Rental real estate can be an excellent investment. Real property offers a significant opportunity to obtain income and capital appreciation for an investor. It also has many advantages to an investor from a tax perspective. These advantages include the ability to exchange property on a tax deferred basis, as well as the ability to write off numerous expenses associated with the property, including depreciation and depletion of the underlying assets.
Investment property can qualify for a “like kind exchange” which is known as a section 1031 exchange. Under a section 1031 exchange, the investor can defer gains on the property as long as the proceeds from the real estate sale are re-invested in another property. Certain requirements must be met, including the identification of a replacement property and subsequent closing on that property within certain time frames, as well as the use of a qualified intermediary to transfer the funds from one property to another. It is important that such an exchange be done in consultation with the appropriate advisers as the rules are complex.
Deduction of investment expenses
In addition to expenses associated with operating the real property including contractor and employee expenses, real estate taxes, utilities, repair costs, and travel related to running and managing the property, real estate investors can also deduct depreciation of the property and of many of the fixtures inside the property. There are certain IRS conventions which are used to depreciate property, including the accelerated cost recovery system (“ACRS”) as well as the modified cost recovery system (“MACRS”). Under these systems the depreciation is calculated based upon the current basis in the property as well as the number of years remaining in the cost recovery period. A unique feature of deducting depreciation expenses is that the cash flow of the property is not affected. In certain situations an investor can operate a property which has positive cash flow but which shows a loss on the income statement, resulting in a tax advantage.