Taxes & Real Estate Investing

Understanding the Tax Impact of Real Estate Ownership

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Welcome to month one of our newsletter mini-series! For the month of April, we will touch on a topic on most people’s minds at this time of year: TAXES, but specifically understanding the tax impact of Real Estate ownership as an investment.

Depreciation Recapture

Owning an investment property creates some tax benefits as well as some tax traps for real estate owners. A benefit of investing in residential real estate is the ability to depreciate the property each year of ownership up to 27.5 years. The actual property, excluding land value, is assumed to be depreciable over time. Depreciation expense is used to offset taxable net income. Each year that depreciation is claimed, the cost basis of the property is lowered by that amount. Once the property is sold, the IRS “recaptures” the depreciation by requiring the use of the adjusted cost basis for calculating the gain on the sale instead of the original purchase price. This is known as depreciation recapture. Depreciation deductions are taxed as ordinary income rates (but generously capped at 25%, thanks IRS!) and the rest of the gain is taxed at the usually lower capital gains tax rate. It is important to know tax implications of owning and selling a real estate property. A highly depreciated property could lead to an ugly tax bill without proper planning. One way to defer paying taxes on depreciation and capital gains is called a 1031 tax-deferred exchange.

1031 Exchange

Section 1031 of the U.S. Internal Revenue Code permits investors to defer the payment of any capital gains tax from the sale of a real estate investment property by reinvesting the proceeds from the sale into a replacement investment property of like kind that is greater or equal value. Some important rules to follow if executing a 1031 exchange include:

  • New property must be like-kind exchange of real estate (same nature, character, or class)
  • Replacement property must be identified within 45 days of closing on sold property
  • Replacement property must be purchased within 180 days of closing on the sale of the sold property
  • Real estate cannot be a personal/primary residence and must be used for investment or business purposes
  • Property must be of equal or greater value
  • Title of the new property must be in the same name as the sold property 

There are multiple reasons a 1031 exchange might be an effective strategy for a real estate investor to use. First, capital gains tax can be deferred into a later year where taxable income may be lower. An underperforming property can be sold to purchase a property with better projected returns. A larger value property can be split up into multiple smaller value properties for purposes of diversification or estate planning. Do not neglect the downside, however, as the tax bill must get paid at some point unless you plan to take that property to the grave!

While a traditional 1031 exchange can make sense in some situations, many people reach retirement with one or more rental properties with very low basis. Many people in this situation no longer want to have the responsibility of managing property in their golden years and also do not want to pay large gain taxes. A solution for this situation may be a 1031 exchange into a Delaware Statutory Trust structure. This allows an exchange of property into a professional managed pooled investment that eliminates management duties. These are somewhat complex structures and due diligence by your CPA and Wealth Advisor is highly encouraged.

2 of 5 Rule

A way to have your cake and eat it too is to utilize the 2 out of 5-year rule. This rule allows for a primary residence property to be owned for 5 years and if 2 years are spent living in the property, the home sale exclusion applies. Married taxpayers are exempted on the first $500,000 of capital gains and single taxpayers are exempted for the first $250,000 of capital gains. An example would be to live in a home for a year, rent it out for three years, and then move back in for 12 months. There are some nuances and exceptions to this rule so be sure to work with your CPA and Wealth Advisor to see if this rule applies to your situation.

3.8% Medicare Surtax

Most of you are familiar with the tax difference between short-term capital gains and long-term capital gains, but what about that sneaky 3.8% Medicare Surtax that applies to higher income households? Thanks to the Affordable Care Act in 2010, if your Modified Adjusted Gross Income is above $250,000 as a married couple (or $200,000 for single filers), you may get taxed an additional 3.8% on your “Net Investment Income”. This extra 3.8% gets tacked on to the typical capital gains, interest, or dividend rates, so as you are building your real estate investment portfolio be conscious of this surtax. It is very possible to put a financial plan together to reduce your exposure to this extra tax on your investment income, so plan wisely.

When it comes to taxes, it is always a clever idea to talk to your CPA and/or Wealth Advisor for expert advice. Colorado Wealth Group is here to help and encourages you to schedule a complimentary consult.

Stay tuned for next month’s mini-series topic, legacy planning.