Investing in real estate continues to be one of the best ways to build wealth and cut taxes. Benefits include the ability to recover the cost of income-producing property through depreciation, to use 1031 exchanges to defer profits from real estate investments, and borrow against real estate equity to make additional investments or for other purposes. Additionally, homeowners can benefit from the personal-residence exemption, which shields profits on the sale of a personal residence from capital gains taxes, as well as the deduction for mortgage interest. Read on to find out whether one or a combination of these strategies is right for you. (For background information, read Investing In Real Estate.)

TUTORIAL: Exploring Real Estate Investments

You can recover the cost of income-producing rental property through annual tax deductions called depreciation. The Internal Revenue Code defines the depreciation deduction as a reasonable allowance for exhaustion or wear and tear, including a reasonable allowance for obsolescence.

Real estate investors generally use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS), in which residential rental property and structural improvements are depreciated over 27.5 years, while appliances and other fixtures are depreciated over 15 years. Depreciation expense often results in a net loss on investment property even if the property actually produces a positive cash flow. This loss, as well as expenses, such as utilities and insurance, are reported on Schedule E, federal income tax form 1040, and deducted from ordinary income.

1031 Exchanges
The 1031 exchange, named for Section 1031 of the Internal Revenue Code, allows investors to defer taxes by selling one investment property and using the equity to purchase another property or properties of equal or greater value. This exchange must occur within a specified period of time. Although a 1031 exchange can broadly include various types of property, the vast majority of transactions relate to real estate. (To read more about this type of exchange, read Smart Real Estate Transactions.)

Property Regulations
In order to successfully complete a 1031 exchange, the properties must meet the following criteria:

  • The aggregate value of the replacement properties must be equal to or greater than that of the relinquished properties.
  • The properties included in the transaction must be like-kind, meaning real property cannot be exchanged for some other type of asset, such as a real estate investment trust (REIT). (For more information on REITs, read The Basics Of REIT Taxation.)
  • The exchanged properties must be held for "productive purposes in business or trade" (an investment).

Any cash or property received through the transaction that is not considered like-kind property is considered boot and is subject to taxation. Cash boot includes not only cash, but also physical property, such as fixtures. Mortgage boot refers to any debt reduction that is achieved through the transaction. Thus, the amount of debt assumed with the replacement property must be equal to or greater than the value of the debt retired when the relinquished property is sold. (For more on like-kind exchanges, read Trade Properties To Keep The Taxman At Bay.)

Investor Regulations
The investor must use a qualified intermediary. A qualified intermediary is an agent who facilitates the 1031 exchange process, largely by holding net proceeds from the relinquished property before they are re-invested in the replacement property. Only a qualified intermediary may hold those funds during the exchange. The Federation of Exchange Accommodators details the role that the qualified intermediary plays in the 1031 exchange process.

The investor is subject to two deadlines:

  • Forty-five days after the sale of the relinquished property he must deliver a written list of qualified replacement property to a qualified party to the exchange, usually the intermediary. There are also several rules that limit the number of properties that can be identified.
  • Additionally, he must purchase the aggregate value of qualifying replacement assets within 180 days of selling the relinquished asset or 180 days after the due date of his tax return for that year, whichever occurs first.

1031 Exchange, Step by Step
In a typical transaction, an investor decides to sell an investment property and invest the proceeds from any gain in another property.

  1. To accomplish this in a tax-efficient way, the investor enters into a 1031 exchange agreement with a qualified intermediary and puts the original property up for sale. At the same time, the investor begins searching for replacement properties.
  2. On the day the investor sells the original property (the relinquished property), the net proceeds after paying all expenses are sent to a special account set up by the qualified intermediary.
  3. The investor then enters into the identification period and has exactly 45 days to produce a list of qualified replacement properties and 180 days to close on the replacement property during the exchange period.
  4. Using the entire proceeds from the sale of the relinquished property, the investor closes on the new investment property or properties.
  5. The qualified intermediary wires those funds to the title company, the special account is closed and the transaction is completed.

Borrowing Against Home Equity
Investors who have built up sizable equity in either their personal home or investment property may simply choose to refinance their properties and pull out equity to make additional investments, improve the home, or for other purposes. Regulations vary from state to state.

In a typical scenario, a lender will loan 80% of the combined loan to value or 50% of the fair market value of the property, whichever is less. For instance, on a $240,000 property with a $100,000 loan, the most a borrower could extract is $92,000 ($240,000 x 80% – $100,000).

The ability to borrow will also depend on a borrower's credit score, their existing debt-to-equity ratio, and their debt-to-income ratio. While this strategy is a bit riskier, for those able to handle the additional debt, it can help build wealth without having to enter into a 1031 exchange or sell a property. (To learn more about home-equity loans, read The Home-Equity Loan: What It Is And How It Works.)

Deferring Taxes on the Sale of a Home
Gains from the sale of a taxpayer's primary personal residence are excluded from capital gains taxation up to $500,000 for married couples and $250,000 for single individuals if the taxpayer has lived in the home for two of the last five years. In addition, should the gains from the sale of a taxpayer's primary residence be greater than those exclusions, the taxpayer may also invest that portion through a 1031 exchange.

Investors who live in areas where home values are appreciating can use a strategy of trading up to both build their personal wealth and minimize taxes at the same time. (To learn more about the tax implications of selling your home, read Will Your Home Sale Leave You With Tax Shock?)

Mortgage Interest Deduction
Homeowners can deduct the portion of their mortgages attributable to interest payments on their tax returns. These payments are higher during the early years of the mortgage and gradually decrease as the mortgage is paid off. (Read more in The Mortgage Interest Tax Deduction.)

The Bottom Line
There are many options available to the real estate owner who is looking to sell while minimizing tax liability.

  • A 1031 exchange allows the returns from a sale to be reinvested into like-kind property.
  • A home-equity loan taps directly into the value of the property and can be used for a variety of purposes.
  • The sale of a principal residence is eligible for special tax treatment.
  • Mortgage interest can be deducted at tax time.

Your personal situation will dictate which of these options is right for you, but any of them will help you get the most out of your real estate investment.

For related reading, see A Tax Primer For Homeowners.

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