When working with clients on real estate investments, you will need to prepare them for a higher level of tax complexity. This might mean encouraging them to think farther ahead than they are inclined to, considering how long they see themselves holding onto a property and when they might want to sell it. New investors might find this advance planning excessive, but as tax planners, we know that the key to a lower tax bill is preparation. A variety of tax strategies are available for real estate investments, but to apply them effectively, you need an eye toward the future.
For instance, a key tax reduction strategy is simply to take advantage of depreciation deductions. Since real estate is a physical asset that typically loses value as it grows older (and requires more repairs), the IRS hands property owners a tax break. Businesses are allowed to gradually deduct the cost of a property over time, but as with all tax laws, there are nuances to who qualifies, how much you can deduct, and what happens if a taxpayer claims too much of a loss from depreciation. Today’s blog will cover the basics of depreciation and recapture and how to discuss these topics with your real estate investor clients.
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Keep Your Eye on That Long-Term Capital Gains Rate
The first thing to make sure your clients understand is the importance of factoring in their future tax rates. A common tax reduction strategy is to shift income from earned to capital—in other words, to avoid ordinary income tax rates and secure a long-term capital gains tax rate. This means your client will need to hold onto that property for at least a year before selling it. As a reminder, properties held for less than a year face a short-term capital gains tax, which will be the same as your client’s ordinary income tax rate. Properties held for a year or more fall in the category of long-term capital gains, which range from 0% to 20% depending on the taxpayer’s income. What’s more, that one year threshold is also the point at which a business can begin claiming depreciation deductions.
Part of your role is to encourage forward-thinking and how to set yourselves up for a lower tax bill, not just this year, but for the years to come. When purchasing a new investment property, your client may understandably be more focused on negotiating the deal and getting that property to generate income. By outlining the benefits of aiming for that 20% (or below) tax rate, you can set your client up for success.
Who Can Deduct Depreciation?
Depreciation deductions offset the increased taxes that would normally come from an income-producing property. Since that property will lose value over time, taxpayers are allowed to deduct part of the cost of that asset each year. Is this option available to all property owners? Not necessarily. To claim a deduction, taxpayers must:
● Own the property. This does not mean they need to have paid off their debt entirely, but it does mean they need to be legally responsible to pay for and maintain the property.
● Use the property in a business or income-producing activity. If the property has a personal use, the taxpayer cannot depreciate the entire value of the property, but they may be eligible for a partial depreciation deduction. For instance, if the taxpayer runs a daycare business from their home, they would need to follow IRS guidelines to determine what percentage of the space they can claim a deduction on.
● Have placed the property “in service” at least a year ago. To put a property in service is to begin using it for business or to produce income, so the moment this takes place, that countdown clock begins. Once a year has passed, the taxpayer can begin the process of claiming depreciation.
If the property meets these criteria, you can factor depreciation into your client’s tax plan.
Plan Ahead for Recapture
The one pothole to avoid on the road to depreciation deductions is the possibility of recapture. Keep in mind that the point of depreciation is to account for a property’s loss in value over time. What happens if the property gains value instead? When a taxpayer sells a property and turns a profit, the IRS will recalculate how much depreciation the owners were actually entitled to. This typically means the taxpayer will owe money to make up for deductions already claimed—also known as recapture.
If the IRS determines that your client owes “unrecaptured” gain, this will either be taxed at their ordinary income tax rate or a special tax rate of 25%. The outcome depends on 1) what year the property was placed in service and 2) how much depreciation that property has undergone at the time of the sale. The amount owed can be complicated to calculate (and this may be where tax planning software comes in handy), but the key here is to be prepared and make sure you and your client are not caught unawares by recapture. If your client is planning to sell a property, look into the tax consequences in advance and make sure they are comfortable taking the hit before they finalize the sale.
Summary
As tax planners, investors can be some of our best clients. They are coming to us to make sense of the especially complicated tax world they find themselves in. Owning an income-producing property sounded like a good idea—until a higher-than-expected tax bill appears! This is where you can leverage your expertise to suggest deductions and other tax savings strategies that help your clients take home more of their earnings and pay less to the IRS. Just being aware of the criteria for depreciation deductions and the possibility of recapture can go a long way in helping your taxpayers make smarter financial decisions.
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Don’t miss the rest of our 4 part Real Estate Investment series!
