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If your inclination is towards investing in real estate, there are pitfalls that an investor should factor in before making any real estate investments.
Tax regulations (code) provided numerous ways to make real estate tax efficient, however you need to consider the downside as well.
For starter there is tax issues as it relates to depreciation; depreciation allows you to take a deduction for each year your own rental property up to the maximum of 27 and half years. The amount is found by dividing the value of the rental at the time of purchase by the number of years allowed.
However, the pitfall comes when you sell the property, all that depreciation year in and year out must be recaptured at the time of sale. Therefore, the depreciation that is recapture is subject to a maximum tax rate of 25 % and in addition you must also pay on the capital gains the property generated.
Another consideration is the mortgage deduction limits which currently stand at a million-dollar mortgage, interest above that amount will not be tax deductible. Mortgage interest deduction only applies to the original mortgage amount, not additional interest that might be added on through refinancing.
There is a tax savings you should consider if you are selling one investment property for another and that would be through a 1031 exchange. This method allows you to postpone the tax liability until death if you choose. At death your heirs get a step-up in basis.
The downside to 1031 exchanges is the fact that the transaction is complicated and rules must be followed to the letter.
Another tax consideration to rental property is whether the property income is considered “passive or active”. If classified “active” you can deduct expenses against earned income providing you meet income requirements.
Passive losses can only be used to off-set passive gains so make sure you understand the differences.
Finally, keep in mind that real estate is not that liquid and it could take significant amount of time to sell if you decide to get out.
Daniel Iuculano, AAMS CMFC
Accredited Asset Management Specialist
Chartered Mutual Fund Counselor
