What are the tax benefits and limitations of real estate investments?
Rental property often offers larger deductions and tax benefits than most investments. While owning rental property is an excellent way to invest capital, it also serves as a tax shelter. Rental property works like any other investment in that the profits earned are subject to tax. However, the way that real estate investments are taxed is unique, allowing additional expenses to reduce taxable income and offer beneficial capital gain treatments. Conversely, investors should also be aware of IRS real estate limitations from a taxation perspective.
Rental real estate is usually considered a passive activity. Passive activity losses are limited to passive activity income. An activity is not considered passive if the taxpayer materially participates in the activity. Most taxpayers can meet the material participation requirement, primarily, by either 1) spending more than 500 hours on the activity, 2) being the only one who substantially participates in the activity or 3) spending more than 100 hours participating and no one else spends more hours on the activity.
Benefits & Limitations
Real estate investors may generally deduct amounts paid for mortgage interest each year. However, limitations exist on prepaid interest and construction period interest. Prepaid interest must be deducted over the period to which the prepayment relates and construction period interest must be capitalized.
An investor in real property is allowed to deduct amounts paid for real property taxes. When purchasing real estate, the buyer may deduct real estate taxes in the year of acquisition allocable to the number of days the buyer owns the property. Special assessment tax levies made for property improvement purposes permitted by the government (e.g., sewer lines, concrete, etc.) cannot be currently deducted. The tax must be added to the basis of the property and deducted through depreciation expense each year over the recovery period.
Owners of residential and nonresidential real property used in a trade or business or held for the production of income may deduct amounts for depreciation of the house or building each year even though no cash expenditure is incurred. Depreciation is the process by which you would deduct the cost of buying or improving rental property by spreading out those costs across the useful life of the property. Rather than taking a single, large tax deduction in the year of purchase, a portion of the cost is expensed each year.
Credits against tax liability are available for certain investments in low-income housing or rehabilitation of old or historic structures. While use of these credits may be subject to certain limitations, credits are more attractive that tax deductions as credits provide a dollar-for-dollar reduction in a taxpayer’s federal income tax, whereas a tax deduction only provides a reduction in taxable income.
Real estate investors may deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business and (1) for the production and collection of income; (2) for the management, conservation, or maintenance of property held for the production of income and (3) in connection with the determination, collection, or refund of any tax.
Routine repair and maintenance expenses and other expenses incurred related to the production of income in connection with the property are deductible in the year paid as business expenses. However, the cost of improvements must be capitalized and recovered through depreciation deductions.
When disposing of the property, the owner may defer tax on the gain by participating in a like kind exchange. The buyer may also be able to spread out the recognition of gain by using the installment method of reporting; however, if the aggregate sale price on all installment loans exceeds $5,000,000, then an interest surcharge may be applied. Furthermore, a limitation exists in that the installment method of reporting is unavailable for sales of real property held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business.
Because of IRC Section 1231, net losses on disposition may be treated as ordinary losses instead of capital losses, not limited to the $3,000 that can offset against ordinary income.
Limitations & Exceptions
As a general rule, an investor takes the same deductions and credits and recognizes income whether the investor owns the property directly or indirectly, through an interest in a limited partnership that “passes through” the deductions, credits, and income.
Deductions and credits are subject to the passive loss rules if the property is used in an activity in which the investor does not materially participate. However, if an investor actively participates and the property is used in a rental real estate activity, then a special exemption for up to $25,000 of passive losses and the deduction-equivalents of credits with respect to rental real estate activities may apply. The $25,000 special allowance is reduced by 50% of the amount by which the taxpayer’s modified adjusted gross income (AGI) exceeds $100,000 and is reduced to zero when modified AGI reaches $150,000.
An exception is carved out for real estate professionals, someone who truly earns their living in real estate trades or businesses, as they are able to use rental losses without limitation.
If an investor owns a second home— rather than renting it out—interest on the mortgage is deductible within the same limits as the interest on the mortgage on your first home. If an investor rents the place out for 14 or fewer days during the year, rental income is tax-free. If the house is rented for more than 14 days, all rental income is taxable. If an investor limits personal use to the greater of 14 days or 10 percent, the vacation home is considered a rental property.
When choosing what to invest in, it is important to diversify among asset classes (stocks, bonds, cash, real estate etc.) in order to reduce risk to your portfolio and potentially increase return. Investing in real estate can provide diversification while offering several tax benefits. It is important to consider how these benefits fit with your overall investment strategy and tax plan.
Susan Schuett is a senior manager in LBMC’s Wealth Advisors Group. She has over 20 years of tax experience focusing on high net worth individuals, family groups and related entities.
Brittney Cooper is a senior in LBMC's Wealth Advisors Group. She focuses on providing integrated tax services for high net worth individuals and their related investments.