At the end of the year, a couple of tax provisions are expiring that have been a great benefit to those who own real estate. First, the 15 percent capital gains tax rate will return to where it was before 2003, to 20 percent. The historically low capital gains tax rate allowed many to sell their properties with a significantly reduced tax obligation. Second, bonus depreciation has made it possible for property owners to write off as much as 100 percent of the cost of machinery, equipment, vehicles, furniture and other qualifying property. This method of depreciation allows the business owner to record lower incomes, and therefore pay less in taxes.
While these tax features will come to an end, Terry Coyne, SIOR, CCIM, an executive vice president with Newmark Grubb Knight Frank, formerly Grubb & Ellis, says there are still solutions that will allow property owners to defer expenses.
Smart Business spoke with Coyne about the changes and what to do if you can’t take advantage of them before they expire.
What real estate tax strategies should business owners take advantage of in the short term?
The capital gains tax rate is scheduled to go up on Jan. 1 from the current, historically low rate of 15 percent to 20 percent because the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act that extended the Bush-era tax cuts until the end of this year will expire. In addition, the Patient Protection and Affordable Care Act, in 2013, will impose a new 3.8 percent tax on certain investment income for households that make more than $200,000 for singles and $250,000 for married couples, which includes real estate transactions. So the net effect of these two tax increases could result in a 23.8 percent tax rate for high earners.
When capital gains rates are raised, those still wanting to unload an investment property should consider a 1031 like-kind exchange. These real estate transactions have actually become less popular in the past couple of years because the capital gains rate has been so low, and building owners are trying to sell by year-end to take advantage of the rates.
This tax-deferred exchange involves selling one qualified property for another within a specific time frame. For example, you can sell a property and take up to 45 days to identify three qualified properties for the exchange. You’ll then have 180 days to close. To do a 1031 exchange, you need to work through a qualified entity, so make sure you’re dealing with someone reputable because if they’re wrong and it blows up, you’ll be stuck with the tax.
Next year, many owners will go from paying the capital gains rate to transacting through a 1031 exchange to avoid paying the taxes on those sales altogether. So, if you can, try to close your transactions this year, and if not, expect to pay more next year if you don’t use a 1031 exchange.
What real estate tax strategies exist for those who own and occupy their building?
For those who own their buildings, the biggest impact could be the potential change to bonus depreciation, which has been around for the past couple of years and was extended by the American Recovery and Re-Investment Act.
Typically, in real estate, you spend money and capitalize it. So, if you put a new roof on your building, you look at the cost of the roof and how long it takes to depreciate it, let’s say over the course of 20 years. Recently, bonus depreciation has allowed you to expense as much as 100 percent of an investment in qualified business properties. The bonus depreciation will likely go away, though it’s not clear when. Going back to standard methods of depreciation is a big deal because it ends a program that provided an immediate tax benefit. Bonus depreciation has had a positive impact on the real estate industry because builders will spend more on improvements or spend on speculation because they’re trading dollars — rather than paying taxes, you’re spending that money on real estate.
You’re well advised to pay close attention to depreciation. The question remains whether it will go back to normal right away or if it will be phased out. If it is phased out, take advantage of it soon because it will never be 100 percent again. Bonus depreciation absolutely creates jobs in the short term because it encourages people to spend money.
What if I miss out on bonus depreciation? Are there other strategies a business owner can use to defer expenses?
It’s a good idea to cost segregate your building, using the expertise of a professional such as an accountant and an engineer, so you can depreciate the components of your property over the life of each component’s expected use and not over 39.5 years, which is a typical depreciation cycle for a building. More sophisticated business owners are segregating their costs and depreciating everything they can because it gives great tax benefits for those who are unable to do bonus depreciation.
The Internal Revenue Service allows you to depreciate a building, not the land, over 39.5 years, so that every year you get a benefit on your taxes, which is a noncash loss. But the code also allows you to cost segregate all of your different costs. For example, the roof is segregated from the parking lot, which is segregated from the HVAC, etc., on a schedule that outlines the ‘life,’ or schedule of depreciation, of the different components of your building. It’s a way to reduce your current income tax obligations.
Terry Coyne, SIOR, CCIM, is an executive vice president with Newmark Grubb Knight Frank, formerly Grubb & Ellis. Reach him at (216) 453-3001 or firstname.lastname@example.org.