Real estate pros enjoy unique tax breaks

Why do individuals invest in real estate? Appreciation in property market value? Leverage benefits of controlling investment property profits with little or no cash down payments? Income tax shelter benefits?

No matter what type of investment real estate you prefer, such as rental houses, apartments, vacant land, commercial buildings, shopping centers or warehouses, they all offer big tax incentives for investors who understand those benefits.

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THE BEST REALTY INVESTOR TAX BREAKS GO TO ‘REAL ESTATE PROFESSIONALS.’ If you spend at least 750 hours per year, or more than 50 percent of your working hours, involved in real estate activities, you probably qualify as a “real estate professional.” That means you are eligible for virtually unlimited income tax deductions from your investment property.

Full-time real estate brokers, realty sales agents, property managers, builders, contractors and leasing agents are examples of qualified real estate professionals. However, the tax law clearly excludes real estate attorneys and mortgage brokers from qualifying for the unlimited investment property deductions against ordinary income.

Realty investors who don’t meet the “real estate professional” test are limited to a maximum annual $25,000 realty investment property loss deduction against their ordinary taxable income from other sources, such as job salary. However, there’s a catch.

The bad news is if the non-professional investor’s annual adjusted income exceeds $100,000, the $25,000 loss deduction gradually phases out. At the $150,000 adjusted income level, the allowable tax loss deduction plummets to zero.

But the good news is any undeducted real estate investment tax loss is “suspended” for future use, such as at the time the property is sold at a profit. Then the unused suspended tax loss can be subtracted from the capital gain to lower the taxable profit.

‘MATERIAL PARTICIPATION’ IS REQUIRED FOR INVESTOR TAX BREAKS. If you qualify as a real estate professional who spends at least 750 hours per year, or more than 50 percent of your working time, in qualified real estate work, and if you “materially participate” in managing your investment property, there is no limit to the allowable tax deductions from your properties that can be subtracted from your other ordinary income.

You can still meet the material participation test, and claim the unlimited tax deductions as a real estate professional, even if you hire a professional property manager to operate your property. However, you must make the major decisions, such as setting rents, approving major expenses, and qualifying new tenants.

But day-to-day operating details, such as collecting rents, evicting deadbeat tenants, and unclogging drains, can be delegated to others, such as your resident manager or a professional property manager.

As mentioned earlier, if you don’t qualify for the real estate professional unlimited tax loss deductions from your investment real estate, but you materially participate in managing your property, you are limited to deducting $25,000 each year if your adjusted gross income is $100,000 or less.

Above that amount, the deductibility gradually phases out to zero at $150,000 annual adjusted gross income. But any unused deductions can be “suspended” for use in future tax years or when the property is sold.

WHY DEPRECIATION IS THE BEST TAX DEDUCTION. Many potential real estate investors, and even current investment property owners, don’t fully understand why depreciation is the best real estate tax deduction of all.

Uncle Sam requires property investors to depreciate their investment properties, such as rental houses, apartments, warehouses, office buildings, and shopping centers. Depreciation is a “paper loss” required for estimated wear, tear and obsolescence. However, land value is not depreciable.

Residential income property is depreciated over 27.5 years on a straight-line basis. Commercial property is depreciated over 39 years. Personal property used in operating the property, such as apartment appliances, is depreciated over shorter periods, typically five to 10 years. Even automobiles and trucks used in the investment operation can be depreciated over their useful lives.

There is also the new first-year 100 percent deduction for up to $100,000 of business equipment purchased to consider.

Because depreciation is a non-cash expense deduction, it reduces taxable income from the investment property. But it doesn’t require any cash outlay, as do property taxes, mortgage interest, utilities, insurance and repairs require.

Although the depreciation expense deduction often turns a positive cash flow property into a tax loss for income tax purposes, the result is the investor’s cash flow from rental income is said to be “tax sheltered.” As explained earlier, the investment property tax loss is usually not an actual loss.

Because most investment properties appreciate in market value each year, on paper their “book value” is depreciating or declining annually. The bookkeeping result is the book value declines while the market value usually goes up.

TWO TESTS FOR PASSIVE ACTIVITY LOSS DEDUCTIONS. Real estate investments, for tax purposes, are said to be a “passive activity.” Unless you are a qualified real estate professional entitled to the unlimited realty investment tax loss deductions against your ordinary income from other sources, such as real estate sales commissions, part-time realty investors who earn less than $100,000 annually can only claim up to $25,000 annual passive activity deductions from their other ordinary income.

To qualify, part-time investors must pass two tests:

1–You must own at least 10 percent of the investment property. The purpose of this tax rule is to eliminate small real estate limited partners from claiming loss deductions against their other ordinary income.

2–You must “materially participate” in property management decisions, as explained earlier. To illustrate, if you own a vacation condo that is in a “rental pool” when you aren’t using it, then that is not considered material participation because you don’t approve each individual who uses your condo.

SAVE UNUSED PASSIVE ACTIVITY DEDUCTIONS FOR FUTURE USE. If you don’t qualify to deduct all your investment property passive activity tax losses against ordinary incomes, those undeducted losses can be saved or suspended for use in future tax years or when the property is sold.

However, unused tax losses from investment properties cannot be carried back to prior tax years to claim a tax refund.

IRS Notice 88-94 allows use of suspended passive activity tax losses from realty investment assets to offset profits from the sale of the property. The tax result is use of suspended property losses on an aggregate basis, rather than property-by-property.

BEWARE OF RECAPTURED DEPRECIATION WHEN SELLING DEPRECIABLE REALTY. The 1997 Taxpayer Relief Act reduced the federal capital gains tax rate to 20 percent. Then the maximum capital gains tax rate was further reduced to 15 percent in 2003 for assets owned over 12 months. But the special 25 percent depreciation “recapture” tax rate remains unchanged. “Recapture” means taxed when a property is sold.

For example, suppose you bought a small investment property for $300,000 and deducted $100,000 of depreciation during your ownership years. That means your book value (also called “adjusted cost basis”) declined to $200,000. Then you sold for $450,000. Your capital gain is therefore $250,000 ($450,000 minus $200,000). Of that $250,000 capital gain, the $100,000 depreciation deducted will be “recaptured” and taxed at the 25 percent special federal tax rate. The $150,000 remainder of your capital gain will be taxed at the new 15 percent maximum tax rate.

However, a superb way to avoid paying the relatively high 25 percent federal recapture tax rate for depreciation deducted is to make a tax-deferred exchange for another investment property, as allowed by Internal Revenue Code 1031.

CONCLUSION. Real estate investment property offers many benefits, especially tax shelter and probable appreciation in market value. Ownership tax breaks are available during ownership and at the time of sale or tax-deferred exchange. Full details are available from your tax adviser.

Next week: Starker Tax-Deferred Exchanges.