Real Estate Investments
Tax Benefits of Real Estate Investing
San Diego CPA and real estate tax consultant Michael Fitzsimmons outlines some key tax rules on real estate. Real estate investing has long been an excellent tax strategy, primary because of depreciation deductions, Section 1031 Exchange, and special real estate depreciation recapture rules.
- Tax law allows a deduction for “depreciation” of rental real estate buildings. This is generally considered a non-cash deduction and contrary to economic reality, since the value of the structure generally goes up, not down, over time. For a cash-flow positive property, some or all of the net positive cash flow is not taxable in the year received, but instead many years later. Some experts call this “phantom income”. For a cash-flow negative property, depreciation results in deductions greater than cash paid each year for rental property expenses. Some experts call this “phantom deductions”.
- Net losses from a rental activity can be deducted in full against net income from another rental activity or passive investment (K-1), or, subject to the following limitations based on modified adjusted gross income, against other income.
- Less than $100,000: can deduct $25,000 of rental real estate losses against other non-passive income
- Between $100,000 and $150,000: can deduct between zero and $25,000 of rental real estate losses against other income
- Over $150,000: all losses are suspended
- If net losses are not deductible in the year incurred, they are suspended and carried forward indefinitely until either there is positive income against which they can be deducted or the property is sold. If the property is sold, the suspended losses are ordinary losses which first offset other ordinary income that year before offsetting any capital gain from the property sale. Even with suspended real estate losses, the taxpayer is essentially creating capital gain income and ordinary losses in the year the property is sold.
- Unlike most other investments, real estate can be sold without taxable income through a Section 1031 Exchange.
- The ultimate tax strategy is to die owning real estate with large unrealized gains built in. Unless you die in the year 2010, the unrealized gains disappear when your heirs inherit the property with a cost basis equal to the Fair Market Value at date of death.
- Benefits also apply for Alternative Minimum Tax (AMT).
Real Estate Investment Analysis
Real estate is a financially complex investment to evaluate because of the many factors affecting cash flows to the owner. Characteristics that distinguish real estate investments from typical “portfolio” investments (stock/bond/mutual fund) include very high leverage (debt), less volatile market value, high cost of purchase and sale transactions, and the many unique tax benefits mentioned above. San Diego CPA and real estate tax consultant Michael Fitzsimmons can help you analyze potential real estate investments by using sophisticated software to illustrate the financial results under varying assumptions (what-if scenario analysis).
Section 1031 Exchange: Tax-Deferred Real Estate Exchange
Internal Revenue Code Section 1031 is a fully legal yet very powerful tax strategy for real estate investors that was written into the tax law by the United State Congress. It has been around for many years and allows a real estate investor to sell one piece of real estate and not pay income taxes on the gain as long as another piece or pieces of real estate are acquired under conditions that are relatively easy to meet. You can’t sell shares of General Electric and reinvest in IBM without paying taxes! If you are contemplating a Section 1031 exchange, get advice from an experienced tax professional such as San Diego CPA and real estate tax consultant Michael Fitzsimmons to structure your exchange properly and get maximum benefit.
Types of Section 1031 Exchanges:
- Ordinary or “Deferred” Section 1031 Exchange
- Identify replacement property(ies) within 45 days
- Close on the purchase of replacement property(ies) within 180 days
- Reverse Section 1031 Exchange
- Acquire the replacement property more than 45 days before selling the original property.
- Usually requires significant financial resources of the investor and setup of a business entity such as a Limited Liability Company (LLC) to own the replacement property for a period of time before the original property is sold.
- Build-To-Suit Section 1031 Exchange
- Acquire land for the replacement property more than 45 days before selling the original property.
- Build a new structure on the replacement land.
- Usually requires significant financial resources of the investor and setup of a business entity such as a Limited Liability Company (LLC) to own the replacement property for a period of time before the original property is sold.
Related notes:
- Sometimes Section 1031 exchanges are referred to as “Starker” exchanges, but that is not really accurate. “Starker” actually refers to a court case that did not rely on Internal Revenue Code Section 1031 to do a tax-deferred exchange of real estate.
- How long should I hold it? This is a question I get all the time. The original and replacement properties generally should be held for business or investment use for two years before and after the exchange, although there can be exceptions to this under the right circumstances. A further issue here is converting between direct ownership and ownership through an entity and how that affects the holding period.
- Tax returns in years of Section 1031 exchanges are especially complicated because of accounting for deferred gains, carryover basis of multiple assets, prior years’ depreciation, and elections that affect subsequent years’ depreciation and accounting. Real estate investors should engage a CPA experienced in this area to avoid costly mistakes and gain maximum tax benefits that are available. San Diego CPA Michael Fitzsimmons has years of experience in 1031 exchange tax return preparation.
Real Estate Flipping vs. “Long-Term” Real Estate Investing
Flipping real estate is very different from long-term real estate investing. Get advice from an experienced professional such as San Diego CPA and real estate tax consultant Michael Fitzsimmons to make sure you avoid pitfalls and understand critical tax issues, such as:
- Capital Gains vs. Ordinary Income
- Self-Employment Tax
- Section 1031 Exchange of “Flip Property”
Switching from Residence to Rental Real Estate
In past years investors have converted properties from residences to rental properties and vice versa, taking advantage of the Section 121 exclusion of up to $500,000 of gain from principal residence and Section 1031 Exchange tax-deferral. New rules recently came out making this more complicated and risky. Consult with an experienced real estate tax professional such as San Diego CPA and real estate tax consultant Michael Fitzsimmons to make sure you understand critical tax issues, such as:
- Section 1031 and the new rules
- Section 121 and the new rules
- How Section 121 and Section 1031 work together
Structuring Ownership of Real Estate Investments / Business Entities
Many investors simply own rental real estate personally in their own names. Others feel the need for the protection of a business entity, like an LLC. Some investors use a separate business entity for each real estate property for maximum liability protection. Even with a business entity, attorneys typically recommend liability insurance.
The most common business entities to own rental real estate are the Limited Liability Company (LLC) and the Limited Partnership (LP). LLC’s have special tax problems in California and are less common here than in many other states. If an LP is used, a corporation (often an S-Corporation) is typically used as general partner to complete the liability protection. Trusts can be used in the right circumstances and can avoid the California $800 minimum annual tax. Corporations, including S-Corporations, are typically not used because the owner(s) cannot get the property out of the corporation without incurring tax liabilities.
When a real estate investor simply owns the property in his or her own name, there is no separate income tax return for the property – it is simply included on the owner’s personal income tax return on Schedule E. When a business entity owns the property, the business entity must file its own income tax return.
Rental Real Estate Income Tax Return
Income tax return reporting of rental real estate income and deductions depends on how the property is owned. For property owned by individuals, Schedule E of the Form 1040 Individual Income Tax Return is used.
Rental property owned by a partnership, LLC, corporation, or trust is reported on the entity’s income tax return on schedules that vary by type of entity. Typically, each rental activity is treated as a separate business activity with its own schedule of income and deductions – its own “P&L” – that is separate from the entity’s ordinary business income and deductions.
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