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Real Estate Investors Smile At Tax Time

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

“Of course,” he replied. Then I followed up by asking 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 wife should sell a rental house they own in Arizona. They seem to be having problems keeping it occupied by reliable renters since it is about 1,000 miles from their primary residence. But then he quickly added, “Our problem, if we sell, is we would owe tax on at least $75,000 of profit.”

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

MAJOR TAX SAVINGS FROM REALTY INVESTMENT PROPERTY. Although the high, runaway-market-value appreciation rates of the last few years for residential 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 “material participation” by investors who want maximum tax savings from their realty investments, they can still delegate day-to-day operating details to a property manager. 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 a property partnership does not qualify, nor do owners of REIT (real estate investment trust) stock and owners of vacation homes who have their properties in “rental pools” managed by others.

Investors who meet the ownership and material participation tests can deduct up to $25,000 of their “passive activity” investment property tax losses from their ordinary taxable income up to $100,000 annual adjusted 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 not actual cash losses. Instead, they are “paper losses,” usually from the depreciation tax deduction for estimated “wear, tear and obsolescence” of the building.

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

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

HOW TO CLAIM UNLIMITED INVESTMENT PROPERTY LOSSES. There is a little-known, perfectly legal way to claim unlimited investment property losses against your AGI regardless how much you or your spouse earns. The solution 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 least 750 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 property deductions against their ordinary income if they spend at least 750 hours per year on their investment activities. Either spouse can qualify. A real estate sales 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 his AGI exceeds $150,000. However, if his wife manages their real estate properties from their home and she spends more than 750 hours annually supervising the properties, making management decisions, inspecting properties for possible purchase, and supervising property sales and exchanges, they qualify. The result is the physician and his wife can claim unlimited property loss deductions from their properties because the wife qualifies as a “real estate professional.”

HOW TO AVOID TAX WHEN SELLING INVESTMENT PROPERTY. Although most investment real estate offers many benefits already listed, when the property is sold Uncle Sam (and most states) are waiting to collect capital gains tax. In addition, Uncle Sam imposes a special 25 percent “depreciation recapture” tax for the portion of capital gain attributable to depreciation 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 depreciable property. Uncle Sam will be so distraught upon learning of your death he will waive any capital gains and depreciation recapture tax that would have been due if you sold the property before you died.

But a more acceptable way to avoid capital gains and depreciation recapture tax is to make a tax-deferred Internal Revenue Code 1031 exchange for another investment or business property of equal or greater cost and 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 1031 trade of their rental property for another qualifying rental property, perhaps an ultimate “dream home,” and later convert it into their personal residence. Most tax advisers recommend renting the acquired property at least 12 months to show rental intent before converting it to the investor’s home.

After owning the acquired rental property at least 60 months, 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 year of home sale), thanks to Internal Revenue Code 121.

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