Tips For Real Estate Investors
If you are a real estate investor I’m sure you are familiar with a number of tax laws and strategies that real estate investors encounter frequently and not so frequently. Things like:
*Tax Rules and Solutions at Purchase and During Ownership of Real Estate *Living With the Passive Loss Regulations *Taxation at the Time of Sale *1031 or Like-Kind Exchanges *Real Estate in Troubled Times
-Passive Loss Limitations may limit the amount of losses you can deduct each year -Depreciation – how to compute and what is the long term effect on my situation -Capital Gains versus Ordinary Gains -Exclusion Rules for Gain on the Sale of a Principal Residence -Converting a Principal Residence to a Rental or Vice Versa -Installment Sales of Real Estate -Office In Home Rules -Repossessions, Cancellation of Debt and Bankruptcy
As an investor you may or may not have a detailed understanding of how these areas affect your taxes and investment. But you should have at least a basic understanding of how different rules affect the types of investments you have. Details on the above are obviously beyond the scope of this text, but feel free to contact us if you feel less than confident in any of the areas or if you are thinking of buying, selling, renting, exchanging, executing a short sale, etc.
Here are some areas I get a number of questions about. If you have any other areas that you have questions, please use the ‘Ask a Tax Question’ button to the right on any page of this website.
1. Repairs versus Improvements – There is a distinct tax difference between “repairs” to a property and “improvements” to a property. On one hand, the cost of repairs made by a business is deductible. On the other hand, the cost of improvements must be capitalized and written off over time via depreciation deductions.
Check out this handout, click here: Is it a repair or improvement?
The life of improvements to a residential rental building is generally 27.5 years. On a nonresidential building it is generally 39 years. A real long time in either case.
A good strategy is to separate repairs from improvements when work is done on a business or rental building. For example, don’t lump standard repairs with a major renovation. If that occurs, it will take longer to write off the cost of the repairs.
Fix the broken window, replace the doorknobs, fix the leaky faucet and the like prior to the more renovation type of work.
A repair keeps the property in good operating condition over the course of its life. Conversely, an improvement extends the useful life of the property, increases its value or adapts it for a different use.
But check this out:
But even the Internal Revenue Manual that tells IRS agents how to audit you admits that distinguishing repairs from improvements is a gray area. You’d think that replacing a roof is pretty clearly an improvement, right? Common sense tells you it adds value and prolongs the property’s life. But a recent tax court case ruled that an investor could deduct a roof as a repair because it just helped keep the property in good operating condition over the course of its existing expected life.
Remember, this strategy is for business property, like rental properties. Personal home improvements are not deductible at all so, in the case of your home or vacation homes, it would be better to lump all little repairs in with a major renovation so it can be added to the cost basis of the property when sold.
2. Cost Segregation
The IRS says your clients can “depreciate” their property over a “class life” intended to approximate its useful life.
Residential property depreciates over 27.5 years. If they have an apartment house worth $500,000, they write off $16,666 per year. Not bad . . . .
Nonresidential property depreciates over 39 years. If they have, say, a medical office worth$500,000, they write off $12,820 per year. Not as good as the apartment – but still not bad.
But all real estate includes specific, identifiable components that depreciate faster.
For example, land improvements depreciate over 15 years. These include paving, landscaping, underground utilities, and site lighting.
And personal property depreciates even faster – just 5 to 7 years. For residential property, this includes flooring, cabinets and countertops, appliances, window treatments, and wall coverings. For commercial and industrial property, add equipment foundations, exhaust and ventilation systems, security systems, and electrical distribution systems.
If we just take the 27.5 or 39 year depreciation we could be wasting thousands in tax deductions we can take today.
A “cost segregation study” is an in-depth analysis, performed by specially-trained experts, that lets them identify and reclassify costs that qualify for faster depreciation.
Faster depreciation translates into immediate tax savings.
The best part is, new IRS rules let owners “catch up” any deductions they missed as far back as 1987. Without even amending old returns! You can do that simply by filing IRS Form 3115. And you can claim those savings in a single year.
That makes cost segregation the closest you’ll come to a real “tax time machine”! It’s all court-tested and IRS-approved. In fact, the IRS offers a 136-page Audit Techniques Guide that details exactly what to do and how to do it. It’s not for everyone but it can make a big difference in the right situation.
3. Depreciation Recapture
Remember that when a property is sold, all depreciation taken over the life of the investment will reduce your cost basis increasing the gain on the sale.
4. Converting Personal Residence to a Rental
You can convert a personal residence to a rental property and if time limits are adhered to, you can still take at least a portion of your tax exclusion for the sale of a personal residence. If you rent it out after 2008 there will be a proration of the exclusion. This can get complex so check it out with an your tax advisor or call us.
You can also go the other way and convert a rental property to your residence and if you live and own it for a long enough period you may be able to exclude some of the gain. Again, a complex issue, call us if you need help.
5. Inherited Property
If the owner of real property passes away, be sure to get an appraisal of the value of the property at the date of death. This will be the new basis for gain or loss on sale and for depreciation. You should get this appraisal even if there is no estate tax return (706) filing requirement.
Also important is if you own property with your spouse make sure that title is held as community property with right of survivorship (if you’re in a community property state such as California). This way the property will get a full step up in basis on the death of the first spouse. If you have a living trust, be sure to run this by your attorney or tax person to ensure it is setup properly.
Call me if you wish to discuss any of these issues. Thank you, Bob (805) 264-3305