Tax Planning Strategies for Real Estate Investors
“Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world” – President Franklin D. Roosevelt.
Owning real estate is the most effective way to build wealth when done right. Real estate investment tax planning is on the minds of novice investors of real estate investment trusts (REIT), those who hold a few rental properties and the institutions that rely on the cash flow from real estate to fund America alike. Real estate investors, not speculators, understand the immense benefits of buying and holding real estate in their portfolio. Whether for leverage, to protect against inflation, for cash flow or for tax benefits, real estate investing has grown more and more popular over the years. There are several tax planning concepts and strategies — depreciation methods, the de minimis election and 1031 exchanges — that help lead to the ultimate real estate goal: generational wealth.
All real estate deprecation is not created equal. Recovery periods for a building differ from land improvements, and land improvements differ from replacing an oven. More specifically, bonus depreciation, unless one elects out, may result in a 100-percent write off for qualified improvement property placed in service (20-year or less recovery period), subject to certain provisions. However, beginning in 2023, bonus depreciation is reduced from a 100-percent write-off in the first year to an 80-percent write-off, with the remaining 20-percent basis depreciated over the asset’s useful life. For those who have projects that will be completed and placed into service by Dec. 31, 2022, that 100-percent write-off can reduce any income from the property in the current tax year.
Regular modified accelerated cost recovery system (MACRS) depreciation for residential real estate (27.5 years) or commercial real estate (39 years) is the foundation for depreciation calculations. Depreciation can easily be projected for the entire year as those methods use a straight-line convention. When working through year-end planning, walk the properties to determine future projects in order to maximize deductions and save tax dollars. For those who are expecting higher than usual income from other income sources or from real estate, purchasing assets or making improvements can result in tax savings which will build wealth.
De Minimis Election
De minimis is a safe harbor election where up to $2,500 per item or invoice can be written off for taxpayers without applicable financial statements. Those who have an applicable financial statement (audited by a CPA) may elect and write off up to $5,000 per item or invoice, all substantiated by the invoice. For example, if a property owner purchases all new windows for an apartment complex, and each window costs less than $2,500/$5,000 (depending on the scenario) the owner can write-off each window rather than capitalizing and depreciating. The de minimis election provides investors with the same cash flow and tax effect: a full write off in that tax year rather than having to depreciate and recover those costs over time. With costs continuing to rise, the thresholds for de minimis elections are more important than ever. Taxpayers cannot write off those costs without electing, so it is very important their personal or business tax return includes that election.
Investors who plan on continuing in the real estate industry must understand the power and popularity of a 1031 exchange. Section 1031 is only for real property used in a trade or business (office building), no longer for personal property used in a trade or business (equipment). A 1031 exchange defers the tax from the gain on sale by exchanging an in-kind property for another in-kind property. An eligible exchange includes an office building for a piece of land, not solely the character of the property — like a building for a building. A 1031 exchange, if all other requirements are met, is an automatic provision. Taxpayers who would rather pay tax now per their planning discussions must structure the transaction in a way that makes a like-kind exchange invalid. These transactions can easily become complex, so be careful in the way it is structured.
Andrew Carnegie said, “90 percent of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined.” Owning real estate is a tried-and-true method to build wealth, which stresses the importance of tax discussion and planning. By understanding depreciation, the de minimis election and the power of a 1031 exchange, new investors can start off on the right foot. There is much to learn in the real estate realm, so investors should plan ahead and keep an eye on their cash flow in order to achieve the goal of generational wealth.
Steven J. Budryk
Steven Budryk, CPA, MS, is a senior accountant at Traphagen CPAs & Wealth Advisors. He is a member of the NJCPA Emerging Leaders Interest Group and Student Programs & Scholarships Committee.
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