Tax implications and benefits of real estate investment
Real Estate Deductions
Allowable deductions for Real Estate Investments:
- Advertising
- Building repair and maintenance
- Business equipment, such as laptops and printers
- Home office deduction*
- Insurance
- Legal and accounting expenses
- Mortgage interest**
- Property management expenses, such as utilities and lawn care
- Property taxes****
- Travel expenses
*Home office deduction – Simplified Option: $5 per sq.ft. up to 300 sq.ft. OR Regular Method: Percentage of home expenses based on area used for
business purposes.
**Mortgage interest – On the first $750K (for MFJ) or $375K (for MFS) of the mortgage balance for primary residence, no limits applicable when the
property is used for business purposes.
***Interest on HELOCs – Interest on a HELOC is deductible if the loan proceeds are used for specific purposes. For a primary residence, interest is
deductible if the loan is used to buy, build, or substantially improve the home that secures the loan. For investment real estate, interest is deductible if the loan proceeds are used for business operations.
****Property taxes – Up to $10,000 for primary residence, no limits applicable when the property is used for business purposes
DEPRECIATION
Investors can deduct property depreciation from their taxable income, allowing for a reduction based on the building’s deterioration over time. Residential properties are depreciated over 27.5 years, while commercial properties are depreciated over 39 years.
Cost Segregation Studies
Cost Segregation is a commonly used strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes.
When a property is purchased, it includes both the building structure and its interior and exterior components. Typically, 20% to 40% of these components fall into tax categories that can be depreciated more quickly than the building structure. A Cost Segregation study analyzes these costs, which would otherwise be depreciated over 27.5 or 39 years, to identify expenses that can be depreciated over 5, 7, or 15 years. For instance, electrical outlets dedicated to appliances or computers should be depreciated over 5 years.
Illustration for understanding purposes only:
| Without Cost Segregation | With Cost Segregation | |
|---|---|---|
| Total Building Cost | $500,000 | $500,000 |
| Depreciation Expense | ||
| Regular Depreciation | $12,821 | $9,615 |
| Bonus Depreciation | $0 | $75,000 |
| Total Depreciation Expense | $12,821 | $84,615 |
| Tax Savings @ 37% | $4,744 | $31,308 |
| Net Tax Savings with Cost Segregation | $26,564 | |
Bonus Depreciation:
Bonus depreciation is a tax incentive designed to stimulate business investment by allowing companies to accelerate the depreciation of qualifying assets, such as equipment, rather than write them off over the useful life of the asset. This strategy can reduce a company’s income tax, which in turn reduces its tax liability.
The maximum benefit of 100% bonus depreciation ended in 2022. Starting from tax years after December 31, 2022, the deduction is gradually reducing by 20% annually until it completely phases out by the end of 2026: 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% in 2027
Proposed changes to Bonus Depreciation: If approved, the proposed changes to Bonus Depreciation would extend 100% bonus depreciation for
qualified property placed in service between December 31, 2022, and January 1, 2026
Section 179 Deduction:
Section 179 of the IRS tax code permits businesses to deduct the full purchase price of qualifying equipment, autos, and/or software bought or financed during the tax year, incentivizing investment. However, it comes with caps—$1,220,000 for total amount written off and $3,050,000 for total equipment purchased in 2024. Once these limits are exceeded, the deduction phases out. Bonus depreciation, currently at 60% in 2024, varies in availability. Bonus Depreciation is advantageous for large businesses surpassing the Section 179 Spending Cap, while also accommodating businesses with net losses. Typically, Section 179 is applied first, followed by Bonus Depreciation, unless the business lacks taxable profit, allowing for loss carry-forward.
DEFER TAXES WITH INCENTIVE PROGRAMS
1031 Exchange
When you sell business or investment property and make a profit, you typically owe taxes on that gain. However, IRC Section 1031 offers an exception that allows you to defer paying taxes on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange within 180 days. It’s important to note that while the gain is deferred in such exchanges, it is not entirely tax-free
Reduced tax burden with Step-up in basis:
The step-up in basis involves adjusting the cost basis of an inherited asset to its fair market value at the
decedent’s date of death. This adjustment is crucial as it minimizes capital gains taxes owed upon the asset’s
sale, thereby reducing the tax burden and enhancing the financial benefits of reinvesting in such assets
Proposed changes to Step-up in basis: If approved, the Budget will end the practice of “stepping-up” the basis for gains exceeding $5 million per individual and $10 million per married couple (or $5.25 and $10.5 million respectively when combined with existing real estate exemptions). This change ensures that gains are taxed if the property is not donated to charity.
Reverse 1031 Exchange
A reverse 1031 exchange follows similar rules and requirements as a regular delayed 1031 exchange but in the opposite order. This type of exchange, like all 1031 exchanges, is applicable only to business or investment properties, such as rental properties or apartment buildings. In a reverse 1031 exchange, the investor acquires the replacement property before transferring the relinquished property. The process begins with purchasing a new investment property of equal or greater value, which triggers a 180-day timeline to sell the old property. This method allows the investor to hold onto their current property until its market value increases, potentially maximizing their profit
1031 Securities (Delaware statutory trusts)
1033 Exchange
Tax-free gain:
The 1033 exchange allows for unique flexibility, as not all equity must be reinvested. If greater financing is secured than that held in the forced conversion, this can offset the required reinvested equity, provided the replacement property’s total value is equal to or greater than the forced conversion value. The remaining equity, not needing reinvestment, becomes completely tax-free and available for the investor’s use at their discretion
Opportunity Zones
The Opportunity Zones program offers three tax benefits:
- Temporary deferral of taxes on previously earned capital gains until 2026 or asset disposal.
- Basis step-up of invested capital gains: 10% increase for 5 years, 15% for 7 years.
- Permanent exclusion of taxable income on new gains after a 10-year investment period.
Investors can choose one or more benefits. The basis step-up benefit ends for new projects in 2026, but the 10-year hold period can extend beyond, enabling the permanent exclusion benefit.
OTHER BENEFITS
Pass-Through Deductions
The pass-through deduction, part of the Tax Cuts and Jobs Act, permits individuals operating real estate businesses through sole proprietorships, partnerships, LLCs, or S corporations to deduct 20% of qualified business income (QBI) from their taxes until 2025. Eligible taxpayers can also deduct 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income
Notes:
> Pass-Through Deductions Exclude Passive Rental Activities.
> The deduction is limited to the lesser of the QBI component plus the REIT/PTP component
or 20 percent of the taxpayer’s taxable income minus net capital gain
Capital Gains Tax Exemption for Primary Residence
Exclusion from Application of Self-Employment Taxes
OTHER TAXES
FIRPTA Withholding Tax
FIRPTA, the Foreign Investment in Real Property Tax Act, mandates that buyers of U.S. real estate from foreign sellers withhold 15% of the gross sales price and remit it to the IRS. The purpose of FIRPTA is to enforce tax obligations on gains derived from the sale of U.S. real estate by foreign sellers. Failure to withhold this amount by the buyer could potentially result in the buyer being held responsible for the applicable tax liabilities if the seller is identified as a foreign person.
A foreign corporation that distributes a U.S. real property interest must withhold a tax equal to 21% of the gain it recognizes on the distribution to its shareholders who are foreign persons
Capital Gain Tax
Capital gains tax applies to the profit made from the sale of real estate. Short-term gains (real estate held for less than one year) are taxed as ordinary income at the regular tax bracket. Long-term gains (real estate held for more than one year) are taxed at rates of 0%, 15%, or 20%.
| Filing Status | 0% | 15% | 20% |
|---|---|---|---|
| Single | $0 to $47,025 | $47,026 to $518,900 | Over $518,901 |
| Married filing jointly | $0 to $94,050 | $94,051 to $583,750 | Over $583,751 |
| Married filing separately | $0 to $47,025 | $47,026 to $291,850 | Over $291,851 |
| Head of household | $0 to $63,000 | $63,001 to $551,350 | Over $551,351 |
Net Investment Income Tax (NIIT)
A 3.8 percent net investment income tax (NIIT) applies to individuals, estates, and trusts that have net investment income above applicable threshold amounts.
In the case of an individual, the NIIT is 3.8 percent on the lesser of:
> the net investment income, or
> the excess of modified adjusted gross income over the following threshold amounts:
$250,000 for married filing jointly or qualifying surviving spouse
$125,000 for married filing separately
$200,000 for single or head of household
ADDITIONAL BENEFIT FOR REAL ESTATE PROFESSIONAL
Real estate professionals can deduct losses against nonpassive income and avoid the 3.8% net investment income tax. To qualify for real estate professional tax status, individuals must meet both of the following criteria:
1. More than half of the personal services performed by the taxpayer during the tax year must be in real property trades or businesses in which the taxpayer materially participates.
2. The taxpayer must perform more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates
OTHER HIGHLIGHTS OF BIDEN'S 2024 BUDGET PROPOSAL
Corporate Changes
> Increasing the top US corporate income tax rate to 28% from 21%.
> Increasing the corporate alternative minimum tax to 21% from 15%.
> Increasing the excise tax on certain corporate stock repurchases to 4% from 1%.
> Denying business deductions for employee compensation above $1 million for all publicly & privately held C Corporations.
Individual Changes
> Reinstatement of the enhanced Child Tax Credit with full refundability from $2,000 to $3,600 per qualifying child under age 6 & $3,000 for all other children.
> Increase the top tax rate to 39.6% from 37% for income above $400,000 (single filers) or $450,000 (married filing jointly).
> The net investment income tax rate would rise to 5% from 3.8% for those earning more than $400,000 in regular income, capital gains, and pass-through business income combined. The additional Medicare tax rate for those earning more than $400,000 would also increase to 5% from 3.8%.
> Billionaire Minimum Tax of 25% on the wealthiest taxpayers with wealth greater than $100 million, imposed on taxpayer’s taxable income and unrealized capital gains less the sum of their regular tax.
> Eliminate preferential treatment of capital gains and qualified dividends for taxpayers with taxable income over $1 million.