David R. Natan, CPA, MST, CVA – January 20, 2024 (Newburg CPA)

Within the real estate industry, there are some very powerful opportunities, should the stars align. One such opportunity arises if a taxpayer qualifies as a “real estate professional.” This qualification, coupled with the compelling tools of cost segregation and 1031 exchange, can make for some dramatic tax savings. As the trifecta requires a certain ordering of events, let’s review how the three opportunities can come together as a nice combination.

Opportunity 1 – Qualifying as a real estate professional

To qualify as a real estate professional, the taxpayer must provide more than one-half of their personal services in real property trades or real estate businesses in which they materially participate and perform more than 750 hours of services in real property trades or businesses and materially participate in each rental activity. It is important to highlight that their time in real estate must exceed other services performed. For example, it would be difficult to qualify if the taxpayer has a 9 to 5 job as a software programmer. While they may meet the 750-hour requirement, it would be unlikely that real estate activities could outweigh this as there is only so much time in the day. Keep in mind that real property trades or business entail a fairly broad definition in real property development, construction, rental, operation, management, brokerage/leasing, or acquisition. Most important is that the taxpayer maintains contemporaneous time logs to capture the services rendered. It should also be noted that for purposes of material participation, the determination is made separately for each property unless a special tax election (Sec 469(c)(7)(a)) to treat all interests in real estate as a single real estate activity is made within your tax return.

Opportunity 2 – Leverage rental losses from depreciation utilizing cost segregation

As you build a portfolio of rental properties, one of the most powerful tax advantages for the qualified real estate professional is the fact that rental losses are not subject to the passive loss limitation rules. Instead, the losses from your rental properties can directly offset your other income or a spouse’s other income. A cost segregation study is a process that integrates an IRS-outlined engineering approach to identify and separate various components of a commercial or residential property (flooring, windows, electrical, fencing, sidewalks, etc.). The ultimate goal of the study is to move components out of the defaulted longer depreciable lives of 39 years (commercial) or 27.5 years (residential) into a 20-year or less depreciable property. 20-year or less property components become quite beneficial as they are qualified for bonus depreciation (accelerated initial year write-off). On average, we find that anywhere from 15-35% of a property’s cost can be moved into 20-year or less components.

Opportunity 3 – Further defer tax on the sale of property via a 1031 like-kind exchange.

While the cost segregation depreciation advantages are quite powerful in offsetting the real estate professional’s other income from year to year, when the property is sold, the gain portion will be subject to depreciation recapture for any prior depreciation taken. This equates to a 25% flat federal tax rate (plus state taxes). The opportunity that lies within a 1031 exchange can further defer any taxable gains into the new property. A 1031 exchange entails essentially rolling the net sale proceeds of a rental property into another “like-kind” rental property through the use of a qualified intermediary. If various metrics are met, the realized gain is essentially rolled into the basis of the new property. Depending on existing debt and any “cash/boot” received, all or a portion of the gain can be deferred. It is important to note that real estate development and flipping would fall under “held primarily for sale,” which would NOT qualify for a 1031 exchange. The IRS does provide safe harbor guidance regarding 1031 exchanges, which entails holding exchanged assets for a minimum of two years along with other caveats (minimum of 14 days rented in a 12-month period, an investor cannot live in the property, etc.). Furthermore, within a 1031 exchange it should be noted that any real property held for productive use in a trade or business or for investments can be considered “like-kind.” The IRS also provides a very specific timetable for property identification (45 days) and exchange completion (180 days).

It is important to note that all three opportunities in the trifecta require thoughtful planning and the use of experienced professionals such as your CPA firm, attorney, cost segregation provider, and a qualified intermediary. Newburg CPA works closely with developers, property managers, brokers, and investors to implement the best strategies to maximize their cash flow and profitability. Visit us at www.newburg.com.