Publications

- March 1, 2019: Vol. 6, Number 3

Tax alert for FAs and RIAs: Revisions to the IRS code offers five significant benefits to CRE investors

by Adam Hooper

The advantages of commercial real estate investments over other types of investments are undisputed, particularly in the current economic environment: higher yields, relatively lower risk and the opportunity to diversify within the field. In fact, so many investors have discovered the upside of CRE investment that in the past couple of decades it has moved from a fringe or alternative category to a legitimate category in the investment world.

Aside from the positives mentioned above, there are also myriad tax advantages to CRE investment of which many RIAs and FAs may not be aware. While some of these benefits are newer and stem from the federal legislation known as the Tax Cuts & Jobs Act of 2017, others have been around longer.

Here, the top five tax benefits of CRE investment that RIAs and FAs should know about:

Opportunity zones: Since the passing of the tax and jobs act at the end of 2017, opportunity zones have become all the rage in CRE circles. A once-in-a-generation tax incentive that has been fairly accurately described as a 1031 on steroids, this new provision affords tax breaks to those who invest in the development of commercial real estate projects in areas of the country the government has designated as opportunity zones — economically distressed, low-income areas. The benefits of opportunity zone investments include the ability to defer capital gains taxes until end of year 2026, a possible 15 percent step-up in basis of the taxable gain, and a tax exclusion on the appreciation of investments made into opportunity zone funds. While the benefits of opportunity zone development are significant enough to entice investors and developers to those areas, the rules for achieving those benefits are strict and have required clarification from federal agencies, some of which was recently provided; however, at this writing, we are still waiting on U.S. Department of Treasury and IRS for final regulations and guidance on some of the finer points of the new provision.

Depreciation: One of the tried-and-true benefits of real estate investing is using the accelerated depreciation afforded to real estate owners. This allows you to reduce dramatically both your tax basis in the real estate as well as your taxable income. Some types of commercial real estate investments can realize the benefits of depreciation more than others. For example, if you contrast and compare direct investments and REITs, you get accelerated depreciation when you invest directly (as in a real estate investment), but not with a REIT; therefore, if you invest directly in commercial real estate, you can use losses from the real estate to offset other income.

1031 exchange: With some leg work, a 1031 exchange can be a powerful tool for deferring capital gains. A 1031 exchange allows for the deferral of capital-gains taxes so long as the gains are used to purchase “like kind” property. The key for investors is to continue to stay on top of both the timing and structure requirements as they execute on each exchange. Because of this, RIAs and FAs must follow current tax laws and understand how they apply to 1031 exchanges for real estate. Would a particular asset be eligible for a 1031 exchange or not? What are the available strategies upon sale if a gain is recognized? Also, some real estate assets are harder to exchange out of, so they might not make sense for all investors.

Qualified business income deduction: Along with opportunity zones, the qualified business income deduction was a major tax benefit to the passing of the tax and jobs act. This deduction states that passive members of an LLC that own an investment property are entitled to a 20 percent tax deduction on income for some investments — and in most cases, commercial real estate qualifies. The National Association of Realtors recently reported that the IRS has issued final rules on which commercial real estate investments qualify for the 20 percent business-income tax deduction. Earlier, the ruling stated that if an investor’s income was more than $157,500 for single filers or $315,000, for joint filers and the investor had exchanged one property for another to defer taxes under section 1031 of the tax code, the amount of the new deduction might be reduced because of the swap. After the association of realtors and other trade groups reached out to the IRS to change this treatment, the IRS made that change. Now, under the final rules, investors can use the unadjusted basis of the depreciable portion of the property to claim at least a partial deduction. In addition, the association of realtors reports, two other provisions were changed by the new rules: the eligibility of rental income for the deduction and how the deduction applies to 1031 exchanges. Now, rental-property income can also qualify for the new deduction, as long as the investor shows that the rental operation is part of a trade or business. The IRS has released proposed guidelines that include a test for determining if a rental-income situation rises to the level of a trade or business. If the scenario qualifies under that test, investors can claim the deduction as long as their rental activities (e.g., maintaining and repairing property, collecting rent, paying expenses, and conducting other typical landlord activities) total at least 250 hours a year. If the activity totals less than that, investors can still try to take the deduction, but they need to show the IRS that the activity is part of a trade or business.

A friendlier tax climate: The environment for investing in commercial real estate has definitely become more tax-friendly in recent months. The biggest impact the tax and jobs act has had for CRE investors from a tax perspective is that it has given the economy a boost in terms of employment and available capital. Real estate growth is tied to job growth and employment statistics. In a sense, the tax environment has generated a positive environment for employment, and real estate is a direct beneficiary of that.

 

Adam Hooper is co-founder and CEO of RealCrowd.

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