...continued from Big Tax Incentives to be had on Investment Properties
“The straightforward explanation is that the number of people age 55 to 64 — the ones with the greatest propensity to purchase a second home — is rising at 5 percent a year,” says American Demographics founder Peter Francese.
Think about our historically low interest rates and the assumption that real estate is a safer place to park cash than the stock market then plug in the myriad of tax benefits, and that is why everybody is out looking for more property. Truly, it doesn’t matter what type of real estate investment property you own — rental houses, commercial buildings, shopping centers, apartments, warehouses, or land — they all offer big tax incentives.
A real estate investor who is not a “real estate professional” is legally limited to a maximum annual $25,000 realty investment property loss deduction against their ordinary taxable income — providing this non-professional investor’s annual adjusted income does not exceed $100,000.
Above the six-figure adjusted income level, the allowable tax loss deduction phases out, flat lining at $150,000. Comfortably, IRS Notice 88-94 allows those in that tax stratosphere to suspend their undeducted real estate investment tax loss until the property is sold. The suspended tax loss is then subtracted from the capital gain to lower the taxable profit at the time of sale.
To qualify, part-time investors must own at least 10 percent of the investment property and must “materially participate” in property management decisions.
A real estate professional (who spends at least 750 hours per year, or more than 50 percent of their business time in qualified real estate work) has deductions galore.
“There is no limit to the allowable tax deductions from your properties that can be subtracted from your other ordinary income,” according to real estate expert Bob Bruss.
The government has gifted property investors the opportunity to depreciate their investment properties. Depreciation is a “paper loss” required for estimated wear, tear and obsolescence. Keep in mind, land value is not depreciable. Residential income property is depreciated over 27.5 years on a straight-line basis (equal annual reductions in the book value of a property). Commercial property is depreciated over 39 years. Personal items used in operating the property, such as apartment appliances, are usually depreciated over five to 10 years. Automobiles and trucks used in the investment operation can be depreciated over their useful lives. There is also the new first-year 100 percent deduction for up to $100,000 of business equipment.
Depreciation is a non-cash expense deduction, which reduces taxable income from the investment property. According to Bruss, for tax purposes, depreciation deductions can turn a positive cash flow property into a tax loss, thus creating a “tax shelter” for that income property’s tax flow. While most investment properties appreciate in market value each year, on paper their “book value” depreciates as the property ages. Accounting shows that the book value declines while the market value goes up.
RECAPTURED DEPRECIATION GETS TAXED WITH THE SALE
The 1997 Taxpayer Relief Act reduced the federal capital gains tax rate to 20 percent. In 2003, the government again reduced the capital gains tax rate to 15 percent for assets owned more than 12 months. By the way, the special 25 percent depreciation “recapture” tax rate remains unchanged. Those depreciation deductions you’ve taken are taxed when a property is sold.
Bruss points out that if you bought an investment property for $300,000 and deducted $100,000 of depreciation during your ownership years, the book value, also known as the “adjusted cost basis,” declined to $200,000. Then you sold for $450,000. Your capital gain is therefore $250,000 ($450,000 minus $200,000). Of that $250,000 capital gain, the $100,000 depreciation deducted is “recaptured” and taxed at the 25 percent special federal tax rate. The $150,000 remainder of your capital gain will be taxed at the new 15 percent maximum tax rate.
“In tax circles, this little adjustment is known as depreciation ‘recapture,’ and essentially it’s the government’s way of making sure you don’t take advantage of depreciation deductions twice,” observes CNN/Money columnist Walter Updegrave.
Many investors will avoid paying the 25 percent federal recapture tax rate for deducted depreciation by exchanging the property for another investment property, better known as a 1031 exchange.
Beyond pride of ownership, so many tax benefits can be had from real estate investment properties. Talk to your accountant about which tax deductions may be right for you.
For your real estate needs, e-mail Jodi Summers at firstname.lastname@example.org, or call 310-260-8269.