Every year, taxpayers find themselves facing tax challenges such as:
Suspended Passive Activity Losses: When passive activity losses are not tax deductible, and carried forward year after year, valuable tax deductions are missed.
Capital Gains and Depreciation Recapture: A tax obligation as high as 42% can exist when selling business or investment real estate – often creating an unwelcome financial result.
These tax burdens can be converted to tax advantages with the following strategies:
Important Tax Strategies
Passive Real Estate Ownership: For tax purposes, passive income can be off-set by suspended passive losses to produce fully non-taxable current income.
IRS Section 1031 – Property Exchanges: Individuals selling eligible real estate can defer up to 100% of federal and state taxes otherwise due at sale by engaging in a 1031 property exchange.
Passive Income & Passive Losses Overview
The Tax Reform Act of 1986 created new categories of income and loss – passive income and loss. The Act mandated that passive losses can only be used to offset passive income. Passive income and losses are generated by a business or entity that the taxpayer owns or invests in, but does not actively manage. In general, ownership of commercial real estate without management responsibility is considered passive activity.
During tax season, many taxpayers realize passive losses that cannot be utilized against their active or portfolio income, and who have no source of passive income. IRS Form 8582 is used to reflect carry-forward passive activity losses.
Income generated by AEI Funds and DSTs is categorized as passive income and may be offset by passive losses from other investments.
A taxpayer’s passive income can be off-set by passive losses dollar-for-dollar to produce non-taxable income. There is no limitation on the amount of passive income that can be off-set by passive losses.
Source: www.irs.gov | Topic 425 – Passive Activities – Losses and Credits
Section 1031 of the IRS Code allows an owner of eligible property to complete a tax-deferred exchange by purchasing “like-kind” replacement property with the property sales proceeds. Such a transaction potentially allows deferral of up to 100% of the capital gains taxes otherwise due on the property sale. The IRS defines “like-kind” as any property owned for business or investment purposes. This includes raw land, farmland, residential rental and commercial properties. IRS Section 1031 does not apply to the exchange of stocks or bonds.
REAL ESTATE TAXES
Gains created by the sale of property are typically taxable at both federal and state levels. The following taxes may be deferred through a 1031 exchange:
- Federal capital gains – Up to 20%
- State taxes – As high as 13%, in some states
- Depreciation recapture – 25% of utilized depreciation
- Net income tax – 3.8%
This tax information is generalized, subject to change, and not intended as tax advice. Please consult with your tax advisor before beginning any 1031 property exchange transaction.
Benefits of a LIke-kind Property Exchange
- Deferred capital gains tax
- Deferred depreciation recapture
- Wealth preservation
- Potentially greater net income
- Estate planning benefits
Completing a 1031 exchange
1
Engage a Qualified Intermediary to facilitate your property sale.
2
Sell your existing property. Cash proceeds are escrowed by your Qualified Intermediary.
3
Within 45 days after the sale of your original property, identify one or more replacement properties.
4
Within 180 days after the sale of your original property, purchase a replacement property, through your Qualified Intermediary, to complete your 1031 exchange.
Benefits of a 1031 exchange
A Delaware Statutory Trust (DST) allows a property seller to purchase a fractional interest in multi-property portfolios. The DST owns title to the properties for the multiple owners of the DST. For tax purposes, each DST investor is treated as owning an undivided fractional interest of the DST properties. IRS Revenue Ruling 2004-86 provides guidance on the use of a DST for property ownership.