With the housing market selling at depressed prices, is this a good time to purchase a home and use it as a rental property? The answer to that question will not be found here, but hopefully you will find this blog of immense value when you make that decision. The adage is that money is made when you buy, not sell real estate. The sale process represents the completion of a prudent buying decision. While you can expect to sell your property at market rates, you may be able to find and buy a property at below market rates as that seller may be misinformed about the market or is facing special circumstances that might make him a more motivated seller. For example, if you are able to close quickly and not have a mortgage contingency, the motivated seller may be willing to sell below market value as he may have already purchased another primary residence and cannot afford two mortgage payments.
This discussion relates to properties purchased as rental investments, and not to vacation homes which have their own set of rules dependant upon the amount of time the home is rented and the amount of time you use the home for personal use.
Rental real estate offers tax advantages and opportunities for tax planning. A portion of the purchase price will be allocated to land; the remainder will be allocated to the building. While land is not depreciable for taxes, the building structure can be depreciated over 27.5 years for residential rentals and a 39-year life for commercial properties. Depreciation is a valuable non-cash tax deduction. Depreciation can be further enhanced, particularly with commercial real estate, if a cost segregation study is done. This study is usually done by engineers who are intimately familiar with IRS rules and procedures. The purpose of this study is to reclassify real property with a 39-year life to depreciable property that may have a 3, 5, or 15-year life. The cost segregation study usually pays for itself due to the acceleration of tax depreciation deductions over the shorter tax lives. If the acquisition is financed, you can deduct the mortgage interest on the property. The costs to own and operate the rental property are usually 100% tax deductible.
Tax deductions are not unlimited!! Real estate income and loss is generally considered passive income and loss for tax purposes. Taxpayers generally cannot use passive activity losses (PALs) to offset ordinary income from W-2 wages, self-employment, interest and dividends, or retirement income. The rental real estate loss allowance and real estate professional status are two important exceptions to this rule. The loss allowance exception to the PAL rules is that taxpayers with adjusted gross incomes (AGI) of $150,000 or less can claim a rental real estate loss of up to $25,000 for property they actively manage. The $25,000 loss limitation is reduced for AGIs between $100,000 and $150,000. Active management does not require regular, continuous, or substantial involvement, but it does require that the taxpayer own at least 10% of the property. Real estate professionals may be able to treat their rental activity as a non-passive activity allowing their losses to offset non-passive income. This exception requires material participation by the real estate professional which is demonstrated by meeting one of seven tests. These tests are complex and include the number of hours of participation and the facts and circumstances of the participation in the activity.
When analyzing a purchase of real estate, you should work very closely with a CPA who is familiar with the tax law and can provide you with a cash flow analysis of your purchase and tell you whether the purchase is within your budget. Most real estate investments, despite the ability to claim tax depreciation, often operate at a negative cash flow during the early years following acquisition.
When the day comes when you decide to sell the property (and realize the fruits of your investment), there are several tax planning opportunities that you need to discuss with your CPA. Assuming that you wish to use the current property to purchase a more expensive property, you can exchange your property for the higher value property without recognizing any current tax gain if made in accordance with IRC Sec. 1031 (a 1031 exchange is where the tax gain is deferred until the replacement property is sold.) If you decide that you no longer wish to own real estate or wish to control the year(s) in which the gain is recognized (perhaps to avoid jumping to a higher tax bracket), you can sell the property using the installment method of reporting the gain. The gains are reported as long-term capital gains, allowing the seller to be taxed on the gain at the lowest tax rate. If the sale is structured as an installment sale, a portion of each payment is considered a return of principal, interest income, and gain.
This blog is not intended to replace specific tax-planning advice. Be sure to read the “Tax Advice Disclaimer” page on our blog.
