Tax Benefits for Real Estate Professionals - Explanation of IRS Rules

According to the Wall Street Journal, almost two-thirds of American households own homes, many other rental properties, or vacation homes. In contrast, a Gallup poll found that only half of Americans own stocks.

Equity is the basis of personal wealth in the United States, which accounts for about two-thirds of the investment in most American households, according to Bloomberg. The expansion of homeownership has been spurred by government programs and tax incentives to encourage home purchases. According to a study of social forces, homeownership leads to "a stronger economy, better schools and an invested and proactive citizenship." Homeowners have higher voting rates and are more involved in civic organizations.

Owning real estate has unique financial advantages. For example, homeowners can deduct mortgage interest, mortgage insurance premiums, and property taxes from ordinary income. Also, the revenue from the sale of a house is treated as a capital gain for taxes: income up to $250,000 can be excluded from income for a single taxpayer or $500,000 for a couple making a declaration joint.

Owning an investment or home real estate offers tremendous benefits for both the business and you individually. Below we show you how to get the most out of your investments.

Real Estate as an investment

Owning an investment property is very different from owning the property in which you live. While investors have many common risks: political lack of transparency, and economic uncertainty, each investment property is unique and varies according to use location, improvement, and permanently. Any investment may be subject to a set of tax rules that affect the net return on investments.

Many people pay a lot for their assets: the income is immediately blocked when the investor buys the property. Due to analytical errors, the investor pays a lot and is surprised when he does not win.

It is recommended that the success of real estate investments requires:

• Comprehensive planning: Many people fall in love with a property without a strategy to make a profit.
• Realistic expectations: Buying, owning, and selling real estate is not an easy way to get wealth. 
• Detailed due diligence: When trying to do business with competitors, many buyers cannot adequately verify the history, conditions, and limits of a potential property purchase, which ends up in surprisingly expensive rehabilitation costs.
• Competent consultants and experts: Successful real estate investors always have a team of consultants who can help them find, analyze, buy, manage, finance, and sell their properties.

Types of properties

The term real estate includes different types of properties, including:

• Undeveloped properties: Investors buy raw land for a variety of purposes, including ranches and farms, the exploitation of natural resources. The price of the gross land depends on the maximum possible use, both in agriculture and in the spaces of an office building. The approximation of urban areas and the approved zoning objectives generally determine the value of the property.
• Residential properties: The real estate sector is commonly used for residential purposes, whether single-family homes or multi-family buildings, including apartments and condominiums. These properties, ranging from a simple duplex to developments with hundreds of rental units, require constant maintenance and active management to maintain employment and increase value.
• Commercial properties: This segment includes office buildings, retail stores such as supermarkets and stores and industrial properties, including warehouses and factories. Commercial buildings require active management due to competition, physical maintenance, constant tenant turnover, and the variety and complexity of rental conditions. The owners regularly encounter legal, zoning, and environmental problems.

Properties are also classified in:

• No improvement: Properties that are not improved are irregular lands that have not been altered by human action, that is, without buildings, structures, roads, lakes, or artificial lakes. Since the land has an infinite useful life, it cannot be depreciated for tax purposes. However, depletion charges may be available if natural resources such as wood, oil, and other minerals are eliminated.
• Improved property: The improved properties are soils that have been modified by the addition of artificial, residential, or commercial buildings and structures. Although the land cannot be depreciated, the improvement costs can be recovered over its useful life. In many cases, accelerated depreciation of real assets is allowed.

Land Tax Laws and Regulations

Owning an investment property can provide significant tax benefits to the owner if properly organized and managed. The general rules applicable to the tax treatment of real estate investments are as follows:

• The costs associated with the purchase of goods (property taxes, registration fees) are added to the cost of the property and amortized
• The costs linked to the financing of an asset (creditor's fees, loan application costs) are amortized over the entire duration of the loan.
• The costs of operating the property (taxes, insurance, and public services) are deductible as current expenses.

However, the tax rules are complex, and their application depends on the type of property and the tax classification of the owner. In other words, one investor can protect other income from tax, while another does not.

As a result, sophisticated owners often use a combination of legal entities (trusts, Company C, Sub-Chapter Selections, and limited liability companies (LLC)) to buy, manage and sell their real estate. Owners generally participate in subsequent complex intercompany transactions to minimize legal and financial liability or to maximize personal tax benefits.

Each strategy is designed to respond to the specific circumstances of the owner, the intended use of the property, the addition of significant improvements, the period of ownership on the business, and the ultimate impact of the strategy on unrelated tax revenues and liabilities. 

The taxpayer may be required to justify a tax position with the IRS. Therefore, obtaining professional accounting and legal advice is always guaranteed, if not essential, before continuing to implement a tax reduction strategy.

Finally, potential property investors should be aware that the benefits of any tax incentive may be limited to higher taxpayers due to phasing out and the Alternative Minimum Tax (AMT).

Additional tax considerations on property

Investors who have improved the real estate sector can use a variety of tax treatments to reduce their tax liability, including:

Depreciation

Depreciation is the process of recovering the cost of an asset over its useful life. Although land with an infinite useful life is not depreciable, non-residential buildings and real estate improvements have a useful life of 39 years, and residential rental properties have a useful life of 27.5 years, according to IRS publication 946.

Depending on the type of property, owners can use a straight-line or accelerated depreciation method. The first method involves a constant deductible value each year over the life of the building (cost of improvements divided by the useful life in years, i.e., $ 3,500,000 / 39 years = $ 89,744 each year). Accelerated depreciation generates the highest depreciation costs in the first years and then decreases.

Investors often separate the different components of a tax structure because of the different useful lives. For example, leasehold improvements, adjustments made to a specific tenant, can be amortized over 15 years or less, while office furniture and accessories last seven years. By separating assets, depreciation is maximized, which results in a taxable or "paper" loss.

Section 179 of the IRS code allows you to charge a fee for the purchase of specific appropriate equipment (such as air conditioning or heating units) up to a limit of $ 500,000 in the year of purchase. Qualified personnel range from commercial and mobile vehicles to the hardware and software needed to do business. Also, Congress anticipates a further depreciation in a few years above the threshold of 179, currently at $ 2 million.

Capital gains and losses

Once sold, personal or investment assets are subject to capital gains tax. The profit or loss of an asset is determined by the difference between the "base" price (the purchase price, which includes adjustments such as depreciation defined in IRS publication 551) and the net sale price. Profit or loss is considered short-term if it is held for less than one year or in the long term if the term is more than one year.

Properties of real estate developers must include all direct and indirect costs in the calculation of the base until the commissioning or sale of the property. The main drawback of the developer rating is the inability to offset expenses incurred under the uniform capitalization rules. Income from the purchase of real estate held by real estate agents is considered ordinary income and does not qualify for capital gains treatment.

Bottom line

While the tax treatment of real estate investments is often confusing, investors can use tax strategies to reduce risk and improve returns. Maintaining competent tax advisers and monitoring changes in rules and regulations yields dividends well above their costs.