The Advisor's Professional Library

Taxation of Real Estate

March 4, 2013

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How does real estate shelter income?

Real estate investments can provide “shelter” from taxes through (1) deferral of payment of tax from one year to another and (2) absolute tax savings.

Tax Deferral

When depreciation deductions and any other noncash deductions are large enough, the taxable income from the property can be substantially less than its positive “cash flow” (the amount of cash receipts remaining after subtracting from gross cash receipts all cash expenses and payments on mortgage principal). Often, the noncash deductions produce a loss that partly or totally “shelters” the net cash flow. In many instances, deductions for depreciation and other expenses can produce a tax loss that offsets other taxable income. Because investment in real estate will generally be a passive activity, such losses may normally offset only other passive income of the taxpayer, although passive losses and the deduction-equivalent of credits with respect to certain rental real estate activities may offset up to $25,000 of nonpassive income of an individual. 

However, when mortgage amortization payments exceed the depreciation on the property, taxable income and even the tax itself can exceed the investor’s share of cash flow or tax savings. This taxable but noncash income is often referred to as “phantom income” and, assuming constant rental income and constant mortgage amortization, phantom income can increase each year. The carryover of disallowed passive losses from earlier years may reduce or even eliminate the phantom income in later years. If the individual has not prepared for phantom income, he or she may want to dispose of the investment. 

Absolute Savings

Some types of real estate investment (e.g., low-income housing and rehabilitation of old or historic structures) provide tax credits that directly reduce the tax on an individual’s income. Because investment in real estate will generally be a passive activity, such credits may normally offset only taxes from passive activities of the taxpayer, although passive losses and the deduction-equivalent of credits with respect to certain rental real estate activities may offset up to $25,000 of nonpassive income of an individual. Investment tax credits can offer absolute shelter of income that would otherwise be spent for taxes, provided the property is held long enough. If not, there is some recapture. Even so, there has been the benefit of deferral.

Use of Limited Partnership

Because a limited partnership “passes through” the income, gain, losses, deductions, and credits of its real estate operations, the partnership provides virtually the same tax benefits offered by direct individual ownership. Passthrough of items may differ somewhat for electing large partnerships, as compared to other partnerships, because of the different requirements for separately stated items for the two types of partnerships. In addition, a limited partnership permits passive investment by providing management, permits participation for less capital investment, has some flexibility in allocating gains and losses among partners, and offers individual investors limited liability. While real estate investment can utilize forms other than partnership, partnership is the most common form. 

A publicly traded partnership is taxed as a corporation unless 90% of the partnership’s income is passive-type income. A publicly traded partnership is a partnership that is traded on an established securities market or is readily tradable on a secondary market or a substantial equivalent. In general, “passive-type income” for this purpose includes interest, dividends, real property rents, gain from the sale of real property, income and gain from certain mineral or natural resource activities, and gain from sale of a capital or IRC Section 1231 asset. A grandfather rule treats electing 1987 partnerships as not subject to corporate taxation if they elect to be taxed at a rate of 3.5% on gross income; such a partnership otherwise operates as a passthrough entity. Taxation as a corporation would defeat the “passthrough” feature of a limited partnership. 

Particular programs vary in their tax sheltering goals and methods. Some emphasize tax-free cash flow, some losses that offset other income, and some appreciation and equity build up. Real estate investments combine these elements in varying proportions – more of one element generally means less of another.

Does the “at risk” limitation on losses apply to an investor in real estate? If so, what effect will it have?

Generally, the “at risk” rules apply to losses incurred after 1986 with respect to real estate placed in service after 1986.[1] However, in the case of an interest in an S corporation, a partnership, or other pass-through entity acquired after 1986, the “at risk” rules will apply to losses incurred after 1986 no matter when the real estate was placed in service.[2]

In general, the “at risk” rules limit the deduction an investor may claim for the investor’s share of net losses generated by the real estate activity to the amount he or she has at risk in that activity. The rules do not prohibit an investor from offsetting the investor’s share of the deductions generated by the activity against the income received from the activity.

Put as simply as possible, an investor is initially “at risk” to the extent that he or she is not protected against the loss of money or other property contributed to the program. One special exception applies in the real estate context, however. An investor is considered at risk with respect to certain qualified nonrecourse financing incurred in the holding of real property. 

[1] .IRC Sec. 465(c); TRA ’86 Sec. 503(c)(1).
[2] .TRA ’86 Sec. 503(c)(2)..

Are investments in real estate subject to the passive loss rules? If so, what is the effect to an investor in real estate?

Rental real estate activities will generally be considered passive activities subject to the passive loss rules.[1] However, if the personal use of a residence that is also rented out exceeds 14 days or, if greater, 10% of the rental days, the rental activity is not treated as a passive activity.[2] In addition, a real property business of a taxpayer is not automatically considered a rental activity subject to the passive loss rules for a taxable year if during the year (1) more than one-half of the personal services performed by the taxpayer in trades or businesses during the year is in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of service during the year in such real property trades or businesses.[3] 

In general, the passive loss rules limit the amount of the taxpayer’s aggregate deductions from all passive activities to the amount of his aggregate income from all passive activities; credits attributable to passive activities can be taken only against tax attributable to passive activities.[4] The rules are intended to prevent taxpayers from offsetting income in the form of salaries, interest, and dividends with losses from passive activities. However, the benefit of the disallowed passive losses and credits is generally not lost, but rather is postponed until such time as the taxpayer has additional passive income or disposes of the activity. If an individual actively participates in a rental real estate activity subject to the passive activity rules, the individual may use up to $25,000 of losses and the deduction-equivalent of credits to offset nonpassive income. An individual need not actively participate in a rental real estate activity to obtain the $25,000 rental real estate exemption with respect to taking the low-income housing or rehabilitation tax credits. 

If the investment is in real estate that is not rental property, the real estate activity will generally be considered a passive activity subject to the passive loss rule unless the taxpayer materially participates in the activity. The $25,000 rental real estate exemption is not available with respect to nonrental property. 

If the investment in real estate is made through a publicly traded partnership subject to the passive loss rules, further restrictions may apply. 

[1] .IRC Sec. 469(c)(2).
[2] .IRC Sec. 469(j)(10).
[3] .IRC Sec. 469(c)(7).
[4] .IRC Sec. 469.

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