There are many types of real estate investments. Everyone has a different tax strategy; however, in this review we will only focus on direct investments in commercial, residential, and multifamily properties.
For most investors, tax strategy plays a crucial role in the profitability of an investment. Without a strategy in place, any realized gains can be quickly eaten away. There are many factors to consider on the front end of real estate investing, from deal structure to investment timing and holding periods. These are important aspects of driving taxation.
Consider the type of lease: Gross leases may be more beneficial than triple net leases for tax purposes. While triple net leases are easier to manage, they can have unintended tax consequences. Most business income is eligible for the Qualifying Business Income (QBI) deduction, up to a maximum of 20%.
Unfortunately, triple-net leases do not qualify for the IRS safe harbor, and the taxpayer must then demonstrate that the investment rose to the level of a trade or business, which can be more complicated. But failing on this deduction is sure to erode real profits.
Consider cost separation studies: For newly acquired properties, there may be an opportunity to accelerate depreciation. A cost separation study essentially breaks down a property into its component parts. This allows accelerated depreciation for components falling into the 15-year, 7-year and 5-year categories. This minimizes taxable income and improves cash flow to fund this or other projects. However, when selling an investment, be aware that depreciation is recovered at ordinary income tax rates.
Consider the passive activity rule: One hurdle in real estate is that to deduct losses for the current tax year, the investor/owner must overcome the assumption that the investment is passive. Section 469 of the IRC code (aka the passive activity rule) treats real estate as passive unless the taxpayer can meet the real estate professional threshold.
The eligibility requirements are strict as they require the taxpayer to spend more than half of the personal services in the real estate transaction or business and to perform more than 750 hours of services on the real estate during the tax year. This is only possible if taxpayers devote most of their time to real estate activities, which investors generally do not. Even if the taxpayer overrides the first assumption, they must demonstrate substantial participation in the activity in order to deduct the loss from ordinary income. Both tests must be considered and factored into the realized return on investment.
Consider the holding period: An investment property held for less than a year and sold is a short-term capital gain and is subject to the ordinary income tax rate rather than the capital gains rate. Also, if held for less than a year, it is likely not eligible for a 1031 exchange.
Consider a 1031 exchange: The 1031 exchange is still one of the good delay mechanisms available. The key is to reinvest the entire proceeds from the sale of the property into a new property. To do this, taxpayers need to have a qualified intermediary hold the proceeds, identify a new property to invest in within 45 days, and close within 180 days.
Consider Installment Sales: Installment sale processing allows revenue to be recognized as it is collected, rather than all at once. With proper planning, you can split your income to lower the overall tax rate you pay on sales.
These are some tax planning strategies, but there are many more in this complex field. Please consult your tax advisor for your specific tax situation.
Melania Powell is a tax partner at HoganTaylor LLP in Fayetteville. Opinions expressed are those of the authors.