In light of the risks associated with a substantial, illiquid, long-term capital investment required for real estate, several forms for real estate investment have evolved, each form offering a degree of mitigation of one or more of these risks.
Particular real estate ventures vary in their goals and methods. Some emphasize tax-free cash flow, some losses that offset other income, and some appreciation and equity build-up. Forms of real estate investments combine these elements in varying proportions – more of one element means less of another. Taxation has a profound impact on the structuring, management and returms of real estate and must be considered at the very beginning of any real estate investment. Given the importance of this issue in real estate investment, this is the first installment of three on the topic of real estate taxation.
As a general rule, an investor takes the same deductions, uses credits, and recognizes income in the same manner whether he owns the property directly or has an interest in a limited partnership that “passes through” the deductions, credits, and income. However, when a publicly traded partnership is taxed as a corporation, investors are unable to take partnership deductions, credits, and income on their own tax returns.
Types of Real Estate Ownership
There are various ways to own real estate, each with its own particular tax implications.
Individual Ownership. An individual may own property directly, by himself, or as a co-owner with one or more other individuals.
Limited Partnerships. An individual may invest in an interest in a limited partnership, either a large publicly offered syndication or a small privately offered venture. Because a limited partnership “passes through” the income, gain, losses, deductions, and credits of its real estate operations, the partnership provides the same tax benefits offered by direct individual ownership. However, certain publicly traded partnerships may be taxed as corporations.
In addition, a limited partnership permits passive investment by providing management, permits participation for less capital investment, provides greater diversification, has some flexibility in allocating gains and losses among partners, and offers individual investors limited liability.
Master Limited Partnership. The master limited partnership (MLP) is a form of business entity that arose as a result of the desire of business owners to take advantage of characteristics of both corporate and partnership business entities. At the most basic level, the MLP is a type of publicly traded entity that is taxed as a partnership, but publicly traded on a national securities market in the same manner as corporate stock. MLPs present attractive return vehicles to draw long-term capital to the energy extraction, energy transportation (“midstream”), and energy distribution (“downstream”) markets. An MLP is required to pay out most of its annual income to investors and is permitted to carry on an active business. Distributions issued to limited partners are treated as a return of capital and act to reduce a limited partner’s basis to the point of that partner’s cost basis. When that basis reaches zero, any subsequent distribution is then taxed at current tax rates.
Real Estate Investment Trusts. A real estate investment trust (REIT) is a corporate entity that owns, operates, acquires, develops and manages real estate. The investment objective of most REITs is to produce current income through rents or interest on mortgage lending.
REITs are often compared to mutual funds because they allow smaller investors to pool capital to invest in larger and more diversified real estate portfolios than might otherwise be available. Both REITs and mutual funds are pass-through vehicles, as income earned is passed through for taxation at the investor level, bypassing taxation at the corporate level.
REITs are required to distribute at least 90 percent of their annual earnings to shareholders. Thus, REITs are popular with investors seeking higher levels of current income and real estate as part of their portfolios. Although current yields tend to be higher than those of stocks and investment grade bonds, the total return of REIT shares can fluctuate substantially because of their sensitivity to the real estate market.
S Corporations. Real estate investment can also be made by small groups of investors through S corporations, which provide the pass-through advantage offered by limited partnerships and the limited liability of a corporate shareholder.
Limited Liability Companies. Limited liability companies may also be used as a vehicle for real estate investment. They do not have some of the same formation restraints as S corporations, but offer similar tax advantages to, and perhaps greater liability advantages than, S corporations.
General Tax Considerations
Traditionally, the objectives of investment in real estate have been income and appreciation in the value of the property. In addition, there can be attractive tax advantages: tax deferral for several years; eventual conversion of ordinary income into capital gain; and, with certain kinds of real estate investment, immediate or continuing tax savings through tax credits.
Deduction of Expenses. An investor in real estate may deduct each year “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business” and all ordinary and necessary expenses paid or incurred during the taxable year (1) for the production and collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax, even if such expenses result in a loss. However, losses may be subject to limitation under the “passive loss” rule or the “at risk” rule.
Qualifying as Trade or Business. The rental and management of real property is generally considered a trade or business even if the owner owns only one property, is actively engaged in another profession or business and carries on all management activities through an agent, or, continuously, over a period of several years, experiences losses from the operation of the business. However, it has been held that when activities were minimal, rental of a single residence was not a trade or business.
Repair and Maintenance Expenses. Routine repair and maintenance expenses are deductible in the year paid as business expenses or expenses incurred in connection with property held for the production of income, but the cost of improvements must be capitalized (added to the owner’s basis in the property) and recovered through depreciation deductions. Amounts paid for repairs are deductible if the amounts paid are not otherwise required to be capitalized. Capital improvements increase the value, prolong the life, or alter the use for which the property is suitable.
Start-Up Expenses. The first $5,000 of “start-up” expenses is deductible, but not until the year in which the active trade or business begins, and the rest must be amortized over a 180-month period, beginning with the month the business begins. The $5,000 figure is reduced by the amount that start-up expenses exceed $50,000.
Expenses included in this category are those (other than interest and taxes) incurred in connection with investigating the creation or acquisition of a new business, creating an active trade or business, and “any activity engaged in for profit and for the production of income before the day on which active trade or business begins.” The expenses must be expenses that would be deductible if incurred in connection with an existing active business.
Accrual and Cash-Basis Taxpayers. Generally, accrual-basis taxpayers may not deduct expenses payable to related cash-basis taxpayers before the amount is includable in the income of the cash-basis taxpayer. The rule applies to amounts accrued by a partnership to its partners, by partners to their partnership, by an S corporation to its shareholders, and by shareholders to their S corporation.
Mortgage Interest. An investor in improved or unimproved real estate generally may deduct each year amounts paid for mortgage interest, subject to certain limitations. Prepaid interest must be deducted over the period to which the prepayment relates. Interest allocable to any construction-period interest must be capitalized. This interest subject to capitalization may not be reduced by interest income earned from temporarily investing unexpended debt proceeds.
Taxes. The investor in real property is permitted to deduct amounts paid for real property taxes subject to certain limitations. In the year of acquisition the buyer may deduct the real estate taxes allocable to the number of days the buyer owns the property. “Taxes” that are actually assessments for improvements (e.g., sidewalks, sewers, etc.) and that enhance the value of the property cannot be currently deducted, but must be added to the investor’s basis in the property (i.e., capitalized) and deducted through depreciation allowances over the recovery period. Real estate taxes allocable to the construction period taxes must be capitalized.
Tax Deferral for Income. In the early years of a real estate investment, when depreciation deductions are relatively large and mortgage principal payments are small relative to interest payments, the taxable income from the property can be substantially less than its positive “cash flow,” producing a cash flow that is partially or totally “tax sheltered.” These tax deductions can even produce a loss that shelters a taxpayer’s other income.
This favorable situation results from the different way cash flow and taxable income are affected by depreciation and leverage: cash receipts are not reduced by depreciation, but taxable income is. However, because investment in real estate is generally 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.
Tax avoided in this manner during early years, however, is only deferred. As mortgage principal payments increase, but tax-deductible depreciation and mortgage interest decrease, taxable income and even the tax itself can potentially—albeit not often—exceed the investor’s share of cash receipts. This taxable but noncash income is often referred to as “phantom income” and can create tax problems for the investor who has not saved for the inevitable “crossover” from sheltered cash flow to taxable income in excess of cash flow. However, with proper tax and investment planning, the carryover of disallowed passive losses from earlier years may reduce or eliminate the phantom income in later years.
Depreciation. An owner of residential or nonresidential improved real property either used in a trade or business or held for the production of income may deduct each year amounts for depreciation of the buildings, but not the land itself, even though no cash expenditure is made. Furthermore, the depreciable amount is not limited to the owner’s equity in the property. However, the deductions may be subject to certain limittions. Also, when accelerated depreciation is used, either all or part of the amount previously deducted as depreciation is subject to recapture on the sale of the property.
Generally, a Modified Accelerated Cost Recovery System (MACRS) applies to property placed in service after 1986. The MACRS depreciation deduction is calculated by applying to the basis of the property either (1) a declining-balance method that switches to the straight-line method at a time that maximizes the deduction or (2) a straight-line method.
The initial basis in the property is the basis upon acquisition, usually the property’s cost reduced by the amount, if any, elected for amortization or an Internal Revenue Code (IRC) Section 179 deduction, and further reduced by any basis reduction required in connection with taking the investment tax credit. The basis of the property is reduced each year by the amount of the depreciation allowable. Optional depreciation tables set out in Revenue Procedure 87-57 may be used in place of the previously described methods. Because land cannot be depreciated, the cost basis of improved land must be allocated between the land and improvements.
Gains and Losses. A “capital asset” includes most property owned and used for personal or investment purposes. When a taxpayer sells a capital asset, the sale usually results in a capital gain or loss. A capital gain or loss is the difference between the "basis" and the amount earned upon the sale of the asset. With respect to property purchased or acquired in a taxable exchange, a taxpayer’s basis is the cost, which is the cash he paid for the property or the fair market value of the property he gave for it.
Capital gains and losses are either long term or short term, depending on how long the property is owned. If a taxpayer owns the property for more than one year, the gain or loss is long term. If the property is owned one year or less, the gain or loss is short term. If long-term gains are more than long-term losses, the difference between the two is a "net long-term capital gain." If the net long-term capital gain is more than the net short-term capital loss, then the taxpayer has a net capital gain.
Applicable Tax Rate. Net short-term capital gains are subject to taxation at the individual’s ordinary income tax rate. The tax rates that apply to net long-term capital gains depend on a taxpayer's income.
For lower-income individuals, the rate may be zero percent on some or all of their net capital gains. In 2013, the maximum net capital gain tax rate was 20 percent. A 25 or 28 percent tax rate can also apply to special types of net long-term capital gains. For most taxpayers, net capital gain is taxed at rates no higher than 15 percent. Some or all net capital gain may be taxed at zero percent for a taxpayer subject to the 10 percent and 15 percent ordinary income tax brackets. Otherwise a 15 percent rate applies. However, a 20 percent rate on net long-term capital gain applies to the extent that a taxpayer’s taxable income exceeds the thresholds set for the 39.6 percent ordinary tax rate (for 2013, $400,000 for single; $450,000 for married filing jointly or qualifying widow(er); $425,000 for head of household, and $225,000 for married filing separately).
Three other exceptions when long-term capital gains may be taxed at rates greater than 15 percent are:
- The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25 percent rate. Section 1250 property is real property subject to depreciation.
- Net capital gains from selling collectibles (like coins or art) are taxed at a maximum 28 percent rate.
- The taxable part of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28 percent rate.
Additional Net Investment Income Tax. From 2013, a taxpayer may be subject to the net investment income tax (NIIT) imposed to pay for the Affordable Care Act (a.k.a. Obamacare). The NIIT applies at a rate of 3.8 percent to certain net investment income of individuals, estates, and trusts that have income above statutory threshold amounts.
Deduction of Capital Losses. A taxpayer can deduct capital losses on the sale of investment property, such as an apartment building, but cannot deduct losses on the sale of personal-use property, such as the family home. If capital losses are more than capital gains, the taxpayer can deduct the difference as a loss on the tax return. This loss is limited to $3,000 per year, or $1,500 if filing married but separate returns. If the total net capital loss is more than the annual deduction limit, the losses above the allowable deduction can be carried over to the following year’s tax return, subject to the limit of the following year.
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