Clever Real Estate Tax Planning
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Clever Real Estate Tax Planning

Palos Verdes. CA. Here are three simple ways to reduce your taxes. Income taxes are derived by multiplying taxable income by an applicable tax rate. The lower the taxable income, the lower the rate, thus the lower the taxes. This article will show you how to do it.

How to Lower Taxable Income

The simple underlying concepts used to reduce taxable income are:

►Spread income over time

►Spread income to various entities

►Group income and expenses

Knowing something about each of these concepts will allow you to implement substantive tax savings.

Spreading Income Over Time

Real estate provides the opportunity to spread income over several years using the installment sales method of reporting. By accepting a relatively low down payment and spreading the principal payments over several years, total taxable income for any one year is reduced.

In the tax-deferred exchange method, income can also be spread over time. Both methods can be structured to give you maximum reporting flexibility.

If you’re a real estate licensee purchasing a property and you want to spread taxes on your commissions over time, have them contingent upon some event taking place to avoid constructive receipt, if the situation warrants. For example, your commissions could be conditioned upon the property maintaining certain levels of cash flow and/or profits.

Spreading Income over Entities

Spreading income to various entities reduces the income any one entity has to report. By transferring ownership of assets to corporations, partnerships, relatives, or trusts, an effective transfer of income can be accomplished as well.

Relatives in low-income brackets can be paid for services provided. As long as these services represent legitimate business transactions, spreading income in this manner can save you thousands of tax dollars.

When operating entities have dissimilar tax reporting years and basis (cash or accrual), it’s possible to spread income and expenses over different years to take advantage of the tax laws.

Grouping Income and Expenses

Grouping income and expenses can lower taxable income. Real estate provides the flexibility to implement this kind of tax-planning tactic. More specifically, rental properties do, because they fit nicely within the definition of active participation rules (which allow a $25,000 write-off against salaries and other active income). This write-off alone represents a substantial tax savings to many individual investors.

When changes in either income or expenses can be projected, the benefits of grouping are phenomenal. For example, refinancing will create a higher interest expense deduction to offset anticipated increases in rental income. Short-term loan contracts with high points will accomplish the same thing.

If expenses are projected to increase, offset them by increasing receipts from installment contracts. Avoid reporting income when notes become due by renegotiating an extension of time. If the senior mortgage matures before your note, subordinate it to new financing to avoid payment.

Capital gains and losses can also be grouped to maximize tax benefits. With restrictions, capital losses may be used to offset capital gains plus additional amounts of ordinary income.

Increasing the Depreciation Deduction

Maximize the deduction for depreciation:

►To increase the depreciable basis of the asset, take the higher

of either the tax role or an independent appraiser’s evaluation.

►To decrease the length of time the asset is depreciated, identify personal property assets. They can be depreciated over shorter lives.

Converting Real Property into Personal Property

The IRS defines tangible personal property as any personal property except land and improvements thereto, such as buildings or other inherently permanent structures (including items that are structural components of such buildings or structures) (Reg. 1.48-1[c]). The courts have concluded that “permanency” is the most pertinent test in the determination of whether an asset is a structural component and not personal property. They have applied the following six tests to assist:

►Is the property capable of being moved and has it in fact been moved?

►Is the property designed or constructed to remain permanently in place?

►Are there circumstances that tend to show the expected or intended

length of affixation?

►How substantial a job is the removal of the property and how

time-consuming is it?

►How much damage will the property sustain upon removal?

►How is the property affixed to the land?

The Last Remaining Tax Loophole

Rental Property ownership still provides the opportunity to qualify as an active participant. In doing so, qualified owners can deduct up to $25,000 per year against salaries and other nonpassive income. You’ll notice that I said “qualified owners.” That’s because there are five basic conditions that must be met to qualify for this write-off:

►The person seeking the write-off must be an individual taxpayer.

Corporations and limited partners do not qualify. The IRS considers a married couple filing jointly to be an individual, so a husband and wife can share the write-off. Tenants-in-common form of ownership meets this requirement.

► The property must be a real estate rental activity. That is, its primary purpose must be that of a rental property to qualify.

►The individual must own a minimum of 10 percent of the rental property at all times. A husband and wife can own 10 percent combined and still qualify because they’re considered an individual by the IRS. An individual may own more than 10 percent, but not less.

►The maximum write-off of $25,000 is phased out when adjusted gross income (AGI) exceeds $100,000. The phase-out is $2 for each $1 of AGI over the minimum of $100,000 for married taxpayers filing jointly. This exemption is unavailable once AGI reaches $150,000.

►The individual must be considered an active participant. Participation requires only that the individual participate (in a significant and bona fide manner) in the making of management decisions or arranges for others to provide services. Examples of management decisions would include setting rental rates and terms and approving capital and repair expenditures. A management company can handle the day-to-day operations as long as the owner makes the major decisions.

ABOUT THE AUTHOR: Eugene E. Vollucci is the Director of The Center for Real Estate Studies, a real estate research institute. He is author of four best selling books and many articles on rental income investing, real estate and taxation. To learn more about the Center for Real Estate Studies and its educational resources, contact Calstatecompanies


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