 Tax
benefits of real-estate investments
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 Dear
Tax Talk,
I am a young entrepreneur who recently purchased a multifamily (four-family)
apartment building with my business partner. I am curious as to
what, if any, tax benefits this will provide on our own personal
taxes. The building is incorporated into an LLC. Any help is appreciated.
Thank you.
-- Matthew Schwab
 Dear
Matthew,
Generally a limited liability company is treated
as a partnership for tax purposes unless the members elect to be
taxed as a corporation. The election is made by filing Form
8832, Entity Classification Election. If corporation status
is elected, you can also change the LLC to an S corporation, which
means that the shareholders will be taxed on the net gain or loss
from the S corp. Form
2553 is used to apply for S corporation status. Certain time
limits apply as discussed in the instructions to these forms.
However, in a real estate deal it is preferable to
remain a partnership or maybe even better to elect out of being
taxed as a partnership altogether. The main benefit of electing
out of partnership treatment is that for tax purposes, each of you
is treated as a 50-percent owner of the property. While this has
little significance in the period of operating and owning the building,
it has implications on the sale of the property. If later one of
you, but not both, want to enter into a like-kind exchange of the
property upon its sale, this would only be possible if you elected
out of the partnership rules. The election out of the partnership
rules can be made any year, but certain formalities as discussed
in IRS Regulation Section 1.761-2 must be followed.
Aside from the choice of entity,
the benefits of owning the property have to do with the write-offs against the
rental income. Aside from the obvious direct costs such as advertising, cleaning
and maintenance, insurance and taxes, you also can claim your interest expense
and depreciation. If you secured a mortgage to purchase the property, that interest
is obviously deductible. If you borrowed funds from elsewhere for the down payment,
then you can allocate that interest to the property. Depreciation
is the method used to recover your cost in the depreciable assets of the building.
You cannot write off the cost of the principal payments on your mortgage, but
you can in effect use the mortgage to add to your depreciation deductions. Suppose
you purchased the property for $500,000 and you put $100,000 down and obtained
a $400,000 mortgage. Your cost is still $500,000 for tax purposes, and after you
determine which assets are depreciable among the $500,000, that will be the amount
upon which you can claim depreciation. Depreciation is computed regardless of
the amortization of the mortgage. (For example, if you make interest-only payments
on the mortgage, you can still claim depreciation on the assets acquired by the
debt.)
Out of the $500,000 purchase price, you have to allocate
your costs to the different assets acquired. Your allocation could
be, for example, the land (which is not depreciable), appliances,
carpeting, furniture (depreciable over five years), landscaping,
fencing and parking (depreciable over 15 years), and lastly the
building (depreciable over 27.5 years in the case of residential
rental property). Depreciation and other rental property issues
are discussed in Publication
527.
Generally, if the property has a loss from its
rental activities, that loss is considered passive. You can only deduct passive
losses against other income (such as wages or business income) if your income
is below $150,000. See Form
8582 for a discussion of passive activity losses.
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