Tax Savings and Deferral Strategies for Real Estate Businesses

Real estate businesses run a unique operation. They invest predominantly in high-cost, highly leveraged assets and prioritize cash flow to ensure long-term stability. These characteristics make them eligible for several tax-saving and deferral opportunities. 

Let’s review some of the most common tax strategies available to businesses with real estate investments. 

Exception to the business interest expense deduction limitation 

In general, businesses with more than $30 million (2024) or $31 million (2025) in average annual gross receipts are limited in how much interest expense they can deduct each year. The limitation is roughly 30% of their adjusted taxable income (ATI). Before 2022, ATI was similar to earnings before interest, taxes, depreciation, and amortization (EBITDA). Now, ATI is based on earnings before interest and taxes (EBIT), which is unfavorable for real estate businesses that typically have significant depreciation and amortization expenses. 

Real estate businesses often incur high levels of interest expense, which makes the limitation particularly problematic. Due to the nature of real estate businesses, not being able to add back depreciation costs meaningfully reduces the available business interest expense deduction. 

Fortunately, there’s an exception to the limitation available specifically to real property trades and businesses. An electing real property trade or business can fully deduct their interest expenses for the year, further reducing their taxable income. 

The exception is claimed by attaching an election statement to the business’s federal tax return. For this exception, real property trades or businesses mean “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business,” according to the Internal Revenue Code. 

Warning: A real property trade or business that elects the exception to the limitation on business interest expense must use the alternative depreciation system (ADS), a less common tax depreciation method, for commercial and residential real property and qualified improvement property. ADS has slightly longer recovery periods than the more common modified accelerated cost recovery system (MACRS). And unlike MACRS, it doesn’t allow for bonus depreciation on qualified improvement property. Your tax advisor can help you recast the depreciation expense deduction for affected property. 

Net operating loss carryovers 

It’s not unusual for a real estate business to incur losses in some years, particularly when qualified improvements are made. Business owners can leverage net operating losses (NOLs) to reduce taxable income in years of profit. Note that NOLs incurred after 2017 can offset up to 80% of a company’s taxable income in a given year but can be carried forward indefinitely; NOLs incurred in 2017 or before can offset the entirety of a company’s taxable income but can only be carried forward for 20 years. 

For example, Company A incurs an NOL of –$75,000 in 2025. In 2026, the company has taxable income of $75,000. Due to the 80% NOL carryover limitation, Company A’s 2026 taxable income can be reduced by only $60,000. The remaining unused NOL of $15,000 can be carried forward to a future year. 

Warning: Entity ownership changes can sometimes limit your ability to take advantage of tax attributes from before the ownership change. Your tax advisor can help you understand the impact of ownership changes on the availability of tax attributes. 

Passive activity avoidance 

Many real estate-related activities are, by default, considered to generate passive income for tax purposes. Renting is a prime example of a passive activity. 

Passive activity treatment isn’t so good for real estate businesses. Passive activity losses (PALs) are only deductible up to the amount of the taxpayer’s passive income. 

This limitation means that PALs can’t offset income from nonpassive activities, such as wages or a business’s operating income. In effect, a taxpayer with modest nonpassive income but steep PALs may still have a tax liability for the year. 

Individuals and closely held corporations working in real estate can avoid PAL limitations—in part—by meeting the definition of a real estate professional, which is a person or business that  

• spends more than one-half of their working hours working in a real estate business, and 

• materially participates in the real estate business for more than 750 hours during the year.  

There’s another hurdle: To be clear of PAL limitations, the person or business must also materially participate in the rental activity that would otherwise be classified as a passive activity.  

Material participation requires meeting one of seven predefined tests in the U.S. Treasury regulations. Your tax advisor can help you determine whether you meet the definition of a real estate professional and assess your material participation in any rental activities that you’re engaged in. 

Like-kind exchanges 

Also known as Section 1031 exchanges, like-kind exchanges let businesses and individuals defer capital gain taxes owed on selling real property when proceeds are used to fund another real property purchase that is used in a trade or business or held for investment purposes. 

A specific process must be followed to qualify for Section 1031 gain deferral. For example, there are time restrictions, and a qualified intermediary must be engaged to facilitate the application of sales proceeds from the original property to the purchase of the replacement property. 

Warning: Section 1031 exchanges sometimes result in a partially taxable event, particularly when you receive cash proceeds from the transaction or trade for a less valuable property. Consulting a tax advisor before engaging in the transaction can prevent surprise taxable events. 

Qualified opportunity zones 

A major item for real estate businesses in the Tax Cuts and Jobs Act of 2017 (TCJA), qualified opportunity zones (QOZs) reward taxpayers by providing tax deferrals on capital gains reinvested in improving real property in communities designated as opportunity zones in the United States. Real estate businesses can invest in QOZs by establishing a qualified opportunity fund (QOF) or joining another entity’s QOF. In general, QOFs are entities with at least 90% of their assets held in QOZ property. 

Capital gains taxes are typically due in the year when appreciated investments are sold. When capital gains from any source are reinvested in QOZs within 180 days, however, the capital gains tax isn’t due until the QOZ investment is sold or the taxpayer’s 2026 federal income tax return is filed, whichever comes first. 

There were (and still are) additional tax perks for holding QOZ investments long-term: 

• QOZ investments held for at least five years on or before December 31, 2026, qualify for a 10% capital gain exclusion. If held for at least seven years on or before December 31, 2026, that 10% goes up to 15%.  

• A QOZ investor doesn’t owe any capital gains tax on the appreciated value of a QOZ investment when it’s held for at least 10 years.  

Assuming no legislative change, the 10% and 15% partial gain exclusion on investments held for five or seven years isn’t available for QOZ investments made today. 

Warning: Qualifying for QOZ capital gain deferral is cumbersome. Among other requirements, real property must be purchased in designated areas, and “substantial improvements” must be made within 30 months of acquisition that double your adjusted basis in the property, excluding the land cost. Working with an experienced tax advisor is essential to ensure you’re on track to meet the many requirements of QOZs. 

Smith + Howard: Your Real Estate Tax Expert 

Smith + Howard tax advisors are proud to serve scores of real estate clients nationwide. They take a proactive approach by staying current on legislative changes that create tax opportunities and helping clients structure their deals to achieve a favorable tax result. Contact an advisor to learn more.