Investors cash in on real estate depreciation

Realty Tax Tips-Part 5: Pros and cons of owning properties
By: Robert J. Bruss: Inman News
(This is Part 5 of an eight-part series. See Part 1, Part 2, Part 3 and Part 4.)
In addition to owning your home, do you own one or more investment properties? If you do, or you would like to own real estate held for investment, it pays to understand the pros and cons so you can obtain maximum benefits.

You are not alone. Millions of U.S. homeowners own second homes and other investment properties.

At the recent International Builders Show in Orlando, economists David Berson of Fannie Mae, David Seiders of the National Association of Home Builders, and Frank Nothaft of Freddie Mac agreed house and condo sales to investors are major residential sales factors, perhaps as much as 10 percent of the market.

Their concern is these short-term speculators might all "dump" their properties on the market at the same time, thus causing significant local home-price declines. For this reason, many builders will sell their new houses and condos only to owner-occupants.

WHY INVEST IN REAL ESTATE? During 2005, the average residence appreciated over 10 percent in market value, according to the National Association of Realtors, the National Association of Home Builders, and other reliable sources. Of course, there are a few depressed areas lacking job growth where residential values appreciated slower or not at all.

Compared to the stock market and other alternative investments, real estate stood out as a great investment in 2005, especially for investors who leveraged their purchases by obtaining 80, 90 or even 100 percent mortgage financing. But the home appreciation rate for 2006 is expected to slow down, according to the economists mentioned above, to around 5 percent or 6 percent. However, that is still an excellent rate.

MAJOR TAX BENEFITS OF REALTY INVESTMENTS. A second major reason investors purchase real estate is for the big tax benefits if they "materially participate" in managing their properties. Even investors who hire professional property managers can meet this tax test by making the major decisions, such as setting tenant selection and repair policies, yet leaving the day-to-day operating details to their manager.

To enjoy maximum tax benefits, realty investors who materially participate in owning and managing their properties must own at least a 10 percent interest in the property. This leaves out investors in large partnerships and other group investments such as REITs (real estate investment trusts). Vacation-home owners who place their properties into a "rental pool" managed by others usually do not meet the material participation test.

If you meet these two management and ownership tests, then you can deduct up to $25,000 of your investment property losses against your ordinary taxable income if your adjusted gross income is less than $100,000. Most investment property losses are known as a "paper loss" (rather than an actual cash loss) because they are not cash-out-of-pocket losses.

When your annual adjusted gross income exceeds $100,000, the realty tax loss deduction gradually phases out to zero above $150,000 AGI.

However, unused deductions can be "suspended" and saved for use in a future tax year, or to shelter capital gains from taxation when the property is sold. IRS Notice 88-94 allows use of these suspended tax losses on an aggregate basis, rather than property-by-property, when selling.

The reason is that most investment property paper losses come from the depreciation deduction. Depreciation is a non-cash allowance for "wear, tear, and obsolescence" of the rental property building. Residential rentals must be depreciated over 27.5 years, but commercial properties are depreciable over 39 years on a straight-line basis.

In addition, depreciation is allowed over shorter 5- to- 10-year terms for personal property used in the rentals, such as apartment building washers and dryers. However, land value is not depreciable because it never wears out.

Your car or truck used to operate your investments can also qualify for tax deductions. In addition, equipment purchased to operate your investment property is also eligible for generous tax breaks, including first year expensing, subject to limitations.

THE BEST TAX BREAKS GO TO "REAL ESTATE PROFESSIONALS." If you are a "real estate professional," such as a realty broker, sales agent, property manager, builder, contractor, or leasing agent, you can qualify for unlimited tax deductions from your investment property against your ordinary income.

To qualify for the real estate professional unlimited investment property tax deductions, you must spend at least 750 hours per year, or over 50 percent of your working hours, involved in real estate activities.

DON'T FORGET DEPRECIATION RECAPTURE WHEN SELLING. The only downside of the depreciation tax deduction, which saves income taxes during investment property ownership, is at the time the property is sold Uncle Sam is waiting to "recapture" and tax the total depreciation deducted during the years of ownership.

To make matters worse, Uncle Sam imposes a special 25 percent recapture tax, with a very few exceptions. This tax rate is considerably higher than the current 15 percent long-term capital gains federal tax rate.

However, if the investor dies while owning depreciable real estate that would have been subject to the depreciation recapture tax rate, then Uncle Sam completely forgives all taxes that would have been due if the decedent sold the property before death. In other words, death is the ultimate tax shelter of all.

But capital gains taxes, and the recapture of depreciation tax, can be fully avoided by making an Internal Revenue Code 1031 tax-deferred exchange. To qualify, the replacement property must equal or exceed the old property's equity and cost without taking out any taxable "boot" such as cash or mortgage relief.

CONCLUSION: Investment real estate offers significant tax benefits both during ownership and at the time of resale or tax-deferred exchange. Not only do most investment properties appreciate in market value, but they also produce significant tax savings.

Next week: How tax-deferred exchanges can pyramid wealth.