QUALIFIED RE PROFESSIONAL & RECAPTURE

Qualified Real Estate Professional

A REP designation will allow the owner to offset gains from other real trades (assuming material participation) or businesses with losses from rental real estate. Also, the depreciation losses can be applied to all the real trades or businesses the owner materially participates in.

There are four (simplified) steps to qualify as a real estate professional:

Number one: Identify the owner’s real property trades or businesses in which he or she materially participates.

Number two: The owner or investor must spend at least 750 hours a year on their rental properties. This could be repairs, bookkeeping, travel to and from, managing the property, etc.

Number three: If the owner or investor has another source of income and spends time performing services to generate that other form of income, the investor must spend at least as much time on his real estate activities as he does his other business. If this is not a real property trade or business, the rental properties would generally be passive. If it is a real property trade or business, the rental activities MAY be non-passive.

Number four: The owner or investor must materially participate in every single rental property. There is an option to aggregate all the rental properties into one so that the owner or investor only must participate in all of the rentals together materially, not each one individually. However, a statement must be sent to the IRS with the taxpayer’s tax return stating that the taxpayer is a real estate professional and meets the criteria.

Materially participates means:

They participated in the activity for more than 500 hours during the tax year.
Their participation in the activity for the tax year was substantially all the participation in the activity of all individuals for the tax year.
They participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other person for the tax year.
They materially participated in the activity for any five of the prior 10 tax years.
The designation of a real estate professional is very complex and misunderstood by many tax professionals. Please be very careful when choosing to designate a taxpayer as a real estate professional.

Recapture

When we do a cost segregation study we are moving real property to personal property which allows for an accelerated depreciable life. Due to higher recapture tax rates on personal property at the time of sale we recommend holding a building for at least 3-5 years after a cost segregation study is applied. This allows time for the tax savings we create to generate cash flow that will outweigh any recapture effects when the building is sold. This can be done by putting the money to use by paying off debt, investing in new property, investing in new business equipment, etc.

Recapture occurs when the building is sold. There are recapture rates for both real property (39/27.5 year property) and personal property (5, 7 and possibly 15 year property). The gains on the sale of personal property are taxed at ordinary income tax rates and gains on real property (39 yr) is taxed at a 25% recapture rate. Any gains made above the original cost basis of any asset are taxed at capital gains tax rates. Essentially the most you could possible pay back in recapture is the amount of tax savings we generate.

You usually would not pay back all of the savings generated as recapture can be minimized by assigning a smaller gain amount to the personal property we identify in the study. This can reasonably be done if the personal property has been in service for close to five years as which point it is fully depreciated. At this point it has diminished in value, and it is not worth as much as it was originally bought for. Therefore, a smaller gain can be assigned to these assets resulting in less recapture. More gains would be assigned to items that appreciate such as the land and building structure. If this is done, a cost segregation can still be beneficial even if a sale occurs soon after application of the study.

Another option to defer gains made in the sale of a building is a 1031 Exchange. The Tax Cuts and Jobs Act eliminated the ability to include personal property in a 1031 Exchange. However, it was clarified that the definition of personal and real property is done at the state level for 1031 Exchange purposes. This means that some, possibly all, of the personal property identified in a cost segregation study could be included in an exchange depending on the specific state definitions.