Even after the housing market collapse, many clients still adore real estate because it's both sexy and concrete. Advisors like it too because it can offer both diversification and yield.

"People are attracted to real estate because on a rental you can get 3% to 4.5% annual yield - and then through rental increases stay ahead of inflation," says Michael C. Berry, a CFP/CPA on Bainbridge Island, Wash. "They can't find that yield elsewhere."

Directly owned real estate has a well-documented ability to diversify a portfolio. For example, the index published by the National Council of Real Estate Investment Fiduciaries - which consists of properties owned by institutional investors and tracks income and appreciation - shows a low correlation to stocks and a negative correlation to bonds. (Publicly traded REITs, however, have greater correlations with stocks.)

But with real estate investments, income and capital gains taxes can be far more complex than many clients imagine. Even when property is not held as part of an advisor's assets under management, planners must be able to help clients manage real estate holdings as part of their overall wealth portfolio - in particular, paying close attention to the interplay between earned income and income and gains from real estate.

Real estate holdings can affect the tax burden faced by wealthy clients significantly, particularly in the wake of last year's tax increases. The overall income tax rate now tops out at 39.6%. Then there's the Medicare surtax of 0.9% on earned incomes of more than $250,000 for married filers and $200,000 for singles, as well as the Medicare tax of 3.8% on net investment income (which includes interest, dividends, capital gains, royalties and net rental income). Perhaps more significantly for real estate, the long-term capital gains tax rate for top earners rose to 20%.

The tax code includes lots of ways to make real estate investments tax efficient. The key is to understand the proper use of each type of tax break and to guide clients to be smarter about their holdings.

Below are a few of the key potential pitfalls real estate investors face, as well as some clarifications and suggestions that could help you set your clients straight.

1. GETTING DEPRECIATION WRONG

Depreciation can be a sweet tax perk, allowing clients to write off a portion of the cost of the building on their property for each year that they own it. They take deductions in the short term and pay them back later. "The money you'll be paying back in the future is worth less than the money you are saving now because of inflation," says Theodore Sarenski, president and CEO of Blue Ocean Strategic Capital in Syracuse, N.Y.

Yet investors tend to get tripped up, believing that it's a tax break that never has to be repaid.

Here's how it really works: Depreciation allows clients to take a deduction for each year they own a piece of property for investment purposes, up to a maximum number of years considered by the IRS to be its "useful life" (currently 27.5 years for individual properties and 39.5 for commercial). The depreciation amount is found by dividing the value of the building at time of purchase by the number of years allowed.

But there's a catch. All that depreciation year in and year out must be recaptured at the time of sale. Here's an example: A client couple buys a property for $200,000, with the building worth $100,000 and the land accounting for the remaining $100,000. Let's say they decided to sell halfway through that "useful life," selling the property for $250,000 (with the building now worth $150,000). Because they had depreciated $50,000 so far, the first $50,000 of that sale price gets recaptured as so-called 1250 income, subject to a maximum tax rate of 25%; they must also pay tax on the capital gains the investment generated.

2. PASSIVE OR ACTIVE?

Owning a ski house in Aspen and renting it out a few weeks a year does not qualify your client as an active real estate professional. "That's not really a business," notes Michael Fitzgerald, president of Fitzgerald Financial Partners in Houston. "People get tricked into thinking that [because] they've done well on the sale of one house, or it generates an income, ... they're real estate professionals."

Why it matters: From a tax perspective, real estate professionals have active income and losses; vacation home owners have passive income and expenses. And only active income and losses can be fully managed alongside a client's other earned income.

"You can't combine the two," Fitzgerald says. "Passive goes with passive and active goes with active." (There is actually an exception, but we'll get to that later.)

In practice, that means any losses incurred from passive activity - such as upkeep, landscaping, plumbing, depreciation and the like - can only be used to offset passive income, which in real estate terms means rental income. It is not possible to use those losses to offset earned (or active) income.

But active losses are attractive because they can be used against earned income, so it might be worthwhile for clients to see how they might be able to get a designation as a real estate professional. To qualify, investors must devote at least 750 hours per year to the activity and meet other IRS criteria. In addition, the activity they engage in must qualify as material - so clients who own property but do not manage it themselves couldn't use losses on it as active losses. (For a full list of the requirements, refer to IRS Form 8582.)

Fitzgerald suggests the following strategy for married couples in which only one is fully employed: The stay-at-home spouse can qualify as an active investor by getting a real estate license or other similar designation. The couple could then use any losses from that active real estate business to offset the working spouse's income.

3. OVERLOOKING LOSSES

So if passive losses can only be used to offset passive gains, what should a client do if there are more losses than gains? After all, fixing the boiler or replacing the roof can be an expensive endeavor.

Clients have a few options, tax advisors say. The Tax Reform Act of 1986 created one exception, allowing taxpayers to deduct some losses against earned income. It's limited to $25,000 in losses if modified adjusted gross income is less than $100,000 for married couples, however, and begins to phase out after that; it is completely unallowable at $150,000.

Even disallowed losses won't be wasted, notes Jeffrey Berdahl, a PFS/CPA with Regan Levin Bloss Brown & Savchak in Allentown, Pa. "Those losses sit on the shelf until you sell that property," Berdahl says.

In the year that property is sold, those accumulated losses can be used to offset any earned income. So the best time to sell - and, therefore, take advantage of those losses - is in a year when your clients' income is high, Berry says. "You don't want to release those losses in a year when you have poor income, because once you release them, they're gone," he says.

Berry tells of a client who moved to Washington from Virginia to take a job paying $300,000. The client left behind a rental property in Virginia that had suspended losses of $125,000. Berry and the client did not know how long his high-paying job would last, so they had a limited window to take advantage of the losses; as a result, Berry advised the client to sell the rental and get the passive losses to offset one year of high income.

4. MORTGAGE DEDUCTION LIMITS

Americans love their mortgage interest deduction. Proposals to phase it out (or even reduce it) typically go nowhere; a 2012 Pew Research poll found that fewer than half of Americans support limiting the deduction.

Still, clients need to remember that the deduction has its limitations. First, it's restricted to up to $1 million in mortgages; also, a client may only take the deduction on a primary residence and one other property. (Real estate taxes are still deductible on a third property, but not the mortgage interest.)

"For a third home, the mortgage interest on that is not deductible," says G. Scott Haislet, an estate planner and tax advisor in Lafayette, Calif. "You'll need to choose which two of your properties is worth taking the deduction on."

And even with only two properties, owners must still navigate that $1 million cap.

Say your clients have a tidy Craftsman bungalow in Palo Alto, Calif., with a $1 million mortgage, and an oceanside condo in Boca Raton, Fla., with a $500,000 mortgage. They would have to choose in any given year which of the mortgages is worth more as a tax break - and that would depend on how much interest is paid on each of the properties. (Note that it could vary from year to year.)

Furthermore, the mortgage interest deduction cannot be taken on rental properties - it's reserved for residences. If your clients live in the property fewer than 14 days or 10% of the time it is rented out, it is considered a rental property - and for rentals, mortgage interest is considered investment interest and can only be used to offset passive income.

Also note that the mortgage interest deduction only applies to the original mortgage amount, not additional amounts that may have been tacked on through refinancing.

5. 1031 EXCHANGE COMPLICATIONS

Clients about to sell one property and about to buy another could potentially avoid paying capital gains tax by doing a 1031 exchange. "It's a way to defer the capital gains taxes indefinitely, even until death," Fitzgerald says. "At death, the heirs get a step-up in basis." In community property states, a surviving spouse gets the step-up in basis at the time of the first spouse's death.

The downside: 1031 exchanges are complicated and the rules must be followed to a T.

Consider this example: A couple owns a small apartment building they bought several years ago for $350,000. They sell it for $1 million. After fees and selling costs, they end up with $950,000 and a capital gain of $600,000.

In order to do the 1031 exchange, they must buy another property - and to avoid capital gains altogether, they must find something that costs at least $950,000. They must also make their intention known prior to the sale of the original property. Then the clock starts ticking: They have 45 days from the date of the sale to identify a new property, and 180 days to close on the purchase of a new property.

Meanwhile, all this must be done through an intermediary who places the proceeds in escrow to be used for the purchase of property. Because no sale has technically taken place, the taxpayer continues on the same depreciation schedule as the original property.

The trouble, Berry says, is that "things can go wrong somewhere along the way ... and then you end up with a capital gain." If the couple finds a replacement property that costs only $850,000, for instance, the excess $100,000 will be considered a taxable gain.

Another knock against 1031s is that they set up the taxpayer on an investment treadmill, always needing to be invested in real estate. But Haislet suggests that clients can actually "convert an investment property into a fun property."

After the sale of an apartment building, a family could buy a vacation home that they rent out for at least two years, again making sure they don't occupy it for more than 14 days per year or 10% of the time that it is rented. After the two-year period, they no longer have to keep it as a rental; at that point, it could become a 1031 replacement property and a family vacation home.

Capital gains taxes would be due when the family sells that replacement property. But for families with no intention of selling soon, the maneuver can be quite attractive because, at the time of death, the property would pass to heirs with a step-up in basis. "Then it can be a family legacy kind of thing," Haislet says.

Most important, experts say, is making sure your client sticks to the schedule - and keeps an eye on that 45-day window. "You have the most control when you're selling a property," Berry says. "Put provisions in there where you can extend the closing 60 days from when you know you've got a deal."

 

Ilana Polyak, a Financial Planning contributing writer in Northampton, Mass., has also written for The New York Times, Money and Kiplinger's.

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