Real estate tax planning strategies with pitfalls

The Trump megalaw opened more pathways to tax savings on real estate investments atop the substantial ones that were already available.

Adjustments and the permanent extension of the opportunity zone tax credits that enable investors to defer or reduce capital gains in certain areas added to perennial incentives and strategies around 1031 exchanges, depreciation and cash-flow investing, said Rich Arzaga, founder of Monument, Colorado-based The Real Estate Whisperer Financial Planning. In that sense, what was possibly “the biggest news for real estate was actually among the items that were talked about the least” during the push led by President Donald Trump and his Republican allies in Congress to pass the legislation by July 4, Arzaga said.

“The opportunity zone benefits really phased out, so if this didn’t pass, the opportunity zones would almost completely go away,” he said. “They brought it back up and gave it new life.”

And investors may not realize that syndicates or real estate investment trusts can offer some of the tax advantages without majority ownership and management of the asset, said Rachel Richards, head of tax products at Gelt, an accounting and artificial intelligence-powered tax services firm that works with high net worth clients and business owners.

“What you’re looking for and how you’re involved in the investment can have an impact on how those investments will be taxed,” Richards said. “You are going to be heavily involved in operating and managing the investment. So it really comes down to prioritizing what tax outcome you’re looking for, versus how much time you’re willing to invest in the opportunity.”

READ MORE: 5 tax strategies that pay off in real estate and homeownership

Opportunity zone credit and 1031 exchanges

That time factor plays a large role in opportunity zone credit, which the new law will cut off at the end of next year and require governors to select new areas under tightened criteria every 10 years beginning in January 2027. Investments in rural areas in particular will get extra tax savings, while enhanced reporting requirements could give researchers and policymakers a clearer picture of the impact of opportunity zones moving forward. On the other hand, the gap between the end of the first version of opportunity zones from the Tax Cuts and Jobs Act of 2017 and the incoming rules under the One Big Beautiful Bill Act will likely reduce those investments across the board for a year or more.

Over the longer term, a real estate seller who uses a 1031 exchange to buy a similar property within 45 days could use the opportunity zone credit to apply their step-up in basis for the postponement of capital gains in the transaction, Arzaga noted. More generally, an “investment policy statement” that identifies the goal and strategy, the type and location of the property they would like to buy and the amount of capital at disposal could aid investors and their representatives in the 1031 process, he said.

“It can help you focus on exactly what sort of property you should be looking at,” Arzaga said. “Their focus gets much more narrow, and they end up with a property that is more to their liking.”

He and Richards pointed out that 1031 investors should avoid a common pitfall in what can turn into a rush to find the second corresponding asset within the deadline for the exchanges to secure the deferral of taxable gains.

“It’s something that you really want to plan in advance,” Richards said. “The closing day isn’t the day to say, ‘Oh, I should really do a 1031 exchange.'”

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Depreciation and other profitable losses

The write-offs from depreciation based on the wear and tear of a real estate property asset work differently by slashing the investor’s taxable income from the asset. That brings tax savings alongside some other frequently overlooked expenses among rental property owners in particular, such as building management fees, a maintenance reserve, utilities and landscaping in the complex mix of costs and income from that type of investment, Arzaga noted. Frequently, they only anticipate expenses such as the cost of a mortgage, property taxes and insurance.

“Those are only three of maybe 10 types of expenses that people can expect to pay,” Arzaga said. “It takes patience, and it takes being thorough, but it’s not that hard.”

For real estate depreciation, the investor must be using the property for a business purpose rather than as their residence, Richards noted. But they can tap into some of those write-offs by joining a group of investors in a syndicate rather than through the majority ownership and all of the obligations that come with it.

“Depreciation is tied to the property, but you don’t need to directly own the property in order to enjoy the benefits,” she said. “They just come to you in a different way than if you are a landlord yourself and owning real estate and renting that out.”

READ MORE: 11 tax tips on mortgages and homeownership

Cash flow over appreciation

Popular narratives about investing in real estate tend to ignore such nuances, instead emphasizing savvy buyers and sellers who “flip” properties after substantial upswings in value. That appreciation strategy ignores the fact that those profits stem from “market circumstances, and the investor has no control over that,” Arzaga noted. Furthermore, most real estate investors own single-family properties or duplexes that tend to appreciate at about 3% a year, with the possibility of incurring taxes during a sale that could further hurt their earnings, he said.

Instead, a strategy based on the precise calculation of returns and expenses that taps into depreciation write-offs and other tax incentives amounts to a thesis based on cash flow, also known as “passive” investing or a “core real estate” holding. That requires a more thoughtful approach — which investors prefer, once their financial advisor or tax professional explains it to them, Arzaga said.

“They say, ‘I’d rather have the cash flow,’ but it’s hard to get, and most people won’t do the work that it takes to get there,” he said.

The realities of the day-to-day issues involved with real estate ownership comes home to many investors who “get really excited about these things, and then they go to execute and find that they’re not really interested in becoming a landlord,” Richards said. That explains why many experts advise clients to pursue cash flow rather than chasing appreciation.

“That cash flow-positive business use can give you that guaranteed return on your investment, and then the appreciation is really the cherry on top,” she said.