Over the years, Congress has recognized the importance of real estate as a key driver in the nation’s economy. As such, many of the best breaks in the tax code are afforded to owners of real estate. As I see it, here are four of the most effective tax deductions in the tax code to take advantage of. The first one is for all home owners and the remaining ones relate to real estate investors.
Section 121 Exclusion: The tax code recognizes the importance of home ownership by providing a significant tax break when you sell your personal residence. Gains of $250,000 for single persons and $500,000 for married persons on the sale of their personal residence are exempt from any capital gains. Some of the requirements to qualify include:
- You owned the home and used it as your primary residence during at least 2 of the last 5 years before the date of sale.
- You did not acquire the home through a like-kind exchange (also known as a 1031 exchange), during the past 5 years.
- You did not claim any exclusion for the sale of a home during the previous 2 years.
Depreciation: Certainly one of the best breaks in the tax code. Depreciation is an allowable tax deduction on the value of rental property assets over a specified period of years. The role of tax depreciation is to account for the declining physical attributes of a property over time. For residential property, the depreciation rate is 27.5 years and for commercial property it is 39 years. This is generally a non-cash deduction. It is a legally deductible item, yet the investor does not shell out any cash for the deduction – a rarity in the tax code.
The reality is that that the physical attributes of the asset usually last longer than the federally allowed depreciable life. Generally, real property’s physical attributes will last for a significant period of time when properly maintained. The bigger risk to the investor is that the physical attributes will become obsolete as newer properties will provide better amenities/efficiencies, i.e. an older apartment building without an elevator makes tenants less likely to rent. Another advantage of the tax depreciation rules is that the allowable depreciation deduction is based on the full cost of the asset, even though the buyer may have used bank financing for 80 percent of the purchase price. For example, a real property asset is purchased for $100,000. The buyer puts $20,000 down and finances the remaining $80,000 via a bank owned mortgage. The investor is allowed to take depreciation deductions based on the purchase price of $100,000.
Basis Step-Up for Heirs: The tax rules allow for the basis of property to be adjusted to its fair market value at a decedent’s date of death. Real estate investors can receive significant benefit from this rule. For example, an investor purchases a property for $400,000. Over the course of 30 years, the investor claims depreciation deductions of $325,000. The investor dies and the property’s fair value is $1,000,000. The investor’s basis is only $75,000 ($400,000 less the $325,000 of depreciation taken), but the decedent’s heirs will inherit the property with a basis of $1,000,000. Thus the $925,000 in potential taxable gain has been erased. Furthermore, the heir can start to depreciate the property based on its updated basis of $1,000,000, giving the heir significant non-cash deductions to take over future years. For this reason, it is much better to inherit real property than to receive it as a gift.
§1031 Exchange: The internal revenue code allows for the deferral of gain “on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” This allows real estate property owners a tremendous tax benefit. An investor can exchange a real property that he/she currently owns for another investment in real property. Assuming that certain rules are met, the gain on this transaction is deferred to until the subsequently owned property is sold. Investors are often able to defer thousands or even millions of dollars in capital gain/recapture taxes, both at federal and state levels by utilizing the 1031 exchange rules. This essentially results in a long-term, interest-free loan from the tax authorities.
If you have any questions regarding this article, please contact Jamie Downey at JMDowney@DowneyCoCPA.com or at 800.849.6022.
