Real Estate Investment Primer
If you look at real estate prices in recent months you might think this is a great time to invest in an income-producing property. Whatever your motivation, there are several tax consequences that must be considered before you go to closing. This article explores some of major tax provisions affecting real estate.
Cash flow is obviously paramount in deciding whether an investment makes sense and in calculating returns, the tax savings generated from depreciation deductions should not be overlooked. These deductions are based on either 27.5 years, or 39 years straight-line amortization for residential rental property and non-residential real estate, respectively. Land is excluded for purposes of these calculations. Buyers should make sure that they keep a record of the contract and settlement sheet for the purchase, as these documents will serve as the basis for determining appropriate deductions and future depreciation charges. Most of the costs of purchase will be combined with the contract price to determine the cost or basis of the property subject to depreciation. Only certain costs like real estate taxes, loan interest, and points may be currently deductible depending upon how the real estate is held and the type of financing acquired. Real property received as a gift or through inheritance requires special calculations.
Often, real estate is evaluated based on the ability to offset gains from other investments through losses generated from the real estate operations – the problem with this is that the Internal Revenue Code limits loss deductions from passive activities (of which most real estate investments qualify) to the extent of other passive income. In other words, taxpayers are unable to deduct most real estate losses against their wages (active income) and portfolio income (interest and dividends). Residential rental real estate investments are an exception to this general rule for those investors who actively participate in managing the investment (I.R.C. Sec. 469(i)). In this instance, a maximum of $25,000 in losses may be deducted against all other types of income subject to a phase-out for those with adjusted gross incomes exceeding $100,000. This exception is limited to individuals and certain trusts and estates. It should be noted that real estate will not be considered a passive investment if more than half of the personal services that a taxpayer performs is in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services as a material participant in these businesses. In this instance, taxpayers may offset losses from their real estate investments against portfolio and active income. “Material participation” in an investment requires involvement in the activity on a regular, continuous, and substantial basis. This standard is higher than that required for “active participation” under the rental real estate exception, however, the taxpayer must have at least a ten percent ownership interest in the real estate activity. There are also at-risk rules that further limit the ability to deduct losses to amounts that are considered “at-risk” or subject to an economic loss by the taxpayer. Certain debt-financed property may run afoul of these rules depending on the type of financing.
Homeowners are afforded a special exclusion of gain when they sell a primary residence. Under I.R.C. Sec. 121, a taxpayer is currently allowed to exclude from income up to $250,000 of gain from the sale of a primary residence ($500,000 if married filing jointly), and they may take advantage of this exclusion every two years if certain requirements are met. A homeowner who converts a primary residence into a rental property may want to weigh the potential loss of this exclusion against any tax benefit derived from the rental treatment. When converting a primary residence into rental property, taxpayers are required to use the lower of the fair-market value or the cost as the basis for depreciation. This may be inadvisable if the property was purchased at the height of the market. Also, any depreciation taken on a rental property is not eligible for exclusion under I.R.C. Section 121 and is potentially subject to a tax rate of 25%. Individuals who convert a vacation home into a primary residence, in hopes of taking advantage of the exclusion rules, should be advised that the Housing Assistance Tax Act of 2008 has greatly reduced the benefit of this opportunity by providing for a period of nonqualified use in the exclusion calculation. This provision basically prohibits the exclusion from applying to a proportion of the gain attributable to any period that the property was not a primary residence after 2008.
Income or loss from any residential rental real estate investment is dependent upon the degree to which the taxpayer/owner occupies the property. I.R.C. Sec. 280A provides for an exclusion of income when a home is rented out for less than 15 days, however, none of the expenses allocable to the rental period are deductible other than real estate taxes and mortgage interest. If personal use of the property is more than the greater of 14 days or ten percent of the fair rental days, then all expenses relating to the property are limited to the rental income. Any expenses not currently deductible are carried forward to future years subject to the same limitations. In situations where the personal use is less than the greater of 14 days or ten percent of the fair rental days, taxpayers must allocate the expenses between the rental and personal portion and are permitted to deduct any loss in full, subject to the at-risk and passive activity loss rules. Taxpayers should be aware that there are two methods of allocating expenses in the rental of a vacation home – the so-called “court approach” made famous in Dorance D. Bolton, T.C. 104 (1982), and the IRS approach. Both of these methods may yield significantly different tax results and should be discussed with your tax advisor to determine which method is most appropriate.
Disposing of real estate investments creates many difficult calculations to determine the tax treatment of any resulting gain or loss. Often, losses from the disposition of the investment are deductible in full against all other income of the taxpayer. On the other hand, gains may be taxed at 25% rather than the lower 20% capital gain rate. If structured properly, a tax-deferred exchange may be arranged to defer the gain on the sale of real estate. The provisions affecting real estate are complex and involve many rules that, if not properly followed, can result in significant negative tax consequences. The professionals at Reger, Rizzo & Darnall can help you structure your real estate transactions using the most tax-wise strategies.