Tax Planning – Tips for the Real Estate Industry
December 11, 2020
By Nitin Illiparambil & Jeffrey Hess
As the ever changing world of taxes continues to become more complex and daunting, here are tips for professionals in the real estate industry that will help lower their tax burden.
Repair and Maintenance Write-Off
Taxpayers in the real estate industry have the potential to maximize deductions by expensing any item costing up to $5,000 per item that otherwise would be capitalized and depreciated. The $5,000 limit is applied item-by-item, so it is important that invoices detail the property that is acquired. In addition, de minimus non-structural improvement to units of property may also be currently deductible.
Real Estate Professional Benefits
For a real estate professional, all real estate losses are treated as non-passive. By treating losses as non-passive, taxpayers can utilize the losses to offset other sources of income. In addition, taxable income and future gains from the sale of real estate assets would not be subject to the 3.8% net investment income tax.
A taxpayer qualifies as a real estate professional if 1) more than 50% of his/her personal services that are performed in all businesses during the year are performed in real property trades or businesses in which the taypayer materially participates and 2) the taxpayer works more than 750 hours a year in real property trades or businesses. Time spent as an employee does not count towards these tests unless the taxpayer owns more than 5% of the employer. A real estate professional can elect to treat all rental real estate activities as a single activity in order to satisfy these tests.
Like-Kind Exchanges – Potential To Permanently Save State Taxes
The use of like-kind exchanges is another key planning tool that should be considered. Like-kind exchanges allow taxpayers the ability to defer any gains on sale of real estate by disposing of real estate assets and acquiring one or more replacement real estate assets. The tax savings on a deferral can even be permanent for state tax purposes if the taxpayer exchanges property from a high-tax to a low-tax or no-tax state.
100% Bonus Depreciation
Real estate professionals can also consider the application of bonus depreciation, which is an immediate write-off of certain capital assets that would normally be depreciated over many years. It should be noted that there may be an impact on how taxable income is recomputed for state purposes, as many states do not recognize bonus depreciation.
The CARES Act also provided a technical correction for qualified improvement property (“QIP”). QIP was previously depreciated over 39 years. The technical correction changes the depreciable life to 15 years, allowing QIP to be completely expensed via bonus depreciation. As discussed above, the state taxation of bonus depreciation needs to be considered as well.
Eliminating Interest Deduction Limits
Taxpayers in the real estate industry have the ability to elect out of the interest deduction limitation rules. By making this election, a taxpayer will have to increase the time periods over which they depreciate their real property assets. The election also precludes the use of bonus depreciation QIP. Since this election is permanent, real estate owners should examine any future capital expenditures and determine what best fits their needs.
Interest Expense Limitations
There have also been changes to the limitations on the deductibility of interest expense. Taxpayers now have higher thresholds, potentially increasing the amount of interest that can be deducted for the 2020 tax year without slowing down depreciation on real property assets. Real estate businesses can elect to not apply the business interest limitations. As part of the change to depreciation for QIP, real estate businesses can revoke the elections made in prior years.
Suspension of Business Loss Limitations
The CARES Act has suspended the excess loss limitations which limited business losses to $500,000 for married taxpayers filing a joint tax return. Given the changes to QIP and the business interest limitation rules discussed above, this temporary change can create net operating losses in 2020.
Net Operating Losses
The TCJA of 2017 eliminated NOL carrybacks. The CARES Act temporarily allows NOLs generated in 2018, 2019 or 2020 to be carried back five years and to offset taxes paid in those earlier years. If the losses do not provide significant benefits in the earlier years, they can be carried forward indefinitely.
Cash Out Refinancing
Taxpayers in the real estate industry have the potential to refinance their properties and distribute the cash to themselves free of current-year tax. The deduction for the interest on the cash out refinancing may be limited by several factors, including the use of funds by the owners, business interest limitation (discussed above) and the operations of the property. If structured correctly and under the right fact pattern, the interest may potentially be deductible without limitations.
Planning for Potential Future Tax Changes
Year-end tax planning in the current tax year may be different than what we are accustomed to due to the uncertain circumstances given our current political landscape. While Democrats will control the White House and House of Representatives, the control of the Senate won’t be decided until 2021. Several changes highlighted in President-Elect Biden’s proposed tax plan will create a need for many taxpayers to change their typical year-end strategies. Instead of accelerating deductions and deferring income, taxpayers should model out multiyear tax projections using anticipated future tax rate increases. If these proposals pass, it may be prudent to accelerate income particularly capital gains to 2020 and defer deductions such as for state and local taxes.