Newsletter 2014
Newsletter 2014
Real Estate
Real Estate
Print Full ArticleLast Reviewed: Jan 2015
Last Modified: Jan 2015
Real estate may be a type of investment you are thinking about or, perhaps, already have. This is not a risk-free area as many, many people learned through a recession that was largely driven by massive real estate losses. There are some tax advantages to owning rental property and, who knows, maybe the tide has turned and real estate is back as a good place to invest. It certainly has been for the last few years within our region. Most clients that have invested in real estate have single or multi-family rental properties. Some have commercial property and others are invested through REITS or TICs (tenant-in-common interests). REITS are more like stock investments and the following benefits really do not apply to them. The rest all have in common the basic notion that they are operated like a business with operating expenses paid and deducted, income received and assets depreciated over time. Of course, it is best to actually show a profit from any business activity including rentals, but there is what can be called a "sweet spot" with rental properties where they generate positive cash flow but a loss for tax purposes (a paper loss if you will). The sweet spot comes from the use of depreciation and the Tax Code fiction that your building will only last 27.5 years (39 years for commercial property). These are the time periods you must use to depreciate your investment in real property. Now, you may have paid cash for your property or you may have borrowed most of the money to make the purchase. Either way, you can deduct the entire amount allocated to buildings and related improvements over these time periods. So, what you have as your rental investment advances through the years is a sizeable deduction that is really not paid for during the year in which you take it. Even with repayments of principal under a loan, you are still taking a larger deduction than you are actually paying out in cash during the early years of your purchase. You can use this deduction to shelter that much rental income from tax or, if you meet the rental loss criteria described below, create a negative income amount that is used to offset other types of income.
Using rental losses is a tricky business because of our passive activity loss rules. The IRS has understood for many years that wealthy taxpayers could acquire an interest in a business run and managed by others and harvest losses from it. There are endless ways in which this type of investment can be configured so IRS limits the use of this type of loss for any activity in which you do not materially participate, better known as a passive activity. With two important exceptions, rental property investments are deemed passive activities and their losses can only be used to offset other passive activity income, which, by the way, does not include investment income like interest and dividends. Fortunately, the two exceptions apply to many real estate investors. The first exception is for people that focus most of their earning activity on real estate as a business, either buying and selling it, managing it or just owning it as an investment. The second exception allows individuals with incomes below $100,000 to take a loss of up to $25,000 against other types of income. There is a phase out of the loss amounts you can use for incomes between $100,000 and $150,000. Above $150,000 no losses can be used in the year incurred. But all is not lost if you have income above $150,000. If you cannot use a passive loss in the year it is incurred it is suspended and carried forward until you either have other passive income or you dispose of the asset. If you have a year with substantial income from any source there can be significant benefits to liquidating an asset with accumulated passive losses.
