Tax Benefits and Risks to Consider in Real Estate Investments

Real estate investment has long been an attractive option for investors seeking to diversify their portfolios and build long-term wealth. With it brings the potential for steady rental income, property value appreciation, and a hedge against inflation. Alongside these well-known benefits, however, lies a complex tax landscape that real estate investors must navigate.

This article will explore both the benefits and risks to consider in real estate investments.

Depreciation and Mortgage Interest Deductions

Owning rental property goes beyond just generating rental income. Investors can also leverage tax-advantaged deduction strategies. This includes deducting regular rental expenses—property taxes, mortgage interest, repairs, insurance, utilities—as well as depreciation on the property. Depreciation allows you to spread the cost of qualifying residential rental property over its useful life of 27.5 years and most qualifying commercial rental property for 39 years, plus any cost of improvements made over the course of ownership.

To claim depreciation on your rental properties, investors must meet the following criteria:

• You must own the property (outright or mortgage)
• You must use the property to produce income
• The property has a definable “useful life” of more than one year

However, even if all the necessary requirements are fulfilled, there are certain limitations to consider. Simply, not all properties qualify. Properties that you live in yourself and sublet, vacation homes you occasionally rent out, and land itself would not qualify.

Tax implications can also differ depending on how the property is managed.

Tax Implications for Ownership Structures

Investors are allowed to take the same deductions, credits, and income recognition whether they hold the property outright or through a limited partnership. In a limited partnership, these tax benefits and income are "passed through" to the investor, ensuring that they receive the same financial advantages.

Simply owning a few rental properties, however, is generally considered a passive investment, which can limit loss deductions depending on involvement. Meaning, if you don’t actively participate in the day-to-day operations, you can deduct certain expenses associated with the property, like repairs and mortgage interest, but your ability to deduct certain losses is limited by the passive activity loss rules.

In other words, passive losses from rental properties can't be used to offset your income from other sources (like wages or a salary) unless your total income falls below a certain threshold. This can be a disadvantage if you're starting out and your rental income doesn't yet cover all your expenses.

If you do actively participate in property management, there is an incentivizing exemption for up to $25,000 of passive losses from rental activities if you meet the following requirements:

• You must own at least 10% of the property
• You are required to make management decisions
• Phaseout begins when modified AGI exceeds $100,000 and ends at $150,000

In addition, investors who manage their rental properties like a business may be eligible for the Qualified Business Income (QBI) Deduction under Section 199A. This deduction allows qualifying investors to deduct up to 20% of their net business income from their taxable income, potentially lowering their tax bill.

The key is to demonstrate that your rental activities are "regular, continuous, and substantial" with the goal of making a profit. This means going beyond collecting rent checks to actively managing the properties, finding tenants, handling repairs and maintenance, and keeping detailed records.

The IRS offers a safe harbor rule to determine eligibility and includes:

• Maintaining separate financial records for each property
• Performing a minimum of 250 hours per year of rental services (direct or outsourced)
• Documenting work on the properties with logs or time reports
• Filing a statement with your tax return claiming the safe harbor

In order to meet the required time commitment, the IRS allows investors to consolidate similar property types, grouping all residential rentals into one enterprise and all commercial rentals into another. Before consolidating, be sure to weigh the benefits of each strategy—whether it’s more advantageous to treat each property individually or as a group, on both your tax return and in other situations.

If most of your days are spent working in real estate beyond owning rental properties, you may qualify as a real estate professional and unlock additional tax benefits, such as deducting rental losses without limitation. This offers a significant advantage compared to the passive activity loss limitations.

The IRS established the following requirements to qualify for real estate professional:

• Spend at least 50% of your time materially participating in real estate activities
• Dedicate at least 750 hours to these real estate activities throughout the year
• Must own at least 5% of the business if considered an employee in the real estate industry

Your level of involvement in managing the rental properties will determine your tax-advantaged treatments.

Cashflow and Appreciation Tax Advantages

The blend of tax deductions and depreciation explained above can show tax losses on paper, even if the real estate property is generating positive cashflow. If a property shows an annual tax loss, extra cashflow distributed to investors will be received without any tax liability.

These annual losses are considered "ordinary losses” and can also be used to reduce your personal tax burden on other income sources, subject to certain income limits. Investors in a high tax bracket of 40% can leverage the property’s tax losses and offset income, potentially lowering the overall tax rate by 15-20%. And when you eventually sell the property, any profit will be generally taxed at a lower capital gains tax rate. Simply put, tax losses generated from a real estate property can act like a shield, protecting other income from high tax rates.

Capital Gains Tax Upon Sale of Property

When it’s time to sell a property, it’s important to be aware that any depreciation deductions claimed in the past might be subject to recapture. This means a portion of the profit from the sale could be taxed as ordinary income (up to a maximum rate of 25%) instead of the potentially lower capital gains rates.

The highest capital gains tax rate is 20%; however, many investors may also be subject to net investment income tax (NIIT), an additional 3.8% tax. Meaning, any depreciation recaptured upon exit and any income related to the previous depreciation claimed is typically taxed at a maximum federal rate of 28.8%.

It’s important to consider the tax impact at the time of exit throughout the entire life of the property so no surprises surface at sale.

Next Steps

An experienced real estate tax advisor can provide you with effective tax planning strategies to minimize the overall tax liability of your investment properties. Contact me at (520) 881-4900 to discuss your personal situation.