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Understanding the Tax Angles

The tax laws regarding investment real estate are unique and far more complex than those regarding homeownership. For example, a homeowner can’t deduct his costs of operating and the repairs and maintenance of his home — but as the owner of a rental property, you can deduct such costs. Also, the benefits of depreciation apply only to rental real estate and aren’t available for property held as a personal residence.

Tax laws change frequently, so check with your tax advisor before taking any action. Use a tax attorney, certified public accountant (CPA), an enrolled agent (EA), or a tax specialist to prepare your tax returns if you have investment real estate. In the sections that follow, we discuss some important rental real estate tax concepts that you should understand if you want to make the most of your property investments.

Sheltering income with depreciation

Depreciation is an accounting concept that allows you to claim a deduction for a certain portion of the acquisition value of a rental property because the building wears out over time. Depreciation is an expense, but it doesn’t actually take cash out of your bank account. Instead, you treat the depreciation amount as an expense or deduction when tallying your income on your tax return, which decreases your taxable income and allows you to shelter positive cash flow from taxation. Depreciation lowers your income taxes in the current year by essentially providing a government interest-free loan until the property is sold.

The use of depreciation by real estate investors can be used to defer, but not permanently eliminate, income taxes. The annual deduction for depreciation is a reduction in the basis (calculated as your original cost in the property plus capital improvements) of the rental property, which is recaptured (added to your taxable profit) in full and taxed upon or sale. Currently, all deductions taken for cost recovery are recaptured and taxed at 25 percent when you sell the property.

Depreciation is only allowed for the acquisition value of the buildings and other improvements, because the underlying land isn’t depreciable. The theory is that the buildings and other improvements ultimately wear out over time but the land will always be there. Because the amount of your depreciation deduction depends on the highest portion of the overall property value being attributable to the buildings, it’s advantageous to allocate the highest fair market value of your rental property value to the improvements to increase your potential deduction for depreciation.

To determine the appropriate basis for calculating depreciation, many real estate investors have traditionally used the property tax assessor’s allocation between the value of the buildings and land. But the IRS doesn’t allow the assessor’s allocation. It does accept an appraisal, which can be quite expensive unless you have a recent one available. But a more cost-effective method that the IRS accepts is the Comparative Market Analysis (CMA) that most brokers offer at a nominal charge or even for free.

Before 1993, depreciation could be accelerated in the early years of rental property ownership. This option led to poor decision making on real estate deals that were motivated by the significant tax shelter offered by real estate, with only a secondary concern about return on investment or appreciation.

But under current tax laws, recently acquired rental properties can only use straight-line depreciation. Straight-line depreciation reduces the value of the rental property by set equal amounts each year over its established depreciable life. The period of time during which depreciation is taken is called the recovery period. For properties placed in service or purchased on or after May 13, 1993, the IRS requires straight-line depreciation with the following recovery periods:

Residential rental property: The recovery period is 27.5 years (or a cost recovery factor of 3.636 percent each year). A property qualifies as residential if the tenants stay a minimum of 30 days or more and no substantial services are provided, such as medical or health care.
Commercial properties: The recovery period is 39 years (or an annual cost recovery of 2.564 percent). Mixed-use properties are classified as commercial unless the income from the residential portion is 80 percent or more of the gross rental income.

The cost recovery deductions for both the year of acquisition and the year of sale must use the midmonth convention requirement, which means that regardless of the actual day of sale, the transaction is presumed to have been completed on the 15th of the month. Thus, the depreciation deduction is prorated based on the number of full months of ownership plus ½ month for the month of purchase or sale.

Commercial property owners typically modify vacant spaces to get potential tenants to sign a lease. The IRS requires that the cost of those improvements be depreciated over 39 years even though the lease and the actual useful life of the improvements are much shorter. This topic is a constant source of lobbying by commercial real estate interests seeking depreciation schedules that more closely coincide with the actual length of lease. The tax laws were changed temporarily to a 15-year cost recovery from 2004 through 2013. You can take a deduction in the current year for the full remaining undepreciated portion of the tenant improvements that were torn out as a result of one tenant vacating and new tenant improvements being installed for the next tenant. For example, if you replace carpet that hasn’t been fully depreciated, you can deduct the remaining unamortized value in that tax year.

Minimizing income taxes

Taxpayers generally have two types of income:

Ordinary income: This category includes wages, bonuses and commissions, rents, and interest and is taxed at the federal level at various rates up to 39.6 percent. The taxable income you receive from your rental property is subject to taxation as ordinary income.
Capital gains: These are generated when investments (such as real estate and stock) are sold for a profit. The income you realize upon the sale of your investment property is subject to taxation as a capital gain. Capital gains are classified as short-term and long-term:
- Short-term: For property held for 12 months or less, capital gains are taxed at the same rate as ordinary income.
- Long-term: For property held for longer than 12 months, gains are taxed at lower rates than ordinary income with a current rate of 0, 15, or 20 percent, depending on your overall tax bracket.

But you can’t pay taxes until you figure out exactly what part of your income will be taxed. To do that, you need to perform a cash-flow analysis. The cash flow from a property — positive or negative — is determined by deducting all operating expenses, debt service interest, capital improvement expenses, damages, theft, and depreciation from rental income.

Calculating the cash flow of a property follows the format shown in Table 18-1. We provide the details for most of these items in Chapter 12. Here, we provide a quick summary and then factor in the taxman.

Start with the Gross Potential Rental Income (GPI) for the property.
This figure is the hypothetical maximum rent collections if the property were 100 percent occupied at market rents and all rents were collected.
Subtract the loss to lease (which is the amount the contract rent is less than the market rent) and the rent that isn’t collected due to vacancy and collection loss (the failure of tenants to pay) to arrive at the Net Rent Revenue (NRR).
Add the other income (laundry, parking, money collected from former tenants, income from the rental of a cellphone tower on the roof, and so on) to the NRR to establish the Effective Gross Income (EGI).
Subtract the operating expenses from the EGI to calculate the Net Operating Income (NOI).
As we discuss in Chapter 12, the NOI is the essential number used in the income capitalization method of determining the value of the property.
Subtract the capital improvements and interest paid on the debt service from the NOI to arrive at the before-tax cash flow (BTCF).
Subtract the straight-line depreciation (which is merely a noncash accounting deduction that reduces your tax liability without requiring an actual cash expenditure) from the before-tax cash flow.
The result is the taxable income.
Multiply this year’s taxable income or reportable loss by your ordinary marginal income rate to determine your tax liability or savings.
Deduct the tax liability (or savings, if the taxable income is negative and the loss can be used in the current tax year) and the annual debt service principal payments from the net taxable income, and then add the noncash deduction for the straight-line cost recovery.
You now have the after-tax cash flow (ATCF).

Table 18-1 Calculating After-Tax Cash Flow

Gross potential rental income	$100,000
Subtract loss to lease	(2,000)
Minus vacancy and collection losses	(2,500)
Net Rent Revenue (NRR)	95,500
Plus other income	2,500
Plus Common area maintenance (CAM) reimbursement (if any)	2,000
Effective Gross Income (EGI)	100,000
Minus operating expenses	(40,000)
Net operating income (NOI)	60,000
Minus capital improvements	(5,000)
Minus annual debt service interest	(35,000)
Before-tax cash flow (BTCF) without principal payments	20,000
Minus the straight-line cost recovery	(12,000)
Net taxable income	8,000
Minus tax liability (or savings)^*	(5,148)
Minus annual debt service principal payments	(4,000)
Plus the cost recovery	12,000
After-tax cash flow (ATCF)	10,852

* Calculation of Tax Liability

Net operating income	$60,000
Minus annual debt service interest	($35,000)
Minus the straight-line cost recovery	($12,000)
Net taxable income	13,000
Times investor’s tax rate	39.6%
Tax liability	$5,148

Understanding passive and active activity

In 1986, Congress enacted passive income and loss provisions to eliminate the use of real estate tax shelters that were structured primarily to provide considerable tax benefits for investors.

Rental owners often start out with their real estate activities serving as second incomes. The majority of their income often comes from professions and sources totally unrelated to real estate. The taxation rules that apply to these part-time real estate investors are different from the ones that apply to real estate professionals. Unless you qualify as a real estate professional (discussed later in this chapter), the IRS classifies all real estate activities as passive and sets limits on your ability to claim real estate loss deductions.

A special IRS relief provision exclusively for rental real estate activities may permit a moderate-income real estate investor to offset other income with up to $25,000 in excess losses from rental real estate. The potential deduction is limited to a maximum of $25,000 per tax year for all real estate investment properties combined. Real estate investors can take a rental property loss deduction of up to $25,000 against other income in the current tax year as long as their adjusted gross income doesn’t exceed $100,000. If the adjusted gross income exceeds $100,000, the real estate investor will be denied 50¢ of the loss allowance for every dollar over $100,000, so that the entire $25,000 loss allowance disappears at an adjusted gross income of $150,000. In order to be able to take this deduction, the following four requirements must be met:

The properties must qualify. Certain types of properties don’t qualify, including net leased properties and vacation homes in a rental pool.
The taxpayer must own a minimum of 10 percent of the property based on value. Interestingly, the IRS allows a taxpayer to include the interests held by his or her spouse even if they don’t file a joint return.
The taxpayer must actively participate in the management. This rule doesn’t mean the real estate investor can’t utilize a management firm. A real estate investor can meet the active participation requirement by simply communicating with his management company about the approval of new tenants, determining the rental terms, approving repairs or capital improvements, or making other similar owner decisions with the management company handling the day-to-day issues.
The taxpayer must file her tax return as an individual. Corporations, certain trusts, and other forms of ownership aren’t allowed to take this special deduction.

Any losses disallowed in one year are called suspended losses and can be saved and applied to reduce rental or other passive income in future years. If the suspended losses can’t be used in this manner, the real estate investor will be able to use them when she sells the rental property to effectively reduce the taxable gain. Thus, the losses ultimately benefit the investor, but the time value of money concept (which shows that money becomes worth less over time due to inflation) indicates that the ability to use the losses now is worth more than some time in the future.

Qualifying as a real estate professional

The IRS passive loss rule states that all real estate rental activities must be treated as passive income with only two possible exceptions:

The maximum of up to a $25,000 deduction for some taxpayers as discussed in the “Understanding passive and active activity” section earlier in the chapter
The relatively small number of individuals who can meet the IRS requirements to be classified as real estate professionals

For a taxpayer meeting the eligibility requirements relating to his real estate activities, the rental real estate activities in which he participates aren’t subject to the $25,000 limitation. Real estate investors who can be classified as real estate professionals are permitted to deduct all of their rental real estate losses from their ordinary income, such as current employment income (wages, commissions), interest, short-term capital gains, and nonqualified dividends.

The IRS has defined a real estate professional as an individual who materially participates in rental real estate activities and meets both of the following requirements:

More than 50 percent of her personal services or employment were performed in a real property business or rental real estate activities, including acquisition, operation, leasing, management, development or redevelopment, construction or reconstruction, and brokerage.
These activities represented at least 750 hours per tax year. (Work hours as an employee don’t qualify unless the taxpayer is at least a 5 percent owner of the employer.)

These individuals are considered active investors and are allowed to claim all their real estate loss deductions in the year incurred, to offset positive taxable income or offset gains at the time of sale. But the IRS considers each interest of the taxpayer in rental real estate to be a separate activity, unless you choose to treat all rental real estate interests as one activity. This choice is an important step. Consult with a tax advisor to determine whether aggregating your rental real estate activities is advantageous and, if so, to make sure you properly make the required election when filing your tax return.

But qualifying as an active investor is complicated. The IRS now allows the taxpayer to qualify as a real estate professional by combining hours spent on rental and nonrental real estate activities. For example, even a part-time real estate broker or property manager may be able to demonstrate over 1,000 hours in a typical year in qualified real estate activities such as listing and selling, leasing and managing rentals, and renovation or construction. So meeting the 750 hours isn’t a problem, but the 50 percent test requires that the 1,000 real estate activity hours be more than 50 percent of all work hours in a year. This threshold can be a problem if you have other extensive nonqualified work activities, and a new calculation must be made each year. If you do qualify, carefully document your activities and the hours spent in each through appointment books, calendars, or narrative summaries.

A potentially useful real estate investment strategy for some married couples is to have a stay-at-home spouse become an active real estate agent or property manager and accumulate at least 50 percent of his or her employment or business time with a minimum of 750 hours per year selling and managing the family rentals. With the real estate professional qualification met, their rental activities are now active, and they can deduct all of their rental real estate losses. However, lawyers can’t get a break, because the IRS has specifically ruled that real estate attorneys can’t qualify.

Material participation, which requires the real estate investor to be involved “in a regular, continuous, and substantial manner,” shouldn’t be confused with active participation (which we define in the “Understanding passive and active activity” section earlier in the chapter).

Considering Exit Strategies

A successful investment strategy doesn’t simply involve buying and operating properties. The disposition or exit strategy has a significant impact on overall success.

Begin your exit-strategy planning while you’re acquiring property. That is, develop a game plan to work towards before you buy the asset. You can always change or modify your plans, but knowing your exit strategy prior to acquisition is good practice.

You do your homework, buy the right property at the right price, and add value by maintaining and improving the property and obtaining good tenants. So, why undo your good work by selling the property for less than it’s worth or paying too much in taxes because you failed to explore ways to defer your capital gains (which can keep more of your money working to keep your portfolio growing)?

When you’re looking to buy rental real estate with appreciation potential, seek those properties that have deferred maintenance and cosmetic problems that allow you to buy them at a good price. When you go to sell your property, you want to get full value, so before you begin to list or show your available property, scrutinize the curb appeal and physical condition, looking for those items that need attention. Don’t rely on your own eye; ask a trained, professional real estate agent or property manager who isn’t familiar with the property to give you some feedback. Some individuals and companies offer services called staging (placing temporary furniture and other items in the dwelling to make it more appealing) to reduce the required marketing time and maximize the value of the property being sold.

We thoroughly cover the purchase agreement and other issues involved in a real estate transaction in Chapter 13. Because we firmly believe that the proper and ethical way to conduct business in real estate is to use standardized forms and practices, there’s no need to present new forms or tactics that are slanted to favor your position as the seller. In the long run, you benefit by treating people fairly in your real estate transactions. If you build a reputation for being ethical, you receive many more opportunities than if you use one-sided methods designed to take advantage of others.

When it’s time to sell the property, you have several options, but not all of them have the same tax consequences.

Selling outright

One exit strategy is to simply sell the property and report the sale to the IRS. As long as capital gains tax rates are low, this strategy may work for taxpayers who are nearing the end of their prime real estate investing years and are looking to slow down and simplify their lives.

In an outright or all-cash sale, you simply sell the property, report the sale to the IRS, and determine whether you have a taxable gain or loss. If it’s a gain, taxes are due; if you’ve held the property for at least 12 months, the low capital gains tax rates of 0 percent or 15 or 20 percent apply. (Seller financing isn’t considered an all-cash sale, nor is an installment sale, which we cover later.) Don’t forget the 25 percent tax rate on cost recovery deduction that’s triggered on the sale.

Although an outright or all-cash sale is fairly straightforward, real estate investors are often interested in postponing the recognition of their gain on sale so that they can postpone the payment of taxes due. This situation is where an installment sale or an exchange (discussed later) can be useful.

Although the sale of a property can make sense, remember that refinancing an investment property with substantial equity is another great way to free up additional cash for real estate acquisitions, other investments or purposes.

Calculating gain or loss on a sale

Preparing and retaining accurate records from the initial purchase of your rental property and throughout the ownership is extremely important because the sale of a real estate investment property must be reported to the IRS.

Several factors go into the required calculation to determine whether there’s a gain or loss on the sale that can either increase or reduce the overall income:

The sales price is a major factor.
Any capital improvements made to the property should be included.
Accumulated depreciation taken during the holding period increases your taxes when it’s recaptured.
Also, if the property had operating losses that couldn’t be taken in prior tax years, those suspended losses increase the adjusted basis and lower the potential taxable gain (or increase the loss available to shelter other income).

Table 18-2 outlines the following gain (or loss) on sale calculation.

Table 18-2 Calculating Total Gain or Loss on Sale

Gross sales price	$1,500,000
Minus selling expenses	(50,000)
Net sales proceeds	1,450,000
Minus adjusted basis (see Table 18-3)	(700,000)
Total gain (or loss) on sale	$750,000

Step 1: Determine the net sales proceeds

The net sales proceeds are the gross sales price minus the selling expenses. The selling expenses are all costs incurred to complete the sales transaction such as real estate commissions, attorney and accountant fees, settlement and escrow fees, title insurance, and other closing costs.

Step 2: Determine the adjusted basis for the property

When the property is just acquired, the basis is simply the original cost of the property (the equity down payment plus the total debt incurred to finance the property plus closing costs, appraisal, and environmental reports). If the owner didn’t purchase the property, the basis is one of the following:

The fair market value at the time of transfer for property received as an inheritance
The carry-over basis if the property is received as a gift
The substituted basis if the property was acquired in a tax-deferred exchange.

However, the basis isn’t static — it changes during the ownership period. To adjust the original basis, take three factors into account (see Table 18-3 for the sample calculations):

Table 18-3 Adjusted Basis Calculation

Original acquisition cost or basis	$750,000
Plus capital improvements	50,000
Minus accumulated cost recovery	(100,000)
Minus any casualty losses taken	0
Adjusted basis	$700,000

Capital improvements: During the holding period, owners often make some capital improvements or additions to the property. Capital improvements are money spent to improve the existing property or construct new property. These capital improvements are added to the original acquisition cost to determine the adjusted basis.
Routine and normal repairs required to keep the property in good working order over its useful life are deductible expenses during the tax year in which they’re incurred. They’re not capital improvements for the purpose of the adjusted basis calculation. For example, replacing a few shingles or even re-roofing a portion of the property is a repair, but completely replacing the roof is a capital improvement. A newly constructed addition that increases the rentable square footage of the rental property is a capital improvement. The capital improvement includes all costs incurred such as contractor payments, architect fees, building permits, construction materials, and labor costs.
Depreciation: At the same time, the straight-line depreciation taken each tax year is accumulated and reduces the adjusted basis of the property. Note that the total accumulated depreciation is included in the overall calculation of the gain or loss upon sale as part of the adjusted basis but is reported separately and is taxed at a different rate on the taxpayer’s tax return.
Casualty losses taken by the taxpayer: Casualty losses can result from the destruction of or damage to your property from any sort of sudden, unexpected, or unusual event such as a flood, hurricane, tornado, fire, earthquake, or even volcanic eruption.

Step 3: Determine the total gain or loss on the sale

The total gain or loss is determined by taking the net sales price and subtracting the adjusted basis (see Table 18-2).

Step 4: Factoring in accumulated cost recovery and suspended losses

If you have suspended losses reported on the taxpayer’s tax returns during the ownership period, deduct them from the net sales proceeds (see Table 18-4). The suspended losses are those losses that the taxpayer couldn’t use in prior tax years because he didn’t meet the strict IRS requirements. See the “Understanding passive and active activity” section earlier in the chapter for more info. That figure is the capital gain from appreciation.

Table 18-4 Capital Gain from Appreciation

Total gain on sale (from Table 18-2)	$750,000
Minus straight-line cost recovery	(100,000)
Minus suspended losses	(75,000)
Capital gain from appreciation	$575,000

Step 5: Determine total tax liability

The net gain on sale is taxed as ordinary income unless the property was held for more than 12 months. Fortunately, most real estate investors do hold the property for more than 12 months and can qualify for the lower long-term capital gains tax rates. In fact, if the property has been held less than 12 months, all depreciation that has been taken is recaptured as ordinary income.

For tax purposes, the net gain on sale must be allocated between the capital gain from appreciation and the recapture of the accumulated depreciation. The seller doesn’t automatically get the benefits of the lower flat 0 or 15 percent maximum capital gains tax and may even have to pay the maximum depreciation recapture tax rate of 25 percent if she’s in a higher income tax bracket as is the investor in our example. (The depreciation recapture rate is based on your ordinary income tax bracket but won’t exceed 25 percent.)

In Table 18-4, the total gain on sale of $750,000 is reduced by $100,000 in accumulated depreciation and suspended losses of $75,000 for a gain from appreciation of $575,000. In Table 18-5, we break the taxation of the capital gain down between capital gain from appreciation and depreciation recapture. The accumulated depreciation is recaptured at 25 percent, resulting in a tax liability of $25,000. The gain from appreciation was taxed at the maximum capital gains flat rate of 20 percent, resulting in a tax liability of $115,000. So, the total tax liability is $140,000.

Table 18-5 Total Tax Liability Calculation

Straight-line cost recovery	$100,000
Times tax rate on recapture	25%
Total tax due for recapture	$25,000

Capital gain from appreciation	$575,000
Times tax rate on capital gain	20%
Total tax due on capital gain	$115,000

Total tax liability	$140,000

If the sale of the property results in a net loss, the loss must first be applied to offset net passive-activity income or gains. If there are none, or after they’re exhausted, the net loss can be applied to reduce the income or gains from nonpassive activities such as earned income or wages.

Selling now, reaping profits later: Installment sale

An installment sale is the disposition of a property in which the seller receives any portion of the sale proceeds in a tax year following the tax year in which she sells the property. The time value of money indicates that it’s generally better to have the use of money today than in the future. Knowledgeable real estate investors seek ways to minimize or defer the taxes that they need to pay. One way to accomplish this goal is by using the installment sale method — within specified IRS limits, the sellers of real estate can report their receipt of funds as actually received over time rather than as a lump sum at the time of the sale.

A taxpayer who sells his property on the installment method is able to report only the pro rata (proportionate) part of the proceeds actually received in that tax year. The advantage is that the taxable gain is spread over several years and can be reported in years in which the taxpayer may have a lower tax bracket. This technique is ideal for property sellers who don’t need to take their equity at the time of sale because they have other sources of income or want to minimize taxes or both.

This scenario includes transactions in which the seller provides the financing and received payments over time. When financing is difficult for buyers to obtain, sellers may offer to take a mortgage note from the buyer for some (or even all) of their equity in the property. As discussed in Chapter 5, having the seller take a note for equity is a common no-money-down strategy.

An installment sale can be an effective way for a seller to assist the buyer in making the purchase as well as to defer the recognition of income and thereby reduce the capital gains tax.

Here’s how it works: A real estate investor sells a property for $1.5 million that has an adjusted basis of $700,000. The buyer makes a down payment of $250,000, assumes the current loan balance of $500,000, and accepts seller financing of $750,000. The terms of the installment sale require the buyer to pay the principal balance of $750,000 owed to the seller at $250,000 each year over the following three years, plus interest. The buyer reports the gain according to the timing of the principal payments.

The amount of the gain that must be reported in a given tax year is equal to the total principal payment multiplied by the profit ratio. The profit ratio is calculated as follows:

Profit Ratio = Gross Profit ÷ Contract Price

The gross profit is the sale price minus the selling costs and adjusted basis.

Sale price	$1.5 million
Minus costs	$50,000
Minus adjusted basis	$700,000
Gross profit	$750,000

The contract price is the sale price minus the current loan balance.

Sale price	$1.5 million
Minus loan balance	$500,000
Contract price	$1 million

Therefore, in this example, you figure the profit ratio as follows:

Profit Ratio = Gross Profit ÷ Contract Price
Profit Ratio = $750,000 ÷ $1 million
Profit Ratio = 75 percent

With the profit ratio, you can compute the gain that must be reported each year.

Year of sale: $250,000 × 75% =	$187,500
Year two: $250,000 × 75% =	$187,500
Year three: $250,000 × 75% =	$187,500
Year four: $250,000 × 75% =	$187,500

Thus, the seller reports $187,500 as the gain in the year of sale, plus $187,500 for each of the next three years. The seller reports the interest paid by the buyer to the seller on the deferred principal payments as ordinary interest income.

If this example were an outright sale, the seller would report the entire $750,000 gain in the year of sale, but the installment sale allows her to report the gain as the principal payments of $187,500 are received each year for four consecutive years. There’s no difference in the total gain, simply the timing of the reporting of the gain.

Although there are many proponents of the buying-and-flipping real estate investment strategy, they often overlook the fact that flipping properties for a quick profit can have significant and expensive tax implications. If the IRS sees that you routinely buy and flip properties, it classifies you as a dealer — a taxpayer who buys property (called inventory in this case) with the intention of selling it in the short run — as opposed to an investor, a person who purchases properties seeking appreciation and income from long-term ownership. It’s possible for real estate investors to simultaneously hold some properties for long-term investment and other properties the IRS classifies as inventory, making the owner a dealer. The dealer label comes with two drawbacks:

Dealers aren’t allowed to use the installment sales method to spread the recognition of their gain over multiple tax years. The entire profit must be reported and fully taxed in the year of the property sale.
Profit from the sale of a property is considered earned income and is taxed as ordinary income at your personal income tax rate — even if you hold the property for longer than 12 months. (If you hold a property for longer than 12 months, it’s typically eligible for the long-term capital gains tax rate, and a dealer would thus lose this benefit.)

Transferring equity to defer taxes

The concept behind a tax-deferred exchange is that an investor can transfer the built-up equity in one property to a new property and maintain, essentially, the same investment except that the physical asset is different. The IRS considers a qualified tax-deferred exchange to be one continuous investment and thus no tax is due on the profit from the sale of the relinquished asset as long as the investor invests all proceeds into the replacement property.

Tax-deferred exchanges are often referred to as 1031 exchanges — the name comes from Section 1031 of the IRS Code that covers them. And there are actually three different types of tax-deferred exchanges:

A straight exchange in which two parties trade properties of approximate or equal value.
A three-party or multiparty exchange, which involves three or more parties buying, selling, or exchanging properties. This situation happens when one party in an exchange doesn’t want a property owned by the other party but prefers the property currently owned by a third party. These transactions can actually involve any number of owners and can be quite complex. They should only be done with the ongoing advice and consultation of an experienced tax professional.
A delayed exchange — sometimes also referred to as a Starker exchange — which allows the sale of the relinquished property and the purchase of the replacement property to occur at different times as long as strict rules are followed. This exchange is by far the most used 1031 exchange. (Reverse Starker exchanges can also be completed when an accommodator, on behalf of the taxpayer, acquires a replacement property first and then sells the relinquished property at a later date.)

The capital gains tax is deferred, not eliminated. If you sell your property during your lifetime and don’t qualify for a tax-deferred exchange, you pay tax on both the capital gain and the recapture of the total depreciation taken since the original investment.

Meeting your goals

A tax-deferred exchange is an important tool if you’re looking to increase the size of your real estate holdings. Tax-deferred exchanges can be effective tools to postpone the recognition of a gain on real estate investments. They allow the investor to transfer equity to a larger property without paying taxes. Plus, there’s no limit to how often or how many times that a taxpayer can use an exchange. Therefore, you can keep exchanging upward in value, adding to your assets over your lifetime without ever having to pay any capital gains tax.

The tax-deferred exchange is particularly useful for real estate investors who specialize in buying and renovating properties and want to reinvest their profits into a larger property rather than sell the property and run the risk of being classified by the IRS as a dealer. A tax-deferred exchange can also help you achieve other goals such as

Trading for a property in a better location.
Acquiring a property with better cash flow.
Making better use of the significant equity that can exist in properties held for many years. Plus, those properties have typically exhausted their depreciable basis, and an exchange can enhance that.

Following the rules

As with any transaction that involves those three letters — IRS — you must play by the rules for the 1031 exchange:

The relinquished property and the replacement property must both be investment real estate properties located in the United States. Actually, the majority of all tax-deferred exchanges involve properties domestically, but the IRS does allow a tax-deferred exchange of a foreign property for another foreign property. The key is that both properties must be domestic or foreign — no mixing and matching is allowed!
You must trade only like kind real estate. Like kind real estate means property held for business, trade, or investment purposes. The broad definition of like kind doesn’t mean same kind. It allows real estate investors to use a 1031 exchange, for example, to defer taxes when they sell an apartment building and buy raw land, or vice versa; exchange a single-family rental home for a small office building; and so on. But neither your personal primary residence nor property held as inventory where the investor is defined as a dealer (see the “Selling now, reaping profits later: Installment sale” section earlier in the chapter) qualifies.
An exchange must be equal to or greater in both value and equity. Any cash or debt relief received is considered to be boot (any receipt of money, property, or reduction in liability owed) and is taxable. For example, if you want to complete a tax-deferred exchange and the property you relinquish is valued at $1 million with a loan balance of $500,000, you must purchase the replacement property for more than $1 million, and its equity has to be equal to or greater than $500,000.
A neutral third party should be involved: This neutral third party, called a facilitator, exchanger, or accommodator, should be appointed prior to the closing of any escrow. An exchange agreement must be signed, and the neutral third party must hold the proceeds unless the properties close simultaneously.
The potential replacement property must be clearly and unambiguously identified in writing within 45 days from the close of the relinquished property. The IRS has limitations on how many replacement properties may be designated, or taxpayers would simply identify a long list of potential replacement properties. There are three specific tests to meet this requirement; they can get quite technical, but the most-commonly used is the three property rule. Under this rule, you can designate a maximum of three replacement properties of any fair market value, and you must purchase one or more of those properties.
The closing of the replacement property must occur within 180 days of the close of the relinquished property. Meeting this requirement isn’t as easy as it may sound, as we detail in the next section.

Refer to www.dummies.com/extras/realestateinvesting for information about not using commingled 1031 accounts.

Counting (and countering) complications and risks

The tax-deferred exchange has some complications and risks. Our experience is that the identification of the replacement property within 45 days can be a real challenge, especially because only a limited number (usually three) of properties can be identified. In a tight or competitive real estate market, the real estate investor can quickly find himself unable to actually complete the purchase of the replacement property within the 180-day limit, in which case the sale becomes a taxable event.

Real estate owners looking for a replacement property (commonly called an upleg) are often tempted to chase a property and overpay. They rationalize that the capital gains deferral is so valuable that they can justify overpaying for the property because they’d otherwise have to pay taxes of the recognized gain. But such investors should realize that this isn’t a tax-free exchange, only a deferral of a gain that may be taxable in the future.

In 2000, the IRS issued new guidelines that clarify the proper use of the reverse 1031 exchange. A reverse 1031 exchange can be complicated and should only be done with the guidance of an experienced tax advisor. Essentially, it allows real estate investors to have an accommodator purchase and hold their new investment properties while they then follow the 1031 guidelines to sell the relinquished property. The advantage is that the real estate investor is sure to have the replacement property in hand; one of the major challenges to a 1031 exchange is the risk involved in having to identify the replacement property within 45 days and complete the acquisition within the 180-day limitation. You should have a written exchange agreement, and title to the replacement property must be taken in the name of the accommodator until your relinquished property is sold.

Calculating the substituted basis

The calculation of the basis of the new property can be quite complicated if anything other than the property is exchanged. In an exchange, the tax is deferred and the potential gain is carried forward by calculating the substitute basis for the new replacement property. An example of a substitute basis calculation without any boot is shown in Table 18-6. This substitute basis would be used in the event you sell the property during your lifetime without doing a tax-deferred exchange and have a taxable transaction. See your tax specialist to deal with any additional variables in the transaction.

Table 18-6 Substituted Basis Calculation in an Exchange

Value of property exchanged	$1,500,000
Minus basis of property exchanged	700,000
Gain on property exchanged	$800,000
Value of property acquired	$3,000,000
Minus gain on property exchanged	$800,000
Substituted basis on property acquired	$2,200,000

Using the capital gains exclusion to earn a tax-free gain

Another great tax benefit available for homeowners and real estate investors alike is the capital gains exclusion under Internal Revenue Code 121. Many investors have found that the principal residence capital gains exclusion can be the core of a profitable (and tax-free) investment strategy known as serial home selling. (For more information on this topic, see Chapter 2.) Simply buy and move into a property that can be renovated and sell it after a minimum of two years, and you can earn a tax-free gain of up to $500,000.

The gain on the sale of a principal residence is tax free up to $250,000 for individual taxpayers and up to $500,000 for married taxpayers who file jointly if they meet some simple requirements:

You must own and have occupied or used the home as your principal residence for a total of 730 days (24 months) in the last 60 months — ending on the date of sale or exchange. The occupancy doesn’t have to be continuous, and the home doesn’t need to be your principal residence at the time of the sale or exchange. Only one spouse needs to legally hold title, but both must meet the use test.
The factors considered by the IRS to determine whether a property meets the principal residence use test include
- Is the residence used as the address of record for driver’s license, tax returns, utilities, credit card bills and other billed items, and employment purposes?
- Is this residence where you actually reside and where you keep your furniture, furnishings, and clothes?
Generally, the seller can only use the exclusion once every two years. Vacations and short absences count as usage for the two-year use test.

The IRS provides partial principal residence exemptions for sellers who don’t qualify for the full exemption. The partial exemption is based on the number of actual months the seller qualified divided by 24 months. A partial exemption is allowed for

Work reasons: For instance, a change in employment where the home seller’s new job location is at least 50 miles farther away from the old principal residence than the former job location.
Health reasons: For instance, the need to move to care for a family member or a broad range of health-related reasons. Consult with your tax advisor, because you can meet this requirement in many ways — particularly if a physician recommended the move.
Unforeseen circumstances: Examples run the gamut and include a divorce or legal separation, engagement break-up, death, incarceration, multiple births, large increase in assessment dues, lost job or demotion, becoming ineligible for unemployment compensation, and so on. Many circumstances can qualify as unforeseen circumstances, so see your tax advisor for more information about your specific situation.

The taxation of real estate is complicated and constantly changing, so we have just covered the tip of the proverbial iceberg here. If you want in-depth details and advanced real estate tax strategies, we strongly recommend Vernon Hoven’s The Real Estate Investor’s Tax Guide (Dearborn Financial Publishing). Vern has a master’s degree in taxation and teaches accounting and tax professionals all the new laws at his popular seminars (www.hoven.com). This excellent book has more than 400 pages dedicated to explaining all the ins and outs of real estate taxation with many examples that bring the material down to an understandable level.

Selling as a lease-to-own purchase

The typical lease option combines a standard lease with a separate contract giving the tenant a unilateral option to purchase the rental property during a limited period of time for a mutually agreed upon purchase price. The tenant isn’t required to exercise the option. (For more on lease options, see Chapter 3.)

Investors can use the lease option to increase cash flow and also sell their properties without paying the usual brokerage commissions. A lease option is really a real estate rental transaction combined with a potential sales transaction and financing technique. The seller can generate additional cash flow because a lease option generally consists of a monthly rental payment that’s higher than the market rent, with a portion of the additional payment being applied to the option purchase price. Both parties can realize a savings on the brokerage commission because the transaction is usually completed without the full services of real estate brokers. But it’s a good idea to have either an experienced broker or real estate attorney review the transaction documents, which is a minor (but worthwhile) expense.

Working through an example

Each lease option is unique, but here’s an example of how a deal may be structured: An investor owns a rental home with a current market rent of $1,000 per month and a current market value of $120,000. Real estate forecasts indicate that appreciation will be 4 percent, or approximately $5,000, in the next 12 months.

The tenant signs a 12-month standard lease and agrees to pay $1,200 per month with $1,000 in rent and $200 as a nonrefundable option fee that applies to the down payment. The investor and tenant also enter into an option-to-purchase agreement that offers the tenant the right to buy the property within 12 months of the lease for $125,000 (the agreed upon estimated fair market value of the property by the end of the option period).

The investor receives an additional cash flow of $200 per month. If the tenant exercises the option, the tenant receives a credit toward the down payment of $200 per month for each month that he paid the option fee. If the investor has used her standard lease form and the lease option documents are drafted properly, she still has the right to evict the tenant for nonpayment of rent or any other material lease default.

In most cases, tenants don’t exercise the purchase option because they haven’t accumulated the money required for the down payment and their share of the closing costs. In the meantime, you’ve increased your monthly rental income by $200 and had a good tenant. At the end of the option, the tenant is aware that he has paid an additional $2,400 in rent that would’ve been applied to the down payment or purchase price if he’d exercised his option. You can either renegotiate an extension of the purchase option with the tenant or you can negotiate a new lease without the purchase option.

Proceeding with caution

Avoid long-term lease options. Real estate appreciation can be unpredictable. Don’t provide a set option purchase price for any longer than one or two years, or include a clause that the purchase price will increase by an amount equal to the increase in the average median home price in your local area.

If you’re interested in using a lease option, have a real estate attorney with extensive experience in lease options review the lease and option contract in advance. Lease options can have serious business and even ethical problems if not properly drafted. If poorly structured, your lease option may be considered a sale with the following negative consequences:

A lease option may trigger the due-on-sale clause with your lender, who may force you to pay off the entire outstanding loan balance.
If the property is deemed a sale by the IRS, you can no longer use your tax benefits of depreciation and deductible expenses.
Your property may be reassessed for property taxes. In many parts of the country, reassessment is based on a change in ownership. An aggressive tax assessor can use the lease option to increase the assessed value. Investigate local reassessment policies in advance.
You may be liable for failure to comply with seller disclosure laws. There are severe penalties if you don’t make the legally required disclosures, including those found on the transfer disclosure statement (TDS) discussed in Chapter 14.
You may not be able to evict the tenant even if he defaults on the lease. The courts may consider that the tenant is really a buyer and that a traditional eviction action doesn’t apply because the lease option is essentially a contract to purchase real estate. This situation may require expensive and lengthy court proceedings.

Ethically, keep the nonrefundable option fee reasonable, so if the value of the property declines or your tenant doesn’t exercise her option for any reason, you can feel comfortable that the tenant has been treated fairly. Or you may want to renegotiate or consider offering an extension.

Transferring your property through a gift or bequest

A property given as a gift carries the same tax basis from the seller to the new owner. For example, if the tax basis of the property is $100,000, even though the fair market value at the time of the gift is $500,000, the recipient’s tax basis remains $100,000. If the recipient were to immediately sell the property, he would have a taxable gain of $400,000. Thus, gifting property to heirs during your lifetime may not be the best strategy.

But death provides a tax-free transfer of real estate. Some investors are determined to avoid paying tax completely and have adopted a strategy of buy and hold for life. They use the tax-deferred exchange for years to rollover their gains into larger and larger properties and then completely avoid paying tax by never selling. Real estate transferred to your heirs upon death receives a full step up in basis. So in the example above, the party inheriting the real estate with a fair market value of $500,000 now has a tax basis of $500,000 and will only owe taxes on any future gain. So, if you want to make your real estate wealth creation strategy span multiple generations, consider taking advantage of these tax benefits!

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