Real Estate Tax Planning

Real estate ownership and investment is one of the most heavily favored activities for US tax purposes.

Here at Evolution Tax and Legal, our team has worked with some of the biggest players in the industry helping them utilize tax-favored strategies for the operation and disposition of real estate as well as help keep those players up to date on their annual tax filings.

This article will help you understand the basics of taxes and how they are applicable to real estate ownership and to help you take advantage of tax planning opportunities available to you. If you have further questions, contact Evolution Tax and Legal to learn more about our specialty tax services in Orange County.

Taxes for Real Estate Ownership and Investing

Whether you own real estate for personal purposes or for investment purposes, there are several types of taxes that can be applicable to you—

· Ordinary income tax from net rental income earned on the property;

· Capital gains taxes on the sale of the property; and

· Property taxes payable to your local government.

Ordinary Income Tax

If you own rental properties or rent a portion of your primary residence, you have to report the rental income earned in a given year on your tax return. The good news is that you get to offset the rental income you report by the expenses related to the rental of the piece of property. Expenses that can be used to offset this rental income are payments for the property’s utilities, mortgage interest, property taxes, repairs and maintenance, the property’s upkeep, insurance. In addition, property ownership is afforded a deduction for what is better known as depreciation. Simply put, you, the owner of the property, get to take a deduction equal to a fraction of the price you paid for said property on an annual basis.

Once your rental income and expenses are netted, the net income from the rental activity is reported on your income tax return for the year. A lot of the time, you see the number reported as a “loss” rather than income even though you netted cash flow from the rental activity in the given year. This is because of the deduction associated with depreciation—while you actually did not make any cash payments or incur any expenses that constitute “depreciation”, it is accounted as a pro-rata return of the initial capital outlay you made to purchase the property. Easier put, depreciation is known as a “paper loss” because there is no real economic expenditure associated with the deduction in the given tax year.

Capital Gains Tax

As many of you know, there are taxes on the “gain” you recognize on the sale of your real property. The “gain” from such sale is generally subject to capital gain taxes under the US tax law. The benefit of having this gain treated as a capital gain is the fact that the income is subject to preferential tax rates under the US tax code, instead of the higher, ordinary income tax rates you generally pay on your wage and salary income.

What is unique about the real estate industry is that there are many opportunities and chances to either exclude or defer this capital gain upon sale. Below is a non-exhaustive list of tools available to either exclude or defer gain from the sale of your real estate–

Exclusion of Gain on Sale of Primary Residence:

Generally, if you sell your primary residence in which you lived in for 2 of the prior 5-years, you are entitled to “exclude” the gain recognized on the sale of your residence from taxation in the given year. The amount excluded depends on your filing status ($250,000 for single filers, $500,000 for married filers).

“Like-Kind” Exchanges (1031 Exchanges):

A “like-kind” exchange allows the owner of real estate held for either business or investment purposes to sell and reinvest such proceeds, within a specified period of time, from the sale of their real estate into other “like-kind” real estate (e.g. held for business or investment purposes) while deferring the gain from the sale of the first property until the second property is later sold. Please note this is a very complex area of the tax code, and a tax advisor should be consulted before trying to undertake such a transaction on your own.

Investments Into Opportunity Zone Funds:

Similar to the “like-kind” exchange listed above, the owner of real estate can sell and reinvest the proceeds of the sale from their real estate into a “qualified opportunity zone fund.” If done correctly and within the correct time constraints, the gain from the sale of such property is eligible to be deferred until the end of 2026, with an additional possibility to lower the amount of tax on the initial gain from the property when later recognized in 2026 and exempt tax on the appreciation of the gain invested into the “qualified opportunity zone fund” when sold in future years. Once again, this is a very complex area of the law, and a tax advisor should be consulted prior to taking advantage of this strategy.

Property Taxes

If you own a house, you’re probably familiar with property taxes. Your local government collects real estate taxes to help pay for services and projects that benefit the community — emergency services, libraries, schools, roads, and the like.

You pay these taxes directly to your local tax assessor each year or as part of your monthly mortgage payment. Property taxes are based on the assessed value of your land and any buildings on it.

As long as you own the property, you continue to pay real estate taxes. You don’t stop when you pay off your mortgage, nor do you stop if you no longer use the home as your primary residence. If the property is in your name, you’re on the hook for the taxes.

Of course, property taxes change periodically, and your bill could be higher or lower than in previous years. This can happen when your home is reassessed or when your local government updates the tax rate (either up or down).

Depreciation for Real Estate: How To Maximize On Your Deductions

Depreciation is the process of deducting the cost of a business asset over a long period of time, rather than over the course of one year. There are various methods used to calculate the annual depreciation deduction based upon the type of business and assets.

Business assets are generally depreciation over one of the following terms of years depending upon their overall classification: 3-years, 5-years, 7-years, 10-years, 15-years, 20-years, 27.5 years, and 39-years.

As it pertains to real estate, land cannot be depreciated whereas residential rental property will be depreciated over 27.5 years and non-residential real property over 39-years.

What is important to note is that certain components and structural improvements to real property can be depreciated under one of the smaller classes thus allowing a faster recovery of the cost of your business asset and increasing your depreciation in the current year.

However, what generally happens is that the cost of these components and other structural improvements is wrapped up into the total purchase price of the real property and depreciated under either the 27.5-year or 39-year recovery class.

In order to properly account for the cost of these assets that qualify for a smaller recovery period, a “cost segregation” study can be undertaken to properly allocate the costs of such components and structural improvements and have the item depreciated under a lower-class life.

Cost segregation is the process of separately identifying personal and real property generally purchased at the same time, with a general benefit of accelerating depreciation deductions (generally 20% to 40% of what would otherwise be depreciated over 27.5 or 39 years as a building).

Generally speaking, a cost segregation study is undertaken by an architect to identify the components and structural improvements qualifying for a lower recovery period and provided to your CPA in order to take the correct depreciation on your return.

This is a simple, low-cost method to lower your overall tax on the operations of rental properties and should be considered on every property.

How Capital Gains Tax on Real Estate can be Deferred 

What is unique about the real estate industry is that there are many opportunities and chances to either exclude or defer this capital gain upon sale. Below is a non-exhaustive list of tools available to either exclude or defer gain from the sale of your real estate–

Exclusion of Gain on Sale of Primary Residence:

Generally, if you sell your primary residence in which you lived in for 2 of the prior 5-years, you are entitled to “exclude” the gain recognized on the sale of your residence from taxation in the given year. The amount excluded depends on your filing status ($250,000 for single filers, $500,000 for married filers).

“Like-Kind” Exchanges (1031 Exchanges):

A “like-kind” exchange allows the owner of real estate held for either business or investment purposes to sell and reinvest such proceeds, within a specified period of time, from the sale of their real estate into other “like-kind” real estate (e.g. held for business or investment purposes) while deferring the gain from the sale of the first property until the second property is later sold. Please note this is a very complex area of the tax code, and an advisor should be consulted before trying to undertake such a transaction on your own.

Investments Into Opportunity Zone Funds:

Similar to the “like-kind” exchange listed above, the owner of real estate can sell and reinvest the proceeds of the sale from their real estate into a “Qualified Opportunity Zone Fund”.

If done correctly and within the correct time constraints, the gain from the sale of such property is eligible to be deferred until the end of 2026, with an additional possibility to lower the amount of tax on the initial gain from the property when later recognized in 2026 and exempt tax on the appreciation of the gain invested into the “qualified opportunity zone fund” when sold in future years. Once again, this is a very complex area of the law, and a tax advisor should be consulted prior to taking advantage of this strategy.

1031 Tax Deferred Exchanges, Better known as “Like-Kind” Exchanges

A “like-kind” exchange provides an exception from the general rule requiring the current recognition of gain or loss realized upon the sale or exchange of real property. If correctly executed, no gain or loss is recognized if real property held for business or investment purposes is exchanged solely for real property of a like-kind to be held either for business or investment purposes.

This tax break, however, is not permanent. The gain is deferred until the property acquires as a result of this exchange is disposed of in a subsequent transaction. This deferred gain represents only a potential tax, which may be avoided altogether, for example, if the exchange property passes through an estate and its basis is stepped up to its date of death value.

There are, however, very strict requirements to be in receipt of this preferential treatment.

First are the use of a “qualified intermediary” to help facilitate the transaction. This is essentially an escrow company who is used to receive the sale proceeds from the sale of the first property, and the reinvestment of such proceeds into the replacement property identified. If not properly utilized, the person selling the property will become taxable on the sale proceeds and will be ineligible for “like-kind” treatment.

Second are the timing requirements of such a transaction. In order to qualify, the replacement property needs to be formally identified with the qualified intermediary after the sale of the first property, and then subsequently closed upon within 180-days within the sale of the first property. There is no exception if you do not meet these deadlines. If you fail to meet these deadlines, you will be required to recognize tax on the sale of the first property.

Finally, are the reinvestment requirements. As a general rule, you will need to reinvest (1) the total gains that would have been recognized had to you been required to recognize them on the sale fo the first property without the application of the “like-kind” exchange provision; and (2) take on, at a minimum, the same amount of debt on the replacement property as you held on the first property. If these bare-minimum guidelines are not met, you will be required to recognize gain on this transaction, even if the other “like-kind” exchange requirements are met.

All in all, the “like-kind” exchange is a very favorable tax provision for owners and investors of real estate. However, it is a very complex provision and an advisor should be consulted to guide you through such a transaction.

Structured Installment Sales

A “structured installment sale” helps defer capital gains on the sale of real estate with the ability to customize structured sales cash flow. Essentially, the “structured installment sale” is a slight derivative of a normal installment sale, whereby a seller of property sells the property to a buyer in exchange for a “note” in which the proceeds are paid to the seller for a number of years. Under a traditional installment sale, the seller is not required to recognize gain on the sale of the property until they receive proceeds from the buyer on an annual basis. Once received, the seller will require their proportionate gain that is applicable to the payment received in a given year.

The downside of a traditional installment sale agreement requires the seller to be dependent upon the financial solvency of the buyer for future periodic payments that the buyer owes to the seller. Since the seller permits the seller to take payment in the form of a periodic payment, the seller could be a risk if the creditworthiness of the buyer is suspect at the outset or later deteriorates. In order to mitigate this credit and default risk, the seller and buyer can agree to consummate a structured installment sale.

Generally speaking, the structured installment sale instead requires the buyer to make full payment of the purchase price of the property to an independent third-party, generally a third-party fiduciary/investment company, which is thereby backed by a secure financial investment into annuities, life insurance, or US treasuries. In this scenario, the seller still is able to defer tax on the sale of their property by receiving periodic payments from the third-party, but now eliminates the credit and default risk for the buyer. In addition, the lump-sum payment made to the third party is now invested into a secure investment and will appreciate over the period in time it is held with the third-party.

This is a complex transaction and an advisor should be consulted to ensure that it is properly structured.

Deferred Sales Trust

The deferred sales trust works with Internal Revenue Code 453, which is a tax law that prevents a taxpayer from having to pay taxes on money they haven’t yet received on an installment sale.

The idea behind a deferred sales trust is to sell the real estate asset to the trust with an installment sale. The trust then sells the real estate to the buyer, and the funds are placed in the trust without paying taxes on the capital gains.

The trust doesn’t have any capital gains taxes because it sold the real estate asset for the same amount it paid for it with the installment sales contract. As the seller, you don’t pay any capital gains taxes yet because you haven’t constructively received (physically received) the funds from the sale.

The installment contract from the sale can be set up any way you wish. You can begin receiving installment payments right away or defer them for several years.

The third-party trustee can invest the funds however you like. You can earn interest income on the money from the real estate sale while it sits in the trust. You only begin paying capital gains taxes when you start receiving principal payments.

A deferred sales trust has to be set up properly, and specific rules have to be followed throughout the process to enjoy the tax benefits.

The process for using a deferred sales trust looks like this:

1. A third-party trust is formed that will be managed by a third-party trustee.

2. The real estate asset is sold to the trust with an installment sales contract.

3. The trust sells the real estate to the buyer and receives the funds.

4. The third-party trustee invests the funds or distributes installment payments at the seller’s direction.

5. Capital gains taxes are paid on any principal amount the seller receives from installment payments.

Capital gains taxes are paid when you profit from the sale of an investment property, commercial real estate, or other business assets. Using a deferred sales trust doesn’t get you out of paying capital gains taxes, but it does allow you to defer them while you reinvest the money.

Delaware Statutory Trust

The Delaware Statutory Trust is a strategy that makes use of a “like-kind” exchange (e.g. a 1031 exchange) that allows the owner of real property to reinvest their proceeds from the sale into a sanctioned investment vehicle managed by a third party. The purpose of this transaction is to take advantage of the capital gain deferral offered as part of the “like-kind” exchange, get rid of their requirement to be the manager of a piece of rental property, and still generate passive income through their ownership of other real property in a syndicated manner.

Generally speaking, a Delaware Statutory Trust (DST) is a legally recognized trust, similar to a family trust or an LLC, that is used to hold title to a piece of real estate. Despite the name, the property and investors do not need to be in the state of Delaware to participate in this investment option.

A typical DST is owned by several dozen investors who pool their funds into the trust. Depending on the DST’s performance, investors may receive a portion of the property’s rental income each month. The DST doesn’t allow investors to take an active role in making decisions about the property — those decisions are up to the sponsor (also known as the “operator”), who is the corporate entity that manages the decisions around the property.

To participate in a DST, an individual must qualify as an accredited investor, meaning they must have a net worth (or joint net worth with a spouse) of more than $1 million, excluding their primary residence. Alternatively, they must have had either an individual income above $200,000 in each of the last two years or a joint income with a spouse of more than $300,000 in those years. Accredited investors are then typically required to invest a minimum of $25,000 into the DST to participate.