Real Estate Tax Benefits
Real Estate investments offer unique tax benefits that make them more attractive than other forms of investing. These benefits include depreciation of a property to increase cash flows early on in the investment, a step up in basis and elimination of capital gains tax upon the owner's death, tax deferral from the sale of a previous property through investing in a new property, and now, tax benefits specific to sustainable developments thanks to the Inflation Reduction Act.
Immediate Depreciation
Depreciation is used for real property to account for the aging of properties, even though these investments often appreciate. Depreciation reduces an investor’s tax basis, thereby reducing potential taxable income and allowing for larger cash flows earlier in an investment. Depreciation schedules are different for personal vs. real property. The Tax Cuts and Jobs Act of 2017 allowed for bonus depreciation of 100% through 2023 for personal property. The TCJA is approaching the expiration of its term; personal property placed in service in 2024 is eligible for 60% bonus depreciation, 2025: 40% bonus depreciation, 2026: 20% bonus depreciation, 2027: 0% bonus depreciation (Thomson Reuters 2023). Bonus depreciation could be resurrected in future tax legislation as this has historically been popular with both parties. In fact, bonus depreciation was first introduced in 2002 under the Job Creation and Worker Assistance Act. This was in response to the economic downturn following the September 11 attacks (Kagan 2024). Real property for residential real estate is depreciated over 27.5 years with the straight-line depreciation method (Kielar 2024).
Cost Segregation Study
Cost segregation studies accelerate the depreciation schedules for different types of property. With a cost segregation study, depreciation schedules can be modified so an investor can take larger sums of depreciation off their taxable investment income earlier during the investment hold period. Traditionally, residential property is depreciated over 27.5 years as “real property”. “Personal property” assessed through the cost segregation study can be depreciated over five to seven years. Land improvements can also be depreciated over 15 years. Our accountants at BDO perform a thorough cost segregation study before the building is placed in service so that after the building is placed in service, we can provide investors with a tax benefit in the first year following the building being placed in service (Bdo.com).
Step Up in Basis
Real Estate investment has substantial benefits for estate planning. A 50% step-up in basis for an investment property occurs if a spouse dies, and a 100% step-up in basis occurs when a property is passed down to heirs upon the owner's death. This allows beneficiaries to avoid paying capital gains taxes on properties that have potentially appreciated and would have otherwise had significant tax implications.
Capital Gains
Properties held for at least one year are eligible for a favorable capital gains tax rate instead of ordinary income tax rates, applied to investments held for less than a year. The current capital gains rates, depending on one’s income, range between 0%, 15%, or 20% (IRS Topic no. 409 2023).
Tax Incremental Financing (TIF)
Tax increment financing is a subsidy for redevelopment, infrastructure, and other community improvement projects. TIF is a public financing method generally applied to public-benefiting projects and infrastructure. In the case of Edison, ~$600,000 in TIF will be awarded for outdoor spaces.
Sustainability Benefits
Sustainable tax benefits have the potential to increase returns to investors thanks to the recent Inflation Reduction Act of 2022. The Inflation Reduction Act was the largest climate investment in US history at $369 billion. Since The Edison is Passive House certified and International Living Future Institute Certified, augmenting the project’s carbon emissions and efficiency with respect to water and energy use, it will benefit from four sections of the Inflation Reduction Act. Our goal is for all of our developments to be Passive House and International Living Future Institute certified so that they can take advantage of these new sustainable tax credits and deductions offered by the federal government.
Section 48: Energy Property Tax Credit
- 30% investment tax credit for energy-efficient building envelope components
- Additional 10% bonus tax credit for US domestic manufactured products
Section 45L: New Energy Efficient Home Credit
- $2,500 credit per dwelling for qualified energy-efficient buildings
Section 179D: Energy Efficient Commercial Buildings Deduction
- Up to $5.65 per square foot tax deduction
Cost segregation - Tax Deduction - 20% of Improvement Cost
- Up to $32,400,000
After factoring in the four benefits specific to Edison, the maximum eligible benefit is $33,819,200. Of that, $2,457,500 are dollar-for-dollar reductions in tax credits, realized in the year the property is placed in service. However, the accelerated timing of the deductions (cost segregation and 179D energy efficiency deduction) only provides a present value of the accelerated tax benefit at investor taxpayers' marginal income tax rates, not a permanent benefit. Additionally, these tax credits could be subject to passive loss rules, leading to tax benefits when the investment is sold rather than upfront. Moreover, the depreciable basis of the property must be reduced by the amount of tax credits on the property. The section 45L credits are realized per dwelling as they are leased.
1031 Exchanges
Overview
The 1031 Exchange is a highly favorable tax benefit for real estate investment. Unlike stocks and other non-real assets, this benefit allows for the deferral of capital gains between exchanges of real property. This means investors can defer capital gains from previous investments by investing an equal or greater amount into a new investment property of equal or greater value (Brock 2024). This deferral allows investors to postpone paying taxes on gains and continue to grow their investments.
Process
Neutral works with many intermediaries, but one of the intermediaries Neutral often works with is Gain 1031 Exchange, which helps facilitate the tax deferral process. Neutral can accept 1031 Exchange investors with the use of an intermediary. The process is as outlined below:
- Neutral to introduce Gain 1031 Exchange to Buyer (i.e., investor),
- Buyer to engage Gain 1031 Exchange or other 1031 Exchange intermediary for property identification,
- Current ownership entity and Buyer to enter into a Tenancy In Common Agreement for purchase,
- Neutral and the Gain 1031 Exchange team complete the closing procedure through First American Title with the Buyer,
- Buyer to deposit funds with Gain 1031 Exchange,
- Gain 1031 Exchange to wire funds to First American Title; and
- 1031 Exchange would then be closed.
Considerations
Once the land held in a 1031 exchange qualifies under the Tenancy In Common Agreement, we can contribute its entire value to equity positions. When we sell the property after you have an equity position, you will not be able to perform another 1031 exchange or “1031 out” and will be liable for the taxes on the capital gain. The "equal or greater value" requirement applies to the total value of the property, not just the equity appreciation. Under a 1031 exchange, you have 45 days to identify a replacement property after selling the previous investment property, and 180 days after the sale to obtain and close on the replacement property.
Figure
The greater the appreciation of the first investment and the higher the tax rate, the more you benefit from using a 1031 exchange.
Tax Reporting
Neutral sets up investment opportunities as a partnership for all investor parties. Tax benefits are distributed proportionally to investors subject to complex tax laws regarding liquidating cash distributions.
Equity
Investors receive their annual K1 form, which will show income deductions. These deductions will show all the credits that each investor will receive. Each investor will receive the credit separately on their respective K1 and receive their proportionate share of the tax benefit. Tax benefits can be used when a building is placed in service and can be used all the way up to the disposition of a property. Tax benefits and passive losses from one investment can be used to offset gains from other investments. However, credits and passive losses from investments cannot offset taxes or income from wages (The Neutral Project Webinar EP 02 2024).
Debt
Investors will receive a 1099-INT. This form reports any income from self-employment, interest, dividends, or tenant rental income. Unlike a W-2, the 1099 Form will show the entire gross income paid to you. A 1099-S will be issued with the disposition of the property (Godfrey 2021).
Works Cited
Brock, Melissa. “What Is a 1031 Exchange?” What Is A 1031 Exchange? | Rocket Mortgage, 25 Feb. 2024, www.rocketmortgage.com/learn/1031-exchange.
Godfrey, Evan. “All about Tax Statements and 1099s for Real Estate Investors.” San Francisco Bay Property Management, Kenny Realty, Inc., 4 Nov. 2021, www.kennyrealty.com/blog/all-about-tax-statements-and-1099s-for-real-estate-investors#:~:text=When%20you%20are%20an%20employee,or%20rental%20income%20from%20tenants.
Internal Revenue Service. “Topic No. 409, Capital Gains and Losses.” Internal Revenue Service, 2023, www.irs.gov/taxtopics/tc409.
Kagan, Julian. "Bonus Depreciation." Investopedia, Dotdash Meredith, 29 Aug. 2023, https://www.investopedia.com/terms/b/bonusdepreciation.asp.
Kielar, Hanna. “What Is Rental Property Depreciation and How Does It Work?” What Is Rental Property Depreciation? | Rocket Mortgage, 24 Apr. 2024, www.rocketmortgage.com/learn/rental-property-depreciation#:~:text=While%20less%20expensive%20items%20such,a%2039%2Dyear%20recovery%20period.
“The Neutral Project Webinar EP 02 - Tax Benefits of Investing in Real Estate with Steve Pullara.” YouTube, YouTube, 16 May 2024, www.youtube.com/watch?v=zbkF49Zbmc0.
Thomson Reuters. “Bonus Depreciation – Overview & Faqs.” Bonus Depreciation – Overview & FAQs | Thomson Reuters, Jan. 2023, tax.thomsonreuters.com/en/glossary/bonus-depreciation.
