If you owned investment property before 1986, you know how advantageous real estate once was as a tax shelter. The tax code has changed considerably, but there are still some unique tax features of real estate that when combined strategically over time, have the potential to produce significant financial benefits for both you and your heirs. Categorically, these advantages are depreciation, 1031 exchanges, and step-up in basis. These strategies help mitigate the tax consequences of leasing, trading and bequeathing real estate, respectively. Used together, they have the potential to offset much of your tax on rental income and all your tax on gains. 3 Pillars of Real Estate Wealth Preservation
Depreciation
The tax code allows you to deduct the notional depreciation of your real estate against your rental income every year. For most owners, the annual cap on this depreciation deduction is between 2.5% and 3.6% of the value of your improvements (i.e., the structures above the land). Once these deductions add up to the original value of the improvements, they stop—unless you have added more improvements (aka capital expenditures) to the property. Depreciation is the method whereby the IRS recognizes an asset’s wear and tear over the course of its “useful life,” which is an arbitrary time period found in IRS tax tables. When a business purchases an asset with a useful life of longer than one year, the IRS requires that asset to be depreciated over a set timeline (27.5 years for most rental housing). For many assets, this approach makes sense; by
the time an asset is used up or worn out, it has no value and its full value has been deducted through depreciation. Real estate, of course, is a little different. Quality buildings typically do not erode over only a few decades, and most properly maintained properties will actually appreciate over time, despite what the tax tables say. It is common for a fully depreciated property to be worth a multiple of its original value. Regardless of whether a property’s resale value is increasing or decreasing, for owners in high tax brackets, depreciation deductions can reduce annual taxes by tens or hundreds of thousands of dollars. But there is a catch. When the property is sold, all of the prior cumulative depreciation is “recaptured” by the IRS at a tax rate that is not much lower than the original income tax that was avoided. Unless you sell your property as part of a…
PAGE 67
Powered by FlippingBook