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Chapter 16 Federal Taxation and Real Estate Finance © OnCourse Learning
Chapter 16 Learning Objectives Understand how the rules and regulations of federal income taxation affect both the value of real estate investments and financing decisions Understand how changes in the tax rules can alter the return on real estate investment © OnCourse Learning 2
Tax Regulations and Their Effect on the Value of Real Estate Investment Definition of income for tax purposes differs from BTCFs Non cash expenses are allowed (e.g. deduct depreciation) Interest payments on debt can be expensed The actual amount of taxes paid affected by: Differential tax rates on income and capital gains Offset of losses against other sources of income Providing for alternative minimum tax (AMTs) Establishing favorable classes of real estate investment (low- income housing, historical structures) 3 © OnCourse Learning
Classification of Real Property Property Held for Principal Residence Property Held for Investment Property Held for Resale to Others Property Held for Use in Trade or Business © OnCourse Learning 4
Property Held as Principal Residence Mortgage interest and property taxes are tax- deductible; maintenance costs are not Cannot depreciate Capital losses are not tax-deductible Capital gains exclusion of $250,000 ($500,000 for married filing jointly) for one sale every two years Owned and occupied two out of the last five years © OnCourse Learning 5
Property Held for Investment Held strictly for income or investment and owner has no participation in operations Generally unimproved land and net leases Limitations on interest deductibility Limitations of capital Loss write offs © OnCourse Learning 6
Property Held for Resale to Others Viewed as inventory Income is taxed as ordinary income (not capital gains) Owners treated as dealers Cannot depreciate Losses are operating losses © OnCourse Learning 7
Property Held for Use in Trade or Business Section 1231 asset Generally the most favorable classification Owned for the purpose of deriving income Can depreciate Operating expenses and mortgage interest are tax- deductible Capital losses are tax-deductible © OnCourse Learning 8
Tax Shelters A tax shelter is an investment whose value is enhanced by tax rules and regulations Real estate has the potential of a tax shelter Tax rules may create value that otherwise would not exist © OnCourse Learning 9
Real Estate Tax Regulations – Definition of Income Taxable income differs from BTCF in the treatment of depreciation and interest as expense Depreciation is a noncash outlay but a tax-deductible expense The value of depreciation is the depreciation amount times the investor’s marginal tax rate © OnCourse Learning 10
Depreciation - Depreciable Basis The Original Cost Basis is the purchase price (of land and improvements) plus acquisition costs Land and the portion of acquisition costs attributable to the land are not depreciable Depreciable basis is the original cost basis minus the value of the land and land portion of acquisition costs Value of the land may be determined by independent appraisal or by property appraiser’s office © OnCourse Learning 11
Depreciation - Cost Recovery Period Is the period over which depreciation can be taken Congress periodically alters the recovery period for depreciation Recovery period is currently 27.5 years for residential income property and 39 years for non-residential income property © OnCourse Learning 12
Methods of Depreciation © OnCourse Learning 13
Methods of Depreciation 1993-1997 Top marginal tax rate of 39.6%; Max. CG tax rate of 28%; 39 years SL depreciation for commercial real estate 1997-2003 Increased holding period for LT gains to 18 months; Max cap. gain rate of 20% Post 2003 Max. marginal income tax rate lowered to 35% Max. tax rate for depreciation capture for section 1250 properties of 25% Max. capital gain rate of 15% 2013 Bush tax cuts from 2003 expired – maximum marginal income tax rate of 39.6% Max. capital gain tax rate of 20% (for 39.6% tax bracket) 14 © OnCourse Learning
Calculating Depreciation The depreciation deduction can be calculated by multiplying the depreciable basis by the depreciation rate Mid-month convention assumes that the asset is put into service (and sold) on the 15th day of the month regardless of the actual day of occurrence © OnCourse Learning 15
Taxes and Interest Payment Original Issue Discount (OID) Rates Debt that is issued at a discount from the face value No coupons or payments over its life Incentive to convert ordinary income to capital gains income when tax rates are different Use of large amounts of nonrecourse debt to sell properties at inflated prices © OnCourse Learning 16
Interest Rate Rules Adequacy-of-Interest Test If the stated interest is less than 110% of the applicable federal rate, an interest rate will be imputed at 120 percent of the applicable federal rate Time Value of Money Test Even though payments may not be made annually the interest must be calculated and reported annually © OnCourse Learning 17
Imputed Interest Rule Properties exempted from OID rules: sales of farms by individuals for less than $1 million; residences under $250,000; and transactions between related parties under $500,000 For properties exempted from OID rules imputed interest rule applies Requires a fair interest rate to be charged or imputed © OnCourse Learning 18
Capital Loss Limitation Allows capital losses to be written off only against capital gains Capital losses in excess of capital gains can be written off against other income up to $3,000 annually Unused balance can be carried forward © OnCourse Learning 19
Passive Loss Limitation Instituted by the the 1986 Tax Reform Act Three categories of income: Active income: Earnings, etc. Portfolio income: Stocks, bonds, etc. Passive income: Real estate Losses are restricted to each category © OnCourse Learning 20
Passive Losses Passive losses cannot be used to offset income from REITs and REMICs Includes non-active real estate activity, specifically limited partnerships Loophole to be treated as active: AGI less than $100,000 can deduct up to $25,000 in losses from other income Is phased out at AGI of $150,000 © OnCourse Learning 21
Tax-Deferred (1031) Exchanges Property must be held for use in trade or business or for investment, owner-occupied residences do not qualify Properties exchanged must be of like kind The exchange must occur; cannot sell for cash and immediately purchase Properties adjusted basis will be equal © OnCourse Learning 22
Tax-Deferred (1031) Exchanges Types of 1031 exchanges Direct Exchanges Third-Party Exchanges Delayed Exchanges Boot - Property that is not like kind such as cash or debt relief Identification period is 45 days Exchange period runs for 180 days © OnCourse Learning 23
Installment Sale Seller takes back a promissory note from the buyer Installment sale vs. outright sale Sale price is paid in installments Gross profit percentage is the proportion of capital gain that is taxed each year © OnCourse Learning 24
Installment Sale Related persons rule If an installment sale is made to a related person who sells the property within a two-year period, the original seller must recognize the balance of the gain at the time the related person makes the sale. Imputed interest rule applies Any down payment amount is allowed Debt amortization vs. installment period © OnCourse Learning 25
Washington Real Estate Fundamentals Lesson 14: Federal Income Taxation and Real Estate © 2011 Rockwell Publishing.
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