Investing in real estate requires careful planning well before the transaction, cautions Douglas G. Schultz of Burr Pilger Mayer. “It is important to step back and look at the big picture. What do you want out of the investment?”
If certain aspects of accounting and tax planning aren’t addressed, they could become huge negatives: higher tax bills, less liability protection than you might have had, and higher estate taxes. “A little creativity can go a long way to minimize taxes and maximize value,” he says.
Smart Business asked Schultz about preparing for your biggest purchase.
What should be addressed before any real estate investment purchase?
It’s important, from a tax and liability protection perspective, to use the proper entity to hold your investment. Thorough consideration of your objectives will determine whether an LLC, limited partnership, or other flow-through entity should be selected.
Much has been written about subprime mortgages we an expect lenders to revert to more traditional underwriting guidelines in 2008, but that shouldn’t prevent qualified investors and developers from moving forward.
Still, you must understand what the property’s cash flow requirements are and what they may entail. That could mean escalating interest rates, increases in operating costs, inflation, or an unexpected event that might disrupt the liability of that space you must have reserves available.
To that end, financing alternatives must be reviewed to make sure any guarantees, equity sharing, and/or collateralization are reasonable and will be sustainable throughout the property’s holding period. Sale lease-backs, interest enhancement mortgages, and seller financing are alternative financing techniques to consider. Loans also present special reporting issues. The calculation of various ratios or investment returns is required for compliance or covenants.
Properly characterize your investment as a passive activity or an active business. Real estate losses by definition are generally considered passive, and the deduction of these losses is limited to passive income unless the owner is a real estate professional. By meeting certain requirements relating to percentage of time and number of hours spent in real estate activities, an individual may be able to convert passive activity losses to non-passive losses, which can offset income such as wages, dividends, and capital gains.
What needs to be considered when disposing of real estate?
Investors need an exit strategy. Do they plan to sell it after it has appreciated significantly, or exchange it for another property? If so, what kind of property makes sense: a tenancy-in-common investment interest, a single tenant triple net lease property, or a similar but more valuable property? If you sell, will you qualify for long-term capital gain rates, or will you be subject to ordinary income tax rates?
If you sell your property and replace it with a new one, a like-kind exchange can reduce taxes. For example, non-income-producing land can be exchanged for triple net leased property for improved cash flow. High-equity property can be exchanged for highly leveraged property for an increase in rate of return.
Any real estate investment must be considered in terms of your overall financial and estate plan. All options family limited partnerships, charitable trusts, and intentionally defective irrevocable trusts (IDIT) need to be weighed. Including these tools in an estate plan can achieve a reduction in estate tax, an increase in wealth transferred to your beneficiaries, and perhaps a significant contribution to charity.
What are some tax strategies?
In real estate, you want to acquire property that will appreciate substantially and can be held and liquidated with maximum cash flow and minimal taxes. Here are two ways to accomplish this: 1) Accelerate depreciation. When a client purchases a property such as a commercial office building, we often recommend a technique called cost segregation. Cost segregation studies provide immediate cash flow savings by accelerating deductions for depreciation, in turn reducing taxes. Certain components of the building that are personal, short-lived assets are segregated from the building’s structural components, typically depreciated over 39 years. Short-lived assets might include carpets, window treatments, cabinets, partitions, and landscaping. This opportunity can be applied to buildings acquired up to 15 years ago and provides immediate tax savings. 2) Take advantage of capital gain rates. Normally, an individual who subdivides land or develops land as condominiums and then sells the land would be taxed at high ordinary income tax rates. Long-term capital gain rates apply to a sale of a property that is a capital asset held more than one year. Inventory is not a capital asset. Investors can qualify for long-term capital gains, but developers cannot. Case law and the tax code can allow a gain, under certain circumstances, to be taxed at lower long-term capital gain rates on the property's appreciated value, even where some development has occurred.
Whatever course is selected, the big picture has to encompass you, your vision and goals, as well as those of your family and their future. <<
DOUGLAS G. SCHULTZ is a tax partner and head of the real estate industry group at Burr Pilger Mayer. Reach him at (415) 421-5757 or firstname.lastname@example.org.