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Two Tax Strategies to Consider for Short and Long Term Rentals

Apr 01, 2024

     Most real estate investors and developers are engaged in the commercial real estate business because of the substantial tax benefits available through a coherent real estate tax strategy. Though the overall IRS tax code is so large and unwieldy, sometimes great tax strategies within the code might be overlooked by the investor(s) or non-real estate focused CPAs.

Here are two tax strategies where cost segregation deductions can be used to offset ordinary income:

  1. Real Estate Professional or Active Participant
  2. Self-Rental Rules in a single “Economic Unit”

Real Estate Professional/Active Participant engaged in the material participation.

     If you (or your spouse if filing jointly) qualify under the IRS definition of a Real Estate Professional or an Active Participant, then this passive activity or losses created can be used to offset ordinary income. This is a huge benefit as not only can the depreciation created losses be used to offset other ordinary income sources, it can also directly impact a spouse’s W-2 wages. So a $100,000 in depreciation deductions, can be used on the jointly filed tax return to offset any ordinary and passive income.

     As the qualifying Real Estate Professional or an Active Participant, you normally cannot be a traditional full-time W-2 wage earner. There can be exceptions to this rule, but you need to work closely with your CPA to ensure you are in complete compliance with IRS guidelines. This is the circumstance where the spouse often takes on this role as a real estate investing couple to offset the W-2 wages. Of course, as a commercial real estate professional it can also offset all your 1099 commission income.

To qualify for Real Estate Professional or an Active Participant status:

  1. a taxpayer must provide more than one-half of their (or the spouses) total personal services, in real property trades of businesses in which they materially participate, and
  2. perform more than 750 hours of services during the tax year in real property trades or businesses.

     In short real property trade or business material participation will involve one or more of the following:

1) develop or redevelop
2) construct or reconstruct
3) acquire
4) converts
5) rent or leases
6) operates and manages
7) brokers commercial real estate properties.

     The IRS has more detailed definitions, and like any tax incentive provision ‘a test’ that involves a series of qualifying questions to be confirmed by your tax professional or CPA. Taxpayers should also prepare contemporaneous time logs that detail the services rendered to document and support their qualification in the event of an IRS audit.

Self-Rental Rule for owner-occupied buildings that are held in a separate LLC.

     A potential passive activity loss can be overcome by taxpayers who treat multiple entities as one “economic unit”, subject to a few stipulations. An owner-occupied property will qualify under the IRS testing criteria as a single economic unit.

     For example, if a dental practice is operating under an S-corporation and owns the building under a separate LLC, the typical strategy is to have the LLC break even each year by paying the necessary rent from the S-Corporation to the LLC to cover all expenses, which could reduce the need for the added deductions of cost segregation. However, by electing to treat the two (2) entities as one economic unit, all income or losses are considered active and become fully deductible in the year incurred. Using a Cost Segregation Study, the LLC would have large “pass through” losses relating to the accelerated depreciation that can offset the ordinary income of the business practice, operating as a single economic unit.

     When grouping the building LLC with the operational business unit, this can eliminate the passive loss limitations to the building LLC and enable the dentist taxpayer, in this example, to take the depreciation deductions against their dental practice ordinary income to maximize the benefits from a cost segregation study.

     There is a “facts and circumstance” test that should be performed to determine whether activities may be grouped together. The factors listed below, all do not need to be met to qualify, are given the greatest weight in determining whether activities constitute an appropriate “economic unit” for the measurement of gain or loss for purposes of IRS Treasury Reg §1.469-4:

1) Similarities and differences in types of trades or businesses
2) The extent of common control
3) The extent of common ownership
4) Geographical location; and Interdependencies between or among the activities.

     This ‘self-rental’ or ‘economic unit’ rule is often overlooked to maximize passive activity deductions for owner-occupiers.

     Investing in commercial or income producing real estate is one of the world’s great wealth building strategies. Using cost segregation as a tool to optimize your depreciation schedule will result in significant cash flow and tax benefits in and of its own. The two strategies outlined in this article are just a couple added ways for you to leverage this passive activity against your ordinary income.

     It is important to understand how to maximize a cost segregation study for your specific tax strategy on your income producing real estate investments. Speak with your CPA or Tax Professional to determine if you qualify to take advantage of these specific tax strategies.

Contact us to see if COST SEGREGATION is a good fit for your business.

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