The Art of the Real Estate Tax Deduction (Part 1)

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As a CPA, are you seeking ways you can demonstrate your unique, value-added worth to clients? Consider introducing your clients to the benefits of real estate tax deductions. For your clients, owning real estate can be a major step forward in creating and maintaining personal wealth. And with the deft use of tax deductions, incredibly enough, a real estate investment could be self-financing—and yield a sizeable profit as well. 

Write Off Your Depreciation

Depreciation occurs when a purchased building ages: it loses value over time. Upon purchase, your client can write off a depreciation loss to cover purchase costs. If you buy a property for $100,000, in theory, your client can recover that cost in a set period. Whether the property is residential or commercial, they can write off that cost either in a 27- or 39-year timeframe.

The Power of Cost Segregation

With cost segregation, engineers and accountants recognize a building is not only one piece of property, but comprised of subcomponents (such as lighting fixtures, heating and air conditioning systems, and other components that deteriorate over time). Unlike the whole of a building, which is seen as having either 27- or 39-year lifespan, subcomponents are granted a five- or 15-year lifespan, making the depreciation deduction larger, especially in the first several years.

If your client owns a property with a class life of 27 years, they can sometimes get a sizeable bonus depreciation in year one. Bonus depreciation is allowable on any class life equal to, or less than, 20 years. As a result, by reallocating some of the building’s assets to a five- or 15-year lifespan, they would qualify for bonus depreciation. The 2017 Tax Cuts and Jobs Act allows for an immediate deduction for the full costs in the first year. Instead of waiting five or 15 years for the depreciation, you can take it all in year one.

Since many components can be written off after a cost segregation study, if your client’s purchase price was $100,000, they can deduct $30-40,000 immediately (the 100% bonus depreciation signed into law by the Tax and Jobs Act). If your client only invested $10,000 of their own money and borrowed the other $90,000, they’ve only spent $10,000, but received a $30,000 deduction!

Let’s assume your client is classified as a real estate professional, or has material participation in a commercial real estate investment, with a $100,000 salary. Because your client can apply their $30,000 deduction to offset taxable income, they’re only paying taxes on $70,000!

Passive vs. Non-Passive Rule

Under the law, with an income of less than $150,000 a year, your client can claim a passive loss up to $25,000. The passive vs. non-passive income rule was a law that Congress passed to shut down tax shelters for the wealthy who were trying to use depreciation losses to offset taxable income. Since real estate rents are considered passive forms of income, if your client sustained a loss in a rental investment, the loss would be deemed to be passive. An investment where your client is a silent partner is also considered passive income.

However, there’s an escape hatch. Here are two ways your client can earn over $150,000 year and still claim the passive loss, even if more than $25,000; it’s by grouping real estate gains and losses under Section 469. Your client must satisfy the criteria for either of one of the two ways of grouping:

  1. Grouping the rental property with other passive activities that produce income that they materially participate in. Your client can group gains and losses if they share common characteristics, which can include:
  • if their businesses are similar
  • common control
  • common ownership
  • geographical location
  • if the activities are interdependent.

There are several requirements for materially participating in an activity, one of which includes spending 100 hours a year on the activity.

  1. Grouping with other passive activities that produce losses because your client or their spouse is a real estate professional. To qualify as a “real estate professional,” your client or their spouse must pass one of two tests:
  • They spend at least 750 hours per year solely focused on operating and managing rental properties in a hands-on fashion. (For example, they spend at least 15 hours a week inspecting properties and interacting with tenants to resolve issues.)
  • They spend 50% of their time on their real estate business.

It’s easier for most taxpayers to choose the first option if they have other passive activities that produce income, such as a partnership that generates income. If they have no other passive income activities, they must meet the more stringent test of 750 hours a year managing their properties, rather than spending 50% of their time doing so.

Even if the taxpayer satisfies these rules, they must also satisfy several other rules, including the basis limitation rules, at-risk rules, and excess business loss rules.

(To be continued in Part 2, where Mr. Gonzalez will delve into the accounting concepts of basis issues, at-risk rules, and excess business loss.)