In recent years, the tax law has focused on real estate as both a great investment and a tax benefit for saving taxes from its use as a business or investment asset.  For example, the use of real estate in an operating business can create many tax benefits, including the ability to claim tax depreciation on the business use, create an eligible investment for tax credits, and even reduce some tax rates for qualified business income.  However, not all investors and owners are eligible for these benefits, since each taxpayer may have limitations on their investments which reduce or defer the benefits until a future event occurs. 

Regardless of the reason for doing so, be prepared to plan ahead if you are trying to benefit from investing in a large asset like real estate. Your preparation and careful tax planning may help determine whether the cost creates any expected tax benefits.

Related Read: Real Estate Investor or Dealer? Your Tax Treatment Turns on It

Determine the scope and role of investors

Any investor has their own goals and expectations for having ownership in real estate. For some, investment is a long term goal of having capital appreciation and selling at a profit in the future.  The gain on real estate is based upon the original purchase price and related improvements and capitalized costs, and the original tax basis may need to be adjusted for the depreciation over the asset life.  If the sale is simply for the real estate alone, then the seller may have a choice whether the proceeds are all realized and the gain will be taxed at lower tax rates.  If the seller is either a pass-through entity or an individual, taxable gain may be eligible for long term capital gain rates (15 or 20%) if the property was held for longer than a one year period, and some gain created from depreciation deductions may be eligible for a 25% tax rate as Section 1250 gain.  For others the real estate is owned for short term use that creates noncash tax benefits for tax depreciation.  Sometimes annual loss is created from tax deductions created through depreciation allowances.  

The issue for investors is whether a tax loss is available as a current benefit for many investors.  The tax rules are often fact specific for each investor.  If an owner is deemed a passive investor, then the ownership of the real estate may create limitations under the passive loss rules, which consider that passive losses may be limited if there is no passive income to offset the loss.   Some real estate investments are managed as full time activities, such as rental properties and regular management of real estate, in which the investor is also a property manager.  Some real estate activities are real estate development projects, in which the property will be improved and used once the completion of development occurs.  If an investor spends all of their time in managing real estate, then the owner may deduct losses as a real estate professional.  The type of activity and time spent can vary on an annual basis, so the tax rules need to be examined for results.

Determine the tax basis of investors

If an investor did not contribute equity or capital, then a loss may exceed their investment and become limited to their cumulative investment and result in no tax benefit until they contribute more capital. An investor can also be responsible for a pro rata share of debt on the real estate (sometimes referred to as qualified nonrecourse debt) and be treated as sharing in liabilities or making agreements for guarantees to pay the debt.  The annual tax results will be important to assess whether losses are claimed every year or carry forward to future years when there is sufficient tax basis to claim tax benefits.  Therefore, the scope of each investor and their share of  equity and debt may impact whether losses qualify for tax benefits. 

Consider the type of real estate activity

Some real estate is not used as an operating asset, but is purchased and developed for resale.  Similar to inventory held for resale, the cost of the property can include improvements and carrying costs and financing costs, which are realized when the final sale of property occurs.  In this example, the tax benefits are available when the property is sold and the calculation of gain occurs.  The taxable gain is based on the final sale and closing of the property transaction.

If real estate has been held for investment or used in a business activity, then the sale can offer more tax advantages.  One tax benefit is the option to reinvest the proceeds in another real estate asset commonly referred to as a Like Kind Exchange.  IRC Section 1031 is a tax law that applies to deferring taxable gain on the sale by reinvesting the proceeds in a similar real estate asset.  The reinvestment has strict rules to identify the replacement within 45 days and complete the closing within 180 days.  The exchange also places a limit on reducing the property debt or receiving cash for part of the proceeds from the sale.  Since the rules are very complex, many investors hire a qualified intermediary (QI) to help manage the details of the transaction.

Evaluate the tax consequences

Many taxpayers assume that the taxable gain from a transaction is determined as the sum of the parts and all of the proceeds received will be treated the same for all of the property transaction.  A typical sale often includes many adjustments and issues at closing, including the payoff of the mortgage, the settlement of an escrow, and a final satisfaction of any debts on the property.  For this reason, the tax consequences may need to be evaluated to identify how each part is taxed.

If all of the gain is from capital gain assets, then recent tax law has allowed Opportunity Funds as a simple way for investors to contribute money in Opportunity Zones. These funds allow you to work with professionals and let them manage your reinvestment and defer the taxable income. Investors will create new capital gains or defer tax on prior eligible gains to the extent the money is invested into the Qualified Opportunity Zone.

Some taxable transactions may be recognized on an installment method basis to report gain as the proceeds are received.  The installment gain is allowed to be deferred to match the timing of the proceeds.  Since the deferral does not apply to ordinary gains, the tax consequences of the character and timing of gain are very critical to qualify for any tax deferral and benefits of a sale.

Consider the scenarios and options

Of course, making the best decision is important if you have a business transaction that requires knowledge of all of the relevant facts and options.  It is best to determine how much time and help is needed to work through the process, and whether you have considered all of your issues.

If you have any questions or concerns, please contact your ORBA Advisor or Tom Kosinski at (312) 670-7444 to review your personal tax situation. Sign up here to receive our blogs, newsletters and Client Alerts.