Commercial real estate can be a productive investment. If rental income flows in, it will provide a steady return on the capital you’ve invested, and if prices rise, you may be able to sell your interest at a profit. Of course, it doesn’t always work out that way. But there also are potential tax advantages that can make such investments very appealing.
There are four key tax advantages relating to rental real estate that you may be able to tap, although a few obstacles could stand in the way.
1. Annual deductions. When you acquire real estate, you likely will have to take a loan and pay interest on it, and you’ll also owe property taxes to the local authorities. Both of those expenses are tax-deductible and can help offset the taxable rental income you receive. Moreover, you can recover the cost of investment property through depreciation deductions. IRS rules specify a cost recovery period of 27.5 years for residential property and 39 years for commercial property. Depreciation is one of the biggest tax advantages on the books and can go a long way toward making an investment in real estate worthwhile.
2. Capital gains on property sales. If you sell a property at a profit, you may be able to pay tax on the gain at the 15% rate that applies to most long-term capital gains (for holdings you’ve owned for more than a year). If you are in the top ordinary income tax bracket, the long-term rate is increased to 20%—still much better than ordinary income tax rates that currently reach as high as 39.6%. In recent years, of course, selling property at a profit often has been problematic, though values now are rising in many parts of the country and investments in real estate have tended to provide favorable returns over extended periods of time.
3. Section 1031 exchanges. One way to avoid a taxable gain on the sale of commercial or investment real estate is to “swap” property with another investor. Under Section 1031 of the tax code, “like-kind” exchanges can be tax-free if certain requirements are met, and the tax law definition of like-kind is quite liberal. For instance, you might be able to swap an apartment building for raw land. Also, to facilitate Section 1031 exchanges involving multiple properties, you’re allowed to utilize a qualified intermediary. Such exchanges allow the indefinite deferral of the taxable gain you would have realized on the sale of appreciated property.
4. Step-up in basis at death. If you never sell your real estate property, your heirs will benefit from a “step-up” in the property’s cost basis for income tax purposes. The basis of inherited property is adjusted to its value on the date of the death of the person it’s coming from. That lets you and your heirs completely avoid tax on the appreciation of the property during your lifetime. There also may be no tax on the transfer of the property. If it goes to your spouse, he or she will be able to take advantage of an unlimited marital deduction, while other heirs may be protected by a generous estate tax exemption for transfers to non-spouse beneficiaries.
There are, however, some restrictions on the tax breaks for real estate owners. Among the most significant is a series of rules relating to “passive activities,” such as the ownership of rental real estate by most investors. Those rules could limit the annual loss you can claim for such property. You’ll generally be able to deduct no more than the amount of your income from that passive activity for the year.
Still, you might be able to claim at least a partial tax loss (beyond the amount of your income from the property) if you “actively participate” in rental real estate activity—for example, by managing tenants, arranging repairs, and other such activities. If you qualify, you will be entitled to deduct a loss of up to $25,000. But that benefit begins to phase out when your adjusted gross income exceeds $100,000, and it ends at $150,000.
You also might be able to deduct losses on a property in full if you qualify as a “real estate professional,” although those requirements are more stringent than the test for active participation. Generally, you’ll be eligible only if more than half of your personal services for the year are devoted to real estate trades or activities and you spend at least 750 hours annually on those trades or businesses. In other words, real estate normally has to be your principal occupation.
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