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.