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Tax Advantages

Exchange Basics

Tax Advantages

  1. Information Advantage - Evaluating real estate investments is much easier than analyzing publicly traded companies based on their annual reports.
  2. Leverage - Real estate is easier to borrow against than stocks, bonds or other investments. The rates of interest on real estate are fixed for long periods, as are the payments generally lower.
  3. Inflation Hedge - During inflationary periods, rents generally go up. However, if the property is financed with long term fixed rate debt, debt payments remain stable. During periods of failing inflation, interest rates fall, allowing owners to refinance at lower rates, while rents remain relatively constant.
  4. Tax Deductions - In general, the costs to operate and maintain the real estate is tax deductible. Furthermore, if those deductions exceed the income generated by the real estate investment, those deductions may offset the investors' other taxable income. The passive activity rules are further discussed below.
  5. Interest deductions are not limited to the amount of income generated by the real estate investment. Furthermore, loans secured by rental real estate are generally offered at lower rates and for a longer term than non-real estate loans.
  6. Tax Deferral - Income earned by rental real estate is offset or sheltered by non-cash depreciation deductions over the useful life of the investment, typically 27.5 years or 39 years. Certain leasehold properties and land improvements can be depreciated over 15 years. Economically this raises the net effective Rate of Return for real estate investments.
  7. Depreciation. As discussed above, rental real estate qualifies for an allowance for wear and tear over the useful life of the asset. The net investment cost, reduced by the portion allocated to land, may be deducted on a straight line basis over 15, 27.5 or 39 years for the leasehold, residential or commercial real estate, respectively. This deduction is allowed to offset income up to the maximum income tax bracket and is recaptured at a 25% tax rate upon later sale, unless otherwise deferred. Income earned by rental real estate is offset or sheltered by non-cash depreciation deductions over the useful life of the investment, typically 27.5 years or 39 years. Certain leasehold properties and land improvements can be depreciated over 15 years.
  8. Tax Credits - Certain investments qualify for tax credits, which offset tax liability dollar for dollar, including the Rehabilitation Credit and the Low Income Housing Credit.
  9. Capital Gain Planning. Real estate transactions at capital gain rates result in significant tax savings because capital gains rates are much lower than ordinary income rates.
    1. Income Tax Rates. The ordinary income of an individual taxpayer is taxed at progressive rates of 10%, 15%, 25%, 28%, 33%, and 35%. Long-term gains for capital assets held for a year and a day are subject to a tax at 0%, 5% and 15% for taxpayers in the 10%, 15% and above 15% tax brackets, respectively. Short term capital gains are subject to tax at ordinary income rates. Collectibles are taxed at 28% and 25% rate for unrecaptured section 1250 gain. The maximum rate of tax that applies to both the ordinary income and the capital gain of a C corporation is 35%. Characterization of corporation's gain as capital gain may be important because a corporation may deduct capital losses only to the extent that the corporation has capital gains for the year. A corporation's net capital losses may be carried back three years and forward five years. An individual taxpayer generally may deduct capital losses to the extent of capital gains, plus up the $3,000, and may carry forward net capital losses in excess of $3,000 indefinitely.
    2. Capital gain and capital loss netting. Current capital losses offset capital gains from the same rate class, e.g. a 15% capital gain offsets a 15% capital loss dollar for dollar. However, a 15% capital loss partially offsets a 25% capital gain. However, a capital loss carry forward offsets the highest rate capital gains. So, for example, a $100,000 capital loss from a 15% class which is carried forward from last year to the current year can offset a $100,000 25% capital gain dollar for dollar.
    3. In the case of a LLC or partnership, where one of the owners wants to get out of the entity, the method that he or she chooses may radically affect his or her net cash in hand. First, if the partner sells his partnership interest, he will be taxed on his shares of hot assets, including depreciation recapture at the effective tax rate. If the partner or member is redeemed out of the partnership or LLC, he is taxed at 15% capital gain. Furthermore, the partnership may distribute out assets in kind, and the partner / member will not be taxed on the distribution, unless cash is distributed.
    4. Sale of an Option. An option is used to gain a commitment from the owner of a parcel of property that they agree to give the right to another individual (optionee) to purchase their property for a set period of time. Selling an option to purchase property at a gain, where the option was held for more than one year, will result in capital gain taxes. If the taxpayer exercises the option and sells the land before more than one year has passed since the taxpayer exercised the option, the taxpayer's gain on the sale of the land will be short-term capital gain, taxed at ordinary income rates.
  10. Dealer Status. Sales of subdivided parcels are taxable at ordinary income taxes up to 35% unless:
    1. The investor has not previously held real estate in the ordinary trade or business and in the year of sale, does not hold any other real estate in the ordinary course;
    2. No substantial improvements are made to the tract of land; and
    3. The investor has held the tract for at least 5 years, unless it was inherited or received by gift.
    4. Substantial improvements do not include water, sewage, drainage or road installation, if the property has been owned for 10 years and would not have been marketable otherwise.
    5. Conversely, Section 1237 does not apply to losses. Thus, if an investor sells lots at a loss, the loss may be treated as an ordinary loss even though all or a portion gain from the sale of the same lots would be treated as capital gain under section 1237.
  11. Discharge of Indebtedness. Income from the discharge of indebtedness is includible into taxable income, including the discharge of non-recourse debt unless:
    1. The debt is discharged in Chapter 11 bankruptcy;
    2. The investor is insolvent under state law;
    3. Discharge of farm indebtedness; and
    4. Discharge of qualified real property indebtedness. The discharge is limited to the smaller of the (i) excess of the debt over the fair market value of the property, or (ii) the adjusted tax basis of the property immediately prior to the discharge. The discharge must be elected on Form 982 attached to the tax return in the year of discharge.

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