Tax Planning for Real Estate Purchases
Originally published on April 16, 2021
Updated on October 30th, 2023
Real estate professionals face a bevy of tax decisions that require careful planning. In a recent episode of our Real Estate Industry Update videos, JMCo partners (and Real Estate Team members) John VanDuzer and Nadia Batey discussed tax planning for real estate purchases.
Depending on the reasons for your purchase (rental, flip, etc.), you’ll likely face different tax treatments and strategies. VanDuzer and Batey walked viewers through their tax planning process for the purchase of real estate.
Why are you buying the property?
This is the first question to ask, because the purpose of purchase helps dictate your tax picture. “There can be many different reasons for purchasing property,” Batey said. “You could be holding it for appreciation, establishing a rental property, using it as a vacation home or second home. Maybe if it’s raw land, you’ll subdivide and develop it. Then a trend that has picked back up is, of course, flipping property.
“Each has a different approach and tax treatment, and it brings to light a lot of different questions.”
What legal entity option will you choose?
Your use of the property will influence your choice of business entity structure, and there are several to consider.
“I get this question all the time. ‘Should I buy this real estate in an LLC?’” said VanDuzer. “And I give the standard CPA answer, which is, ‘It depends.’”
Your business entity helps protect you from some liability issues, so it’s best to involve an attorney in this choice. That said, we can discuss how your choice affects your tax picture.
Well… should I create an LLC?
An LLC can be single member (sole proprietor) or multiple member (partnership). In addition to having the simplest tax treatment, it introduces flexibility that comes in handy as your business changes.
“The LLC structure gives you that flexibility to have a waterfall or returns that change over the performance or the life of the investment,” said Batey. “ can be really helpful as the professionals are making their deals. And I always tell my clients, ‘What did you agree to economically? Write down what your deal points are, and then we’ll help you make sure your operating agreement matches the deal you made’—not the other way around.”
If you choose a single member LLC for a rental property, you won’t need a separate tax return. The income is reported on a Schedule E that supplements your individual return.
A multi-member LLC is by default a partnership for tax purposes. A partnership could be a married couple, family members or unrelated outside investors. An LLC provides plenty of flexibility with income allocation and distributions that can take all scenarios into account. It also introduces tax benefits for contributions or distributions of appreciated property.
Partnerships file their own separate tax return (Form 1065) and are known as flow-through entities. A flow-through entity generally does not pay tax as an entity; instead, the income (and the associated tax liability/benefit) flows down to the individual owners of the entity.
Regardless of whether your LLC is single member or a partnership, ordinary income is generally subject to self-employment tax. To get around this, you could elect to have your business taxed as an S corporation and save money on your return. However, you lose some of the benefits mentioned above so it is a careful balancing act.
“I always say rental activities are great in a partnership type setting, but the more short-term or active holdings are probably better in an S corporation,” said VanDuzer. “And the biggest benefit there is those S Corporation earnings aren’t subject to self-employment tax.”
Yet many real estate professionals don’t zero in on just long-term rentals or just property flips. What should you do when one entity type doesn’t suite all of your business? “If you’re going to have rental real estate and you’re going to have your flipping operations, sometimes just segregate those and put those into two separate entities,” said Batey. “That way you have the option of electing S corporation for your flipping activity but keeping your rental real estate in a partnership. So try and keep those as separate as possible.”
We recommend taking considerable time to compare partnerships vs. S corps to see what works best for your arrangement.
What other tax strategies or considerations should I know about?
Cost segregation studies are a popular tax strategy. This is a formal study on the components of a property to see if anything can be depreciated more quickly. In large acquisitions (especially multifamily properties), a sizeable portion of the gross purchase is depreciated in year one. Whether you can take advantage of this depends on your business structure.
“This leads to one of those tax structure considerations on partnership versus S corp on whether or not you would have the basis to actually even take those losses if you were to get them,” said VanDuzer. “One of the benefits of partnership is you can claim basis for the debt of the partnership, and then that’s a differentiator between the rules for S corporation and partnership. So it’s a very big deal to think about, what is depreciation going to look like for this entity.”
You should also consider passive activity loss rules. If you’re not actively involved in the operations of your real estate business, there are restrictions on deducting losses. According to Batey, this happens regularly; a client buys property with the assumption they’ll deduct losses in the first year, which may end up being limited.
However, the IRS has specific rules on the number of hours and percentage of activity to demonstrate that you materially participate in the business. “If you don’t pass the rules, the loss limitation is around $25,000, but it’s phased out for higher income taxpayer,” Batey explained. “So that can be a huge disappointment if you’re expecting to be able to take significant losses in the first year.”
Thankfully, you can meet the requirements of the real estate professional classification to avoid having your losses classified as passive. This classification also exempts you from paying the 3.8% Medicare Net Investment Income Tax on your non-passive rental income/gains.
Batey and VanDuzer also discussed aggregation. If you have more than one rental activity, you can aggregate those activities into one and only have to meet the rules for that particular activity.
Several other popular year-end tax moves can actually be made year-round:
- Qualified improvement property (also known as section 179 expensing, accelerated depreciation for any nonstructural interior improvement to nonresidential real property)
- Qualified business income deduction and safe harbor
- Deferring gains on property sales with a like-kind exchange
Your real estate CPA can guide you through these and other helpful tax strategies for your business.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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