive losses that still exist may be deducted when the property is sold.

TAX-DEFERRED EXCHANGES

Fast-forward several years. Assume that John Smith is about to retire and move to Florida. He no longer wants to manage the apartment building near his current home in Connecticut.

Tax trap: If John sells the building, he faces a sizable tax bill. Not only will he owe tax on the building’s appreciation, he also will owe tax on all the depreciation deductions he has taken.

Strategy: John can enter into a tax-deferred exchange for another investment property. This exchange does not have to be for another apartment building.

Instead, the exchange can involve any type of investment real estate.

Example: John wishes to exchange his Connecticut apartment house for a mini-storage facility near his intended retirement home in Florida. He expects to hire a manager — reducing his personal time commitment — and collect retirement income from the property.

How it works: John can sell his apartment building in Connecticut. The sales proceeds will be held by an unrelated party acting as intermediary. He might ask a trusted adviser, such as his attorney or accountant, to suggest someone who works in tax-deferred exchanges to be an intermediary.

Then John can find a replacement property in Florida. Once a purchase is negotiated, the intermediary can use the money from the Connecticut sale for the acquisition.

Required: After you transfer your property, you have up to 45 days to identify potential replacement properties, in writing, to the intermediary.

You can name up to three properties of any value. Or you can name any number of properties with an aggregate value of no more than 200% of the price you received for your property.

You have 180 days from the time you relinquish your property to actually close a deal for replacement property.

Result: If these criteria are met, all taxes on the original sale will be deferred…

  • The amount you pay for the replacement property must be at least as much as the price you receive for the property you relinquish.
  • All the cash you receive must be reinvested in the new property.
  • Any debt relief (debt on old property that has been paid off) must be replaced by a combination of new debt and additional cash put into the deal.
  • If you satisfy the first two tests, you’ll pass the third one as well.

    However, any cash or debt relief (in excess of new debt and additional cash put into the deal) you receive from these transactions is known as “boot,” which will be subject to income tax.

    Note: Excess passive activity losses previously suspended from the Connecticut property will not become deductible because of the exchange. Instead, the losses will be carried forward and be deductible against income from the Florida property.

    State tax benefit/trap: An increasing number of states impose tax on like-kind exchanges of in-state property for out-of-state property. However, Connecticut is not one of them.

    Thus, if John becomes a Florida resident, no state income tax ever will be paid on the gain from the Connecticut property. Connecticut will treat the transaction as a qualifying like-kind exchange, and Florida has no income tax.

    However, if the apartment building were in, say, Vermont, there would be state income tax on the sale imposed by Vermont. That would be the case because the replacement property is outside of Vermont.

    Bottom line: Not every real estate investment will go as smoothly as the one illustrated above. Nevertheless, today’s weak market may create buying opportunities, and the tax benefits of real estate can enhance the profit potential.