Owning real estate produces steady income for investors, but the sale of residential and business properties can generate a large tax bill because of capital gains.
Investors should understand the various factors that can help them mitigate and potentially defer paying capital gains tax from selling real estate properties.
Rental property owners will benefit from lower ordinary income tax rates and other favorable changes to the tax brackets for 2018 through 2025, says Michael Underhill, chief investment officer of Capital Innovations in Pewaukee, Wisconsin.
Changes in tax laws have resulted in more complications, and owners of rental properties should invest more time and resources on tax planning, says Sarah Hallock, a tax senior manager for New York-based tax and accounting firm EisnerAmper.
“Recent legislation has granted some benefits to real estate investors, such as the potential tax savings from the 20% deduction for qualified business income and the immediate write-off for qualified improvements,” she says.
On the other hand, the limitation on business interest expense deductions has had a significant negative impact on leveraged rental activities, Hallock says.
“The Coronavirus Aid, Relief, and Economic Security (CARES) Act offers some much-needed relief with regard to the temporary easing of the limitation on interest expensing,” she says.
Impact on Tax Loss Harvesting
Many real estate investors faced limitations on the deduction of losses as a result of the passive activity loss limitations that have been in effect since 1986, Hallock says.
“Rental losses are generally treated as passive and can only be used to offset passive income, with any excess losses carried forward to subsequent years,” she says.
Real estate professionals, known as REPs, are a category of investors whose activities predominantly involve real estate. They were exempt from these limitations.
Recent tax reform under the Tax Cuts and Jobs Act of 2017 introduced additional limitations on the ability of taxpayers, including REPs, to deduct losses by instituting limitations on the deduction of net operating losses and annual business losses, Hallock says.
“In light of the impact that the COVID-19 pandemic has had, the CARES Act offers some temporary relief to REPs by delaying the limitations on loss utilization,” she says.
Options for Investors
Purchasing a rental property certainly isn’t the only way for investors to participate in the real estate market, Hallock says. Individuals can also invest in publicly traded real estate investment trusts, or REITs, private equity funds and qualified opportunity zone funds, she says.
Another approach some investors have taken is using a 1031 exchange, which comes from Section 1031 of the U.S. Internal Revenue Code.
Some real estate investors choose this option to minimize tax liability when they are planning to buy multiple properties over time, says Bill Golden, a real estate agent with RE/MAX Around Atlanta Realty who helped a client invest in rental property via a 1031 exchange and has been an investor and owner himself.
When investors sell one property and buy another, they can invoke the 1031 exchange, if the properties qualify, and defer capital gains, he says. “Even though your swaps are taxable, if they meet 1031 requirements, the investor has no tax or at least fewer taxes due at the time of the exchange.”
A 1031 strategy can be used several times, allowing investors to defer capital gains, eventually paying at a long-term capital gains rate, Golden says.
“There are a lot of ins and outs and nuances to 1031 exchanges, so real estate investors should work both with a realtor who has some familiarity with them and an attorney who is specifically familiar with 1031 exchanges,” he says.
Rental properties are a “great” short-term and long-term investment strategy since being a landlord is financially rewarding, Golden says. It can also be challenging and frustrating.
Cash flow and occupancy are the keys to return on investment.
“Just because you purchase a great property doesn’t mean you will find a tenant and keep the place rented,” he says. “Understand that in today’s credit market, financial independence is a prerequisite to owning. Lenders have tightened guidelines and require more reserves and larger down payments to offset added risk.”
Rental properties are the “most active and time-consuming forms of real estate investing in which you can engage, contrary to popular belief,” Underhill says. He started answering phones at his family’s real estate agency at 8 years old. Underhill worked there until age 18 and saw firsthand how much time and effort it took to invest in real estate.
Tax laws should never drive the decision to make a real estate investment, says Adam Salis of Salis Law in Mission Viejo, California.
“There are certainly myriad tax benefits from investing in real estate, including interest deductions and depreciation, but the fundamentals of a good investment should always be in place regardless of the tax benefits,” he says.
He adds that investors should consider the overall physical and environmental condition of the real estate land and improvements as well as “the durability of the income stream, the potential for future improvement to the real estate or to that income stream and, of course, that old axiom of location, location, location. Tax laws change over time, but these fundamentals do not change.”
Where to Seek Advice on Real Estate Investments
Since real estate transactions can be complicated, investors should seek advice from more than just one type of expert. A good accountant will provide more than just financial statements and tax compliance, Hallock says.
“Your accountant might connect you with a financial services consultant to assist with a loan restructuring if your property is distressed or a management consultant if your family real estate business is experiencing growing pains,” she says. “An experienced real estate accountant can also help put together your team.”
Investors should seek guidance from investment and loan brokers, Salis says. After an investment is identified, a team of experts should include the accountant, real estate attorney and other professionals to assist with property evaluation and due diligence, he says.