Despite the positive outlook for sustainable real estate investments, the market is uncertain. Real estate is traditionally a hedge against inflation and provides steady income even during a recession. However, owners, developers, and investors are still feeling the pressure of rising costs, flat or lower revenue, and regulatory compliance. Especially in an uncertain environment, tax planning is key. Thankfully, real estate companies have several tax strategies that can help create or preserve cash flow. To help clients, prospects, and others, Smith Schafer has provided a summary of the key considerations below.
Also called like-kind exchanges, 1031 exchanges allow real estate investors and owners to delay paying the capital gains tax on a property if it is swapped for a similar one. The timing can be tough.
Once Property A is sold, the owner or investor holds the sale proceeds with a qualified intermediary. Then, the taxpayer has 45 days to identify up to three replacement properties and 180 days from Property A’s sale to complete the transaction with the replacement Property B.
There are different types of 1031 exchanges, too.
- Delayed: traditional like-kind exchange described above.
- Build-to-suit uses the proceeds from the sale of Property A to fund improvements on Property B.
- Reverse: Property B is purchased first and the full transaction is still completed within 180 days.
- Tenancy-in-common: a group of pooled investors purchases a property; when Property A is sold, each investor performs an exchange on their interests.
These exchanges are a popular choice in the real estate tax planning toolbox and for good reason. The top capital gains tax rate for real property held longer than a year is 20 percent; property held less than a year would be taxed at the ordinary rate, which tops off at 37 percent.
Cost Segregation Study
New construction, as well as renovation and expansion projects, may benefit from a cost segregation study. As its name suggests, these tax-advantaged studies separate assets into depreciable and personal property. Structural property has a much longer lifespan – 27.5 years for residential rental property and 39 years for commercial property. Since the tax benefit is spread out longer, there’s a less immediate benefit. Personal property, on the other hand, has a much shorter lifespan. Once a cost segregation study segments these assets, the taxpayer benefits from accelerated depreciation.
For example, assets like furniture, lighting fixtures, flooring, carpeting, cabinets, and fencing have much shorter recovery periods.
To qualify for a cost segregation study, a building must be owned or leased by the taxpayer, used in an income-producing capacity, and the asset(s) must have a determinable useful life of at least one year. Land, inventory, and other property disposed of in the same year it was placed in service, intangible property, and term interests are ineligible.
Even if a building isn’t new, a cost segregation study can still be valuable.
Bonus depreciation, or the ability to take a full deduction of an asset in its first year, decreases for tax years after 2022. Since it became effective in 2018, 100 percent bonus depreciation has allowed real estate owners and developers to make capital purchases and write the full depreciable cost off in the first year.
Up until December 31, 2022, property placed in service is still eligible for 100 percent bonus depreciation. Starting in 2023, it will decrease to 80 percent and will continue to diminish by 20 percent each year until it phases out at the end of 2026.
Charitable Land Contributions
If done right, charitable land contributions can result in a tax-favorable transaction for the greater good.
To be eligible, the property, which can be a residential home, rental property, or undeveloped land, must have been held for at least one year. It should be debt-free and transferred irrevocably and without a benefit to the taxpayer. For example, if a developer were to donate land to a state agency but then receives a permit to build there, the charitable donation would be disallowed.
Conservation easements, which are large donations of property or land, historic or otherwise, occur when a private owner gives up land or building rights to preserve it for future generations.
Be aware that the IRS closely scrutinizes these transactions. If the taxpayer is found to have derived any benefit from the donation, it will be disallowed partially or fully. Often, legitimate easements also have restrictions on property modifications and zoning.
Other Tax Incentives
Aside from these larger tax strategies, there are other tax incentives that can make a difference for Minnesota real estate owners, developers, and investors.
For example, the cost of advertising, subscriptions, memberships, and expenses related to looking for new property are deductible.
Another option for underperforming rental properties is to write off passive losses against income. There’s a cap of $250,000 in losses for single taxpayers or $500,000 for married filing jointly until 2025. Suspended passive losses aren’t deducted immediately; instead, they can be carried forward indefinitely until there’s passive income to deduct again or the owner sells or transfers the property.
There are other rules and considerations suspended passive loss deductions, so taxpayers will need to talk with their advisor about the best approach.
Other operating expenses, like owner-paid utilities and property management and maintenance fees, can be deducted.
Real Estate Tax Strategies in the Inflation Reduction Act
Tax incentives can sometimes be the difference between a profitable project and one that doesn’t get off the ground. Going green has its perks, as the saying goes.
The recently passed Inflation Reduction Act (IRA) will have a significant impact on commercial real estate and construction tax planning. Several new and extended tax credits will give investors and developers opportunities to recoup their costs and incorporate sustainability into the strategic plan.
Section 179D, the energy efficiency tax deduction for commercial buildings, has been revamped. Though its base amount has decreased, there are substantially more bonus opportunities for the most energy-efficient projects and those that use prevailing wage and apprenticeships. Plus, REITs can qualify for Section 179D now, too.
Owners and developers of multi-family residential units can use a 30 percent residential clean energy credit to install onsite clean energy storage and production units, like solar electric, solar water heating, small wind energy, geothermal heat pumps, battery storage, and more.
The Section 45L tax credit has been retroactively extended and expanded for residential real estate developers. Tax credits of up to $2,500 or $5,000 per unit are available for homes that meet Energy Star and DOE Zero Energy Ready standards, respectively. This credit is also now available to all multi-family properties – even those more than three stories tall unlike the previous version – that meet prevailing wage requirements.
There are several tax-saving opportunities available to real estate companies depending on eligibility. The available federal incentives and credits can open the door to significant tax reductions. If you have questions about the information outlined above or need assistance on a tax or accounting issue, Smith Schafer can help.