Tax Shelters For U.S. Real Estate Investors
FAS CPA & Consultants
What are the tax benefits of being a Real Estate professional?
When you invest in Real Estate there is a thing called tax shelters. The benefit is that when you use Real Estate and you use financing like mortgages, you use two main tax shelters the one is depreciation that help you reduce your taxes by creating a reduction year to year of the amount of the property and that reduction is applied as an expense, you’re going to have less profits of the real estate activity therefore paying less taxes. The second benefit of a mortgage in the property is that in interest on the mortgage creates a deduction that reduces the profits of the company or activity. So if you have a property that is for investment and you have a mortgage this will allow you to deduct interest, this will create a lower profit of your activity therefore paying less taxes. There is also other benefits like expensing out the repairs.
How can I pay less taxes on Real Estate?
We have 2 taxes, the real estate tax on the property and the real estate tax on the income of the rental activity. If you want to pay less taxes on the property it all depends of the location and the value, properties in New York have a higher tax rate compared to properties in Miami. To pay less taxes on the rental income is basically using tax shelters, like depreciating the property and having a mortgage to develop the interest.
What can Realtors write off for taxes?
Realtors enjoy a special classification in the code and their profession is related to the real estate, they can deduct all the expenses that they incur when they are dealing with clients, when visiting clients or properties. This convention is allowed for non-realtors but they are real estate professionals but only if they have certain amount of hours per year. But for the active licensed realtors and actively working with clients for real estate they can deduct the entire expenses for the activity, meaning entertainment, car mileage, licensing for real estate, if they have a company they can deduct the office branding, if they have property they can take the depreciation.
What is the maximum Real Estate tax deduction?
It all depends of the expenses that you have and can prove them. For example if you just improved your house and want to deduct the expenses, you have to have the receipts. However, if you have an incurring expense in the property and you can verify it from an invoice then at that point the amount that you have incurred in the property is deductible, the maximum deduction depends on the amount of the expenses and the bill for that particular expense.
What are the income brackets?
After the 2012, 28 tax reforms brackets have changed. For singles, for example, from 0 to $10,000 they pay 10%, from $10,000 to $40,000 they pay 12%, from $40,000 to $80,000 they pay 22%, from $80,000 to $150,000 they pay 27% and things go up until it gets to $410,000 that it ends paying 35%. Remember that if you earn $200,000 is not that you are going to have to pay automatically 27%, the first portion goes the $10,000 , the 10%, the second portion goes to 12%, the third portion will be 22% until you get to $200,000 and you pay 27%, it goes by brackets.
Is passive income taxed differently?
Passive income is real estate income. The difference with active income is that it comes from an active business. For example, whenever I’m giving services to my clients using my energy to provide for a service that is an active income. In that case that income 100% taxable and I can only match that active income with active expenses. Passive income is the opposite of active income, it’s something that I don’t do but I get income from it, for example rental income, I just buy the property and the property generates a rent, that’s passive income. Passive income and active income are taxed the same, the difference is the amount of expenses that I have for deduction, I can only deduct passive expenses to passive income. There is no different taxation it only is different categorization of the expense.
Is Real Estate a tax shelter?
Yes it is, because it shelters your income. But there is a catch, whenever you depreciate the property it does not mean that you are tax free, whenever you take depreciation it only means that you are deferring the tax on that property, because when you sell the property you have to take back the depreciation meaning that I buy a property for $300,000 and is a commercial property every year I’m going to depreciate $10,000 so I’m going to pay from the rental income of the property minus $10,000 so obviously my taxes are reduced because I’m paying less for the profits but when I sell the property I have to take every $10,000 that I took for the years that I owned the property and pay taxes on that.
GAAP Reporting for Real Estate Investors
When you interview prospective accountants, go into their backgrounds. For example, are they personally invested in real estate property? Discuss their fees and enquire about their tax preparation strategies. Do they assist in business structuring and registration?
GAAP Vs Income Tax Basis
Public Real Estate Companies or private real estate enterprises with institutional investors as partners require GAAP reporting as governing bodies dictate. However, income tax basis financials might be more helpful, transparent, and informative for the rest of the real estate universe.
GAAP Accounting Principles
US GAAP [Generally Accepted Accounting Principles] is the critical system for public companies that produce financial statements. However, despite being a legal requirement for public companies, GAAP will result in more obscure accounting outcomes that are not as well aligned with the economics of a real estate business regarding cash flows resulting from leases.
GAAP Vs Income Tax Basis Financials
Things change: Twenty years ago, real estate prices reached a fever pitch, and financiers assumed prices would automatically rise. Today government intervention and climate activists rule the roost, and real estate firms must take special care in determining fair value in harsh market conditions.
World, According To GAAP
- Companies must determine if any impairments affected the value of their real estate holdings. They must record an impairment charge in their earnings if they discover any impairments.
- When holding property for long-term use, they must determine whether the expected future cash flows are less than the fair carrying value [Cost – Accumulated Depreciation].
- If so, the impairment must be recognized, reducing the carrying amount to its fair value.
- The fair value of a property is often determined by discounting the future net cash flows used to determine impairments under GAAP.
- Alternative methods use comparable sales or capitalization “cap” rates.
Since impairments are not extraordinary items, they are not segregated as separate line items. As a result, the impairments will form part of Operating Income under any separate line item sub-total in the income statement. Despite the likelihood that analysts calculating EBITDA will add back the impairment charge, it is not depreciation or amortization.
- Models are used to test for impairment. Very often, independent appraisals will be required by third parties. Sometimes assessments are needed to determine if undiscounted future net cash flows exceed the carrying amount concerning the assumptions on which terminal value is based.
Therefore it will be included, barring a special carve-out in the loan documents if financial covenants [including EBITDA] are calculated.
Rent-Holidays and Step-Ups
- Rent is recognized on a straight-line basis for the life of the lease.
- The above monthly rent income is recognized, even if the bill to the tenant is substantially different. The actual cash flow produced by the lease similarly has no impact on the reported monthly rent income.
- If the lease provides for rent step-ups and free rent periods, these are factored into the initial determination when a constant rent for the life of the lease is determined.
Income Tax Basis
- Reporting is straightforward. Rent income for Year 1 is $900,000. If Tenant X pays his rent every month, the amount billed by the firm and the income reported on the firm’s tax return for 2010 will sync. Reporting mirrors the cash flows generated by the lease.
- If a tenant pays the rent due on January 1, 2010, in advance on December 10, 2009, a firm using the income tax basis for reporting would recognize the payment as income during December 2009 – the cash flow mirrors the accounting treatment.
- For GAAP reporting, the income received in 2009 would be recorded as deferred revenue on the balance sheet [a liability] until it was earned in terms of the lease in January 2010.
Allocation of Purchase Price for Income-Producing Real Estate
The purchase price of an income-producing property must be allocated to both tangible assets [land and buildings] and intangible assets [including in-place leases and above-and below-market leases]. Tangible assets purchased along with an income-producing property include land, land improvements, buildings, and personal property, including furniture, fixtures, and equipment using appraised values, real estate tax assessed values, cost segregation studies, or any other rational allocation method.
- The rationale for attributing value to in-place leases is that a leased-up building has more incremental value than an empty building, which should be valued separately. The value includes savings on not providing tenant improvement allowances to the tenants already in and paying lease commissions.
- Value is attributable to above-market leases equal to the discounted cashflows of the above-market leases in place minus the discounted market rates, which the buyer paid for in the acquisition price.
- A negative value is attached to a property with leases in place that are below market value. The negative value equals the difference between the discounted cashflows from the below-market leases and discounted market-rate rents.
If the in-place leases have five years remaining after the acquisition date, amortization for the year ending December 31, 2010, would be $400,000. It would be reflected as a reduction in rent income in 2010. When negotiating, the debtor should carefully consider whether tangible assets are included as assets in any calculations. This is because the value assigned to them could be substantial.
Income Tax Basis
No part of the purchase price is allocated to any leases. Instead, the buyer will report real estate assets of $50,000,000. No reduction of rental income will be reported because no intangibles are amortized.
The tax basis rent income would be $400,000 higher than reported according to GAAP, but depreciation expenses would be higher due to the higher carrying value of the property.
Depreciation of building and equipment is determined using the straight-line method [or some other systematic approach] over the asset’s useful life.
- If the asset’s useful life changes, the asset’s carrying value must be depreciated in terms of the new estimated useful life.
- A commercial building purchased on January 1, 2010, has a remaining useful life of 20 years. The purchase price was $10,000,000. Therefore, depreciation for the calendar year 2010 would be $500,000 [$10,000,000 ÷ 20 years].
Income Tax Basis Reporting
The IRS requires using statutory useful lifetimes, methods, and conventions to depreciate assets. Hence the statutory life for a commercial property purchased in 2010 is 39 years.
- A commercial building purchased on January 1, 2010, has a remaining useful life of 39 years. The purchase price was $10,000,000. Therefore, depreciation for the calendar year 2010 would be $246,000 [$10,000,000 ÷ 39 years] ¾ $254,000 less than according to GAAP.
- For residential buildings, the useful life for Income Tax Basis Reporting would be only 27½ years. However, according to GAAP, the same 20 years of useful life would apply.
- According to GAAP, tenant improvements must be depreciated over the shorter of the asset’s useful life or the life of the related tenant lease, typically excluding exercise option periods.
- GAAP depreciation yields expenses almost four times greater than Income Tax Basis Depreciation.
- Under GAAP, if the tenant vacates the space before the end of the lease, the undepreciated assets can instantaneously be written off to expenses. In contrast, under the Income Tax Basis, the assets will remain in service when a new tenant moves in, whence it would continue depreciating over the remainder of its statutory tax life.
Related Party Transactions
Many Real Estate owners use affiliated companies to provide leasing, cleaning, and other services for their properties. Many of these enterprises use the Cash Basis Accounting System.
- Real estate enterprises that follow the accrual income tax basis of accounting incurs expenditures for services rendered by a cash-basis-related party it has not paid yet, the spending cannot be deducted from income tax basis financials until paid.
Key Performance Metrics For Real Estate Enterprises
You must track key performance metrics for your enterprise and for every one of your properties to optimize performance and enhance decision-making.
Net Operating Income [NOI]
Total income for the year [excluding mortgages or taxes] minus expenses.
Capitalization Rate [Cap Rate]
When you divide NOI by the cost of the property [or its current value]. The higher the Cap Rate, the riskier the investment. A low Cap Rate shows high value and strong property demand.
Cash-on-Cash Return [CCR]
The annual pre-tax cash flow is divided by the total cash invested. Serves as a measure of investment performance.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intended for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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