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Washington Real Estate Fundamentals Lesson 14: Federal Income Taxation and Real Estate © 2011 Rockwell Publishing
Basic Taxation Concepts Progressive tax Progressive tax: Taxpayers with higher incomes are taxed at higher tax rates. Not only must pay larger tax amount, must also pay higher percentage of income in taxes. Federal income tax is a progressive tax. © 2011 Rockwell Publishing
Basic Taxation Concepts Progressive tax Progressive tax contrasts with two other types: Proportional tax: All income levels taxed at same rate. Regressive tax: Higher income levels taxed at lower rate than lower income levels. © 2011 Rockwell Publishing
Basic Taxation Concepts Tax brackets Tax rates increase in uneven steps called tax brackets. If additional dollar earned crosses line into higher bracket, its taxed at higher rate. But that doesnt increase rate charged on dollars previously earned. © 2011 Rockwell Publishing
Basic Taxation Concepts Income For tax purposes, income includes more than just salary or wages. Income: Any economic benefit realized by a taxpayer, unless specifically excluded from income by tax code. © 2011 Rockwell Publishing
Basic Taxation Concepts Deductions and tax credits Deduction: Expense that may be subtracted from income before the income is taxed. Example: mortgage interest deduction Tax credit: Amount taxpayer allowed to subtract directly from taxes owed. Tax credit represents greater savings than tax deduction for same amount. © 2011 Rockwell Publishing
Basic Taxation Concepts Gains and losses Gain: Results when taxpayer sells asset for more than amount invested in it. Gain is taxable income unless tax code provides specific exception. Loss: Results when taxpayer sells asset for less than amount invested in it. Loss is deductible only if tax code provides specific deduction. © 2011 Rockwell Publishing
Gains and Losses Deductibility of losses Business entities can generally deduct all losses. Individual taxpayer may deduct losses only if connected with: taxpayers trade or business transaction entered into for profit theft or casualty loss of taxpayers property © 2011 Rockwell Publishing
Gains and Losses Capital gains and losses Capital gain or loss: Gain or loss from sale of capital asset, which is property held for: personal use, or investment purposes Capital gains are taxed at lower rate than ordinary income. Capital losses also receive special tax treatment. © 2011 Rockwell Publishing
Capital Gains and Losses Deductibility of capital losses Even though loss on principal residence or other property held for personal use is capital loss, not deductible. Capital losses on property held for investment purposes are deductible. © 2011 Rockwell Publishing
Capital Gains and Losses Net gain or net loss Capital gains and deductible capital losses are netted against each other. Net capital loss may be deducted. But annual limit on amount that can be deducted as net capital loss. Net losses over limit may be carried forward and deducted in future years. © 2011 Rockwell Publishing
Gains and Losses Tax shelters Tax shelter: Arrangement that allows taxpayer to reduce taxes by deducting losses from one source from gains (income) from another source. © 2011 Rockwell Publishing
Basic Taxation Concepts Basis To determine gain or loss on property transaction, you must know taxpayers basis. Basis: Property owners investment in the property. Maximum amount taxpayer could receive without realizing a gain. © 2011 Rockwell Publishing
Basis Initial basis Initial basis: Original cost of acquisition. How much owner paid to acquire the property. Typically purchase price plus closing costs. © 2011 Rockwell Publishing
Basis Adjusted basis Initial basis may be increased or decreased to get adjusted basis: start with initial basis add capital expenditures subtract allowable depreciation deductions When property sold, IRS will use adjusted basis to calculate capital gain or loss. © 2011 Rockwell Publishing
Adjusted Basis Capital expenditures Capital expenditures: Expenditures that add to a propertys value or extend its life. Examples: remodeling, new roof Maintenance expenses are not capital expenditures. Examples: painting, fixing leaky plumbing © 2011 Rockwell Publishing
Adjusted Basis Allowable depreciation deductions For certain types of property, taxpayers basis also reduced by depreciation deductions (discussed later). Initial basis (acquisition cost) +Capital expenditures -Depreciation deductions Adjusted basis © 2011 Rockwell Publishing
Basic Taxation Concepts Realization Gain not taxed as income until it is realized. For income tax purposes, increase in propertys value not realized until owner sells or exchanges it. Sale or exchange separates gain from asset. © 2011 Rockwell Publishing
Realization Amount realized Amount realized: All benefits received by seller, minus selling expenses (such as brokers commission). Also called net sales price. Benefits received may include: cash property seller received in exchange debt buyer is assuming from seller © 2011 Rockwell Publishing
Realization Calculating gain or loss Amount realized -Adjusted basis Gain or loss © 2011 Rockwell Publishing
Basic Taxation Concepts Recognition Taxes must be paid on gain in year it is recognized. Usually recognized in same year realized. But nonrecognition provisions in tax code permit exceptions in certain transactions. Taxpayer allowed to defer recognition (and taxation) of gain until a later year. © 2011 Rockwell Publishing
Summary Basic Taxation Concepts Income Deduction Tax credit Gains and losses Capital asset Initial basis Adjusted basis Capital expenditure Realization Recognition © 2011 Rockwell Publishing
Classifications of Real Property Tax code has 6 classifications of real property: principal residence property personal use property unimproved investment property property held for production of income property used in trade or business dealer property © 2011 Rockwell Publishing
Classifications of Real Property Principal residence Principal residence property: Home owned by a taxpayer that he lives in most of the time; also called main home. Taxpayer can have only one principal residence at a time. © 2011 Rockwell Publishing
Classifications of Real Property Personal use property Personal use property: Real estate owned for personal use that is not taxpayers principal residence. Example: vacation home © 2011 Rockwell Publishing
Classifications of Real Property Unimproved investment property Unimproved investment property: Vacant land that is held for appreciation and produces no income. © 2011 Rockwell Publishing
Classifications of Real Property Property held for production of income Property held for production of income: Any type of property (residential, commercial, or industrial) used to generate rental income for the owner. © 2011 Rockwell Publishing
Classifications of Real Property Property used in trade or business Property used in a trade or business: Land and buildings a taxpayer owns and uses in her trade or business. © 2011 Rockwell Publishing
Classifications of Real Property Dealer property Dealer property: Property a taxpayer is holding primarily for sale to customers. Example: subdivided land available for sale to public. © 2011 Rockwell Publishing
Nonrecognition Transactions Taxpayer generally must pay tax on gain in the year gain is realized. But tax code allows recognition of gain to be deferred to a later year in: installment sales involuntary conversions tax-free exchanges © 2011 Rockwell Publishing
Nonrecognition Transactions Installment sales Installment sale: When seller receives less than 100% of price in year sale occurs. Buyer pays seller rest of price in subsequent year(s). Nearly all seller-financed transactions are installment sales. © 2011 Rockwell Publishing
Installment Sales Deferral of taxation With installment sale, only the part of the gain seller receives in a particular tax year is taxed that year. Gain basically prorated over term of installment contract. Installment sale reporting permitted for all classes of property except dealer property. © 2011 Rockwell Publishing
Installment Sales Gross profit ratio Amount of gain seller must report each year is based on the gross profit ratio. Gross profit ratio: Relationship between sellers gross profit and contract price; also called gross profit percentage. Gross profit: Difference between sales price and adjusted basis plus selling expenses. © 2011 Rockwell Publishing
Installment Sales Gross profit ratio To calculate gross profit: start with the contract price (sales price) subtract sellers basis at time of sale subtract selling expenses To calculate gross profit ratio: divide gross profit by contract price © 2011 Rockwell Publishing
Installment Sales Example Contract price: $300,000 Sellers adjusted basis: $248,500 Brokerage commission: $18,000 Other selling expenses: $3,500 Whats the gross profit? $300,000 - $248,500 - $18,000 - $3,500 = $30,000 gross profit Whats the gross profit ratio? $30,000 gross profit ÷ $300,000 contract price =.1, or 10% gross profit ratio © 2011 Rockwell Publishing
Installment Sales Calculating the years gain Principal payments received ×Gross profit ratio Gain to be taxed that year Gross profit ratio not applied to interest. Interest always taxed in year collected. © 2011 Rockwell Publishing
Installment Sales Example, continued Gross profit ratio: 10% In year of sale, seller received: $27,500 downpayment $2,067 in principal payments $19,725 in interest payments Whats the taxable income from the sale for this year? $27,500 downpayment + $2,067 principal = $29,567 $29,567 ×.10 = $2, recognized gain $2,957 gain + $19,725 interest = $22,682 taxable income for year of sale © 2011 Rockwell Publishing
Nonrecognition Transactions Involuntary conversion Involuntary conversion: When property converted into cash without owners voluntary action. May occur through: condemnation destruction theft © 2011 Rockwell Publishing
Involuntary Conversion May result in gain Involuntary conversion often involves gain for owner. Government or insurer compensates owner. Compensation is based on propertys current replacement cost or market value. © 2011 Rockwell Publishing
Involuntary Conversion Deferral of gain IRS allows deferral of gain if taxpayer replaces property within allowed replacement period. Replacement period: generally lasts for 2 years. Any gain not applied toward replacement property will be taxed as income. © 2011 Rockwell Publishing
Nonrecognition Transactions Tax-free exchanges Tax-free exchange: When real property is exchanged for other real property and owner allowed to defer recognition of gain. Also called a 1031 exchange. Not actually tax-free. Taxation deferred indefinitely, but not avoided altogether. © 2011 Rockwell Publishing
Tax-free Exchanges Eligible types of property Eligible for tax-free exchange: unimproved investment property property held for production of income property used in trade or business Not eligible: principal residence personal use property dealer property © 2011 Rockwell Publishing
Tax-free Exchanges Like-kind property To qualify, properties exchanged must be like-kind properties. Real property must be exchanged for other real property located in the U.S. Like-kind property not necessarily the same type of real property. Example: apartment building can be exchanged for unimproved land. © 2011 Rockwell Publishing
Tax-free Exchanges Boot Boot: Anything received in an exchange other than like-kind property, including: cash stock personal property debt relief (difference in mortgage balances) Boot recognized in year exchange occurs. © 2011 Rockwell Publishing
Tax-free Exchanges Example Taxpayer who owns apartment building trades it for office building. Apartment building: $970,000 mortgage Office building: $880,000 mortgage How much boot is the taxpayer receiving? $970,000 - $880,000 = $90,000 boot (debt relief) Only the boot will be taxed in the year of the exchange. Taxation of any other gain (if the office building is more valuable than the apartment building) will be deferred. © 2011 Rockwell Publishing
Tax-free Exchanges Basis in new property As a general rule, taxpayers basis in property that was traded away is transferred to the property received. But if exchange involved boot, then adjustments to basis are necessary. © 2011 Rockwell Publishing
Summary Property Types and Nonrecognition Principal residence Personal use property Unimproved investment property Property held for the production of income Property used in a trade or business Dealer property Installment sale Gross profit ratio Involuntary conversion Replacement period Tax-free exchange Like-kind property Boot © 2011 Rockwell Publishing
Sale of Principal Residence Gain on sale of a principal residence may be permanently excluded from taxation. Not just deferred (as in exchange or installment sale). © 2011 Rockwell Publishing
Sale of Principal Residence Limits on exclusion of gain Taxpayer may exclude entire gain on sale of principal residence, up to: $250,000 for individual taxpayer $500,000 for married taxpayer filing joint return Any amount in excess of $250,000 or $500,000 taxed as capital gain in year of sale. © 2011 Rockwell Publishing
Sale of Principal Residence Qualifying for the exclusion Within last five years, taxpayer must have: owned home for at least two years, and lived in it as principal residence for at least two years. Only one spouse must meet ownership test, but both must meet use test. Exclusion can generally be used only once every two years. © 2011 Rockwell Publishing
Deductions for Property Owners Deductions: Subtracted from income before tax rate applied and taxes calculated. Deductions available to property owners: depreciation repairs property taxes mortgage interest © 2011 Rockwell Publishing
Deductions Depreciation deductions Depreciation deductions: Allow taxpayer to recover cost of asset over a period of years. Also called cost recovery deductions. Apply only to: property held for production of income property used in a trade or business © 2011 Rockwell Publishing
Depreciation Deductions Ineligible types of property Depreciation deductions not available for: principal residence personal use property unimproved investment property dealer property © 2011 Rockwell Publishing
Depreciation Deductions Depreciable property Assets are depreciable only if they will eventually wear out and need to be replaced. Includes structures as well as equipment for a farm or business. Does not include the land, which does not wear out. © 2011 Rockwell Publishing
Depreciation Deductions Time frame Entire expense of acquiring asset cant be deducted in year incurred. Expense deducted over a specified number of years, depending on type of asset. For most real estate, recovery period between 27½ and 39 years. © 2011 Rockwell Publishing
Depreciation Deductions Depreciation subtracted from basis Allowable depreciation deductions subtracted from initial basis to arrive at adjusted basis. Initial basis +Capital expenditures –Allowable depreciation Adjusted basis Depreciation deductions subtracted even if taxpayer did not take them. © 2011 Rockwell Publishing
Deductions Repair deductions Repair deductions: Property owner may deduct expenditures made to keep property in ordinary operating condition. Not available for principal residence or personal use property. Capital expenditures (which add to propertys value and may prolong its life) not deductible. Instead, these are added to basis. © 2011 Rockwell Publishing
Deductions Property tax deductions General real estate taxes are deductible. Special assessments: deductible if for maintenance or repairs not deductible for improvements © 2011 Rockwell Publishing
Deductions Mortgage interest deductions Interest paid on a mortgage loan is deductible for all types of property. But there are limits on this deduction for personal residences: principal residence second home © 2011 Rockwell Publishing
Deductions Mortgage interest deductions For personal residence, taxpayer can deduct interest paid on: Loan of up to $1,000,000 used to buy, build, or improve home. Home equity loan of up to $100,000. For married taxpayer filing separately, limits are $500,000 and $50,000. Interest on loan amount over limits not deductible. © 2011 Rockwell Publishing
Deductions Deductibility of points and loan costs Buyer may deduct origination fee and discount points for new loan. Treated as prepaid mortgage interest. Even seller-paid points (but buyers basis reduced). Fees lender charges buyer for specific services not deductible. Sellers prepayment penalty also deductible as form of interest. © 2011 Rockwell Publishing
Summary Exclusions and Deductions Exclusion for sale of principal residence Depreciation deductions Depreciable property Repair deductions Property tax deductions Mortgage interest deductions and limits Deductibility of points Deductibility of prepayment penalty © 2011 Rockwell Publishing
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