Investing in real estate requires careful
planning well before the transaction, cautions Douglas G. Schultz of Burr Pilger Mayer. “It is important to step back and look
at the big picture. What do you want out of
the investment?”
If certain aspects of accounting and tax
planning aren’t addressed, they could
become huge negatives: higher tax bills, less
liability protection than you might have had,
and higher estate taxes. “A little creativity
can go a long way to minimize taxes and
maximize value,” he says.
Smart Business asked Schultz about
preparing for your biggest purchase.
What should be addressed before any real
estate investment purchase?
It’s important, from a tax and liability protection perspective, to use the proper entity
to hold your investment. Thorough consideration of your objectives will determine
whether an LLC, limited partnership, or
other flow-through entity should be selected.
Much has been written about subprime
mortgages — we an expect lenders to
revert to more traditional underwriting
guidelines in 2008, but that shouldn’t prevent
qualified investors and developers from
moving forward.
Still, you must understand what the property’s cash flow requirements are and what
they may entail. That could mean escalating
interest rates, increases in operating costs,
inflation, or an unexpected event that might
disrupt the liability of that space — you must
have reserves available.
To that end, financing alternatives must be
reviewed to make sure any guarantees, equity sharing, and/or collateralization are reasonable and will be sustainable throughout
the property’s holding period. Sale lease-backs, interest enhancement mortgages, and
seller financing are alternative financing
techniques to consider. Loans also present
special reporting issues. The calculation of
various ratios or investment returns is
required for compliance or covenants.
Properly characterize your investment as a
passive activity or an active business. Real
estate losses by definition are generally considered passive, and the deduction of these
losses is limited to passive income unless the
owner is a real estate professional. By meeting certain requirements relating to percentage of time and number of hours spent in
real estate activities, an individual may be
able to convert passive activity losses to non-passive losses, which can offset income
such as wages, dividends, and capital gains.
What needs to be considered when disposing
of real estate?
Investors need an exit strategy. Do they
plan to sell it after it has appreciated significantly, or exchange it for another property?
If so, what kind of property makes sense: a
tenancy-in-common investment interest, a
single tenant triple net lease property, or a
similar but more valuable property? If you
sell, will you qualify for long-term capital
gain rates, or will you be subject to ordinary
income tax rates?
If you sell your property and replace it with
a new one, a like-kind exchange can reduce
taxes. For example, non-income-producing
land can be exchanged for triple net leased
property for improved cash flow. High-equity property can be exchanged for highly
leveraged property for an increase in rate of
return.
Any real estate investment must be considered in terms of your overall financial and estate plan. All options — family limited
partnerships, charitable trusts, and intentionally defective irrevocable trusts (IDIT)
— need to be weighed. Including these tools
in an estate plan can achieve a reduction in
estate tax, an increase in wealth transferred
to your beneficiaries, and perhaps a significant contribution to charity.
What are some tax strategies?
In real estate, you want to acquire property
that will appreciate substantially and can be
held and liquidated with maximum cash flow
and minimal taxes. Here are two ways to
accomplish this:
1) Accelerate depreciation. When a client
purchases a property such as a commercial
office building, we often recommend a technique called cost segregation. Cost segregation studies provide immediate cash flow
savings by accelerating deductions for depreciation, in turn reducing taxes. Certain components of the building that are personal,
short-lived assets are segregated from the
building’s structural components, typically
depreciated over 39 years. Short-lived assets
might include carpets, window treatments,
cabinets, partitions, and landscaping. This
opportunity can be applied to buildings
acquired up to 15 years ago and provides
immediate tax savings.
2) Take advantage of capital gain rates.
Normally, an individual who subdivides land
or develops land as condominiums and then
sells the land would be taxed at high ordinary
income tax rates. Long-term capital gain
rates apply to a sale of a property that is a
capital asset held more than one year.
Inventory is not a capital asset. Investors can
qualify for long-term capital gains, but developers cannot. Case law and the tax code can
allow a gain, under certain circumstances, to
be taxed at lower long-term capital gain rates
on the property’s appreciated value, even
where some development has occurred.
Whatever course is selected, the big picture has to encompass you, your vision and
goals, as well as those of your family and
their future. <<
DOUGLAS G. SCHULTZ is a tax partner and head of the real estate industry group at Burr Pilger Mayer. Reach him at (415) 421-5757
or [email protected].