(This is Part 5 of an eight-part series. See Part 1: Recent changes to the $250,000 home-sale tax exemption; Part 2: Personal-use time determines vacation-home tax break; Part 3: Moving costs beef up real estate tax deductions; Part 4: Homeowners take refuge in casualty loss assistance; Part 6: Tax savings abound with real estate exchanges; Part 7: Home-business expenses add up to tax savings and Part 8: 10 most often overlooked real estate tax deductions.)
At the 2005 International Builders Show in Orlando, Fla., economists David Seiders of the National Association of Home Builders, David Berson of Fannie Mae, and Frank Nothaft of Freddie Mac agreed that mortgage loans to rental-home investors are becoming a significant factor in home sales. As much as 9 percent of home sales, they reported, involve investors buying houses and condos for rentals rather than owner-occupancy.
Purchase Bob Bruss reports online.
With average annual residence market value appreciation hovering around 10 percent nationally, they opined, savvy investors are probably buying rental homes as a very profitable alternative to the stock market.
In addition, investors in rental houses, apartments and commercial buildings should also consider the tax-shelter benefits, leverage control of investment property with little or no cash down payments, and investment safety.
BIG TAX BENEFITS FOR REALTY INVESTORS. Major benefits for realty investors involving owners who “materially participate” in management of their property come in the form of income tax savings and tax deferrals. Even if you hire a professional property manger, you can meet this participation tax test by making the major decisions.
To meet the material participation criteria, the investor must be involved in setting rents, approving major expenses and qualifying new tenants. But day-to-day operating details, such as rent collection, evicting non-paying tenants and fixing clogged toilets can be delegated to a resident manager or a professional property manager.
Investors who meet the material participation test and have less than $100,000 adjusted gross income can deduct up to $25,000 of property tax losses against their other ordinary taxable income. But most of these losses are a “paper loss,” rather than an actual cash loss, from the depreciation deduction explained below.
Above $100,000 adjusted gross income, the realty investment loss deductibility gradually phases out to zero at $150,000 adjusted gross income. However, any unused deductions are “suspended” for use in future tax years or when the property is sold.
REAL ESTATE PROFESSIONALS GET THE BEST TAX BREAKS. If you spend at least 750 hours per year, or more than 50 percent of your working hours, involved in real estate activities, you probably qualify for the maximum tax breaks as a “real estate professional” with unlimited investment property tax loss deductions.
Examples include real estate brokers, realty sales agents, property managers, builders, contractors and leasing agents. But the tax law clearly excludes real estate attorneys and mortgage brokers from qualifying for the unlimited investment property deductions against their ordinary income.
INVESTOR TAX SAVING BENEFITS FROM THE DEPRECIATION DEDUCTION. Whether you qualify as a “real estate professional” or as an ordinary realty investor, it is important to understand the major tax saving benefits from the depreciation tax deduction.
Depreciation is a special expense tax deduction for “wear, tear and obsolescence” of depreciable assets, such as buildings and equipment. The big benefit is the owner need not spend any cash to claim the depreciation tax break.
In other words, depreciation is a “paper loss.” Residential income property, such as rental houses and apartments, must be depreciated on a straight-line basis over 27.5 years. But commercial property is depreciated over 39 years, presumably because it lasts longer.
Personal property used in operating the rental property, such as furniture and appliances in an apartment rental, is depreciated over shorter periods, such as five to 10 years. Automobiles and trucks used in investment operations are also depreciable.
But the tax benefits for recent purchases get even better. For qualified personal property business equipment placed in service in 2004, you can elect to deduct up to $102,000 of the actual cost on your 2004 tax returns. Of course, then you can’t depreciate such recently purchased business assets.
But the maximum expense deduction for a business automobile placed in service in 2004 is $10,610. However, this generous first-year expensing is not allowed for buildings, structural improvements, furniture used in rentals, and personal assets converted to rental use such as a home computer used for your rentals.
First-year expensing is reported on IRS Form 4562 for calculating depreciation deductions. But the first-year expensing deduction for personal property business use cannot exceed the income from all your active businesses.
TWO TESTS TO QUALIFY FOR PASSIVE ACTIVITY REALTY INVESTMENT LOSS DEDUCTIONS. Regardless how much time a realty investor spends managing his or her property, the IRS considers property management to be a “passive activity.”
That means, unless you are a “real estate professional” described above who is entitled to unlimited realty investment tax loss deductions against your ordinary taxable income, you can claim up to only $25,000 annual passive activity losses.
To qualify for passive activity deductions up to $25,000 (or unlimited deductions if you are a real estate professional), a part-time realty investor must:
1 – Own at least 10 percent of the investment property. This tax rule eliminates many real estate limited partners from claiming tax losses against their ordinary income, and
2 – You must “materially participate” in major property management decisions, as explained earlier. For example, if you own a second- or vacation-home condo that is in a “rental pool” when you aren’t using it, since you don’t approve each individual who rents your condo, you aren’t considered to materially participate in management.
UNUSED PASSIVE ACTIVITY DEDUCTIONS CAN BE SAVED FOR FUTURE USE. But don’t despair if you can’t deduct all your investment property passive activity tax losses against your ordinary taxable income. Save those undeducted losses for use in future tax years or when the property is sold to offset the taxable capital gains.
But unused investment property tax losses cannot be carried back to prior tax years to claim tax refunds. However, IRS Notice 88-94 allows use of unused “suspended” tax losses on an aggregate basis, rather than property-by-property.
WATCH OUT FOR RECAPTURED DEPRECIATION TAX WHEN SELLING DEPRECIABLE REAL ESTATE. In 2003 the maximum long-term capital gain tax rate for assets held over 12 months was reduced to 15 percent. However, a special 25 percent “recaptured depreciation” tax rate applies to depreciation deducted after May 6, 1997.
However, another real estate investment benefit is avoidance of all real estate capital gains taxes, including depreciation recapture, if you make an Internal Revenue Code 1031 tax-deferred exchange for another investment or business property of equal or greater cost and equity. This is called “trading up.”
SUMMARY: As shown by the recent major increase in mortgage loan volume to rental house investors, investors realize rental property offers important tax benefits. These tax shelter benefits are available both during ownership and at the time of resale or tax-deferred exchange. For full details, please consult your tax adviser.
Next week: New tax-deferred exchange benefits.
(For more information on Bob Bruss publications, visit his
Real Estate Center).
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