December 3rd 2024.
I'm not one to obsess over real estate investments. Don't get me wrong, I do think it's a smart choice to have real estate as part of your investment portfolio. However, there are convenient and efficient options like investing in a REIT index mutual fund or EFT.
Some people may also consider purchasing the home or apartment they live in, which can be a wise decision. But beyond those obvious choices, I don't have a strong opinion. That is, except for one particular real estate investment that I believe all entrepreneurs should consider: Self-rental property for their business.
Self-rental property is a great option for entrepreneurs, and the reason is simple. If done correctly, it allows you to unlock depreciation deductions that are typically not available to other real estate investors. To put it simply, you can save a significant amount of money on your taxes without having to spend too much time or put in too much effort.
It's worth noting that a real estate professional can also unlock depreciation deductions, but they need to meet certain requirements. This includes spending more than 750 hours and more than 50% of their time on a real estate trade or business, as well as actively participating in the properties they own. This can be challenging for some.
On the other hand, short-term rental investors can also enjoy significant deductions on their tax returns, with the added benefit of being able to participate with minimal hours. However, they are required to manage the average rental interval of guests, which must be 7 days or less to qualify as a short-term rental investor.
For entrepreneurs, self-rental property is a much simpler option. The Self-rental Property Depreciation Deduction Estimator is a helpful tool that can give you an idea of the depreciation deductions you can expect from a self-rental property that costs $1,000,000. This calculator uses the bonus depreciation numbers for 2024 and assumes that the cost segregation engineer has separated the price into real property and personal property.
Once you click the Calculate button, the Estimator will provide you with the depreciation deductions for the first seven years. The calculations are based on a property worth $1,000,000, with 25% of the value being attributed to land, 15% to five-year property, 30% to fifteen-year property, 0% to 27.5-year property, and 55% to 39-year property. Additionally, the bonus depreciation percentage is assumed to be 60%, the correct percentage for 2024. What's noteworthy here is that, unlike most real estate investors who are unable to take advantage of these significant deductions, entrepreneurs can benefit greatly from them.
It's important to remember that the deductions calculated by the Estimator may not be applicable to your specific real estate investment. However, you can easily adjust the percentages to match your potential investment and get a more accurate estimate of the depreciation deductions you could deduct from your taxes.
The usual problems with real estate depreciation and other deductions are that, in most cases, you cannot actually use them. The Internal Revenue Code limits the deductions on passive investments, such as real estate, to the income earned from other passive investments.
However, there is a special provision for self-rental property that has been set up correctly by an entrepreneur. If the rental property is grouped with the active trade or business, then the Section 469 rules do not consider it a real estate rental activity.
In order to qualify for this grouping, two requirements must be met. First, the ownership of the rental property must match the ownership of the other active trade or business. For example, if two shareholders own 60% and 40% of an engineering firm, they must also own the same percentages of the building that the firm rents.
Secondly, the grouping must be made in the first year of owning the property or operating the trade or business. So if you purchase a building this year to house your engineering firm, you must make the grouping election on this year's tax return.
It's worth noting that not all grouping and aggregation elections need to be made in the first year of an activity or trade or business. However, for Section 469 grouping elections, such as self-rental, not grouping in the first year is seen as a default grouping. This means that you will not be able to regroup later on, except in special circumstances and with the permission of the Internal Revenue Service.
On a final note, I must caution you about the potential risks of using this tax strategy. While you may be able to save a significant amount of money on your taxes, it's important to consider the return on investment. Just like any other business investment, it's important to calculate the expected return and explore options for using borrowed funds to cover part of the purchase price. It's always wise to approach a potential real estate investment with careful consideration and planning.
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