Net Operating Losses

For many investors, buying income-generating real estate isn’t too different from buying corporate bonds or stocks. But there is one major advantage: losses on rental properties can be deducted from taxable income.

Getting that provision into the tax code was a rocky road. In 1986, Congress passed a law that treated virtually all investments in rental real estate properties as passive investments (much like stocks or bonds).

This meant property owners could no longer deduct any operating losses on their properties from their taxable income. In the following years, property prices went into a tailspin. Legislators blamed the 1986 law in part for causing the Savings & Loan crisis by discouraging investment in real estate, according to a 1994 Chicago Tribune report. So they changed the rules again.

Since 1993, rental property owners can deduct operating losses on their properties from their taxable income, provided they spend at least half their working hours and at least 750 hours a year as a “real estate professional.”

Other Mechanisms of Tax Reduction

Depreciation is the most famous — and counterintuitive — way real estate investors can shrink their tax bill. The IRS treats real properties as assets that lose value over time, along with cars, desks and refrigerators.

Property owners can deduct a certain portion of a property’s value every year until that value reaches zero. For residential rental properties, the typical depreciation period is 27.5 years, according to the IRS website.

As useful as depreciation is to property owners, it is a gradual process and rarely generates a sudden sizeable loss.

Another way developers can lower their tax exposure is through cancellation of debt, or outstanding debt that has been forgiven after negotiations. Typically, this kind of debt forgiveness is treated as income on a tax bill, but current laws allow taxpayers to deduct this debt if it is tied to Chapter 11 bankruptcy or if the taxpayer is insolvent — meaning their debt is greater than the total market value of all assets

Developers have long used these strategies. After a recent article in The New York Times about Donald Trumps reported losses — $915,729,293 — on his tax forms in 1995, tax services firms sought to seize the moment by sending out email blasts advertising their tax reduction services.

One email from South Florida-based Property Tax Appeal Group, titled “Donald Trump Knows How to Avoid Taxes in Real Estate,” urged investors to file property tax appeals and “take advantage of what the law allows.”

“This is truly a win-win situation,” the email read.

Photo courtesy of seniorliving.org

That April 15^th (or this year, April 18^th) deadline looms large over many of us, causing us to put all sorts of items on our financial and business plan to-do list on hold, held in a stasis until our filing is complete.

But now the taxes are hopefully behind you (expect for you extension filers). It’s a great time of year to do some reflection and consider what you have been putting off for far too long:

• Updating and/or creating your estate plans. Estate plans are not a one-shot document. Life changes occur. New children, grandchildren, marriages, even illnesses or debilitating events may have an impact as to how your finances are organized. Now is a good time to review your documents and discuss them with your attorney to make sure they are current and reflect what you want.
• Tax planning far in advance to alleviate the sting of April 15, 2017. May and June are great times to discuss with your tax attorney and your accountant what steps you can take advantage of to lessen your future tax burden. Not only will these professionals now have the time to meet with you to have such a conversation, they will be thrilled to be on the planning end of things and not just the filing end. Thinking through the course of the year, are there capital investments including equipment purchases that you should make by December 2016? Are there bonuses or payments that should occur in 2016 or should they occur in 2017? What hiring decisions do you anticipate making in the next year? Are they any timing consequences to these decisions?
• Review significant business documents. If you own your own business, you may be wallowing in documents of all types. But there are few key ones that need regular review and even tweaking. These include but are not limited to employee handbooks, operations manuals, finance and payroll documents, and even emergency procedures.
• Compare health care plans. You are likely to have a yearly re-enrollment date for your health care plan. Regardless of the date, take time to compare what’s out there and be sure the plan you are selecting is working well for your family financially and in terms of care. Now that the taxes are done, you may also have an aggregate amount of unreimbursed health care costs. Are you taking out enough from a health savings account or are you taking out too much and leaving that money on the table? If you or your spouse will be phasing into Medicare within the next year, do the research now on which supplemental insurance you want to purchase.

Conduct your own legal spring cleaning right now, locating relevant documents, consulting with expert advice and moving from putting out fires to moving forward in a planful, comprehensive manner.