There are various types of real estate investments. Each has different tax strategies; however, in this commentary, we will solely focus on direct investment in commercial, residential and multifamily properties.
For most investors, tax strategies play a crucial role in the profitability of the investment. Not having a strategy in place can quickly eat away any realized gains. There are numerous items to consider on the front end of investing in real estate, from the deal structure to the time invested and the holding period. These are all essential aspects that will drive taxation.
Consider the type of lease: For tax purposes, a gross lease could be more advantageous 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 would then have to prove that the investment rises to the level of a trade or business, which can be more complex. But losing out on this deduction would certainly eat into real profits.
Consider cost segregation studies: With newly acquired real estate, there could be an opportunity to accelerate depreciation. The cost segregation study essentially breaks out a property into its components. That allows depreciation to be accelerated for the components that fall into the 15-, seven- and five-year categories. That can minimize taxable income and improve cash flow to fund the project or other projects. However, be mindful when selling the investment that depreciation is recaptured at ordinary income tax rates.
Consider the passive activity rules: A hurdle in the real estate space is that to deduct losses in the current tax year, the investor/owner must overcome the presumption that the investment is passive. IRC code section 469 (aka the passive activity rules) deem real estate passive unless the taxpayer can meet the threshold for a real estate professional.
The qualifications are rigorous as they require that the taxpayer spends more than one-half of the personal services performed in trades or businesses in real property trades or businesses and performs more than 750 hours of services during the tax year in real property. That can only be accomplished if the taxpayer devotes most of their time to real estate activities, which investors are often not doing. Even if the taxpayer overcomes this first presumption, they then must prove material participation in the activity to deduct losses against ordinary income. These two tests must be considered and factored into the realized returns for the investment.
DISPOSITION OF THE INVESTMENT
Consider 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’s most likely not eligible for a 1031 exchange if not held longer than a year.
Consider a 1031 exchange: The 1031 exchange is still among the great deferral mechanisms available. The key is reinvesting the entire proceeds of the property sold into a new property. For that to happen, the taxpayer needs to have a qualified intermediary hold the proceeds, identify a new property to invest in within 45 days, and then close by 180 days.
Consider an installment sale: Installment sale treatment allows a gain to be recognized as it is collected instead of recognizing the entire gain at once. With proper planning, you can split the income to reduce the overall tax rate paid on the sale.
These are a few tax planning strategies, but there are many more in this complex area. Please consult your tax adviser 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.