REAE 5311 Blog Post
Introduction
There are a multitude of investment options available to investor’s these days. An investor can put their money to work in such vehicles as stocks, bonds, certificates of deposit, and if they are really risk averse they can leave their funds in an interest bearing savings account. But what about investing in real estate? What are the advantages of putting one’s money to work in real property assets?
Many benefits are commonly cited for investing in real estate. Among these are that real estate provides for diversification of one’s portfolio, current income from the net cash flow of the property, amortization of the mortgage loan balance, providing capital appreciation, the use of leverage to maximize return on equity, the tax benefits of depreciation, the favorability of capital gains over ordinary income, and finally, real estate serves as an excellent hedge against inflation. (Masters 2000, 32)
As with any investment, the tax consequences of any transaction needs to be taken into account in order to maximize profits and cash flows. Long-term financial planning, which includes effective tax planning, is necessary for maximizing wealth. Not taking the effect of income tax rules and regulations into account in one’s financial planning can have very negative effects on one’s cash flows. For example, ineffective tax planning could lead to the loss of the Sec. 1031 tax deferred exchange benefit resulting in the taxation of a capital gain resulting from a property sale.
So, for the investor contemplating real estate, what are some of the income tax implications? Several areas will be addressed: Passive activity limitations, depreciation, and Sec. 1031 exchanges.
Many benefits are commonly cited for investing in real estate. Among these are that real estate provides for diversification of one’s portfolio, current income from the net cash flow of the property, amortization of the mortgage loan balance, providing capital appreciation, the use of leverage to maximize return on equity, the tax benefits of depreciation, the favorability of capital gains over ordinary income, and finally, real estate serves as an excellent hedge against inflation. (Masters 2000, 32)
As with any investment, the tax consequences of any transaction needs to be taken into account in order to maximize profits and cash flows. Long-term financial planning, which includes effective tax planning, is necessary for maximizing wealth. Not taking the effect of income tax rules and regulations into account in one’s financial planning can have very negative effects on one’s cash flows. For example, ineffective tax planning could lead to the loss of the Sec. 1031 tax deferred exchange benefit resulting in the taxation of a capital gain resulting from a property sale.
So, for the investor contemplating real estate, what are some of the income tax implications? Several areas will be addressed: Passive activity limitations, depreciation, and Sec. 1031 exchanges.
Business Entity?
Before addressing these areas, one of the most important questions to deal with, not just for tax reasons but also for liability issues, is the business form of the investment, or what type of business entity to hold the real asset in. “The choice of which business form to adopt, as a vehicle to invest in commercial real estate, is critical to the success of the real estate investor.” (Haight and Singer 2005, 49) Many individual investors seek to have their real estate holdings in subchapter S-Corporations, limited partnerships, and limited liability companies (LLC’s). The reason is twofold. One, these forms of ownership provide for the liability protection of the owner(s). The personal assets of the owner(s) are shielded from creditors in the event of mortgage default or bankruptcy, except where the individual serves as the general partner of the limited partnership. The investor’s liability is limited to his/her basis in the business entity, as well as his/her share of any non-recourse debt held by the entity. Secondly, these flow-through entities avoid the double taxation of income of the C Corporation, as well as allowing for the distribution of cash flows tax free! (Technically speaking, income generated in these flow-through entities is taxed at the individual level whether or not cash is distributed, which is why cash distributions are not taxable to the individual.) It is not advisable for the investor to operate as a sole proprietor due to the lack of liability protection, nor is it advisable to hold real estate in a C Corporation because of the loss of preferential capital gains treatment and the above mentioned double taxation of income.
Passive Activity Limitations[i]
Real estate activities are viewed as passive activities in the Internal Revenue Code. For example, Code Sec. 469(c)(2) defines passive activities to include any rental activity. The general rule in passive activity limitations is that income generated in rental activities are included in the taxpayer’s ordinary income and taxed and the individual’s marginal tax rate while losses are deductible only against passive income. The limitation is that losses generated in passive rental activities cannot be used to offset either active or portfolio income. In the event that the taxpayer has passive activity losses and no other passive activity income, said losses are “suspended and carryover to future years where they can offset passive income in those years.” (Pope, Anderson and Kramer 2008, 9-26) On the other hand, if the investor owns multiple properties and one property has current income, this income can be offset with losses generated by other properties thereby minimizing the taxes owed.
Depreciation
Depreciation
Depreciation is often cited as one of the benefits of investing in real estate.[ii] But what is depreciation? Depreciation is the “systematic allocation of the cost of an asset over its economic life.” (Pope, Anderson and Kramer 2008, 10-2) That is, the code allows taxpayer’s to take a deduction against current income for a prorated portion of the cost of an asset. For example, nonresidential real property, such as an office building, is Code Sec. 1250 property and as such has a class life of 39 years and each year the taxpayer would be allowed a deduction equaling 1/39th of the cost of the asset. Residential real property, such as apartment buildings, is also Code Sec. 1250 property but it would be depreciated over 27.5 years.
Two benefits of deprecation should be readily apparent. One, taxpayers are allowed deductions based on the full purchase price of the asset and not just on their equity portion. Because of the high capital requirements of investing in real estate and the scarcity of dollars at the investor’s level, most real properties are mortgaged at loan-to-value (LTV) ratios commonly between 70-80%. For example, suppose a taxpayer invests in an office building for $1,000,000 and obtains a mortgage with an LTV of 75%. This taxpayer would receive a loan of $750,000 and would be required to put up equity capital of $250,000. Based on current rules, the taxpayer would be allowed an annual deduction of $25,641 ($1,000,000/39 years) as opposed to $6,410 ($250,000/39 years) if the depreciation deduction were limited to actual cash expended to purchase the property.
Secondly, it is a non-cash deduction against current income. The cash was expended upfront in purchasing the property and yet every year the taxpayer is able to include in their net rental income this non-cash expense. In the above example, the taxpayer did not spend $25,641 and yet he/she is able to take this deduction against current income thereby reducing taxable income and the resultant taxes paid. The beauty of depreciation is that a property can be generating positive cash flow and yet there be little or no taxable income. (Wendt 1969, 79) Taxpayers are able to convert some of the ordinary income (which can be taxed as high as 35%) generated by the property to capital gains (which are taxed at the lower rate of 15%) through depreciation deductions.
While depreciation has its benefits, there is one drawback that without effective tax planning can come back to bite you. This drawback is the depreciation recapture rule and is found in Sec. 1250 of the Code. The basic rule is that if Sec. 1250 property is sold or disposed of at a gain, that portion of the gain due to excess depreciation would be treated as Sec. 1250 ordinary gain. In other words, a portion or even all of the gain would be converted from capital gain taxed at the lower rate of 15% to ordinary income taxed at the taxpayer’s highest marginal tax rate. Excess depreciation is the “excess of the actual amount of accelerated deprecation over the amount that would be deductible under the straight-line method.” (Pope, Anderson, and Kramer 2008, 13-12 – 13-13) Accelerated depreciation refers to the double-declining (200%) or 150% declining balance methods of depreciation. For example, using the 200% DB method of depreciation in our example above would result in a deduction of $51,282 ($25,641*2) in year 1 and in this case the excess is $25,641 and would be taxed as ordinary income.
Since all real property placed in service after 1986 is required to be depreciated using the straight-line method, Sec. 1250 depreciation recapture rarely comes into play. Congress therefore enacted the Unrecaptured Sec. 1250 gain rule. This rule states that any long-term capital gain resulting from the sale or disposition of Sec. 1250 property “due to depreciation other than excess depreciation is unrecaptured Sec. 1250 gain taxed at a maximum rate of 25%.” (Pope, Anderson and Kramer 2008, 13-12) Basically, that portion of the gain due to depreciation deductions would be taxed at the 25% rate rather than the current capital gains rate of 15%. While depreciation does provide positive benefits to the taxpayer during the holding period of an asset, it can get cost one in the end.
Sec. 1031 Exchanges
Two benefits of deprecation should be readily apparent. One, taxpayers are allowed deductions based on the full purchase price of the asset and not just on their equity portion. Because of the high capital requirements of investing in real estate and the scarcity of dollars at the investor’s level, most real properties are mortgaged at loan-to-value (LTV) ratios commonly between 70-80%. For example, suppose a taxpayer invests in an office building for $1,000,000 and obtains a mortgage with an LTV of 75%. This taxpayer would receive a loan of $750,000 and would be required to put up equity capital of $250,000. Based on current rules, the taxpayer would be allowed an annual deduction of $25,641 ($1,000,000/39 years) as opposed to $6,410 ($250,000/39 years) if the depreciation deduction were limited to actual cash expended to purchase the property.
Secondly, it is a non-cash deduction against current income. The cash was expended upfront in purchasing the property and yet every year the taxpayer is able to include in their net rental income this non-cash expense. In the above example, the taxpayer did not spend $25,641 and yet he/she is able to take this deduction against current income thereby reducing taxable income and the resultant taxes paid. The beauty of depreciation is that a property can be generating positive cash flow and yet there be little or no taxable income. (Wendt 1969, 79) Taxpayers are able to convert some of the ordinary income (which can be taxed as high as 35%) generated by the property to capital gains (which are taxed at the lower rate of 15%) through depreciation deductions.
While depreciation has its benefits, there is one drawback that without effective tax planning can come back to bite you. This drawback is the depreciation recapture rule and is found in Sec. 1250 of the Code. The basic rule is that if Sec. 1250 property is sold or disposed of at a gain, that portion of the gain due to excess depreciation would be treated as Sec. 1250 ordinary gain. In other words, a portion or even all of the gain would be converted from capital gain taxed at the lower rate of 15% to ordinary income taxed at the taxpayer’s highest marginal tax rate. Excess depreciation is the “excess of the actual amount of accelerated deprecation over the amount that would be deductible under the straight-line method.” (Pope, Anderson, and Kramer 2008, 13-12 – 13-13) Accelerated depreciation refers to the double-declining (200%) or 150% declining balance methods of depreciation. For example, using the 200% DB method of depreciation in our example above would result in a deduction of $51,282 ($25,641*2) in year 1 and in this case the excess is $25,641 and would be taxed as ordinary income.
Since all real property placed in service after 1986 is required to be depreciated using the straight-line method, Sec. 1250 depreciation recapture rarely comes into play. Congress therefore enacted the Unrecaptured Sec. 1250 gain rule. This rule states that any long-term capital gain resulting from the sale or disposition of Sec. 1250 property “due to depreciation other than excess depreciation is unrecaptured Sec. 1250 gain taxed at a maximum rate of 25%.” (Pope, Anderson and Kramer 2008, 13-12) Basically, that portion of the gain due to depreciation deductions would be taxed at the 25% rate rather than the current capital gains rate of 15%. While depreciation does provide positive benefits to the taxpayer during the holding period of an asset, it can get cost one in the end.
Sec. 1031 Exchanges
This brings up the biggest tax advantage for holding real estate assets in one’s portfolio, and it is known as the Sec. 1031 exchange. Sec. 1031 of the Internal Revenue Code covers like-kind exchanges, and this provision of the code allows taxpayers to defer the tax on the capital gain resulting from the sale or disposition of real property. In order to qualify for Sec. 1031 treatment the Code specifies that replacement “property be identified and that exchange be completed not more than 180 days after transfer of exchanged property”.[iii] The taxpayer has 45 days after disposition of property to identify the replacement property and complete this exchange in 180 days.[iv] If this requirement is not met then the benefit of Sec. 1031 is lost and any gain would be taxable with the provisions for depreciation recapture in full effect.
Note that this is a tax deferred exchange and not a tax free exchange. The gain on the sale is deferred in that the basis of the new property is written down by the amount of the gain. In our example above, suppose that our investors sold the property that they purchased for $1,000,000 at a gain of $500,000, and entered into a non-taxable exchange by acquiring a like-kind asset for $2,000,000. The purchase price of $2,000,000 would be adjusted downward by $500,000 and the new property would have a tax basis of $1,500,000. If this property were later sold for $2,500,000, the resulting gain would be $1,000,000, not $500,000. Through this provision of the Code taxpayers are able to shield capital gains from taxation and increase cash flow available for other investments. In this case our investors saved $75,000 ($500,000*0.15) in taxes by utilizing Sec. 1031. Another benefit of Sec. 1031 is that it can be used indefinitely. A taxpayer can roll over real estate assets multiple times thereby shielding income from taxes, and in the event of death, if the taxpayer is still in possession of a 1031 asset, this asset can be bequeathed to an heir. In this event, the basis in the asset would be adjusted to fair market value thereby excluding the accumulated capital gains from taxation. Sec. 1031 tax deferred exchanges are very powerful tools for increasing wealth, cash flows, and also very useful in estate planning.
Conclusion
Real estate investing offers many tax advantages for the small taxpayer. Among these benefits are depreciation, Sec. 1031 like-kind exchanges, and the preferential treatment of capital gains over ordinary income. Investing in real estate can be a vital part of the overall financial plan of any investor seeking to provide both current income and for maximizing one’s wealth. In addition, real estate can be used in estate planning and passing on one’s legacy to heirs, thereby contributing to the continued prosperity of one’s family.
Note that this is a tax deferred exchange and not a tax free exchange. The gain on the sale is deferred in that the basis of the new property is written down by the amount of the gain. In our example above, suppose that our investors sold the property that they purchased for $1,000,000 at a gain of $500,000, and entered into a non-taxable exchange by acquiring a like-kind asset for $2,000,000. The purchase price of $2,000,000 would be adjusted downward by $500,000 and the new property would have a tax basis of $1,500,000. If this property were later sold for $2,500,000, the resulting gain would be $1,000,000, not $500,000. Through this provision of the Code taxpayers are able to shield capital gains from taxation and increase cash flow available for other investments. In this case our investors saved $75,000 ($500,000*0.15) in taxes by utilizing Sec. 1031. Another benefit of Sec. 1031 is that it can be used indefinitely. A taxpayer can roll over real estate assets multiple times thereby shielding income from taxes, and in the event of death, if the taxpayer is still in possession of a 1031 asset, this asset can be bequeathed to an heir. In this event, the basis in the asset would be adjusted to fair market value thereby excluding the accumulated capital gains from taxation. Sec. 1031 tax deferred exchanges are very powerful tools for increasing wealth, cash flows, and also very useful in estate planning.
Conclusion
Real estate investing offers many tax advantages for the small taxpayer. Among these benefits are depreciation, Sec. 1031 like-kind exchanges, and the preferential treatment of capital gains over ordinary income. Investing in real estate can be a vital part of the overall financial plan of any investor seeking to provide both current income and for maximizing one’s wealth. In addition, real estate can be used in estate planning and passing on one’s legacy to heirs, thereby contributing to the continued prosperity of one’s family.
Footnotes
[i] The following discussion of passive activity limitations assumes that the taxpayer is not engaged in a real property trade or business and does not actively participate in rental real estate activities. In the event of active participation, the taxpayer may offset up to $25,000 of non passive income with passive activity losses generated from rental real estate activities. See Code Sec. 469 (i).
[ii] See for example, http://www.mortgage-investments.com/Investors_in_Real_Estate/tax_benefits_of_owning_investment_real_estate.htm, http://www.christinawhipple.com/General-Interest/Real-Estate-Investing-Generates-Big-Tax-Benefits.html, http://www.therealestatefoundation.com/investing-benefits/investment-real-estate-tax-shelter/, and http://www.inman.com/buyers-sellers/columnists/real-estate-investing-generates-big-tax-benefits.
[iii] Code Sec. 1031(a)(3).
[iv] Code Sec. 1031(a)(3)(A) and Sec. 1031(a)(3)(B).
Bibliography
Greer, Gaylon E. and Michael D. Farrell, “Investment Analysis for Real Estate Decisions” 2nd Ed. USA: Longman Financial Services Publishing, 1988.
Kyle, Robert C. and Jeffrey S. Perry, “How to Profit from Real Estate: Investing under the New Rules.” USA: Longman Financial Services Publishing, 1988.
Masters, Nicholas. “How to Make Money in Commercial Real Estate for the Small Investor.” New York, NY: John Wiley & Sons, Inc., 2000.
Pope, Thomas R., Kenneth E. Anderson and John L. Kramer, eds. “Prentice Hall’s Federal Taxation 2008: Comprehensive.” Upper Saddle River, NJ: Pearson Prentice Hall, 2008.
Haight, G. Timothy, and Singer, Daniel D. “The Real Estate Investment Handbook.” Hoboken, NJ: John Wiley & Sons, Inc., 2005.
Wendt, Paul F. and Alan R. Cerf. “Real Estate Investment Analysis and Taxation” New York, NY: McGraw-Hill Book Company, 1969.
[i] The following discussion of passive activity limitations assumes that the taxpayer is not engaged in a real property trade or business and does not actively participate in rental real estate activities. In the event of active participation, the taxpayer may offset up to $25,000 of non passive income with passive activity losses generated from rental real estate activities. See Code Sec. 469 (i).
[ii] See for example, http://www.mortgage-investments.com/Investors_in_Real_Estate/tax_benefits_of_owning_investment_real_estate.htm, http://www.christinawhipple.com/General-Interest/Real-Estate-Investing-Generates-Big-Tax-Benefits.html, http://www.therealestatefoundation.com/investing-benefits/investment-real-estate-tax-shelter/, and http://www.inman.com/buyers-sellers/columnists/real-estate-investing-generates-big-tax-benefits.
[iii] Code Sec. 1031(a)(3).
[iv] Code Sec. 1031(a)(3)(A) and Sec. 1031(a)(3)(B).
Bibliography
Greer, Gaylon E. and Michael D. Farrell, “Investment Analysis for Real Estate Decisions” 2nd Ed. USA: Longman Financial Services Publishing, 1988.
Kyle, Robert C. and Jeffrey S. Perry, “How to Profit from Real Estate: Investing under the New Rules.” USA: Longman Financial Services Publishing, 1988.
Masters, Nicholas. “How to Make Money in Commercial Real Estate for the Small Investor.” New York, NY: John Wiley & Sons, Inc., 2000.
Pope, Thomas R., Kenneth E. Anderson and John L. Kramer, eds. “Prentice Hall’s Federal Taxation 2008: Comprehensive.” Upper Saddle River, NJ: Pearson Prentice Hall, 2008.
Haight, G. Timothy, and Singer, Daniel D. “The Real Estate Investment Handbook.” Hoboken, NJ: John Wiley & Sons, Inc., 2005.
Wendt, Paul F. and Alan R. Cerf. “Real Estate Investment Analysis and Taxation” New York, NY: McGraw-Hill Book Company, 1969.
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