Real Estate Investment Tax Planning

Real Estate Investment Tax Planning:

Get it Right, Save a Bundle

One of the best reasons to invest in real estate is the potential for tax savings. The US tax code contains numerous provisions that real estate investors can use to reduce their tax liability and accelerate their wealth.

But “advantageous” does not mean “layman-friendly.” The sections of the tax code that apply to real estate investing are just as complicated, labyrinthine, and ever-changing as the rest of the tax code. If you aren’t a tax-preparation pro — or even if you just don’t keep up with annual changes in the law — you could end up paying thousands of dollars in taxes that you don’t need to pay.

For most real estate investors, these savings more than justify relying on a professional pair of eyes to square away their taxes. A Gerber & Co tax preparation specialist can help you squeeze the maximum tax savings out of your investment property. Here are some tax considerations for real estate investors that our qualified tax experts address:

Ordinary Income vs. Capital Gains

Not all real estate income is created equally. Some real estate income may be taxed as “ordinary income,” while other income may be a capital gain.

“Ordinary income” is taxed like income from your job. The statutory rate can change every year, but generally speaking, ordinary income is taxed at a higher rate than capital gains.

Generally speaking, rental income and “fix-and-flip” income are taxed at the ordinary income rate, while proceeds from sale face capital gains tax. This is typically because the earning cycle for the money lasts less than a year. 

If you hold a property for more than a year, however, the capital gains rate kicks in. Most “buy-and-hold” strategies cycle through multiple years … but not always. Knowing whether your profit will be taxed as ordinary income or capital gains can make a big difference in your ROI.

One of the key benefits a tax-preparation specialist can offer a real estate investor is to correctly — and advantageously — classify real estate income as a capital gain or as ordinary income.

Property Management Oversight

A professional property manager can be a godsend. For a reasonable percentage of the rent, your property manager can advertise the property, source the tenants, collect the rent, manage repairs, process evictions, and prepare financial reports.

No banging on doors, no filing eviction reports, no answering “broken-toilet” phone calls at three in the morning. Having a great property manager frees the investor to work the day job, source new investment opportunities, or just chill on the beach!

But the investor buys that freedom by giving up a lot of control. A degree removed from their valuable asset, investors place a lot of trust in their property managers. Property managers can — and do — violate that trust sometimes.

That’s where a qualified third-party audit comes in handy. Gerber & Co can provide critical oversight over the property manager’s activities by providing a thorough review of the financial reports, receipts, and supporting documents generated by the property manager. We can identify inflated costs, missing income, and other early signs of trouble. That way, you can take action before little discrepancies become financial catastrophes.

Depreciation

Real estate investors love depreciation. It’s essentially a dummy expense that the IRS allows you to declare on your taxes … even though it doesn’t take any money out of your pocket.

Essentially, a portion of the cost basis of the property (that is, the cash it took to buy it) is eligible to be deducted from your taxes every year. This is based on the assumption that the property becomes less valuable over time due to wear-and-tear.

Of course, real estate investors know that property tends to become more valuable as years pass, not less valuable. But they are still allowed to deduct depreciation. This is a huge write-off that can reduce the investor’s overall tax liability dramatically.

If you sell the property at a profit, depreciation must be “recaptured” … i.e. you owe the deduction back. Ideally, the proceeds of the sale are there to cover for it, and the overall effect of depreciation is a net-positive over the life of the investment.

Cost Segregation

Depreciation becomes even more powerful if you can perform cost segregation on a rental property.

According to the tax code, the most you can deduct each year is the cost basis for real estate improvements divided by 27.5. “Improvements” mean the building, utilities … everything but the land itself.

If you hold the property for 27.5 years, you will no longer be eligible to deduct depreciation, since the property will be considered fully depreciated.

This is where cost segregation comes in. Real estate improvements must be depreciated over a schedule of 27.5 years … but some of the property fixtures may not be real estate improvements. Some of it may be eligible for a shorter depreciation schedule — seven, five, even three years.

If even a small portion of the property’s value can be depreciated on an accelerated schedule, this could massively increase your depreciation deduction in the first few years of a real estate investment. It’s not uncommon for a real estate investor to wipe out their tax liability entirely, thanks to accelerated depreciation.

Ask your Gerber & Co tax consultant whether cost segregation for accelerated depreciation makes sense for your investment property.

1031 Exchange

Section 1031 of the US Tax Code describes one of the most powerful methods of accelerating real estate wealth — the “1031 Exchange.”

If you sell an investment property at a profit, that profit is usually liable for capital gains tax. However, Section 1031 allows investors to flip the cash proceeds from an investment sale into another investment property. If they sold at a profit, investors can often afford a bigger property with higher cash flow potential.

By executing this “1031 Exchange,” investors can defer their capital gains liability. If they keep flipping their sale proceeds into bigger and bigger properties, with bigger and bigger cash flow potential, they can defer their capital gains liability indefinitely.

1031 Exchanges can help investors build net worth and cash flow much faster. How? By preventing big chunks of sale profit from being diverted to the pocket of Uncle Sam.

Gerber & Co can advise you on how to legally execute a 1031 Exchange.

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Real estate investing is big business. Hundreds of thousands, even millions of dollars routinely change hands. The tax liability can be dizzying … but the tax code contains the solutions to help savvy investors pocket more of their hard-won gains. If they have the wherewithal to take advantage of those solutions, that is.

With thousands of dollars in tax liability at stake, it makes no sense to wing it or learn on the fly. Trust a professional. Talk to the real estate tax experts at Gerber & Co. The difference in your tax bill could make even a lackluster real estate investment seem like a cash cow.

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