By Jodi Summers

Our historically low interest rates, coupled with the assumption that property is a safer place to park cash than the stock market have made real estate the investment of choice in recent years. Some go for income producing properties, others retirement homes. It doesn’t matter what type of real estate investment property you own — rental houses, commercial buildings, shopping centers, apartments, warehouses or land — they all offer big tax incentives.

As tax time draws near, here are some additional tax deductions you can take.

LOSS DEDUCTION

A real estate investor who is not a “real estate professional” is legally limited to a maximum annual $25,000 realty investment property loss deduction against their ordinary taxable income — providing this non-professional investor’s annual adjusted income does not exceed $100,000. Above the six-figure adjusted income level, the allowable tax loss deduction phases out, flatlining at $150,000. Comfortably, IRS Notice 88-94 allows those in that tax stratosphere to suspend their undeducted real estate investment tax loss until the property is sold. The suspended tax loss is then subtracted from the capital gain to lower the taxable profit at the time of sale.

To qualify, part-time investors must own at least 10 percent of the investment property and must “materially participate” in property management decisions.

A real estate professional — who spends at least 750 hours per year, or more than 50 percent of their business time in qualified real estate work — has deductions galore. “There is no limit to the allowable tax deductions from your properties that can be subtracted from your other ordinary income,” according to real estate expert Bob Bruss.

DEPRECIATION

The government has gifted property investors the opportunity to depreciate their investment properties. Depreciation is a “paper loss” required for estimated wear, tear and obsolescence. Keep in mind, land value is not depreciable.

Residential income property is depreciated more than 27.5 years on a straight-line basis — equal annual reductions in the book value of a property. Commercial property is depreciated over 39 years. Personal items used in operating the property, such as apartment appliances, are usually depreciated over five to 10 years. Automobiles and trucks used in the investment operation can be depreciated over their useful lives. There also is the new first-year 100 percent deduction for up to $100,000 of business equipment.

Depreciation is a non-cash expense deduction, which reduces taxable income from the investment property. According to Bruss, depreciation expense deductions can turn a positive cash flow property into a tax loss for income tax purposes, thus creating a “tax shelter” for that income property’s tax flow. While most investment properties appreciate in market value each year, on paper their “book value” depreciates as the property ages. Accounting shows that the book value declines while the market value goes up.

RECAPTURED DEPRECIATION GETS TAXED WITH THE SALE

The 1997 Taxpayer Relief Act reduced the federal capital gains tax rate to 20 percent. In 2003, the government again reduced the capital gains tax rate to 15 percent for assets owned more than 12 months. The special 25 percent depreciation “recapture” tax rate remains unchanged. Those depreciation deductions you’ve taken are taxed when a property is sold.

Many investors will avoid paying the 25 percent federal recapture tax rate for deducted depreciation by exchanging the property for another investment property, better known as a 1031 exchange.

Since 1921, Internal Revenue Code 1031 has sanctioned tax-deferred exchanges of investment and business properties. A 1031 exchange allows individuals and corporations to trade in existing business and investment property for new property — and defer the capital gains tax along the way. A qualified tax-deferred trade up is viewed, taxwise, as one continuous investment. Traditionally, 1031 exchanges were used most by owners of large commercial real estate properties, but the real estate boom has made exchanges a favorite among smaller investors as well.

“This is one of the last goodies in real estate,” said Kelly Yates, an attorney and house counsel to the Exchange Facilitator Corp. “Our typical customer is the mom and pop who maybe inherited land many years ago and want to move unproductive land into income-producing property. We also see the phenomenon of people in their 40s and 50s looking ahead to retirement and looking to sell a property to buy a home in Florida that they can rent and maybe retire to someday.”

Advocates of 1031 exchanges say the best part about them is that you’re able to reinvest the money you would otherwise have spent in capital gains taxes. To qualify for the tax-deferred status, the proceeds from your sale must go back into your replacement property, but those are pre-tax dollars you’re putting to work for you.

According to Tim Egan, executive director of the Federation of Exchange Accommodators, like-kind exchanges have been going strong for the past decade, since the treasury department adopted new guidelines for executing a tax-deferred exchange.

“The feedback we are getting from our members is that the preponderance of business these days is coming from small, mom-and-pop investors. They are the ones who benefit from this the most,” Egan said.

Any serious 1031 exchange prospect begins the process with a visit to a qualified intermediary, a firm approved by the IRS to facilitate 1031 exchanges.

A proper 1031 exchange will see that you don’t pay taxes on the transaction until you sell the replacement property. By that time, most investors are well into their retirement years and fall into a lower tax bracket. If you have a smart team offering investment advice, you may be able to avoid paying taxes altogether. That’s because the capital gains tax you owe on replacement properties are forgiven upon your death, meaning your heirs won’t get hit for taxes either.

“This can be a great estate planning tool,” said Margo McDonnell, president of 1031 Corp., a qualified intermediary.

(Jodi Summers is director of the investment division at Boardwalk Realty Santa Monica. For your real estate needs, e-mail Jodi Summers at jodis@boardwalkrealty.com or call 310-309-4219.)