Real estate has long been a popular investment. Rental properties, in particular, can be a source of income with many income tax benefits. In particular, real estate can provide a tax-deferred income stream due to the deduction of a non-cash expense called depreciation. Additionally, real estate provides many methods of transferring income to family members who might be in a lower tax bracket.
Another reason investors love real estate is that it has historically provided an inflation hedge. Add real estate’s high potential for capital appreciation and the ability to leverage your investment with financing, and it easy to see why so many taxpayers have real estate investments.
Unfortunately, very few taxpayers take advantage of many of the tax benefits that real estate offers investors. Here is a list and brief description of the major tax benefits available.
- Maximize the depreciation deduction. Depreciation cuts taxable income from rental real estate by deducting the cost of your investment over a period of time. Land is not depreciable, but everything else is. The building is depreciable over 27.5 years for residential property and 39 years for commercial property. Unless your losses are limited by passive activity limitations, it pays to maximize depreciation by allocating as much as possible to depreciates items more quickly. Here is a four-step process for increasing your depreciation deduction for your rental property:
- Divide your land between items that are “land”, “land improvements”, and the building structure. Land that is not depreciated by land improvements will generally be depreciated over a 15-year life. Here are examples of land improvements:
- Curbs or sidewalks
- Driveways and parking lot paving
- Landscaping
- Lighting
- Site concrete
- Site piping
- Divide your land between items that are “land”, “land improvements”, and the building structure. Land that is not depreciated by land improvements will generally be depreciated over a 15-year life. Here are examples of land improvements:
- Divide the building “structure” and “personal property”. Personal property is generally deducted over five years. The best way to document this is to have an engineering study called a “cost segregation" study. The following are examples of personal property:
- Appliances
- Cabinets or countertops
- Carpeting
- Fire suppression
- PA or sound system
- Signage
- Window treatments
- Movable walls or partitions
- Supplemental power
- If you are doing any land improvements or adding personal property to rental property (as described in 1a and 1b above), try to do so before the end of the year. For 2016, land improvements and personal property qualified for a 50 percent write-off in the first year.
- Properly allocating expenditures between repairs and improvements can save real estate investors thousands in dollars of taxes. Repairs keep your property in good condition but do not add to its value or extend the life of the asset. These include things like painting the building, replacing broken windows, or repairing broken plumbing.
- Take advantage of Safe Harbor for Small Taxpayers (SHST). The SHST is a great tax savings opportunity for smaller landlords. If you qualify, you may deduct expenses on your return for your annual expenses for repairs, maintenance, and improvements for your rental building. There are three safe harbor elections for rental property.
- Direct expensing up to the lesser of $10,000 or 2 percent of the building costs. (You can write off rather than capitalize $2,000 if your property cost you $100,000.)
- Routine maintenance allows you to deduct costs in the current year. The repair must be something that is expected to occur more than once every 10 years and cannot result in the betterment of the property.
- Expenses under $2,500 can be deducted rather than capitalized.
- Take advantage of tax credits available to real estate investors. They include:
- The Rehabilitation Tax Credit is for the cost of rehabilitating certified historic buildings. The credit can be up to 10 percent of what you pay to rehab commercial buildings placed in service before 1936, and 20 percent of what you pay to rehab certified structures. Review this with your tax advisor ahead of time.
- The Disabled Access Credit can be claimed by small businesses for expenses used to improve access for the disabled. This can reduce your tax bill up to $5,000.
- Hire your spouse to manage your rental property so you can set up benefits for them. Your spouse must be an employee, which means you will have to pay payroll taxes. The possible benefits include a pension plan, medical reimbursement plan, and education benefits. You will definitely need help from your tax advisor to run the numbers and make sure you follow all the rules and regulations.
- Hire your children to manage or maintain your property. They can earn up to the standard deduction ($6,300 in 2016) tax free, and the next $9,075 will only be taxed at 10 percent. Document the work, collect time sheets, and pay a reasonable wage. If you personally own the property, you will not have to pay Social Security and Medicare taxes until your children are 18, and they would be eligible for the same benefits as your spouse.
- Consider using your IRA, Roth IRA, or other retirement plan for real estate and related real estate investments (mortgages, notes, and tax liens). The key is to find a trustee who offers true self-directed accounts and will ensure that all IRS rules and regulations are followed.
- Don’t forget you and your spouse can exclude up to $500,000 in home sale gain. Here's how you qualify for this exclusion of gain:
- You own it for two of the last five years.
- You occupy it as your primary residence for two of the last five years.
- You haven’t used the exclusion within the last two years.
Many investors have used this exclusion multiple times by buying a distressed property, living in it for two years while renovating it, and then selling it at a gain. This gain is excluded, and then the investor repeats the process. Of course, this assumes one's willingness to move every two or three years, but you can make a nice tax-free income this way.
- Don’t lose your $500,000 income exclusion on the sale of your home! Many investors break into the rental market by renting their old home when they buy a new one. The problem is that you are losing the income exclusion explained in #9 above. A better strategy is to sell the old home and use the proceeds to buy a different home that you can then rent. You will also most likely get a higher depreciation amount, as the cost of the new home will usually be higher than the old home that you purchased years ago.
- Plan to use installment sale status when you sell a property at a taxable gain. An installment sale occurs when you receive the sales proceeds in more than one tax year. This allows you to defer the tax into a future year. Because tax rates rise as you make more income, you will likely pay a lower tax rate on the total gain.
- Explore using a Section 1031 exchange to defer taxes on the sale of property. Section 1031 is basically a tax-free exchange of one piece of property for another. These are complicated, so once again, I’m recommending that you get tax advice in advance. Here are some key points to know about 1031 exchanges.
- “Like kind” is defined loosely in real estate. You can trade raw land for developed acreage, and residential property for nonresidential property.
- You will need a qualified intermediary to arrange the transaction and hold the sales proceeds so that you don’t receive the actual proceeds and trigger a taxable event. Many title companies can handle this type of transaction.
- You must roll all of the proceeds from the property you sell into buying the replacement property.
- You will have a taxable event if you receive cash, other non-like kind property, or mortgage relief in the exchange.
- The exchange doesn’t have to happen at exactly the same time. You have 45 days from the date you relinquish your original property to identify the replacement, and an additional 135 days to actually close on your replacement.
- You can exchange properties as many times as you want, for a nearly unlimited tax deferral.
- Rather than selling real estate, borrow money and improve the property. This strategy is based on the idea that borrowed money is not taxable. As a recent example, a taxpayer took out a $100,000 loan on a property with a paid-off mortgage. They used $40,000 to fix up the property. They raised the rent enough on the newly renovated units to cover the loan payment, and pocketed the remaining $60,000 tax free. Their monthly cash flow stayed the same and they are letting the tenants pay off the new loan. It doesn’t get much sweeter than this in the tax law.
- Pay your 2016 property taxes before December 31, even if they are not due until next January.
- Consider using a charitable trust for appreciated properties. Charitable trusts let you avoid tax when you sell appreciated assets such as real estate, a business, or securities. This requires “splitting” the asset into two parts: an income portion that is payable to you for up to 20 years or until your death, and the property portion that is transferrable to the charity when the income period ends.
- Consider making the election to treat yourself or your spouse as a real estate professional. Doing so may be an excellent tax-cutting option if you have passive real estate losses from rental properties and you can’t deduct the losses against ordinary income.
You can only deduct the losses against other income if your adjusted gross income (AGI) is less than $100,000. This deduction starts to phase out above that amount and is eliminated in total once your AGI exceeds $150,000.
There are some criteria you must meet to elect real estate professional status.
- You must have at least 750 hours of real estate activities and more hours in real estate activities than in any other trade or business. You or your spouse must meet the test alone; you cannot combine hours.
- You must have material participation defined as:
- 500 hours of material participation in the property.
- 100 hours of participation and more than any other person in regards to the property, or more than everyone else combined.
Each property must stand alone, but you and your spouse can combine your hours.
At the risk of sounding like a broken record—this area is very complicated, filled with many rules and exceptions. Ask your tax advisor if this is an advantageous strategy for you.