Real estate can be a great investment; when executed tactfully investors can expect to see great returns. One of the principal advantages of investing is the plethora of options available to optimize an investor’s tax situation. From tax-advantaged retirement accounts to low, long-term capital gains rates, the government wants to give citizens these tax concessions to incentivize them to invest their capital back into the economy through real estate. If considering investing in real estate, investors should consider these four tax implications that could make or break an investment strategy.
Double-Taxation vs. Pass-Through Taxation
The first tax implication to consider is “double taxation” versus “pass-through taxation” (also referred to as flow-through taxation). The Internal Revenue Code (“IRC”) classifies most businesses into one of two broad categories: Businesses whose investors are taxed twice on their income under subchapter C of the IRC, and those that avoid double taxation as pass-through entities. The term “double taxation” refers to the multiple layers of tax imposed by subchapter C of the IRC. Under subchapter C, generally, all income earned by the business and distributed to investors is taxed twice: first, the business pays an entity-level tax when it earns income in the form of a federal and state income tax, and second, the owners pay an income tax when profits are distributed to the owners individually. Businesses that are not taxed under subchapter C are called pass-through or flow-through entities. Under this structure, the business does not pay an entity-level tax on its income. Instead, all income of the business is “passed through” to the owners directly, who report the income on their personal income tax return and pay taxes at their effective marginal rate. Because the business does not pay an entity-level tax, pass-through entities avoid double taxation. Similarly, if the entity is operating at a loss, the individual owners may be able to deduct their respective share of the loss on their own income taxes. Considering double or pass-through taxation in certain investments may make certain opportunities more or less attractive. Pass-through structures are a common first choice for individual and small investor groups as they commonly allow for a lower overall tax on profit and allow for operating losses to be passed on to the income tax of the investor. Real estate often involves larger investments in new property, renovations, and improvements; these initial capital outlays can result in an initial or temporary net operating loss which can be deducted from the investor’s individual income tax as an offset against other income for the year or carried forward in a pass-through structure. However, too much loss passed on to the investor can impact the investor’s own concerns including existing and new financing opportunities, which is where double taxation structures, designed to separate the investors from those risks, shine. Structures with double taxation create a degree of separation from the investment’s losses while still allowing for monetary distribution. Generally, the entity either earns revenue and is then taxed on that revenue or operates at a loss and need not pay income tax as a result. Investors can share in net revenue through shareholder distributions such as a monetary dividend. Such a distribution is then subject to the investor’s own income tax return, hence a second, or double, tax. These double-taxation entities also open up other doors for raising capital with a greater number of investors and typically attract larger lenders who are enticed by the independence of the entity. The less an entity relies on one or two key individuals to survive (more common in a pass-through entity) the more likely it is to survive over time. Thus, real estate investors whose tax strategies could benefit from flow-through operating losses may benefit from a pass-through entity structure while those investors who are seeking capital investments on larger projects with discerning lenders or more than a handful of investors often prefer entities that result in double-taxation.
Next, depreciation is a very important tax implication to consider when purchasing real estate as an investment. Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property. Commercial buildings include industrial, warehouses, manufacturing, offices, shopping centers, supermarkets, retail, restaurants, hotels, motels, casinos, entertainment, auto dealerships, self-storage, hospitality, hospitals, etc. Apartments and rental homes are considered a residential property that qualifies for a shorter building depreciation life than commercial buildings. Commercial and residential building assets can be depreciated either over 39-year straight-line for commercial property, or a 27.5-year straight line for residential property as dictated by the current U.S. Tax Code. Depreciation is an extremely helpful tool for reducing income tax over the life of a real estate investment and, the length of the depreciation term may play a pivotal role when considering whether to invest in commercial or residential real estate.
Third, real estate investors often consider a “1031 exchange.” A 1031 exchange is a real estate transaction in which a taxpayer sells real estate held for investment or for use in a trade or business and uses the funds to acquire replacement property. A 1031 exchange is governed by Code Section 1031 as well as various Internal Revenue Service (“IRS”) Regulations and Rulings. Section 1031 provides that “[n]o gain or loss shall be recognized if property held for use in a trade or business or for investment is exchanged solely for property of like-kind.” This indicates that both the relinquished property you sell and the replacement property you buy must meet certain requirements. Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. Under section 1031, any proceeds received from the sale of a property remain taxable. For that reason, proceeds from the sale must be transferred to a qualified intermediary, rather than the seller of the property, and the qualified intermediary transfers them to the seller of the replacement property or properties. A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property, essentially like a broker. The qualified intermediary can have no other formal relationship with the parties exchanging property. This type of exchange can be an effective method of altering a real estate investment strategy by, for example, exchanging a gas station in one area of the city for one in another area the investor anticipates to have a higher performance over time. However, this is a complex transaction subject to strict regulations and penalties for non-compliance. It requires the contracting of an intermediary (in addition to other professionals such as licensed real estate brokers) to facilitate the transaction which can become costly.
Finally, the IRS permits individuals to use certain retirement accounts, such as an IRA or 401(k) plan, to invest in real estate. A challenging aspect of investing in real estate using retirement funds can be navigating the IRS prohibited transaction rules. In general, pursuant to Internal Revenue Code (“IRC”) Section 4975, the retirement account holder cannot make a retirement account investment that will directly or indirectly benefit one’s self or any disqualified person (lineal descendant of the retirement account holder and related entities), perform any service in connection with the retirement account investment, guarantee any retirement account loan, extend any credit to or from the retirement account, or enter into any transaction with the retirement account that would present a conflict of interest. The purpose of these rules is to encourage the use of retirement account for the accumulation of retirement savings and to prohibit those in control of the retirement account from taking advantage of the tax benefits for their personal account.
Real estate has many advantages and disadvantages. Many individuals and businesses take opportunities presented to them with a property without a strategy to see benefits in the short and long term. Consulting with an attorney, along with other important professionals, to inquire about how the tax implications mentioned above and how they could affect your real estate finding, analyzing, purchasing, financing, managing, and selling of properties. Real estate investment properties can provide significant tax benefits to the owner if properly organized and managed.
 Treas. Reg. § 301.77-1-2(b)(1).  Id.  I.R.C. § 1366(a)(1).  Treas. Reg. § 1.1366-1(a). U.S. Department of the Treasury. Internal Revenue Service. Publication 946 (2019), How To Depreciate Property. Retrieved from https://www.irs.gov/publications/p946 pdf (2019).  Id.  Id.  U.S. Department of the Treasury. Internal Revenue Service. Publication 544 (2019), Sales and Other Dispositions of Assets. (2019) (retrieved from https://www.irs.gov/publications/p544).  Id.   U.S. Department of the Treasury. Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips. Retrieved from https://www.irs.gov/newsroom/like-kind-exchanges-under-irc-code-section-1031 (2019).  Id.  Id.  Treas. Reg. §1.1031(k)-1(g)(4)  Id. Id.  26 U.S. Code § 4975.