Deciding to invest in real estate can be a rewarding financial option for you and your business.  While the ultimate goal of real estate investing is positive investment growth, it is also critical to understand the real estate investment tax rules so you can enter into your investment fully aware of the financial impacts of your decision.

Capital Gains and Losses

Real property that is not held for sale to customers is classified by the IRS as a capital asset.  Upon the sale or exchange of such property, the taxpayer must recognize a capital gain or loss for the difference of the amount received for the property less the adjusted basis in the property.  The tax code currently treats capital gains and losses more favorably to the taxpayer than ordinary income or losses, which occur from regular activities performed in the course of your business, taxing at 0%, 15%, or 20%, depending on the taxpayer’s level of income.  Capital losses can be used to offset capital gains, and can even be used to offset ordinary income up to $3,000 annually. 

Adjusted Basis

Your adjusted basis in the property is the original cost, plus or minus certain items that occur during the course of your investment, such as the cost of improvements or additions, and depreciation allowed to be taken on the property. A sale price higher than the adjusted basis generates a capital gain, whereas a sale price lower than the adjusted basis generates a capital loss.  When you contribute property that you own to your business entity, the entity then takes over your basis in the property.  This event is generally not considered a taxable transaction.  So for example, if you contribute an office building with a basis of $100,000 to your partnership, the partnership’s basis in the office building becomes $100,000 as well.

Tax-Free Exchanges

You have the opportunity to defer capital gain recognition on the exchange of real property if the transaction meets the requirements for a Section 1031 tax-free exchange set forth by the tax code.  To meet these requirements, both the relinquished property and the replacement property must be business or investment property and be of “like kind”.  This means that they must be of the same class of property.  It is also important to adhere to the 45-day time limit provided in the code to qualify for the tax-free exchange.  When the requirements are met, the tax-free exchange allows you to defer the gain until the final disposition of the property at some point in the future.

Benefits to the Business Owner

Owners of pass-through entities receive the benefit of the capital gain and loss treatment on their individual tax returns.  These items pass-through on Schedule K-1 to each owner.  The individual then includes the capital gain on their personal return and can use the capital losses to offset their personal ordinary income.  Assuming the business owner completes a tax-free exchange, the deferral of the gain in the tax-free exchange also allows the business owner to keep funds on hand for further investment that would otherwise be used to pay the increased income tax from the gain on the sale of the asset. 

The benefits from structuring a tax-free exchange can be substantial.  Please reach out to our team for assistance in navigating the complex rules and regulations associated with your real estate investments.  We can help you ensure compliance and get the most benefit out of the tax deferral for you and your business! Schedule a FREE virtual consultation today to get started.