Though it was a lesson learned the hard way, Scarlet O’Hara eventually realized the value of land in “Gone With the Wind.” Of course, moguls such as Donald Trump—and many other wealthy investors—have long known the secret to turning rental real estate into profits, and even investors with much lower profiles can benefit from owning property.
What’s more, with the federal income tax landscape changing recently, the tax benefits for real estate will become even more attractive than they have been. The higher tax rates that are coming will effectively increase the tax value of real estate investments, while the basic tax breaks remain intact. Let’s take a closer look at the foundation for this traditional tax shelter.
Four tax pillars of real estate
1. Annual deductions. If you acquire real estate, you’ll likely have to pay mortgage interest to a lender plus annual property taxes to local authorities. But these expenses are deductible and can offset the rental income you receive. Significantly, you can also recover the cost of investment property through an IRS-approved system of depreciation deductions. The cost recovery period is 27.5 years for residential property and 39 years for commercial property.
In other words, if you hold the property long enough, you’ll get back most or all of its cost in the form of depreciation deductions. This is the backbone of the real estate tax shelter.
2. Capital gains on sales. Many of the rich get richer by buying and selling real estate properties. Beginning in 2013, the maximum tax rate on a long-term gain from the sale of real estate (that applies to sales of property you’ve held one year or longer) of 15% was increased to 20% for high-income investors. Nevertheless, that’s still better than paying tax at ordinary income rates.
Moreover, though there has been a recent slump in real estate values through most of the country, property has historically appreciated over the long term, enabling savvy investors to accumulate wealth.
3. Section 1031 exchanges. Instead of selling and buying real estate in separate transactions, you can arrange to trade a property you own. Assuming you meet the technical requirements for a like-kind exchange under Section 1031 of the tax code, there’s no current tax on such a swap of properties. The tax is deferred until when and if you sell the new property. However, you will owe tax to the extent that you receive any “boot” in the deal, including cash or forgiveness of a mortgage.
Also, there are two key timing requirements for Section 1031 exchanges: The replacement property must be identified within 45 days of transferring legal ownership of the relinquished property. And title to the replacement property must be transferred within 180 days of the transaction or the due date of your tax return (plus extensions) for the tax year of the transfer—whichever comes first.
4. Step-up in basis at death. Under current federal tax laws, real estate inherited by the younger generation receives a "step-up" in basis upon the owner’s death—that is, for capital gain purposes, the property’s basis becomes its value on the date of death, rather than what it was worth when it was purchased. An inheritance of property will still be subject to estate tax, but it may be sheltered by the owner’s estate tax exemption. The exemption is now permanently set at $5 million and is indexed for inflation ($5.49 million in 2017). The step-up in basis means there's no federal income tax on appreciation in a property's value during the time you owned the property. If your heirs then sell the property, they’ll owe tax on only the difference between the selling price and the stepped-up basis.
The step-up in basis means there’s no federal income tax on appreciation in a property’s value during the time you owned the property. If your heirs then sell the property, they’ll owe tax on only the difference between the selling price and the stepped-up basis.
Caution: Be aware of certain restrictions on the tax breaks for real estate owners. Most important, rules relating to “passive activities”—and that normally includes investor ownership of rental real estate—may limit the losses you can claim for such property. Generally, deductions are allowed only up to the amount of your income from that passive activity. On the other hand, you may be in line for a complete or partial tax loss if you “materially participate” in a rental real estate activity (for example, managing tenants, arranging repairs, etc.), although this tax break is phased out for high-income taxpayers.
Investing in real estate is not for the meek. Usually, there’s a large sum of money at stake. However, if you invest astutely, you may be able to benefit from a multitude of tax breaks as your fortune grows.