Real Estate Tax Shelters: Involuntary vs. Voluntary
A detailed look into the two tax shelters all real estate investors can take advantage of
In a previous post, we talked about the overall benefits of investing in real estate and how it stacks up against typical investment vehicles such as stocks. The concept of tax shelters – protection against tax – was introduced along with a brief glaze over how depreciation can actually help a real estate investor. The purpose of this post is to better detail the extent to which depreciation benefits your investment property in the long term. For the sake of this post we identify depreciation as an involuntary tax shelter due to its inherency in real estate and the aging of property. We will then introduce another shelter we identify as a voluntary tax shelter one can choose if they decide to sell their investment. Although there are other tax shelters associated with real estate investment, the purpose of this post is to give a detailed outline of the two every investor should know in depth before dealing with others.
Involuntary – Depreciation
The concept of depreciation is used to acknowledge that an asset wears down over time. These types of assets are typically machinery and equipment, but also include real estate. Real estate is unique in this case as it’s depreciation is an income tax deduction that allows taxpayers to recover the cost of certain property and its components, meaning it is a non-cash deduction that reduces the investor’s taxable income. Some investors refer to this as a “phantom” expense because they are not actually writing a check, the IRS is simply allowing them to take a tax deduction based on the perceived decrease in the value of real estate – even though real estate tends to appreciate over time. This is why real estate is a unique case and an investor may actually have positive cash flow and still experience a tax loss. This entire concept is known as lowering (sheltering) your tax liability, and is one of the main reasons real estate investing is so attractive.
Before you get too excited, there are a couple limitations/exceptions to real estate depreciation that everyone must take into consideration. The first is your entire property cannot be depreciated. Land itself cannot be depreciated, only the building and the improvements you have erected on the land can be put into the deductible equation. Therefore, this concept would not affect you if you only had raw land, there must be a building present for this to pertain to you otherwise it is an inexhaustible asset. Second, the IRS only allows you to take tax deductions for your real estate as long as it is used for business and income producing activity. If you live in this property as your personal residence the property is not tax-deductible. However, with those exceptions aside, depreciation can be a real estate investors best friend.
Depreciation begins when the investor places the property ‘in service’. Say for example you buy the building in May and make some renovations but do not list the apartment to be rentable until July. ‘In service’ in this case means the depreciation toward your property can begin in May, you do not need to wait until someone moves in to the space. Each year the investor deducts the amount of depreciation from the property’s cost basis, which is the owners’ expenses (maintenance, insurance, mortgage, etc) plus any improvements made, less any depreciation the owner has already taken. Residential properties must be depreciated over 27.5 years, while nonresidential properties over 39 (who knows how these numbers came to be, IRS sorcery). In both cases a straight-line method is used for tax purposes, which means an equal amount is depreciated year after year until the asset has fully depreciated. For a residential property with a depreciable improvement cost of $150,000 for example, the owner could take $5,454 each year ($150,000/27.5yrs) as a depreciation expense until the asset is fully depreciated.
There is a very important component to the depreciation process that can greatly increase the effect of this depreciation benefit. This component is the tax assessor. The tax assessor comes to the property to determine what percentage of your properties value goes towards improvements and what percent towards land, because remember land cannot be depreciated. The IRS will generally accept the tax assessor’s value apportionment, therefore if the assessor determined 92% of the properties value goes toward improvements, then that would be the value that can be depreciated. The higher the percentage towards the improvements, the better shape you will be in. Thus, in theory one should invest as much as they can towards the building and its improvements rather than the land itself (however, it is obviously important to not neglect your land completely for aesthetic purposes).
Here is simple example comparing scenarios with and without depreciation (as seen in our Real Estate as an Asset Class post):
Scenario 1 (w/o depreciation expense):
$5,000 taxable rental income x 25% federal income tax = $1,250 owed
Scenario 2 (w/ depreciation expense):
$5,000 income – $3,000 depreciation expense = $2,000 taxable income
$2,000 x 25% federal tax rate = $500 owed
Tax Savings = $1,250-$500 = $750
As you can see with depreciation expense your overall taxable income becomes less than it would be without depreciation. Because this lesser number is multiplied by the same federal tax rate, the overall owed taxes are less in the scenario with depreciation expense. This, in a much grander scheme, is how real estate investors benefit from depreciation.
Prior to 1986, many well off syndicates of investors would pool together resources to invest in properties to take advantage of these tax shelters. As the government caught on to this, the Tax Reform Act of 1986 was passed in order to decrease the value of investments which were held for tax-advantaged status, as opposed to non-tax aspects of their profitability. It also limited the extent to which losses associated with the investments can be deducted from the investor’s gross income. There are some exceptions to this act depending on annual income, etc., however this is just a general overview that the tax shelters are still present – just not as drastic as they once were.
Voluntary – 1031 Exchange
When it comes to real estate, the easiest way to drive your long term growth is to simply not sell. With selling comes transaction fees, commissions, and capital gains taxes on the profits you make from the sale. Not to mention your tax shelter gained from depreciation when holding the investment will be recaptured when you sell, meaning you will have to pay it back. These fees can be very costly to your long-term investment performance. Hence, selling has a huge opportunity cost associated with it. The good news is there are ways you can avoid paying capital gains tax, one of the more well-known being the 1031 exchange. The 1031 exchange allows you to trade one property for another without paying taxes, so long as meticulous IRS rules are followed.
As a general guideline, it should be known that the replacement property an investor seeks must be of equal or greater value (net closing costs) than the relinquished property. All of the equity gained from the exchange must be reinvested for the full tax deferral. So essentially you are trading for something a bit better without cashing out. The property being sold and the new replacement property must both be held for investment purposes, and must be like-kind properties (there are guidelines and certain time constraints associated with what exactly is “like-kind”). There can be situations where ‘non like-kind exchanges’ can occur, however a certain amount of taxes on this sort of exchange must be paid therefore they are not completely deferred. An example of this sort of exchange is when a sale might include cash payments to be used toward capital improvements at the replacement property. This is called a boot and the taxes on the boot portion of the exchange must be paid.
There are multiple exchange options one can use when the decision to sell is made. One very important note to consider is in most cases a qualified intermediary must be used to complete the necessary legal documents to ensure that you are in compliance with all laws and rulings. Prior to the close of sale and purchase transactions, it is imperative to assign the intermediary into the Contract Agreement and disclose the escrow instructions in order for the 1031 exchange to be qualified. With that being said, the following are the three exchange options:
Deferred/Delayed 1031 Exchange
This is the most common type of 1031 exchange. Here, the investor closes on the relinquished property and within 45 days, a period knowns as the identification period, a replacement property must be identified. In order for the replacement property to be approved, one of the following three criteria must be met:
- Three Property Rule: investor identifies up to three different properties as potential purchases within identification period, regardless of total fair market value of the properties.
- 200% Rule: investor may identify an unlimited number of replacement properties, as long as fair market value does not exceed 200% of the value of relinquished property.
- 95% Rule: investor may identify unlimited exchange properties as long as they receive at least 95% of the value of all identified replacement properties before the end of the exchange period.
In addition to the identification period, an investor is limited to 180 days from when they close their relinquished property to close on the replacement property.
Simultaneous 1031 Exchange
The investor closes on the relinquished property, then closes on the replacement property almost immediately after (usually 1 day).
Reverse 1031 Exchange
The investor has already acquired a replacement property before closing the relinquished property.
As already expressed, tax shelters are a significant benefit to real estate investors. These benefits will only favor you more the longer you hold onto your investments, as this is encouraged. Some shelters are involuntary – like depreciation (among others we will get into in later posts) – and are inherent in dealing with real estate. Others are voluntary and give you the option to reinvest your money in an ‘upgrade’ property, giving you the ability to grow your wealth more so than some other investment vehicles. Overall, real estate investing gives you the power to move your money based on your preference and capabilities, often yielding benefits along the way. After all…. is this not the point of investing?