By Meghan Hall
Taxes can be tricky for anyone to navigate and particularly stressful when saved for the last minute. And, with recent changes to the tax code, the process can seem all the more daunting as investors and property owners sort out the year’s finances. Many real estate investors lacked a cohesive tax strategy, a trend that Heath Silverman, CEO and co-founder of Stessa, an asset management tool, and Brandon Hall, CEO of The Real Estate CPA continued to notice amongst their clients. Together, the two created a Rental Property Tax Guide in an effort to give rental property owners strategies and additional tools to prepare for and understand 2018 tax filings.
“We’ve been doing Stessa now for a few years, and I can tell you in that time I’ve spoken to hundreds of investors who all say they manage their properties using Excel spreadsheets and receipts,” said Silverman. “They don’t look at their bottom line unless maybe once a year, at tax time, and it becomes one of the most painful times of year. We wanted to create the ultimate tax guide to show how investors should be educated to effectively manage the finances of your properties when it comes to tax time.”
The guide, said Silverman and Hall, can be particularly helpful to investors given several changes in legislation that went into effect over the course of the past year, including the Tax Cuts and Jobs Act and the implementation of Opportunity Funds throughout the United States.
“There’s a lot of legislative changes that everyone needs to be aware of, even if they aren’t going to prepare their own taxes — which, honestly, I hope people in commercial real estate don’t,” said Hall. “People need to be aware of changes in order to maximize deductions on commercial real estate, and if people don’t make certain elections, they could lose out on benefits.”
According to Silverman and Hall, there are several important changes that commercial real estate owners should be cognizant of moving forward, particularly as they pertain to capital improvements and depreciation — two of the main deductions that property owners can claim on their taxes.
In January of this year, the IRS released Section 199A, the final version of its pass-through rules for the Qualified Business Income Deduction. Colloquially known as the 20 percent “pass-through” deduction and originally introduced by The Tax Cuts & Jobs Act, the deduction allows certain business owners to deduct 20 percent of qualified business income if a property owner’s taxable income is below $157,500 if single or $315,000 if married. Those who earn more than $157,000 or $315,000, respectively, are phased out of the deduction.
However, as part of the rules, the IRS released a safe harbor that allows landlords and property owners to qualify rental property as a trade or business in order to qualify for the deduction. To qualify for the safe harbor, landlords must prove that more than 250 hours of rental services are performed for the enterprise, maintain separate books and records to reflect income and expenses for each real estate activity, and maintain contemporaneous records delineating the dates and descriptions of services performed for the business.
Hall was careful to note that the safe harbor, however, does not apply to buildings with triple net leases in which the tenant or lessee is responsible for the ongoing expenses of the property.
“This does not mean that landlords cannot necessarily qualify the property as a trade or business,” explained Hall. “It just becomes a little bit harder to do so. The whole purpose of qualifying property as a trade or business is to qualify for that 20 percent pass-through deduction. The safe harbor makes that easier.”
Hall and Silverman also stressed the importance of deprecation, which is one of the most important deductions for real estate investors because it can reduce taxable income but not cash flow. Because land is never depreciated, it is important to allocate as much of the property’s purchase price to building value as possible. Typically, between 20 to 30 percent of the property’s purchase price can be reclassified under shorter class lives of five, seven or 15-year rates of depreciation to increase near-term deductions. Cost segregation studies, which classify parts of a building as personal property or land improvements, can help landlords maximize their deductions.
“I definitely think that anybody who is buying commercial real estate should look at cost segregation studies, especially in markets like the Bay Area, where property is pretty expensive,” said Hall.
With The Tax Cuts and Jobs Act, however, five, seven and 15-year property is now eligible for 100 percent bonus depreciation, which means its entire cost can be written off within the first year of ownership.
“It definitely makes commercial real estate that much more attractive as a tax sheltering strategy and from an immediate investment perspective,” explained Hall of the change’s immediate impact. “Longer term, it is kind of a toss-up. It might cause people to hold assets for a little longer than their plans allow, because whenever they sell, they have to recapture some of the bonus depreciation. However, the gain is bigger at the end, due to the immediate write-off.”
There are several ways that landlords and property owners can defer or reduce their tax liabilities when they decide to sell property. The newest of these, and of great interest to multifamily investors, said Silverman, is opportunity funds.
“Many multifamily investors are not syndicating deals,” said Silverman. “Opportunity Funds are a pretty hot topic right now in the investor community, because it is an easier tool to roll your money over for taxes.”
“It’s probably one of the best tax shelters I’ve ever seen, but you have to have the capital gains for it,” added Hall.
Unlike 1031 exchanges, investors are only required to redeploy the capital gains tax from the sale of any capital asset as opposed to the entire sales proceeds. Investors can roll their capital gains into an Opportunity Fund and hold it for five years, reducing their original taxable capital gain tax liability by 10 percent; hold for seven years and that the original gain liability is reduced another five percent. After holding the investment for 10 years, the new capital gain from the Opportunity Fund itself becomes fully tax exempt.
However, after seven years, in 2026, all investors will have to pay taxes on their investments, meaning that the time to maximize investment is now.
“The beautiful thing about Opportunity Funds is that they are more flexible,” said Hall. “In 2026, that’s when everybody has to recognize capital gains. So, we tell clients that if they want to maximize on this, they need to invest by the end of 2019.”
