Year-End Tax Strategies for Real Estate Developers and Professionals

By James A. Schmidt, Senior Accountant, Cherry, Bekaert & Holland, L.L.P. (CB&H) | bio

An earlier, extended version of this article appeared as "Talking Taxes" © CCIM Institute. Reprinted with permission from Commercial Investment Real Estate, volume XXVI, no. 6, pages 42-44.

The year is coming to an end, and nobody wants to hear about the latest tax saving technique at the New Year’s Eve party. But there is still time to save substantially on this year’s taxes.

Timing is Everything
If location is the key to real estate, then timing is the key to taxes. Attempt to defer until early 2008 any sales, including the collection of rents, that will result in taxable income or gains. If it is not possible to defer the entire transaction, then consider structuring the transaction as an installment sale. You can lock in the contract price today, close on part of the deal before year-end, and then pro rate the remaining gain over the future tax years in which the remainder of the payments are received.

If a sale is of an asset or activity that has been generating losses you have not been able to deduct on your returns in recent years, then the entire accumulated loss may be deductible in the year of disposal. However, if you have a significant gain on that sale, be aware that the accumulated loss might not be sufficient to offset other unrelated taxable income.

For stocks or other investments that have substantially declined in value, realizing losses on sales of these assets may be a good strategy to offset taxable gains for the year. By selling these assets, you may be able to minimize or eliminate a significant tax liability. Beyond offsetting those gains, each year you are also entitled to offset up to $3,000 of ordinary income with realized capital losses.

As for your business expenses, attempt to pay as many bills as possible before year-end. For cash-basis taxpayers, your taxable income is a function of your cash receipts less your cash expenses as of the last day of the year. It's better to pay a bill in the last week of December than the first week of January. Consider using a credit card to pay expenses if you might not have cash on hand. Expenses paid with credit cards are deductible as long as the charge is made before year end, regardless of when the credit card bill is paid.

Along the same lines, you are allowed to write off up to $125,000 of capital expenditures in 2007 (phased out if the total cost of new assets exceeds $500,000). If you are planning a large investment, consider doing so before the end of the year and obtain the write off on this year’s taxes. This deduction can be especially useful if you are able to obtain zero or low interest financing on the purchase, thereby creating a positive cash flow from the tax savings.

Qualified Accounts
Transferring funds to retirement accounts is one of the quickest and easiest ways to reduce your income tax burden. Many individuals have IRA, SEP, Simple, and 401(k) accounts, yet most never fully fund them. Deposits into these accounts reduce taxable income ‘dollar for dollar,’ the same way deductible business expenses do, only the cash is still yours.

These accounts can invest in real estate; however, there are certain factors that should be considered before doing so. The qualified account is segregated from your other investments and it must thus be sufficient to purchase, carry, manage and maintain the real estate investment it owns. While the profits and gains from transactions within the account grow tax deferred over a long investment horizon, the eventual distributions are taxed at ordinary tax rates, and not as capital gains. Distributions typically cannot begin before the age 59 1/2.

Because Congress has increased the maximum contributions to these accounts, some additional financial flexibility may be needed to ‘max-out.’ Individuals over the age of 49 are eligible to make even greater contributions, known as ‘catch-up’ contributions. Fortunately, some qualified accounts may be funded as late as the extended due date of the return, which can be as late as October 15, 2008.

Active vs. Passive Participation
Those involved with rental real estate may want to consider whether they qualify under the IRS definition of a real estate professional. Individuals not meeting the definition are subject to a limitation on rental real estate passive losses of $25,000 (phased out if your income exceeds $100,000 and completely eliminated at $150,000). Those considered a real estate professional, however, are not limited to the amount of loss that they could take in the course of rental real estate business in which they materially participate.

To qualify, an individual must spend more than half of the personal services performed in trades or businesses during the tax year in real property trades or businesses. A minimum of at least 750 hours is required. The hurdle here is when the individual holds a full-time job (est. 2,000 hours per year) which does not include real property activity.

Cost Segregation
Cost segregation must be on any real estate professional’s checklist. Typically, commercial real estate is depreciated over a 39-year life. However, an owner may segregate the cost basis (often the purchase price, or cost to build) into various asset classes, with 5-, 7-, 15- and 39-year asset life-spans. Depreciating the property in this fashion accelerates non-cash depreciation expense and significantly reduces taxable income in the near-term.

In addition to the expected tax benefits from accelerating your depreciation expense, there is another beautiful aspect to this concept. In the year in which the change in asset life is adopted, the tax forms recompute what your depreciation should have been in prior years and the year of adoption, the taxpayer is entitled to a ‘catch-up’ expense. Even if the asset has only been in service for a year or two, this amount can be very significant.

For example, a group of office buildings in service for a couple years were together worth about $30 million dollars. After completing the cost segregation study and computing what the depreciation could have been, the taxpayer received an extra $2.3 million dollars in catch-up expense for that year. Because he was in the highest tax bracket (35%), the cost segregation study saved him roughly $805,000 in cash on his fiscal year tax return.

With the assistance of a CPA who is expert in this area of tax law, you can confidently embark on an estimate of what cost segregation could save you on this year’s tax bill. Another upside is that the work doesn’t have to be done before the year-end, only before you file the return.

So, as 2007 winds down, go forth and do your part to reduce your income tax burden. And at this year’s New Year’s Eve party, it will be you holding court by the eggnog bowl enlightening others as to the savvy tax strategies of the year.

James is a Senior Accountant with Cherry, Bekaert & Holland, L.L.P. (CB&H) and a member of the Firm's Real Estate and Construction Industry Group. He can be reached at 813.251.1010 or via email at jschmidt@cbh.com.