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The Top 3 Tax Loopholes For Real Estate Investors 

The Top 3 Tax Loopholes For Real Estate Investors 
Ines Zemelman, EA
01 August 2022

People invest in real estate to either build wealth. Real estate investment can become complex when you need to figure out your taxes. If you already have or are planning to invest your money in a property you need to be aware of the ways to minimize your tax liability. In this article, you will learn about the top 3 tax loopholes for real estate investors that you can use to lower your tax bill. 

1. Starker Loophole: Section 1031 Exchanges

Normally when you sell a property for more than what you have purchased it for you will have a capital gain and that gain is taxable depending on how long you have held that property. Section 1031 exchanges provide an exception where you are allowed to defer your capital gain tax if you reinvest the proceeds in the like-kind property. 

Note that Section 1031 allows you to defer tax it does not make the gain tax-free. At some point in the future when the gain is realized you will have to pay it. The Section 1031 exchanges can take place in one of the three ways mentioned below.

  • Simultaneous Swap: Where one property is swapped for another. Generally in this type of swap, no gain is realized so the tax is deferred. 
  • Deferred Exchange: Where you dispose of property and acquire like-kind replacement property after a while. Care must be taken not to consider selling one property and buying another as a deferred exchange. This is a taxable transaction. According to the Internal Revenue Service Fact Sheet;
  • In a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property.

To execute deferred exchange you might have to use an exchange facilitator. 

  • Reverse Exchange: Where the process is reversed. In this exchange, the investors buy the new property first & within 45 days they have to identify potential replacement properties in writing. And the sale of the property should be completed no later than 6 months. 

During this period an exchange accommodation title holder will hold the title of the replacement property under the qualified exchange accommodation arrangement.   

Now let’s see what does the exchange looks like. It can either be:

  • An Exclusively like-kind property 
  • A Like-Kind property along with liabilities, cash, and property that are not like-kind: This scenario can trigger some taxable gains in the year the exchange takes place. This means you might have realized & deferred gain in the same transaction. This happens when the exchanged property is of lesser value.

Who Qualifies For 1031 Exchange Deferral?

  • Owners of investment and business property 
  • Individuals 
  • C corporations, 
  • S corporations, 
  • Partnerships (general or limited), 
  • Limited liability companies, 
  • Trusts 
  • Any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties

Which Property Qualify For A Like-Kind Exchange?

The property you are selling and the one you are buying:

  • Must be held for use in a trade or business or for investment. It is worth noting that the primary residence or vacation home or second home is not included in a like-kind exchange. This means when you sell them & have gain that will be taxable.
  • Must have enough similarity to be classified as “like-kind” For e.g. real property that is improved with a residential rental house is like-kind to vacant land. However, the property located in the US is not like-kind to the property situated outside of the US.  There are different rules for foreign investors who invest in US real estate

2. Stepped-Up Basis Loophole- Inherited Property 

The stepped-up basis is one of the tax loopholes for realtors. Those who own real estate often consider whether to give their property to their heirs while they are alive or after they die. This is an important consideration as it is going to have tax consequences. 

If one decides to give away their property after they die then their loved ones get the benefit of a stepped-up basis permitted for inherited properties. It is a tax code that allows them to raise the cost basis to its market value at the decedent’s death. This means if the inheritors decide to sell the property there would be no taxable gain.

This is applicable to both principal residence and rental properties. 

Principal residence

Let’s say Mr. Sims bought a house 20 years ago for $300,000 and its market value now is $1 million. Mr. Sims gave his principal residence to his son John while he is still alive. Now if John sells it then he would have a taxable gain of $700,000. This taxable gain would become tax-free 

if John inherits the property after his father’s death as he can step up his cost basis to $1 million. 

Rental property

Now let’s assume that Mr. Sims had a rental property worth $3 million dollars, which he bought for $1.5 million. There are more complexities involved in rental real estate income tax as compared to conventional income tax. You either pay tax on rental income or the capital gain results from its sales. 

In this case, when John inherits the property after his father’s death the cost basis for John would be $3 million dollars & if he sells the house his gains will not be taxable. 

Additionally, since it is a rental property therefore Mr. Sims was eligible to claim a depreciation deduction which he did during the time he held the property. 

Now after the application of a stepped-up basis John can also write off the depreciation expense. This means the depreciation is claimed twice while the property remained in the family.

3. Non-Cash Deception Loophole- Depreciation Deduction

One of the tax loopholes for real estate investors is depreciation. It is a non-cash expense that the Internal Revenue Service allows you to use as tax deductions to reduce your tax bills. 

This means the cost of your revenue-generating asset which is giving you a positive cash flow will be recovered over time using this non-cash depreciation deception loophole. 

Modified Accelerated Cost Recovery System (MACRS) is the most widely used depreciation method for real estate. In this method, you depreciate the residential rental property over 27.5 years & appliances & other fixtures over 15 years. 

There are other real estate tax loopholes such as selling your primary residence will give you tax-free gains of 250,000 if you are single & $500,000 if you are married & file jointly. If there is an excess gain you can re-invest it in the like-kind property& use section 1031 to defer taxes. 

There are many more real estate developer tax loopholes. A real estate professional can advise you best about the tax loopholes for real estate investors. So do seek their help. 

Ines Zemelman, EA
Founder of TFX