Why tax planning for real estate is becoming more important

As the real estate market slowly recovers and potential taxes go up for many, tax planning for real estate is becoming more important. Higher-income taxpayers could see the benefit of some of their home-related deductions reduced with the reinstatement of the itemized deduction phase-out as well as face higher income tax rates plus the new 3.8% net investment income tax on real estate income and gains.

Here is a summary of the 2013 tax rate changes and phase-outs that may affect individual taxpayers.

  • Tax rates (ordinary). While the existing tax brackets of 10%, 15%, 25%, 28%, 33% and 35% were left in place, the new 39.6% bracket starts when taxable income hits $450,000 for joint filers ($400,000 for single). Income of less than $450,000 is still taxed at these various brackets.
  • Tax rates (capital). The existing 15% tax rate applied to qualified dividends and long-term capital gains remains for taxable income below $450,000 for joint filers ($400,000 for single), but increases to 20% for those above $450,000.
  • Net investment income tax (NIIT). A new 3.80% tax is assessed on net investment income if one’s adjusted gross income (AGI) exceeds $250,000 for joint filers ($200,000 for single). See below for more discussion on this tax.
  • Payroll (Medicare) tax. A new 0.9% tax is assessed on earned income such as wages that exceed $250,000 for joint filers ($200,000 for single). This tax is imposed on the employee but not the employer.
  • Itemized deduction and personal exemption phase-outs: This “phase-out” concept reintroduces a strategy from a few years ago that takes away deductions from those whose AGI exceeds $300,000 for joint filers ($250,000 for single). Effectively, by allowing fewer deductions, taxable income that is subject to tax is higher. There is a cap that prevents no more than 80% of itemized deductions from phasing-out.

New net investment income tax (NIIT)

Effective January 1, 2013, a new 3.8% tax is assessed on net investment income for those with AGI above $250,000 for joint filers ($200,000 for single). The NIIT tax is an extra tax that is assessed in addition to your regular income tax. Investment income includes interest, dividends, capital gains, royalties, rental income, and “passive” business activities. The tax is assessed only to the extent of the income that exceeds $250,000.

Real estate activity rules

Income and losses from investment real estate or rental property are passive by definition — unless you’re a (1) real estate professional or (2) are able to group your rental activity with a trade or business in which you materially participate. Why is this important? Passive income may be subject to the 3.8% net investment income tax, and passive losses are deductible only against passive income.

  1. Real estate professional. To qualify as a real estate professional, you must annually perform:
    • More than 50% of your personal services in real property trades or businesses in which you materially participate, and
    • More than 750 hours of service in these businesses during the year.
  2. Grouping election. Beginning in 2013, the IRS permits you to make a “fresh start” by regrouping activities that may otherwise be subject to the net investment income tax. This election may be useful for taxpayers who own rental property that is rented to a trade or business in which the taxpayer materially participates.It is important to keep in mind that although the regrouping provision can be used to treat net income from the newly combined group as non-passive and avoid the NIIT on that income, this can have a negative effect of the inability to utilize passive losses from other investments against this now non-passive income.

Finally, here are two additional real estate related tax breaks that have gone into effect for 2013:

Home office deduction

If use of a home office is for your employer’s benefit and it’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses. Further, you can take a deduction for the depreciation allocable to the portion of your home used for the office. You can also deduct direct expenses, such as a business-only phone line and office supplies.

Recently, the IRS announced a new simplified home office deduction, which is available beginning in 2013. The optional deduction is $5 per square foot for up to 300 square feet of home office space for a maximum annual deduction of $1,500. If you choose this option, you can’t deduct depreciation for this portion of your home. But, you can take itemized deductions for otherwise allowable mortgage interest and property taxes without allocating them between personal and business use.

Sales tax on commercial leases

Effective July 1, 2013, sales taxes on commercial leases between affiliated entities are no longer subject to the 2% City of Tucson sales tax. In addition, the .5% Pima County sales tax, which is administered through the State, was eliminated effective September 13, 2013 for commercial leases between affiliated entities. Affiliated entities are those that have at least 80% common ownership.

Prior to July 2013, only commercial leases between affiliated corporate entities were eligible for the sales tax exclusions. As of the dates listed above, the corporate entity requirement for the City and County sales tax exclusions has been lifted.

[authorblurb name=”Kim Paskal” image=”7482″ url=”/about/leadership-team/kim-d-paskal/” text=”is a shareholder at BeachFleischman and can be reached at 520-321-4600.”]