Last year, the SoCal six-country region — San Diego, Los Angeles, Orange, Riverside, San Bernardino and Ventura — relaxed after the impressive real estate escalation that ran between 2000 and 2005, during which time property values in many communities doubled and then some.
Many people speculated on investment properties during this accelerated market, and they are now entitled to a slew of pleasing tax breaks. Here’s an overview of real estate tax benefits for investors LOSS DEDUCTION Real estate investors who own at least 10 percent of a property and materially participate in managing the property are able to deduct up to $25,000 annually in realty investment property loss deduction against their ordinary taxable income. Actions as simple as setting tenant selection criteria and repair policies fulfill this material participation requirement.
The maximum deductible of $25,000 annually applies only if an investor’s annual adjusted gross income does not exceed $100,000. Above the six-figure adjusted income level, the allowable tax loss deduction phases out as dictated by the government, flat lining 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.
Real estate professionals who spend at least 750 hours per year or more than 50 percent of their business time in qualified real estate work have deductions galore. According to real estate expert Bob Bruss, “There is no limit to the allowable tax deductions from your properties that can be subtracted from your other ordinary income.”
DEPRECIATION The government has given property investors the opportunity to depreciate their investment properties. Depreciation is a paper loss for estimated wear, tear and obsolescence. Land value is not depreciable.
Residential income property is depreciated over 27.5 years on a straight-line basis, meaning there are equal annual reductions in the book value of a property. Commercial property is depreciated over 39 years. Personal property used in operating the property, such as apartment appliances, is usually depreciated over five to 10 years. The vehicles used in the investment operation can be depreciated over their useful lives. There is also 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.
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. Please note, however, that the special 25 percent depreciation recapture tax rate remains unchanged. Those depreciation deductions you’ve taken are taxed when a property is sold.
Along this line, Bruss notes: If you bought an investment property for $300,000 and deducted $100,000 of depreciation during your ownership years, the book value declined to $200,000. Then you sold for $450,000. Your capital gain is therefore $250,000 ($450,000 minus $200,000). Of that $250,000 capital gain, the $100,000 depreciation deducted is recaptured and taxed at the 25 percent special federal tax rate. The $150,000 remainder of your capital gain will be taxed at the new 15 percent maximum tax rate.
“In tax circles, this little adjustment is known as depreciation recapture, and essentially it’s the government’s way of making sure you don’t take advantage of depreciation deductions twice,” says CNN/Money columnist Walter Updegrave.
Many investors will avoid paying the 25 percent federal recapture tax rate for deducted depreciation by exchanging the property for another investment property, which is also known as a 1031 exchange.
The financially savvy truly enjoy investment properties because they appreciate in market value and also produce significant tax savings — both during ownership and at the time of resale or tax-deferred exchange. Talk to your accountant about which tax deductions may be right for you.
JODI SUMMERS negotiates investment properties for Sotheby’s International Realty. For your real estate needs, or call (310) 260-8269. Visit her Web sites at www.socalinvestmentrealestate.com or www.santamonicalandmarks.com.
Originally published in the Santa Monica Daily Press print edition on February 7, 2007. Read the original PDF.