Education, Finance

The Tax Benefits Associated with
Owning Investment Property

smartland-the-tax-benefits-associated-with-owning-investment-property.mp3 In this article, we look at the tax benefits for investment property owners and the many benefits of owning commercial property... Listen to this article

Introduction

Unlike stocks, bonds and cash equivalents, which are all considered “traditional” investments, commercial real estate has long been considered an “alternative” investment. There are several reasons for this classification, including but not limited to the fact that the sector is highly nuanced. Information about individual assets is not always widely available to the marketplace and in turn, it is considered “riskier” than other investment vehicles. Real estate also has notoriously high barriers to entry.

That said, the federal government has recognized the risks associated with owning commercial property and in turn, has made changes to the tax code that make real estate a highly tax-advantaged asset class for those willing to invest.

In this article, we look at the tax benefits for investment property owners and the many benefits of owning commercial property.

Depreciation Deduction

By far, the most prominent tax benefit associated with owning rental property is what’s called “depreciation”. The IRS allows investors to deduct “a reasonable allowance for exhaustion or wear and tear, including a reasonable allowance for obsolescence.” In other words, although a property’s actual market value may be appreciating in value, the IRS allows investors to write off a portion of that value with the understanding that properties eventually physically deteriorate. Depreciation is a way for investors to offset the costs of making property improvements necessary to maintain a building over time. Depreciation can be used to offset the amount of taxes owed on income generated by the property that year.

Investment property is usually depreciated using one of two methods: straight-line depreciation or accelerated depreciation.

Straight-line depreciation is when an investor writes off an equivalent share of the property each year. Residential properties can be depreciated over a 27.5-year period. Commercial properties, such as office buildings or retail centers, are considered to have a 39-year lifespan and are therefore depreciated accordingly.

Depreciation is a way for investors to offset
the costs of making property improvements
necessary to maintain a building over time.

Accelerated depreciation is an increasingly popular way for investors to recover the value of property depreciation earlier in the hold period. Using what’s known as a “cost segregation study,” an investor can front-load the value of their depreciation in the first few years of ownership.

A cost segregation study essentially assigns a useful life to each individual building component, from individual locks and doors to appliances, HVAC systems and more. Depending on the remaining life of each building component, an investor may fully depreciate a property in just a few years rather than equally over 27.5 or 39 years.

There are practical implications to utilizing accelerated depreciation. For example, an investor who invests $200,000 in an investment property and then front-loads depreciation may be able to take a $100,000 depreciation deduction the following year. This allows an investor to earn a 50% return on their initial capital investment after the first year of ownership—in addition to any cash flow or other dividends collected during that period.

By putting more money back into their pocket sooner, an investor can then redeploy that capital into another investment as he or she chooses.

A few things to note about the depreciation deduction. First, the deduction can only be used to offset the revenue generated by the property. If there is no (or otherwise insufficient revenue) generated during that period, the depreciation deduction can be carried forward (or backward) and applied to income earned in other years.

Second, only real property can be depreciated. This means that buildings and physical land improvements can be depreciated, but not the value of the underlying land itself.

Lastly, the value of the depreciation deduction is partially recovered upon the sale of a property through what’s known as “depreciation recapture.” The current depreciation recapture rate is 25%, which is often lower than the taxes an investor would otherwise owe on capital gains if they are in a higher tax bracket.

Mortgage Interest Expense Deduction

The mortgage interest expense deduction, often referred to as simply an “interest expense” deduction, is a deduction investors can take equal to the amount of mortgage interest they pay each year.

For example, if an investor purchases a $10 million property with a $7 million loan, they might be spending tens of thousands of dollars on interest payments each year. Let’s say, for example, that the mortgage interest expense is $8,000 per month. That translates into a $96,000 interest expense deduction each year.

The interest expense deduction is especially valuable to
anyone with a high-interest rate, or for those utilizing short-term,
more costly construction loans.

Of course, the way loans are structured, most borrowers pay a disproportionately high percentage of interest relative to principle in the first half of property ownership. This makes the interest expense deduction more valuable in the first few years of ownership as loans first begin to amortize.

Over the lifetime of the loan, the balance between mortgage payment vs. interest payment begins to flip and the amount of interest paid each year goes down. Correspondingly, the value of the mortgage interest expense deduction will go down as well.

The interest expense deduction is especially valuable to anyone with a high-interest rate, or for those utilizing short-term, more costly construction loans.

Non-Mortgage Income Tax Deductions

While commercial real estate can be highly lucrative, there are also many costs associated with owning rental property. These costs, referred to as “non-mortgage income tax deductions,” can all be written off as well.

Non-mortgage income tax deductions include, but are not limited to, the cost of repairs and maintenance, property management, utility bills, travel to and from properties, marketing expenses, attorney’s fees, and more.

Long-term capital improvements, like major unit renovations or a roof replacement, must be depreciated instead of written off in the year in which the expense occurred.

Qualified Business Income (QBI) Deduction

In 2017, through the Tax Cuts and Jobs Act, the federal government introduced the “qualified business income” (QBI) tax deduction. The QBI deduction, sometimes referred to as the Section 199A or “20% Pass-Through Deduction” allows owners of pass-through businesses to deduct up to 20% of their qualified business income.

Figuring out how to leverage the QBI deduction as an investment property owner can be challenging. This is because rental property is considered to generate “passive income,” and passive activities are typically excluded from the IRS definition of a qualified business or trade.

Property owners must be able to justify that the income generated from the property is associated with a business and not simply the returns on an investment.

In order to qualify for the QBI deduction, an individual or entity must be able to show (with documentation) that their involvement in the rental property is “continuous” and “regular”. Their activities associated with the property must be for the sake of earning income or profit.

For those who qualify, the QBI deduction can be significant. It is equal to 20% of the property’s taxable income as calculated before the QBI deduction, minus any net capital gains. For single filers with more than $207,500 in taxable income, the QBI deduction is limited to the greater of 50% of their share of W-2 income paid out in the business (OR) 25% of their share of W-2 income paid out of the business PLUS 2.5% of qualified property.

The QBI deduction is set to expire in 2025 unless further congressional action is taken to preserve this tax benefit associated with owning rental property.

Delayed Payment of Capital Gains Taxes (1031 Exchange)

Another benefit to owning commercial real estate is the ability to take advantage of what’s known as a 1031 exchange. Using a 1031 exchange, investors can defer paying capital gains tax if they roll the proceeds from the sale into another “like-kind” property, such as another piece of real estate of equal to or greater value.

Many real estate investors will use 1031 exchanges to continue growing their real estate portfolios, often delaying the payment of capital gains tax indefinitely.

Utilizing a 1031 exchange is often easier said than done. There are strict IRS guidelines that must be followed closely. For example, an investor only has so much time to identify suitable investment properties and then close on that property in order for the proceeds from their sale to maintain their tax-deferred status.

Investors who rush a sale without taking the proper steps to line up the pieces needed for a 1031 exchange may find themselves subject to significant tax bills if their sales proceeds lose that tax-deferred status.

Many real estate investors will use 1031 exchanges to
continue growing their real estate portfolios,
often delaying the payment of capital gains tax indefinitely.

One of the primary benefits to using a 1031 exchange is that the tax savings associated with not having to pay capital gains tax in the short term allows investors to reinvest into other assets that allow them to grow their investment portfolios faster than if they were paying taxes after the sale of each individual property.

For example, an investor who might have been facing a $50,000 capital gains tax bill can instead use a 1031 exchange to invest that $50,000 into another like-kind property (in addition to the sales proceeds) which allows them to scale their rental portfolio.

Stepped-Up Basis for Beneficiaries

Another tax benefit associated with owning rental property is that a person’s heirs will often inherit property at a stepped-up basis.

Let’s consider an investor who uses 1031 exchanges for multiple property transactions. Over a person’s 30-year investment career, they may have deferred paying capital gains tax on multiple sales. In the process, they’ve grown their rental portfolio. Typically, if an investor were to eventually sell their property, they would then be forced to pay at least a portion of the capital gains that had been deferred over the years.

However, if those properties are held in a trust for the benefit of someone else, then when an investor passes away, the beneficiaries inherit the property at what’s called a “stepped-up” basis. Essentially, the IRS resets the value of the property to market rates and any future capital gains taxes are owed only on the incremental increase above that stepped-up basis.

For instance, an owner who may have otherwise owed $5 million in capital gains taxes if they were to sell their portfolio can instead pass these properties onto their heirs—who can immediately resell the property on a stepped-up basis without having to pay these taxes at all. In other words, heirs can inherit property virtually tax-free.

Conclusion

Given the many tax benefits associated with owning commercial real estate, it’s no wonder the asset class has grown in popularity over the years. Investors can make their dollars stretch further by taking advantage of these savings compared to investing in traditional asset classes, like stocks, bonds or other equities.

Of course, navigating all of these tax benefits is no easy task. Real estate investors are always advised to consult with a CPA or tax attorney to be sure they are following all proper regulations when trying to leverage these cost-saving tools.

Another option is to invest with a qualified real estate sponsor who can help outline the relevant tax benefits for individual, passive investors. A sponsor will track all income and expenses on behalf of investors which will make navigating these deductions significantly easier come filing time.

Interested in learning more? Contact us today to learn about Smartland’s investment platform.


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