As a long-time advocate of real estate investment as a means to build wealth, I would argue that the strategic use of the federal tax code is one of the most powerful tools at any investor’s disposal. While it is essential to consult a qualified tax professional before taking any tax deductions, in this blog I’ll point the way to how one can leverage the tax code to maximize returns on a real estate investment.
Depreciation
Mortgage insurance, repair and maintenance costs, fire and casualty insurance, management fees, and property taxes are among the expenses one can deduct in the year they are incurred. But there is also depreciation, which is a method of deducting the cost of property acquisition and improvement over time to reduce taxable income and improve cash flow.
In general, the Internal Revenue Service (IRS) considers the “useful life” of a rental property to be either 27.5 years or 30 years, depending on the method of depreciation used. Rather than allowing an investor to depreciate the entire cost in the year the property is purchased, the IRS allows for incremental depreciation over the predetermined useful life of the property. Using 27.5 years as the baseline, that means one can depreciate the property 3.64% each year.
Suppose that in January of this year I purchased a townhome at a total cost of $550,000, excluding the cost of the land since land does not depreciate. Depreciation starts the moment I put it in service as a rental. That means I can depreciate the property by $20,020 ($550,000 x .0364) each full year I own it. If I’m in the 35% tax bracket, I’ll save $7,007 ($20,020 x .35) in taxes, effectively increasing my monthly cash flow for the year by $583.92 ($7,007/12).
Of course the tax code, having been designed by committee, is not quite so straightforward. The IRS allows some settlement costs such as transfer taxes, property surveys, title insurance, any back taxes one may have agreed to pay, as well as legal, deed preparation, and recording fees, to be included in the calculation of the property’s basis for depreciation purposes. Closing costs such as charges connected to acquiring a loan, including points, mortgage insurance premiums, credit report costs, and appraisal fees cannot be included in the basis for depreciation purposes. Anyone who isn’t a professional real estate investor (and even those who are) should have an excellent accountant.
The 1031 Exchange
Deriving its name from section 1031 of the IRS tax code, 1031 Exchanges provide an excellent opportunity to delay and reduce capital gains taxes on the sale of property. An investor can sell one rental property and buy another of equal or greater value, deferring the tax bill until the sale of the second, presumably when long-term capital gains rates can be applied. Even better, the sale proceeds can be used to purchase multiple properties as long as the value of those properties does not exceed 200% of the original. This leverage allows the investor to use the tax code to grow the number of properties in his or her portfolio.
Again, the rules can be more than a little complicated. First, the investor must never take possession of the sale proceeds. A 1031 Exchange is a “hands-off” transaction from the investor’s point of view as far as the sale proceeds are concerned. The funds must be directly deposited into a third-party facilitator’s account. The investor then has 45 days to identify a pool of three “target” properties from which a purchase will be made, if the idea is to make a one-to-one exchange. If more than one property is to be targeted, the pool can consist of five properties. The same 45-day rule applies. From the date of the original sale, the investor has a maximum of 180 days to complete the purchase of the new property or properties.
Qualified Opportunity Zones
The 2017 Tax Cuts and Jobs Act created federal Qualified Opportunity Zones in low-income urban, suburban and rural census tracts. As the IRS puts it, “Their purpose is to spur economic growth and job creation in low-income communities while providing tax benefits to investors.” The carrot for investors is deferral and reduction of capital gains taxes. Capital gains taxes are not owed if the property is held for more than 10 years.
The stick is that to fully qualify for the tax benefits, the property must be substantially improved if existing property is acquired. Golf courses and certain other business purchases do not qualify for the investment tax breaks, but residential rental property most definitely qualifies.
Bureaucracy will not be denied. The investment must be made by a Qualified Opportunity Fund (QOF), an investment vehicle created specifically for investing in Qualified Opportunity Zones. The QOF can be formed as a corporation, partnership, or LLC.
According to the IRS, “to certify and maintain a Qualified Opportunity Fund, an entity must:
- File a federal income tax return as a partnership, corporation, or LLC that is treated as a partnership or corporation;
- Be organized for the purpose of investing in Qualified Opportunity Zone property under the laws in one of the 50 states, the District of Columbia, a U.S. possession, or a federally recognized Indian tribal government; and
- Hold 90% of its assets in Qualified Opportunity Zone property.
If one is willing to navigate the bureaucracy, this is a great opportunity for investment tax breaks as well as an opportunity to invest in underserved communities. Currently, Virginia has 212 census tracts that have been structured into Opportunity Zones, and these will remain static through 2028.
Low Income Housing Tax Credit
Created by the Tax Reform Act of 1986, the Low Income Housing Tax Credit (LIHTC) provides state and local governments with funds to underwrite tax credits for the acquisition, renovation or construction of low-income rental housing units. The IRS has announced that in 2024, states will receive a minimum of $3,360,000 up to a maximum of $2.90 for every resident. With just over 39 million residents, California’s share will amount to more than $113 million. Virginia can look forward to more than $25 million based on its population of 8.6 million. According to the Department of Housing and Urban Development, the total federal budget for the program will be roughly $9 billion.
Together, these tax incentives offer investors a menu of options for leveraging their investment dollars. Several offer investors an opportunity to align their investment goals with socially beneficial outcomes.