Any real estate investor who has been in the game for a while knows the benefits of direct property investment. Among the major asset classes, real estate enjoys many unique positive tax advantages, particularly when compared with traditional investments such as stocks and bonds.
However unrealistic in today’s market, consider a stock with a dividend yield of 6 percent, a bond coupon at 6 percent and a piece of real estate generating 6 percent annual return per year. At first glance, the current returns appear to be equal. But, if you take into consideration the tax implications, the property’s after-tax returns are considerably higher because of your ability to deduct depreciation and interest expense.
Even so, many investors don’t fully appreciate all of the tax benefits afforded by real estate investments or factor these into their decision-making process, often leading to lower-than-anticipated returns.
Mortgage Interest Deduction
One of the advantages of real estate is the ability to easily obtain a mortgage, giving an investor the opportunity to purchase larger properties and increase cash flow. Investors often overlook the advantages of deducting mortgage interest from a property’s cash flow when calculating annual income taxes.
Depreciation
Depreciation expense, or the amount of wear-and-tear that can be deducted from the property value each year, reduces an investor’s taxable income on the cash flow his or her properties produce. The tax code allows some types of properties to be depreciated more rapidly than others. When a property is depreciated over a shorter period, more of the income from the property is “sheltered” from taxes because of the higher depreciation expense. While residential income properties like apartments, duplexes or rental houses are depreciated over 27.5 years, and commercial investment properties are depreciated over 39 years, you may be able to depreciate certain elements of a property in as little as five years.
Depreciation and interest expense shelters 75 percent to 100 percent of a property’s cash flow from federal and state income taxes paid each year. This translates into a significant difference in the after-tax cash flow you get to keep each year. Let’s assume you’re in the 35 percent federal tax bracket and you don’t pay state income taxes. If 100 percent of your property’s income is sheltered, it’s providing you with 35 percent more after-tax cash flow than other investments, such as stocks and bonds, that don’t enjoy these advantages.
1031 Exchange – Rolling Over the Tax Benefits
Depreciation is wonderful when you own a property, but can be a killer when you sell if you don’t take advantage of a 1031 exchange. All of the deprecation you have taken as a tax deduction over the years you owned the property is “recaptured” when you sell a property. Depreciation recapture, and federal and state capital gains, can easily amount to 30 percent to 40 percent of an investor’s profit on the sale. However, if you execute a 1031 exchange when selling a property, you can defer all capital gains and recapture taxes. The opportunity to defer these taxes using a 1031 exchange is yet another tax benefit enjoyed by real estate, but not most other asset classes.
While a 1031 exchange is undoubtedly one of the most valuable tools that investors have at their disposal, it is also full of hoops you need to jump through. Starting on the day a property is sold, the IRS dictates that investors have a mere 45 days to identify replacement properties in which they are interested and 180 days to complete their purchase. This narrow purchase window is the equivalent of an economic 100-yard dash and creates big problems for even the most experienced real estate investor.
Additionally, to defer all of his or her taxes, an investor must find one or more properties that are of equal or greater value than the property being sold and take out a mortgage greater than or equal to the mortgage balance that was paid off when it was sold. If the purchase price or the mortgages on the new properties are too low, the investor will owe taxes on the difference. If the purchase price is too high, the investor may have to come to the closing table with additional funds.
Failing to Plan Is Planning to Fail with Taxes
As a general rule when it comes to taxes, failing to plan results in missed opportunities and unintended consequences. Sophisticated advisers strongly suggest that clients considering a 1031 exchange start looking at replacement property options months before listing a property for sale. Many investors believe they are relegated to reinvesting in local properties that they are required to manage. The combination of technologies and the Jumpstart Our Business Startups (JOBS) Act passed by Congress in 2013 offer new reinvestment options for smaller 1031 exchange investors.
Among the most interesting of these new options for individuals is the ability to diversify investment by co-investing a portion of their equity with other 1031 exchange investors in Class A apartment complexes, medical office buildings and portfolios of retail properties leased to large corporate tenants. This option not only allows deferment of capital gains taxes, but also permits the investor to finally stop actively managing his or her rental property and find that Holy Grail of investment—long-term, passive income.
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