In the article The Potential Effects of Tax Reform on the Real Estate Industry, GPP Managing Partner Allan Peiser wrote about how proposed tax code changes are likely to affect those in the real estate industry. That article made clear that change is the air, even though details and the timeline haven’t been set just yet.
Until those changes work their way through the legislative process, there’s still time to improve a real estate company’s tax position and hold onto more earnings for the long term.
The term “loophole” sometimes refers to ways to game the tax code and follow the letter of the law instead of the spirit of it. Often politicians refer to loopholes as means to cheat the system. That’s not what this blog is all about.
These are perfectly legal and ethical loopholes that were built to counteract specific unfavorable market forces in the industry. Too many real estate professionals do not take advantage of them because they either don’t know about them or they don’t know how they should be applied. Without going into too many fine details, here are eight favorable tax laws that every real estate professional should know.
- The Sidestep -- Normally, professionals can’t use real estate write-offs like depreciation to shelter investment or earned income, but there is a sidestep. It’s currently covered in Section 469 -- Passive Activity Losses. If you make under $100K annually, you may be able to write off up to $25K for passive losses.
- The Spouse Sidestep -- If you or your spouse spend more time in real estate activities than other “non-real estate” business (at least 750 hours), there’s potentially no limitation to the passive loss. Even if only the taxpayer's spouse is devoted to real estate, the taxpayer can take this shelter. Be careful, though, because the 750 hours can’t be spread across two individuals or two properties, except under particular circumstances. This takes careful tax planning with a professional advisor.
- The ACA Tax -- The Affordable Care Act is still in effect. Until it is fully repealed, the tax code assesses a 3.8 percent tax on real estate gains and income. However, that tax doesn’t apply to rental income or income by a real estate professional.
- Cost Segregation -- Commercial real estate is typically depreciated at up to 39 years and residential up to 27.5 years. It can all be front-loaded, though, if the value of the property is segregated into assessment and costs. For example, a $1 million building could be broken into a half million valuation with a half million assigned to fixtures and equipment. Only the assessed value would need to be depreciated over the full lifetime, and the fixtures/equipment could be depreciated over the first few years.
- Tangible Property -- The “de minimis” safe harbor which says that if you spend $2,500 or less as of January 1, 2016 (or $500 or less before that date) on some item, you can just deduct the item. For example, if you buy ten $2,500 appliances for your apartment house, you can write off in the year of purchase the $25,000 spent on the appliances.
- Safe Harbor -- This is a relatively new real estate investor loophole related to maintenance safe harbor. The routine maintenance safe harbor says if you make a repair several times during the years you owe the property you can deduct the expenditure.
- The Disposition Loophole -- When there are improvements or repairs on any items that were previously being depreciating, the taxpayer can write off the rest of that old item’s undepreciated cost and also remove the accumulated depreciation. For example, if you add a roof on your property you will need to depreciate the new roof, but with the new TPRs, you get to write off whatever is left of your old roof. Whatever depreciation you accumulated on the old roof, by writing off the rest of the old roof, won’t have to be “recaptured” when you later sell the property. (This is another part of the benefit and will reduce the amount of depreciation you “recapture” when you sell.)
- The Trump Loophole -- One of the loopholes that the new tax changes are meant to close is this one, which may have been a favorite of the current president in his real estate days. Net operating losses come from a situation where a real estate company’s deductible expenses are larger than its annual gross income. If the real estate business is a partnership or a limited liability corporation, then all of these net operating losses can be deducted from all other income, even if it wipes out all taxable income. That means the taxes go down to nothing owed and any unaccounted for losses would be carried forward up to 15 years and backward up to 3 years.
There are likely to be significant changes on the horizon for the tax code. Before that happens, make sure your real estate business operates from the most competitive tax position. The word “loophole” suggests that you are trying to get around the system in a tricky way, but that’s not really true. These tax laws were put in place in recognition of the inherent challenges facing the real estate industry. Contact the tax professionals as Goldin Peiser & Peiser to help you navigate these complex formulations and prepare for the coming changes.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.