There are many different ways in which real estate investment can be profitable for an individual or an organization by virtue of the various tax savings that can result from such investments. Some of the most important tax savings available from real estate include real estate depreciation and deferred tax gains through 1031 exchange.
Learning how these methods work will help the investor generate higher profits. However, there are various tax regulations for each of these that need to be understood.
In this article, we will explain the concepts of real estate depreciationand 1031 exchange along with the relevance of outsourced accounting services for real estate businesses in the USA.
What Is Real Estate Depreciation?
Real estate depreciation is a tax write-off that enables property investors to recoup the costs of an income-producing real estate over time.
According to the IRS, the value of a building and some property improvements depreciates as a result of wearing out, becoming older, or losing value. In light of the above, investors are entitled to claim a portion of the value of their property annually as a business expense.
Importance of Real Estate Depreciation for Investors
While many investors pay attention to rental income and the appreciation of property, depreciation is very important because of its ability to increase after-tax gains from investments.
Advantages of real estate depreciation:
- Decreased amount of taxable income
- Increased cash flow
- Higher profitability of the investment
- Decreased annual taxes
- Enhanced tax planning
In many cases, it is possible to have positive cash flows while lowering the amount of taxable income.
Which Properties Qualify for Depreciation?
As a general rule, depreciation relates to investment and business assets but not to personal homes.
The following examples include:
- Residential rental assets
- Commercial structures
- Industrial assets
- Office buildings
- Multi-unit dwellings
The following criteria apply for depreciation:
- Ownership of the asset by the taxpayer
- Income-producing use of the asset
- A determinable useful life of the asset
- An estimated life of more than one year
The land is not depreciable since it does not deteriorate like buildings.
How Real Estate Depreciation Is Calculated
In general, tax depreciation usually involves depreciation of the value of the building rather than the total cost of acquisition.
Basic steps include:
- Determine the Basis of the Property
- Generally, the basis of the property includes:
- Cost of Purchase
- Acquisition Cost
- Improvements that qualify for depreciation
Land Valuation
Since there is no depreciation allowed for the land, the value of the property needs to be allocated between land and building.
Use the Correct Recovery Period
Under the current federal tax law, residential rental property will have a recovery period of 27.5 years and 39 years for commercial properties.
Common Depreciable Assets Beyond the Building
Apart from the main structure, some other improvements can also be included under the deprecation category.
These include:
- Roof systems
- HVAC systems
- Flooring
- Appliances
- Parking spaces
- Fencing
There might be different depreciable life of assets due to the categorization of those assets.
What Is Depreciation Recapture?
One concept that investors need to understand regarding depreciation is depreciation recapture.
Depreciation recapture takes place when the seller is required by the IRS to pay taxes on the already claimed depreciation deduction.
Thus, depreciation recapture leads to the generation of additional tax liability for the seller.
As a result, investors look for methods like a 1031 exchange to defer tax liabilities.
What Is a 1031 Exchange?
Investors can use a 1031 exchange to defer capital gain tax on the sale of one investment property to buy another investment property that meets the eligibility criteria for 1031 exchange.
The term “1031 Exchange” is derived from Internal Revenue Code Section 1031.
Instead of having taxable gains recognized in the year they occur, investors can defer taxes through the process of investing their proceeds back into another eligible investment property.
Why Do Investors Choose 1031 Exchange?
There are many benefits for choosing a 1031 exchange.
These include:
- Tax deferral on capital gains
- Tax deferral on depreciation recapture
- Increased purchasing power
- Diversification of portfolio
- Increased wealth accumulation
With deferred taxes, investors have more purchasing power to invest in new properties.
Understanding the Basic 1031 Exchange Rules
Several important 1031 exchange rules must be followed for a transaction to qualify.
Non-compliance with these criteria will lead to instant tax implications.
Rule 1: Both the Properties Must Be Held For Investment/Business Purposes
The properties to be exchanged must normally be held for investment or business use.
Residential property is not usually eligible.
Rule 2: Like-Kind Requirement
In accordance with present-day 1031 exchanges, both properties should be of the same class.
In the case of real estate property, the like-kind requirement is quite liberal.
Some examples may be:
- Renting property for business property
- Apartments for raw land
- Retail property for industrial property
Rule 3: Work With a Qualified Intermediary
The investor should never receive the proceeds of sale.
Funds are received by a qualified intermediary who assists investors in completing the exchange.
Rule 4: Comply With the 45-Day Identification Deadline
Normally, an investor has 45 days to make identification of potential replacement property.
Rule 5: Conclude the Exchange in Given Time Periods
Investors have 180 days period since the sale to acquire replacement property.
The Relationship Between Depreciation and 1031 Exchanges
One of the reasons why investors tend to use 1031 exchanges is tax deferral on capital gains and depreciation recapture.
In case the property used as an investment is sold, the tax deductions on depreciation become a problem.
By doing a valid exchange, the investors have a chance to defer these taxes and develop their portfolios.
Thus, depreciation of the real estate properties and 1031 exchanges become powerful means of real estate investing.
Typical Mistakes by Investors
Most of the investors run into troubles because of lack of knowledge about tax laws.
Failure to Monitor Depreciation
It is crucial to keep records to calculate tax payments.
Violation of Time Limits of the Exchanges
The time limits of 45 days and 180 days are strictly observed.
Taking of the Proceeds of the Exchange
The funds obtained from an exchange can destroy the deal.
Improper Identification of Replacement Properties
The requirements for the replacement properties should be followed.
Disregard for Professional Advice
Tax planning for real estate properties can be complicated.
How Depreciation Improves Cash Flow
One of the greatest benefits of depreciation comes through its effect on annual cash flows.
Since depreciation is a non-cash expense:
- Taxable income will be lowered
- Tax will be reduced
- Cash becomes available for investments
It is an added benefit in terms of ROI of investment properties.
Depreciation works as an asset to many investors.
Cases When 1031 Exchange Would Not Be the Right Solution
A 1031 exchange does not fit in every case, despite all the benefits of the process.
An investor might decide not to use the exchange if:
- They require the money immediately after selling their property
- The taxes due are quite low
- They do not plan to invest further into real estate
- Proper replacement properties are not found
Every investment case must be considered individually.
Best Practices for Real Estate Investors
There are a number of practices which one must follow for maximizing the benefits from taxes.
Maintain Accurate Documentation
This will assist in depreciation calculation and tax filing.
Property Sales Planning
One must take into account tax implications before selling out the investment properties.
Be Familiar with 1031 Exchanges
It helps to prepare oneself for meeting the requirements of 1031 exchanges.
Consult with the Professionals
Tax specialists, qualified intermediaries, and accountants can help in dealing with complex tax laws.
Check Your Investment Objectives
Investment plans must be consistent with your tax strategy.
Both depreciation in real estate and 1031 exchange bring about great tax benefits for property investors. One is able to save on the taxes through depreciation while generating cash flow whereas the second option enables investors to defer capital gains and depreciation recapture taxes when investing in other properties.
By having a clear understanding about 1031 exchange rules and depreciation, one can become a more informed investor and save their capital while building up a portfolio with The Fino Partners’ outsourced accounting services for real estate businesses in the USA.
