Income properties have many financial advantages, including some tax benefits. Learn how to take advantage of tax laws for income property ownership.
One advantage of investing in real estate is the tax benefits. People considering the purchase of real property must examine the tax benefits and burdens of their purchase. Many times, the tax implications will seriously affect a sale and cause a buyer or seller to realize that – because of the taxes – full value of ownership may not be possible. What might look like a good deal could turn into a losing proposition after tax considerations.
The tax laws reward an investor for the financial risk taken and benefit the economy from the investment by allowing the taxpayer to reduce tax liability in numerous ways. As long as an investment is income producing, such as with an apartment building or commercial property, certain reductions in tax liability are allowed.
An investor may claim depreciation and other deductions, such as mortgage interest, property taxes, insurance, management, maintenance, and utilities, to reduce the tax bill. One of the most important tax benefits of income property ownership is the depreciation allowance. Depreciation is a tax advantage of ownership of income property.
Depreciation for tax purposes is not based on actual deterioration, but on the calculated useful life of the property. The theory is that improvements (not land) deteriorate and lose their value. A building is thought to have a certain number of years in which it can generate an income, and after that, it is no longer considered a practical investment. The investor is compensated for the loss by being allowed to deduct a certain dollar amount each year based on the useful life of the property until – on paper, at least – the property no longer has any value as an investment.
However, tax laws regarding depreciation change so often that it is advisable for the investor to check current Internal Revenue Service (IRS) rules for calculating depreciation.
A common method that one can use to determine the dollar amount per year that may be deducted is the straight-line method by which the same amount is deducted every year over the depreciable life of a property. When using the straight-line method to calculate depreciation, the value of the improvements is divided by the depreciable life of the property to arrive at the annual depreciation that can be taken.
Example: Determine what the IRS allowance for the depreciable life of a residential income property is by checking current tax law. For our purposes, let’s assume it is 27.5 years. Subtract the value of the land from the value of the property to determine the value of the building:
Value of property: $400,000
Subtract the value of land: – $160,000
Value of building: $240,000
$240,000 divided by 27.5 years = $8.727 annual depreciation allowance
The gain on an income-producing property is calculated much like that for a personal residence, except any depreciation that has been claimed over the years must be subtracted from the adjusted cost basis. This means the dollar amount that has been deducted for depreciation over the time of property ownership must be subtracted from the cost basis to arrive a the adjusted cost basis. The amount of taxable gain is then calculated by subtracting the adjusted cost basis from the selling price.
Unlike a primary residence where a certain amount of gain may be excluded from being taxed, taxes are owed on any profit made whenever income-producing property is sold. However, there are ways an investor may legally defer the gain to a later time. If an income property is sold at a loss, the loss may be deducted.
Example Part 1: Calculate the Adjusted Costs Basis of the Property
Add the cost of improvements and subtract the depreciation from the property:
Purchase Price (cost basis): $600,000
Add cost of improvements: +$100,000
Subtract Depreciation -$75,000
Adjusted Cost Basis $625,000
Example Part 2: Calculate the adjusted selling price of the property
Selling Price $700,000
Subtract Expenses of Sale -$42,000
Adjusted Selling Price $658,000
Example Part 3: Calculate the Capital Gain (or Loss)
Adjusted Selling Price: $658,000
Subtract adjusted costs basis: –$625,000
Capital Gain (or Loss) $33,000
An installment sale is one in which payments are made by the buyer to the seller, over a period of more than one year. This is one way capital gain and the tax payments owed can be spread out over a period of time. Part of the tax liability can be deferred by the seller taking back a note and trust deed, or an All Inclusive Trust Deed (AITD) or contract of sale, with monthly payments. Only the amount of the gain that is collected in the tax year is taxable income, and the tax due on the rest can be deferred until collected. Once again, the investor should check current tax laws about installment sales.
1031 Tax-Deferred Exchange
The 1031 Exchange, sometimes called a tax-deferred exchange, is a method of deferring tax liability. It allows an investor to exchange a property for a like property, and defer the gain until the property is sold. It is not really a tax-free exchange. The taxes are simply put off until a later date. The exchange can be simultaneous or non-simultaneous (deferred). The deferred exchange is often called a Starker Exchange. In a Starker Exchange, the investor must identify a replacement property within 45 days from the date the relinquished property is sold, and must go to settlement on the replacement property within 180 days from the previous sale. A two-party, simultaneous exchange seldom occurs because it is difficult to find two parties with properties of equal value who are willing to trade. Therefore, the Starker delayed-exchange, which allows the investor 45 days to locate and identify a replacement property, is used.
Most real property qualifies as like property, as long as it is held as an investment. It may be investment property (raw land), property held for the production of income (apartment or commercial building), or property used in a trade or business (an operating business). However, a personal residence would not qualify as a like property in an exchange with investment property.
If equities are not equal in the two properties being exchanged, money or anything of value (cars, boats, stock, furniture) – other than like-kind property – may be put in by the investor who is trading up to balance equities. This extra cash or non-like property put into an exchange is known as a boot. The person who receives boot will be taxed on the net amount received up to any gain recognized from the exchange.
Example: Property A Property B
Value $400,000 $600,000
Less Loans -$50,000 -$200,000
Equity $350,000 $400,000
To qualify for a tax-deferred exchange, Investor A need to add $50,000 (boot) to the sale to make the equities match. Investor A would have no tax liability on the sale and Investor B would be taxed on the amount of the boot received in the year of the sale (if s/he realized a gain from the sale). If the amount of the boot exceeds the amount of the gain, tax liability is limited to the amount of the gain.
In calculating the gain on each property, the cost basis of the property being exchanged becomes the cost basis of the property being acquired, if no boot is given or received, and the cost basis follows the taxpayer through subsequent exchange or sales. The profit or taxable gain is determined by subtracting the adjusted cost basis from the fair market value of the property. Tax-deferred exchanges can become very complicated. An accountant should be consulted before entering into the sale of tax-deferred property. In this text, our discussion is mainly an overview of the subject. We recommend that you study the topic further if you find it of interest.