Taxes, Taxes, Taxes

This may be stating the obvious, but the tax consequences of a real estate transaction are one of the most important aspects of the deal. Although most generic measures of property value, such as cap rate and NOI seek to exclude taxation in order to generate values that can be comparable across investors, an individualized tax assessment of any real estate acquisition is essential to determining its true rate of return of and its opportunity costs.

Although I am not a tax professional, tax expert or tax adviser, I would like to briefly discuss various real estate investment tax considerations. I will attempt to address a few of the more popular tax considerations at the property, entity and security level:

Property Tax Considerations

Many of the tax considerations on the property level address the deduction of operating expenses, however, mortgage tax incentives and 1031 exchanges, some of the considerations that can influence the purchase or sale of a property.

Depreciation: This federal tax code allows property owners to deduct the value of the deterioration of improvements to land (structures on the property that are not land) over the "useful life" of the structure. This includes buildings, certain upgrades to buildings and building fixtures. Residential structures are depreciated over 27.5 years and commercial structures are depreciated over 39 years, if they do not qualify for any other depreciation under the Internal Revenue Code. All tax depreciation is calculated on a straight line basis.

Interest: Interest from the mortgage of most rental properties is tax deductible, so long as the loan was obtained to acquire or improve the property. Other factors may affect this determination and a tax professional should be consulted for each individual case. On a related note, mortgage points paid are deductible over the life of the loan, although they are paid upfront.

Insurance: Most property insurance premiums are tax deductible.

Repairs/Improvements: Repairs to a property are deductible. Fixtures are typically depreciated over their useful life or that of the property. Tenant allowances can be either taxable to the property owner, tenant or untaxed, depending on how they are structured.

Professional Services: Accountant fees, legal fees, appraisal fees and other real estate service fees can be deducted as operational expenses, so long as they are related to the operation of the property.

Wages: Wages paid to employees that are part of the property's operation are deductible.

Casualty Losses: Losses due to fire or acts of God (such as earthquakes, floods, severe weather, etc.) and most unforeseen happenings can be tax-deductible. In the case of a total destruction, however, the entire value of the property will like not be able to be deducted as a loss.

1031 Exchange: When considering the sale of property, a 1031 exchange is a way to defer taxes resulting from a sale, by scheduling the subsequent purchase of another "like-kind property" as defined by IRC section 1031. Although the definition of a "like-kind property" is fairly broad, a 1031 has specific deadlines for identifying an exchange property and the closing that make it a specialized transaction. It must be stressed that in a 1031 exchange does not eliminate taxes, but defers them. It is not uncommon, however, for a property owner to undergo a number of successive exchanges over time, deferring the tax liability from the original sale to a point beyond the lifetime of the owner.

Entity Level Considerations

Tax considerations at the entity level should inform both the choice of business structure and the type of participation that each investor will have in the structure.

Retained Earnings/Pass Through Taxation: The decision of whether to have corporate ownership of real estate assets under a C-corporation or own them through an unincorporated entity, such as a limited partnership or limited liability corporation, should factor in the tax consequences choosing each entity. All unincorporated structures and the nearly abandoned S-corporation provide for what is called pass-through taxation, which means that each member of the entity will treat the income of the entity as personal income on a prorata basis. There are some nuances of pass-through taxation that are too detailed to explain in this post, such as how income is classified for limited partners and non-manager members of a manager-managed LLC and when self-employment taxes are paid. As a general rule however, unincorporated entities pass-through all of their income to their members, including limited partners in a limited partnership. As such, the income of these entities is only taxed on the individual level.

Corporations, on the other hand, are not required to distribute all of their earnings to their shareholders. Corporations are, therefore, taxed on all of the income that is retained in the corporate structure the is considered retain earnings.

Asset Appreciation: Yet another tax consideration at the entity level is the determination of how asset appreciation will be taxed, based on the business structure of the owning entity. Corporation are taxed on the appreciation of the value of an asset upon sale, if its value has appreciated from the time it was purchased until it was sold. As a result of pass-through taxation, unincorporated entities are not taxed on the appreciation of assets upon sale at the entity level.

Real Estate Professional Designation: Generally, individuals earning less than $100,000 a year in income are limited to claiming $25,000 in rental real estate losses when filing taxes. This amount is phased out as personal income raises and is totally phased out at $150,000 a year in income. Individuals that are considered Real Estate Professionals by the IRS, however, can treat rental income from a property as non-passive income and not subject to the $25,000 limit. This designation can be particularly helpful to participants in pass-through entities that own real estate.

To be designated a Real Estate Professional by the IRS, one must spend more than 50 percent of his/her time in real estate activities and more than 750 hours in real estate activities. The IRS defines real estate activities as development, redevelopment, construction, reconstruction, acquisition, conversion, rental, management, operation, leasing or brokerage. As with all of the other tax considerations above, specific nuances apply and a tax professional should be consulted for each individual case.

Note/Security Level Considerations

Income that result from owning notes and real estate securities is considered portfolio income by the IRS. For those who are unfamiliar with the IRS categories of income, they are active, passive and portfolio. While most rental income from property ownership is passive, notes and real estate securities are considered debt instruments by the IRS.

Tax considerations at the securities level are extremely idiosyncratic and take into account a number of factors. Since most real estate securities are debt, the owner of a note or security must figure out his or her Original Issue Discount (OID). The OID reports the effective discount paid over the term of the note or bond and takes into consideration such factors as whether or not the instrument was bought during the original issue or in a secondary sale, the discount at the time of purchase and any acquisition premiums. This consideration becomes even more complex if the security held is an interest in a REMIC (Real Estate Mortgage Investment Conduit) or a FASIT (Financial Asset Securitization Investment Trust), since the IRS has specific rules for those securitization vehicles.

I truly hope that this very cursory overview of real estate tax considerations at all levels has served to give a "10,000 foot view" of the role of taxes in real estate investment. As stated above, I am by no means a tax professional, nor am I attempting to give any tax advice. All individual situations should be brought to a competent tax professional, who can assess the situation and offer appropriate counsel.

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