Real Estate: Tax Strategies Edition

By Greg Freyman, CPA and Angela Freyman, MBA

“Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world”
~ Franklin D. Roosevelt

If you have a topic of interest you would like to see us cover, feel free to reach out and let us know; we are always happy to hear your thoughts, ideas, and feedback.

There are so many fascinating aspects to real estate. In this edition we will briefly go over important information on financial and tax topics of real estate as personal and investment use.

Since the real estate industry is such a broad theme, and we need to keep this blog to a reasonable length, we will cover the main ideas without diving in too deeply into any one topic.

Real estate as a home

They say home is where the heart is and in the world of financial planning, a common goal met towards retirement would be to eliminate or reduce the amount of future housing costs. Hence, we would hope to have the home as a primary residence already fully paid for.

The faster we can pay off the mortgage to the home we live in, the closer we get to financial independence from the lender. A typical mortgage runs for 30 years, basically meaning one can pay quite a bit in interest over that time frame.

Prepaying the mortgage reduces principal and interest that will have to be paid over the lifetime of the debt, so paying in extra principal each month is an election most should try to accomplish.

Most people focus on paying off all their other debts, as we are taught that mortgage debt is considered good debt, and the credit cards are bad debt. Debt is debt, good or bad, it is something we should all try to minimize in our lives.

For tax purposes, your personal-use home is considered a capital asset, and as such, if you sell your home at a capital gain (you sell the home for more than you purchased it for), it is subject to capital gains taxes.

Depending on the details, in most cases, one can currently exclude up to $250,000 of capital gains if filing as single, and as much as $500,000 if filing as married. This is one of the very last tax-free giveaways the government has to offer.

Planning tip

What if you are planning to sell more than one of your residences in the near future? One tax strategy is to compare anticipated gains from both sales. Since there are limitations on how often you can claim the primary home sale exclusion, it’s important to plan ahead. In some cases, it may be advantageous to elect to be taxed on the smaller gain, to claim the larger exclusion on the subsequent sale. This will produce an overall smaller tax burden.

Fantastic tax strategy you never hear about – The Masters “Augusta” Rule

Section 280A(g) of the Internal Revenue Code (IRC), gives you permission to rent out your home for fewer than 15 days, without having to report the income on your tax return. The days don’t have to be consecutive, and you don’t get to deduct any expenses along with it, but if the company you own chooses to rent your property to conduct an event or a meeting at your primary residence, you don’t have to pay federal income tax on the money you earn, up to $25,000. Of course, the amount you charge for such rental has to be reasonable market value.

The home office deduction

When working from home, and all tax tests are met, the part of your home that is used regularly and exclusively for business, will allow for new deductions, such as insurance, repairs, and utilities. Be careful though, when you are selling the home, the part that was treated as business use, would now be subject to tax, where no tax would have existed, had you never converted the space to begin with.

People often use the term, real estate as an investment, interchangeably with rental real estate, but for tax purposes, these two are not one and the same.

Real estate held for investment

Real estate is a great way to save for your retirement and to produce investment income. Real estate that is held for investment is treated the same way as any other investment for tax purposes, no different from the stock you purchased from a broker.

Real estate held for investment does not produce ongoing tax benefits, it is simply meant to grow in value, to be later sold for a gain at favorable tax rates. If you hold the investment for under a year, the capital gain is taxed at ordinary income rates, and would not produce any advantageous treatment, hence, it is very important to sell the real estate, if at a gain, after a one-year holding period has been effectively reached.

Real estate as a rental activity

They say without risk there comes no reward and real estate is absolutely no different, in fact, real estate can be even sweeter if it produces rental income and grows in value at the same time.

A lot of risks can be mitigated with the right set up:

  • Tailored insurance coverage for rentals
  • Forming an entity to protect from litigation
  • Hiring a management company
  • Creating a budget and cost analysis before you buy

The production of income from the rental activity will ultimately produce profit, loss, or break even.

In any of these situations there are still benefits to reap as the tenants will be contributing to the equity, and therefore helping you achieve your financial goals.

Converting your personal residence or investment property into a rental status comes with its own set of tax savings.

Tax benefits of rental activity

  • Depreciation on the property is a non-cash outflow item that allows for a tax break without having to lay out any cash. For this reason, real estate is coined to be a tax shelter, as it would typically produce tax losses but create positive cash flows “sheltered” from income taxation.
  • The sale of the rental property receives capital asset treatment, and gains can be taxed at favorable lower capital gains rates.
  • When the rental activity produces net losses, a taxpayer is allowed to deduct up to $25,000 of those losses if the owner materially and actively participates in the activity. The $25,000 rule does not apply to real estate professionals. With other investments that receive capital loss treatment those losses can not exceed $3,000 ($1,500 for married filing single taxpayers) in any given year with the difference in losses carrying over to the future to be harvested indefinitely.
  • When a rental property is sold at a taxable gain, there can be a partial capital gain tax exclusion for certain living arrangements. To receive such exclusion one would have to have lived in the property for a specified amount of time as their primary residence, and not have excluded similar gains within certain time limits. However, the depreciation is not eligible for the exclusion, and one would still have to pay taxes on any depreciation recapture.
  • The new section 199A deduction also applies to rental property, and one can potentially exclude up to 20% of their taxable profits. For example, if you earn $10,000 in net rental income, only $8,000 would be taxable.
  • The Tax Cut and Jobs Act (TCJA) created under law commencing in 2018 imposes restrictions on the amount of property taxes that can be deducted, however, this new law does not apply to the rental real estate activities.
  • Rental activity is not subject to self-employment taxes as other income producing activities can be.
  • Ability to conduct like-kind exchanges and defer income recognition.
  • Additional list of “dual-use” tax deductions, such as writing off part of your cell phone bill, or taking a trip to inspect your property.
  • Using your rental property as a vacation home, when unoccupied.
  • Ability to write off 100% on certain qualifying expenditures by electing either the Bonus depreciation or the Section 179 deduction methods of cost recovery.

Tax detriments of rental activity

  • Depreciation recapture on disposition, aka smoke and mirrors. Upon disposition of the property, whether or not you previously claimed tax benefit from depreciation, you will have to recapture the depreciation deduction. This means that we need to tack on depreciation to the property cost value, and hence produce a taxable gain where there was no true “cash” gain. In other words, a gain only for tax purposes. Some people are surprised as to why they have to pay any taxes when in their eyes, and in terms of net cash, they lost money on the deal.
  • If you have losses from rental real estate that exceed the $25,000 mark, in any given year, they would be suspended, and carried forward indefinitely.
  • If you have a modified adjusted gross income (MAGI) of over $150,000 ($75,000 for married filing separately taxpayers), all your losses are suspended and carried forward indefinitely. This happens more often than one would realize.
  • Capital improvements tend to fall under sections of the tax code that require the costs to be capitalized and depreciated over many years as opposed to reaping the benefits in the year you pay for them. For example, a roof replacement can cost as much as $15,000, and all that can be deducted in most situations would be $363 (27.5 year life) per year.
  • Rental income can place you in a higher tax bracket. Net rental income would be treated as ordinary income, and can also give exposure to investment taxation. This would be worse than receiving income from tax preferred investments. Some examples of tax preference investment income items would include stocks that pay qualified dividends, or interest from municipal bonds.
Harvesting suspended losses can be achieved if any of the following conditions are met:
  • Other income items of similar kind exist to offset the losses
  • Income decreases
  • The property is sold
  • Real estate professional designation in terms of tax law is achieved

Protecting your real estate investment

In light of possible litigation and privacy concerns, one would hate to be caught off guard. Enter a good insurance policy to help mitigate the risks. Once you have your new real estate all ready for its intended use, you will now need to have slightly more expensive insurance coverage, as there are additional risks involved. This is not an all-inclusive list, but one should consider the following add-ons to their insurance policy:

  • Request renters’ insurance of the renter
  • Consider an umbrella policy
  • Increase the limits on your liability insurance

The Limited Liability Company (LLC) – to LLC or not to LLC, that is the question

Are there other ways to help safeguard your assets? Yes, you can also use a limited liability company (LLC) as a way to protect your personal assets from ever being up for grabs in case something goes wrong and you are being sued. Let us examine the pros and cons of transferring title for a rental/investment property into an LLC.

Pros of using an LLC for real estate venture

  • Offers limited liability, an additional layer of legal protection.  
  • Protects other rental properties from being exposed to potential litigation.
  • Allows for different ownerships, for example you can buy property A with your brother, and property B with your mother.

Cons of using an LLC for real estate venture

  • Gives no different tax treatment.
  • Would not offer litigation protection from one’s own torts.
  • If you have a partner, including your spouse, you would need to file a partnership tax return.
  • Adds more risk to the insurance policy and a commercial policy may be required.
  • Transfers are typically not permissible if there is a mortgage and the property is not owned free and clear.
  • Loss of privacy, as the owner of the LLC is disclosed to the public on the division of corporations’ website. All one would need to find out this information would be to have the name of the LLC and the state it is conducting business.

Planning Tip:

A little-know work around that can be done for financial or estate planning purposes would be to transfer the property to a land trust and have the owners as beneficiaries with an LLC as the trustee. This will indirectly help mitigate the liability exposure. 

  • Annual fees and filings that are not necessarily related to partnership tax filings, for example, annual LLC and biennial LLC reports and fees.
  • In some states there is a mandatory newspaper publishing done to announce that a new LLC has been formed and is doing business in said state/jurisdiction. In a city like New York, the cost of such publishing can be as high as $1,000 and up.
  • Transferring property title to the LLC name also generates additional spending on the transfer and you can add the stamp and transfer costs to your bottom line. The cost will vary by jurisdiction and property value.
  • Trouble obtaining financing as the LLC would have little to show for itself in terms of credit and income history.

Common tax pitfalls when dealing with rental or investment property

  • Doing it yourself, thinking that your little condo does not need professional tax help, and either having your taxes done very cheaply or simply using a tax software solution to help you navigate the myriad of tax rules and regulations that come with such activity.
  • Electing subchapter S corporation status for tax purposes on your LLC that holds title to the real property.
  • Transferring the property into an S type corporation when it is only to be held as investment or rental real estate for tax purposes (some minor exclusions apply).
  • Deducting costs on your tax return simply because you paid them, but where you had no legal obligation to pay, in other words, not correctly structuring the deductions.
  • Not understanding the IRS form 1099-MISC reporting requirements and not issuing the annual forms as is mandatory to do in certain circumstances.
  • Not keeping appropriate records over the years on all repairs and capital improvements made.
  • Not deducting all expenses incurred simply because you paid with cash, or lost the receipt.
  • Not seeking the help of tax professional that has an in-depth understanding of the tax laws and regulations that deal with the major difference between repair and capital improvement.
  • Reporting investment property as a rental property, the tax outcomes and liability will vary due to the differences in tax law.
  • Not allocating non-renter expenses in a unit that is partially occupied by the owners.
  • Failing to declare depreciation on the tax filings, not claiming the right kind of depreciation, or including land in the depreciation.
  • Not understanding how to exclude the property from taxable gain, and by not selling it at the right time.
  • Not taking advantage of a 1031 like-kind exchange and paying taxes on the gain from disposition.
  • Not filing partnership returns when needed, and electing partnership status when not needed.
  • Creating a partnership and not taking into consideration that a spouse or partner could have legal recourse to the property.
  • Placing properties that you plan to flip in the future into an LLC, as the correct structure is to place it into an S type corporation.
  • Paying self-employment taxes on the rental or investment property income.
  • Not reporting the sale of a primary residence (even if gain is correctly excluded) on your tax return when you are required to.
  • Purchasing a home in a different state with the assumption that this will allow you to switch your tax residence, and help you save on income taxes because the new state you purchased your additional home has lower or no income taxes.
  • Incorrectly paying net investment income taxes on a property that is not treated as an investment.
  • Accidentally not utilizing real estate professional status to absorb an unlimited amount of passive losses against active income.

Other rookie mistakes when dealing with financial aspects of renting out the property

  • Not hiring a professional manager to help in the rental aspect, at the very least for the first year of rental.
  • Avoiding hiring professionals to save in fees and attempting to do it yourself.
  • Signing lease agreements that were not reviewed by a qualified party.
  • Having too many clauses in the lease agreement, or not having the right ones.
  • Not reviewing the cash flows before making a purchase, and not accounting for all expenses that will come up with the rental property, ultimately, a net loss for the owner.

Section 1031 like-kind exchanges for real property (last one standing)

No real estate blog would be complete without a brief discussion of the income recognition deferral as allowed under the IRC Section 1031.

The latest tax reform, Tax Cuts and Jobs Act of 2018, has limited the types of property eligible for the tax-deferred exchanges. Real property is now the only property allowed to be exchanged under the Section 1031 rules.

If you are selling your appreciated business property at a gain, with an intention of purchasing a similar property in its place, then the 1031 exchange may be a good option for you. This transaction allows you to defer the taxable gains on the appreciated property, but there are a number of rules and procedures that must be followed exactly, in order to not disqualify from the benefits, and you cannot receive cash in the transactions (or payoff of your mortgage) if you intend to fully defer your gains.

It’s advisable to speak with your tax professional before initiating this transaction. Contact our office at 904-330-1200 or email us at [email protected] to discuss real estate tax strategies, or if you have any questions.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Unless otherwise noted, all content is produced internally by Freyman CPA, P.C., who is the legal copyright holder of all intellectual property on this blog and any reprint or publishing of this material requires express written permission.

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