There are different types of real estate investments. Each has different tax strategies; however, in this commentary, we will focus only on direct investments in commercial, residential and multifamily properties.
For most investors, tax strategies play a crucial role in investment profitability. Lack of a strategy can quickly wipe out any gains made. There are many items to consider on the real estate investment front, from the structure of the deal to the time invested and holding period. All these are essential aspects that will drive taxation.
Consider the type of lease: For tax purposes, a gross lease may be more favorable than a triple net lease. While triple net leases are easier to manage, they can have unintended tax consequences. Most business income is eligible for the qualified business income (QBI) deduction, which can be up to a 20% deduction.
Unfortunately, triple net leases do not qualify under the IRS safe harbor, and a taxpayer will then have to prove that the investment rises to the level of a trade or business, which can be more complex. But the loss of this discount would certainly eat into real profits.
Consider cost allocation studies: With newly acquired real estate, there may be an opportunity to accelerate depreciation. The cost breakdown study essentially breaks down a property into its components. This allows depreciation to be accelerated for components that fall into the 15-, seven-, and five-year categories. This can minimize taxable income and improve cash flow for financing the project or other projects. However, be aware when you sell the investment that the depreciation is recaptured at ordinary income tax rates.
Consider passive activity rules: One hurdle in the real estate space is that in order to deduct losses in the current tax year, the investor/owner must overcome the presumption that the investment is passive. IRC section 469 (known as the passive activity rules) considers real estate passive unless the taxpayer can meet the threshold for a real estate professional.
The qualifications are rigorous as they require the taxpayer to spend more than half of the personal services performed in a trade or business in a real estate trade or business and perform more than 750 hours of services during the tax year in real estate. This can only be achieved if the taxpayer devotes most of his time to real estate activities, which investors often do not. Even if the taxpayer overcomes this first presumption, then he must prove material participation in the activity to deduct the losses against ordinary income. These two tests must be considered and factored into realized returns on investment.
PROVISION OF INVESTMENTS
Consider the holding period: Investment property held for less than a year and sold is a short-term capital gain and is subject to ordinary income tax rates instead of capital gains rates. Additionally, it will most likely not qualify for a 1031 exchange if it is not held for more than one year.
Consider a 1031 Exchange: The 1031 exchange is still among the great deferral mechanisms available. The key is to reinvest all the proceeds of the sold property into a new property. For this to happen, the taxpayer must have a qualified broker hold the proceeds, identify a new property to invest in within 45 days, and then close within 180 days.
Consider an installment sale: The installment sale treatment allows a gain to be recognized as it is collected rather than all of the gain being recognized at once. With proper planning, you can split the proceeds to lower the overall tax rate you pay on the sale.
These are some tax planning strategies, but there are many more in this complex field. Please consult your tax advisor for application to your specific tax situation.
Melania Powell is a tax partner with HoganTaylor LLP in Fayetteville. The opinions expressed are those of the author.