A version of this article appeared in Commercial Property Executive on June 24, 2015.
Real estate assets are rising in value, which is great news for your investments, but maybe not for your tax exposure.
That makes this a good time to look into tax strategies you can implement now. Doing so while the market’s experiencing an uptick could have a profound impact on how much you’re able to make of current gains, regardless of whether you plan to reinvest them right away or keep them around as downside protection. Furthermore, good tax planning brings benefits on the personal side too, particularly for taxpayers in the upper brackets, many of whom must now pay the net investment income tax on top of increased tax rates on regular income and capital gains. Our tax code isn’t getting any simpler, so it’s important you know what your planning options are and what strategies are available to you if you hope to make the best of things.
So, what are some of the strategies you should consider for holding onto more of your gains? Let’s look at six of the best ways you can reduce how much tax you and your real estate firm are required to pay.
Cost segregation is a tax deferral strategy that front-loads depreciation deductions into the early years of ownership. Segregating the cost components of a building into the proper asset classifications and recovery periods for federal and state income tax purposes results in significantly shorter tax lives. Rather than the standard 27.5-year and 39-year depreciation periods, assets depreciate over a five-, seven-, or 15-year period. In other words, you’re able to defer taxes, putting more cash in your pocket today.
Whether you’re building, remodeling, expanding, or purchasing a facility, a cost segregation study can help increase your cash flow. Many property owners don’t take advantage of these provisions, and as a result, they end up paying federal and state income taxes sooner than they need to.
Tangible Asset Incentives
Since you’ll likely need to review your compliance with the IRS’s new tangible property regulations, take the opportunity to examine your assets for potential write-offs and losses as well. This is especially relevant now, because 2014 is the only year you can look back to prior years to claim write-offs and losses. If you’ve extended your return, you still have time to examine these additional opportunities. If you’ve already filed, there are still opportunities to claim write-offs and losses moving forward.
Real estate companies in particular that don’t take advantage of the opportunity to claim partial disposition losses could be forfeiting significant tax savings opportunity, depending on the scope of their business and holdings. To put it in concrete terms, take the following example: A firm that spent $500,000 to improve a building in 2008 (assuming the original building was placed into service in 2006) might be expected to uncover as much as $400,000 in losses, an amount that could reduce its tax liability by $158,000 at the 39.6 percent tax rate.
Passive Activity Rules and the Net Investment Income Tax
The IRS is increasingly auditing taxpayers with rental real estate activities in an attempt to reclassify their associated losses as passive, which can generally be used to offset only passive income. If you’re faced with an audit and your losses are recategorized as passive, you won’t be able to offset as much of your active income, which could lead to a large resulting tax bill. Certain taxpayers can avoid this treatment if they qualify as a real estate professional. Be sure you understand what participation levels are required of a real estate professional and carefully consider the one-time activity grouping options to improve your tax outcome.
Deducting losses isn’t the only reason to take a hard look at the real estate professional and passive activity regulations. They’re also applicable to the new 3.8 percent net investment income tax, which is imposed on income from a “passive” business and is in effect as of the 2013 tax year. These regulations are a minefield for the average taxpayer, so use caution when implementing a strategy to reduce your exposure to this tax.
Section 1031 Planning
This technique allows investors to trade one qualified property for another and defer capital gains tax on the transaction. Involving your tax professional early on in this kind of transaction is the best way to generate the outcome you’re looking for.
If implemented properly, a land banking strategy will generate long-term capital gains on the appreciation of real property before development occurs. This strategy can save a lot of money, but it has to be done right. In a nutshell, it works like this:
- The taxpayer holds appreciated raw land on which development has not yet begun but that the taxpayer wishes to develop.
- The taxpayer sells the land to a related S corporation, recognizing a long-term capital gain on the predevelopment appreciation.
- The S corporation develops the land and sells the finished plots to customers, recognizing ordinary income on any subsequent appreciation.
Structuring an arrangement like this generally involves a time frame of several years, and since there are some unique rules surrounding it, it’s important to work with an accounting firm experienced in the real estate industry to make sure you don’t run afoul of the regulations.
Contrary to what many businesses may think, property tax isn’t a fixed operating expense. For owners (and often renters) of real estate, if the assessed value is higher than current fair market value, there are ways to challenge and mitigate property tax assessments, which can help you ease your overall tax burden.
Yet many companies with significant investments in real and personal property often lack the internal resources to take charge of their property tax assessments. This can result in overpayment of tax liabilities as well as penalties and interest. Note, for example, that the requirements and category definitions for reporting on real and personal property tax differ from the definitions used for federal income tax. This discrepancy in definitions and requirements often results in overreported costs, duplicate assessments, and assessments on property that should be exempt.
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By taking steps now to reduce or defer the tax impact of the market upswing, you’ll be able to retain more of your gains and create tax efficiency for later on, when you might not be as free to explore and implement new strategies.
For more information about the tax opportunities described here, or to learn whether one or more of them could be a good fit for your firm, contact your Moss Adams professional.