Taxes Taxes are a levy imposed upon people or legal entities by a governmental entity. There are many forms of taxes including income taxes, property taxes, capital gains taxes, consumption taxes, exc...
Taxes are a levy imposed upon people or legal entities by a governmental entity. There are many forms of taxes including income taxes, property taxes, capital gains taxes, consumption taxes, excise taxes, retirement taxes, sales taxes, tariffs, toll taxes and transfer taxes. This article focuses on reducing income taxes for real estate owners.
Income taxes often seemed unavoidable. However, real estate investors have multiple opportunities to defer and reduce federal income taxes. Real estate owners receive income tax breaks not available to investors for many other asset classes. These include depreciation, income tax rate reduction, and the like-kind exchange. This article discusses how real estate owners can reduce income taxes by increasing the level of depreciation, using tax-deferred changes, casualty losses, maximizing expenses and planning to minimize estate taxes.
Depreciation is a non-cash expense which can both defer and reduce the level of federal income taxes. In some cases, depreciation actually eliminates federal income taxes. When an owner claims depreciation, and does not sell the property before it passes into his estate, the income deferred by the depreciation is never taxed.
Most real estate owners know depreciation defers federal income taxes. Few know real estate depreciation also reduces federal income taxes. The common perception is that depreciation simply shifts payment of income taxes from when income is earned until property is sold. However, depreciation often changes the character of income from ordinary income to capital gains income.
Consider the following example: George purchased an apartment complex in 2005. After obtaining a cost segregation study, approximately 20% of the cost basis of the improvements was allocated to 15 year property, such as landscaping, paving, sidewalks, parking lot striping and exterior signs. If George sells the property in five years, one-third of the cost basis of the 15 year property will have depreciated. Isn't it also reasonable the market value of this property will be one- third less than when the property was purchased?
More often than not, tax preparers believe the market value of short-life property is similar to the remaining basis when property is sold. This means there is no gain upon sale. Hence, additional depreciation was taken for short-life property (which could be used to reduce income taxable as ordinary income rates) while George owned the property. At time of sale, the portion of the gain equal to the short-life depreciation is taxed at the capital gains rate. This is how cost segregation reduces federal income taxes. Hence, federal income taxes are both deferred from the time income is earned until a sale occurs and the tax rate is reduced from the ordinary income tax rates to the capital gains rate.
Cost segregation can lead to meaningful deferral of federal income taxes. However, its most significant power is its ability to convert income taxed at the ordinary income rates to income taxed at the capital gains rate.
A like-kind exchange allows you to defer recognizing gain after selling of property if you purchase a "like-kind" property. Most exchanges of real estate for real estate qualify as a like-kind exchange. It is not possible to exchange real property for personal property and receive the benefits of a like-kind exchange. There may also be some limited interests in real estate, other than a fee simple interest, which do not qualify as real estate for purposes of a like-kind exchange. This might include exchanging the interest in leased land with five years remaining on the lease for fee simple title to another parcel.
The basics of executing a tax-free exchange are fairly simple. You must identify the replacement property within 45 days of the time you sell your property. You can identify up to three replacement properties or an unlimited number of replacement properties whose market value does not exceed twice the value of the property you sold. The replacement property must be purchased within 180 days of selling your property. A qualified intermediary must handle the exchange. To defer all of the gain, the market value, debt and equity of the replacement property must be equal to or greater than the market value, debt and equity of the property that was sold. Rules for like-kind exchanges are rigid, but there are experts who can guide you and allow you to legally defer substantial amounts of income.
A casualty loss for real estate investment property could include fire, flood, hurricane, tornado, or mudslide. Real estate owners incur both financial and emotional distress following this type of casualty. There's also a significant amount of work involved to coordinate with the insurance adjuster, tenants, contractors, vendors and lender. Even if the owner has complete insurance for building repairs and business interruption, a casualty loss deduction can legitimately be taken.
Casualty losses provide the opportunity to depreciate a large portion of the cost basis of real estate. The basis for calculating a casualty loss is the value of the property immediately before the casualty versus the value of the property immediately after the casualty plus insurance proceeds.
Consider the following example: a 200 unit apartment complex in Beaumont Texas was flooded with 3 feet of water on the first of two stories. The owner has casualty insurance expected to cover 100% of the cost to recover repair the property. He also has business interruption insurance to cover lost income while construction occurs and the property is leased. The initial reaction in reviewing this situation may be there is no casualty loss since the physical repairs and lost rents are covered. However, the market value of the property immediately after the casualty is substantially less than the market value of the property before the casualty. It is highly unlikely someone would purchase the property and agree to undertake the work required to negotiate with the insurance company, contractors, tenants, vendors and the lender without expecting a profit for their work. The magnitude of the casualty loss would have been much larger if the owner did not have business interruption insurance. In either case, a real estate investment group seeking to purchase the property immediately after the casualty would likely require an appropriate return for their capital and an entrepreneurial profit for the effort to renovate and lease the property.
Operating expenses are a tax deduction. Increasing operating expenses reduces taxable income and income taxes. Reviewing all cash expenditures annually can reveal operating expenses which have inadvertently been coded as a capital expenditure. Correcting this error prior to filing a tax return increases current year deductions. A fixed asset review can uncover errors which allow for substantial current year deductions. It is possible to claim current year depreciation or deductions after correcting a fixed asset listing. Corrections can be as a result of classifying operating expenses as capital expenditures. Another option for generating current year deductions is identifying assets which have been ascribed in excess of depreciation life. For example, if the cost to install substantial new landscaping was given a 39 year life, depreciation can be increased by correctly assigning a 15 year life and catching up previously under reported depreciation. Combining business and personal travel can increase deductions. Perhaps you need to schedule a business trip. If you add several days for leisure, the cost of the business trip can still be deductible. Scrutinizing personal expenses for lawful deductions can generate additional deductions. Any costs related to investment activity are deductible. This can include a computer at home for maintaining records for rental properties, mileage related to maintaining rental properties and memberships and publications related to investment activity.
Perhaps the most distasteful type of tax is the estate tax. For that tax, advance planning is necessary to substantially reduce estate taxes. While the current year exemption for 2006, 2007 and 2008 is $2 million, those with the states substantially in excess of $2 million need to consider detailed planning to minimize estate taxes. Options for reducing estate taxes include gifts during your life, partial interests, gifts upon death, bypass trusts, and a variety of other options.
Real estate investors are subject to income taxes, capital gains taxes, estate taxes, property taxes, and sales taxes. Real estate investors are fortunate that federal tax laws provide more opportunities to reduce income taxes than are available to most other business owners. In some cases simply consulting with a tax preparer may allow real estate investors to minimize taxes. However, in most cases utilizing a team of tax advisers with specialized knowledge enhances the investor's ability to minimize taxes.
O’Connor & Associates is a national provider of investment property consulting services including due diligence, income tax,business valuation, tax deduction, tax reduction, property tax, real estate consulting, market research, Denton Central Appraisal District, Tips and Tricks for Appealing Your Property Taxes in Collin, Collin county appraisal and Federal tax reduction. Our appraisers are competent to appraise virtually all types of property including land, neighborhood shopping centers, warehouses, bowling alleys, motels, mobile home parks, self-storage units, retirement homes, multifamily housing, movie theatres, veterinary clinics, single-tenant retail centers, funeral homes, bars, amusement parks, hospitals, schools, night clubs, apartments and medical facilities.
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ABOUT THE AUTHOR
Patrick C. O'Connor has been president of O'Connor & Associates since 1983 and is a recipient of the prestigious MAI designation from the Appraisal Institute. He is also a registered senior property tax consultant in the state of Texas and has written numerous articles in state and national publications on reducing property taxes. He continues to set the standard in direction and quality of our appraisal products, adding services ranging from business valuations and business appraisals to cost segregation analysis for income tax reduction.
Patrick C. O'Connor