The Art of the Real Estate Tax Deduction (Part 2)


(In the first part of this article, Mr. Gonzalez discussed how CPA firms can demonstrate their invaluable worth to clients by pointing out how taking advantage of real estate tax deductions can be a major stepping-stone in the creation of personal wealth; they can potentially make a commercial real estate investment not only self-financing, but profitable. He discussed the concept of depreciation, the usefulness of cost segregation studies in triggering tax savings, and the IRS’ passive vs. non-passive income rule, which governs if taxpayers can claim a passive loss up to $25,000 a year.

(Here in Part 2, Mr. Gonzalez explains the accounting concepts of basis issues, at-risk rules, and excess business loss.)

Basis Issues  

In accounting, the term “basis issues” refers to the amount (the basis) of a property that’s subject to taxation under law. Basis issues can make it more difficult to sell a property, because your client might take a bonus appreciation sum so large, it dwarfs their property’s real value. If they took a bonus depreciation and no basis remains, they must pay back the bonus depreciation if they sell.

As a result, if your client is unwilling or unable to pay back the bonus depreciation, they either have to hold onto their property or undertake a 1031 property exchange, where they swap their property and essentially do a “trade-in” on it. Or they can sell the property, then buy another one in the same tax year, and use the depreciation to offset the capital gains and/or the recapture tax.

At-Risk Rules 

At-risk rules are tax shelter laws that limit the amount of allowable deductions a taxpayer can claim from engaging in at-risk activities that can result in financial losses. The rules are designed to guarantee that losses claimed on returns are valid and that taxpayers aren’t trying to manipulate their taxable income using tax shelters. If your client’s property investment has no risk or limited risk, they may be unable to claim any losses incurred when filing an income tax return.

At-risk basis is calculated by combining the amount of an investment in a property with any amount borrowed or made liable for regarding that property. If your client bought a $100,000 property with a $90,000 mortgage and they’re not at risk for the $90,000 loan, they can only take 10% of their loss and must write off the rest of the loss in succeeding years.

Excess Business Loss  

An excess business loss is the amount by which total deductions exceed total gross income and gains, plus $250,000 (or $500,000 in the case of a joint return). Let’s say you buy a small apartment complex for $10 million, which is split between the land and the depreciable property (the building): both are worth $5 million.

By undertaking a cost segregation study, your client can write off at least one-third of that depreciable property; let’s say it’s $1.5 million. Of that $1.5 million, they would take out $500,000 (their maximum allowed excess business loss if they filed jointly) and roll forward the remaining $1 million, which becomes a net operating loss carryforward. Under Section 461 as modified by the Tax Cuts and Jobs Act of 2017, they’re only allowed to take up to 80% of that sum to mitigate their tax obligation for future income.

For example, let’s propose that in year 2, your client reports a $500,000 gain in income. They could apply 80% of that taxable income ($400,000) to their existing $1 million net operating loss carryforward. Over the next few years, they could use up that remaining $600,000 in net operating loss carryforward to offset further taxable income.

The Benefits of Real Estate Deductions 

It almost sounds too good to be true—but it is. If your client buys a property for $100,000, puts down $10,000, gets back $30,000 in bonus depreciation, and then collects rental fees on the property, the government is essentially buying that property for them. They get their $10,000 back, and their financial benefit is more than their outlay.

Right now, the accounting profession is at a turning point. A shrinking workforce and intense competition are making it more urgent than ever for CPAs to embrace the transformation from compliance to advisory. Instead of merely helping clients comply with current tax laws and file returns, CPAs must adopt a more pro-active stance and demonstrate their value as trusted advisors, showing their worth as strategic partners. An excellent way to begin is by underscoring to clients the immense value of real estate tax deductions.

It should be added that it’s very important to select the right partner to support your client behind the scenes when it comes to these arcane tax and convoluted matters. Choose a company that specializes in the science of cost segregation, something like Engineered Tax Services, to help you. But whichever partner you chose, please do not ignore the game-changing aspects of real estate tax deductions. It could make all the difference in the world to your clients’ financial health.