Real estate investors smile at tax time

(This is Part 5 of an eight-part series.)

“Why buy real estate in a flat market?” That isthe essence of a question my airline seatmate asked me after he learned Iinvest in and write about real estate. But rather than answer his questiondirectly, I asked him, “Do you own your home?”

Purchase Bob Bruss reports online.

“Of course,” he replied. Then I followed up byasking him the benefits of owning his home. As I recall, he listed security,pride of ownership, tax savings, market-value appreciation, building equity,investment safety, no rent increases, and perhaps a few I forgot.

My seatmate then asked me if I thought he and his wifeshould sell a rental house they own in Arizona. They seem to be having problemskeeping it occupied by reliable renters since it is about 1,000 miles fromtheir primary residence. But then he quickly added, “Our problem, if wesell, is we would owe tax on at least $75,000 of profit.”

Although I pointed out the current low federal long-termcapital gain tax is a maximum of only 15 percent, my new friend seemed highlyadverse to paying taxes. So I suggested he make a tax-deferred exchange for arental house close to his residence so he can better manage it.

MAJOR TAX SAVINGS FROM REALTY INVESTMENT PROPERTY. Althoughthe high, runaway-market-value appreciation rates of the last few years forresidential properties has shifted to a “plateau” in most cities,long-term realty investing still provides major tax benefits for owners who”materially participate” in operating their properties.

Although federal tax law requires “materialparticipation” by investors who want maximum tax savings from their realtyinvestments, they can still delegate day-to-day operating details to a propertymanager. Owners who make the major decisions, such as setting rents,establishing rental rules and authorizing major expenditures, easily quality.

However, an investor who owns less than 10 percent of aproperty partnership does not qualify, nor do owners of REIT (real estateinvestment trust) stock and owners of vacation homes who have their propertiesin “rental pools” managed by others.

Investors who meet the ownership and material participationtests can deduct up to $25,000 of their “passive activity” investmentproperty tax losses from their ordinary taxable income up to $100,000 annualadjusted gross income (AGI). For realty investors with AGI between $100,000 and$150,000, the deduction gradually phases out to zero above $150,000 AGI.

Fortunately, most of these so-called tax losses are notactual cash losses. Instead, they are “paper losses,” usually fromthe depreciation tax deduction for estimated “wear, tear andobsolescence” of the building.

Residential real estate is currently depreciated over 27.5years, and other realty is depreciated over 39 years. Personal property used bytenants, such as appliances and furniture, has a much shorter depreciableuseful life. But land value is not depreciable.

Investors who find they can’t offset their rental propertytax losses against their AGI must “suspend” those unused losses. IRSNotice 88-94 says these unused suspended losses can be used in future tax yearson an aggregate basis, rather than property-by-property, when selling.

HOW TO CLAIM UNLIMITED INVESTMENT PROPERTY LOSSES. There isa little-known, perfectly legal way to claim unlimited investment propertylosses against your AGI regardless how much you or your spouse earns. Thesolution is to become a “real estate professional.”

Real estate brokers, realty sales agents, property managers,builders, contractors and leasing agents clearly qualify if they work at least750 hours per year (about 14 hours a week) on their real estate activities.

However, realty investors also can qualify as”professionals” entitled to the unlimited investment propertydeductions against their ordinary income if they spend at least 750 hours peryear on their investment activities. Either spouse can qualify. A real estatesales license is not required.

For example, suppose a married physician’s AGI is $500,000.Normally, he would not be entitled to any property loss deductions because hisAGI exceeds $150,000. However, if his wife manages their real estate propertiesfrom their home and she spends more than 750 hours annually supervising theproperties, making management decisions, inspecting properties for possible purchase,and supervising property sales and exchanges, they qualify. The result is thephysician and his wife can claim unlimited property loss deductions from theirproperties because the wife qualifies as a “real estateprofessional.”

HOW TO AVOID TAX WHEN SELLING INVESTMENT PROPERTY. Althoughmost investment real estate offers many benefits already listed, when theproperty is sold Uncle Sam (and most states) are waiting to collect capitalgains tax. In addition, Uncle Sam imposes a special 25 percent “depreciationrecapture” tax for the portion of capital gain attributable todepreciation deductions enjoyed by the owner.

However, there are several ways to avoid these taxes. The”ultimate tax shelter” is to die while still owning a depreciableproperty. Uncle Sam will be so distraught upon learning of your death he willwaive any capital gains and depreciation recapture tax that would have been dueif you sold the property before you died.

But a more acceptable way to avoid capital gains anddepreciation recapture tax is to make a tax-deferred Internal Revenue Code 1031exchange for another investment or business property of equal or greater costand equity. Personal residences are not eligible. But cash or “boot”such as net mortgage relief taken out of such an exchange is taxable.

However, savvy investors can make a tax-deferred IRC 1031trade of their rental property for another qualifying rental property, perhapsan ultimate “dream home,” and later convert it into their personalresidence. Most tax advisers recommend renting the acquired property at least12 months to show rental intent before converting it to the investor’s home.

After owning the acquired rental property at least 60months, 24 months of which it is occupied as the owner’s principal residence,then the owner can sell it and claim up to $250,000 tax-free profits (up to$500,000 for a qualified married couple filing a joint tax return in the yearof home sale), thanks to Internal Revenue Code 121.

SUMMARY: Owning real estate investment property providesmany tax benefits, both during ownership and at the time of sale ortax-deferred exchange. Most rental properties appreciate in market value overthe long term and offer many additional tax benefits. Full details areavailable from your tax adviser.

Next week: The many benefits of tax-deferred exchanges.

(For more information on Bob Bruss publications, visit his
Real Estate Center

Copyright 2007 Inman News

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