How to Create a Sound Tax Strategy for Real Estate Investors: Part III
Real estate is a massive field for investment and as such, it involves various risks and strategies for each specific type. After we looked at the general principles of managing common risks and exploring popular strategies in our previous posts, we will put a focus on individual types of real estate and the best strategies for managing risks associated with them.
If you are investing in a vacant land you can add the following deductions to your tax return:
- Interest on indebtedness resulting from buying the land
- Real estate tax
- Expenses related to the holding of land and subject to the “passive loss” rule
- Inventory costs
- Expenses for the management, preservation, and maintenance of a property held for the production of income, situated on the land.
If the investor is renting out the land on which there’s a property held for business or trade activities, this is considered incidental activity in a business or trade rather than trade activity if:
- The investor owns an interest in the business or trade during the year
- The property was predominantly used for business or trade activities during the year or in two of the 5 preceding years
- The gross rental is less than 2% of the lesser of
- Unadjusted basis of the property, or
- The fair market value of the property.
There is a difference between accrual and cash basis rental income. The former is included in the tax return as rental income as it accrues over the lease period and the lessee can deduct the rental expenses during that term. In the cash basis case, the taxpayer includes the income when it is returned and the lessee deducts the rental expenses when they are paid.
Rent accrues in the tax year in which it has been made applicable by the terms of the lease and the amount of rent is formed by the sum of the following:
- Fixed rent for any period of the same tax year
- A ratable portion of any other rental portion in the same tax year
- Any contingent rent accrued during the same tax year
You can find a detailed explanation of these rules and requirements in the Advisor’s Guide for Commercial Real Estate Investment or speak to one of our advisors.
Master Limited Partnerships (MLPs)
MLPs are very popular due to their many tax benefits, mainly related to a special treatment. Such business entities provide limited liability for investors and trade unions and the tax advantages of pass-through partnerships, where partners are allowed to take losses, deductions or credits on an individual level and avoid taxation on entity level. MLPs are very attractive to investors because they usually offer to distribute “all available cash” quarterly to all investors.
A useful piece of information is that if 50% of an MLP is sold it leads to its dissolution and a formation of a new one. This means that any credits may be recaptured and pushed down to investors.
Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts are organizations that own, develop, acquire, operate and manage real estate. There are different types of REITs including:
- Publicly traded
Publicly listed REITs usually list their shares on the New York Stock Exchange, but they can do it to any national stock exchange and they must abide by the rules of the stock exchange where the shares are listed. Most new or small investors prefer to invest in publicly listed REITs as their shares are more liquid and information about their performance is widely available.
REITs also come in different classes:
Equity REITs hold properties mainly for rental income or for gains from appreciation.
As a contrast, mortgage REITs don’t own any properties but hold mortgages on income-producing commercial properties. Hybrid REITs are a combination of property-owning and mortgage providing entities.
REITs and mutual funds are pass-through ventures, which means they benefit from a special tax treatment. The annual income is distributed to investors on a pro-rata basis and each of them is responsible for including it in their individual tax return. The entity is not liable for corporate taxation.
To qualify as a REIT, at least 75% of an entity’s assets have to consist of:
- Cash items
- Government securities
- Real estate assets
at the end of each quarter of the tax year.
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Fulton Abraham Sanchez, the founder of FAS CPA & Consultants of Miami, FL, is a Certified Public Accountant specialized in Tax Planning. You can email him to email@example.com.
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