The Gulf Opportunity Zone Act of 2005 (GO Zone Act, P.L. 109-135, 12/21/05) has many special tax incentives to help boost the economies of those areas hit hard by last year's hurricanes. It is an excellent opportunity for real estate investors nationwide. As such, I called Annie Chen CPA, one of the best real estate accountants I have met and owner of Real Estate Tax Pro, Inc., and asked her to write a column for our e-newsletter readers. She was kind enough to oblige. Here is what she wrote:

What is the Greatest Tax Benefit of the Go Zone Act for Real Estate Investors?

The most attractive incentive for real estate investors is the new special 50% bonus depreciation for real estate investments in the GO Zone Areas hit by Hurricanes Katrina, Rita, and Wilma during 2005. The GO Zone Act allows investors to claim additional first- year bonus depreciation equal to 50% of the adjusted basis of qualified GO Zone property, which includes, among other things, residential and nonresidential real property.

In general, the IRS allows real estate investors to depreciate an equal portion of the building and improvements on the real property over a specific number of years. However, the GO Zone allows an additional 50% bonus depreciation to be taken in the first year the property is placed in service.

 

Example of How the Bonus Depreciation is Taken:

• Investor purchased a house for rental in Go Zone Area for $100,000; closing date on 1/2/06.

• Depreciation is deducted straight line over 27.5 years for residential and 39 years for business on the improvement portion, not land. For tax purposes, the property is assumed to have been placed into service at the middle of that particular month (1/15/06).

 

• Land Allocation 20% (based on property tax assessor or appraisal report) = $20,000

• Building Allocation 80% (based on property tax assessor or appraisal report) = $80,000

 

• 50% Bonus Depreciation = $40,000

 

Total Rental Depreciation Deducted on Schedule E of Return

In the first year of purchase, the depreciation deduction would be $41,394. This is based on $40,000 of 50% Bonus Depreciation plus $1,394 Current Year Depreciation ($40,000 remaining 50% tax basis x 1/27.5yrs x 11.5/12 months)=$41,394. This deduction would be allowed on Schedule E of Form 1040 for that particular rental property if the property is owned by a disregarded LLC or the individual directly. Whether the full amount will be deducted in the current year or suspended as passive losses to future years, depends on the individual taxpayer’s situation (see further discussion in Planning Techniques below).

In the 2nd year of purchase, the depreciable basis of the property has decreased by 50%, and therefore the depreciation deduction would be lower for the next 26.5 years at $1,455 per year (40,000 / 27.5 years).

 

What is the Qualified GO Zone Property?

Qualified GO Zone property requires the property to be used in the GO Zone Area. The GO Zone areas include specific counties in Alabama, Florida, Louisiana, and Mississippi, and Texas. For a full list of qualified counties in the GO Zone, please go to http://www.irs.gov/pub/irs-pdf/p4492.pdf for publication 4492.

In addition, the property can only be purchased and placed into service during the period after August 27, 2005 and before December 31, 2008 (Code Sec. 1400N(d)). Any written contracts to purchase the property cannot be signed prior to August 28, 2005. The original use of the property in the GO Zone must begin with the taxpayer after Aug. 27, 2005.

 

If the property is not a brand new property, additional capital expenditures to recondition or rebuild property must start with the taxpayer after August 27, 2005. There is no requirement that the nonresidential real property or residential rental property be built to replace a structure destroyed by Hurricane Katrina, or that the taxpayer rehabilitate a damaged structure. In other words, for example, a brand-new building will do just as well if it meets the above conditions.

No bonus depreciation is allowed if the building is used for one of the “prohibited” types of businesses such as gambling, country clubs, liquor stores, etc.

 

Planning Techniques on How to Use the 50% Bonus Depreciation

Offset Current Year Rental (“Passive”) Income - The 50% bonus depreciation accelerates the amount of paper losses for the rental property, thus increasing the overall passive losses in the tax year. The additional depreciation expense can be used to offset the positive rental income from all rental properties owned by the investor in the current year.

Offset Long Term Capital Gain from Sale of Rentals - If an investor sells a long term rental (held more than 1 year) and yields long term capital gain from that investment property, that long term capital gain is considered passive income (or rental income). To minimize that capital gain or “passive income” that is subject to tax, passive losses from the 50% bonus depreciation can be used to offset this long term capital gain from the rental property that was sold.

 

Offset Current Year Taxable Income - An investor who qualifies as an "Active Real Estate Investor" (see your CPA) is permitted up to $25,000 in net rental (passive) losses against all ordinary taxable income, if such investor's combined Adjusted Gross Income does not exceed $100,000. Example: if a person has $100,000 Adjusted Gross Income ($100,000), he is allowed to have up of $25,000 in net passive rental losses to offset his income. If he has already reached the maximum of $25,000 in net passive rental loss income, then the 50% bonus depreciation from a GO Zone property will not be useful to offset against his current year taxable income. The first year bonus depreciation will then be carried forward to future years until it can be used to offset against his long term capital gains from sales of investment properties, positive passive income or loss in the year of sale.

If the investor qualifies as a "Real Estate Professional" (see your CPA), then the investor can take all the passive losses generated by the rentals, including all of the 50% bonus depreciation, against his total taxable income, even if he has high income.

 

But Tax Incentives Alone Are Not Valid Reasons to Invest in the Go Zone

The 50% bonus depreciation is an exciting incentive useful for tax planning strategies for the real estate investor; however, investors should always evaluate the merits of the investment based on the property’s own appreciation and cash flow potential - purchasing the wrong property is not worth the tax savings it generates.

Thanks again to Annie Chen for taking the time to explain what looks to be a valuable incentive for real estate investors to invest those areas hit hard by last year's hurricanes.

Great stuff.....

<< Back to list