1 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHAPTER 4 FOUR CLASSES OF REAL PROPERTY Real estate held as a personal residence. Real estate held for sale to others--dealer property. Real estate held for use in a trade or business-- trade or business property. Real estate held as an investment for the production of income - investment property.

2 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Types of Taxable Income Active income (e.g., salaries, wages, bonuses, and commissions). Portfolio income (e.g., interest, dividends, and capital gains). Passive income (e.g., rents from real estate, and royalties from oil and gas rights).

3 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin General Tax Formula for Individuals

4 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin PASSIVE ACTIVITY LOSS RESTRICTIONS Passive losses cannot be used to reduce active or portfolio income. Passive losses may be used to reduce other passive income. Passive losses not used may be used in future years or at the time of sale. Active participants may deduct up to $25,000 in passive losses against other non-passive income, subject to limitations.

5 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin TAX ON OPERATIONS

6 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin AFTER TAX CASH FLOW FROM OPERATIONS

7 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Tax Shelter Partial Tax Shelter: NOI is positive but taxable income of asset reduced due to depreciation and costs of financing Deep Tax Shelter: NOI is negative (tax loss) due to depreciation and costs of financing –Tax losses may be used to reduce the taxes due on other passive income ordinary and portfolio income of qualified active participants

8 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Interest Expense and Amortized Financing Costs Interest and Prepaid Interest Costs of Financing Financing costs amortized over the term of the loan. Unused balance taken in the year sold.

9 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Depreciation Basis The original cost basis includes all costs associated with acquiring the property and transferring the title Land value cannot be depreciated The depreciable basis is the total value that can be depreciated over the recovery period Depreciable Basis = Cost Basis - Land Amount

10 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Annual Depreciation Deduction Annual Depreciation = Depreciable Basis / Recovery Period –mid-month convention

11 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Cost Recovery Period Residential Income Property (27.5 years) Other Commercial Income Property (39 years) Personal Property (3-15 years)

12 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Original Cost Basis and Depreciation The original cost basis is affected by depreciation and substantial (capital) improvements

13 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin TAX DUE ON SALE

14 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin AFTER TAX CASH FLOW FROM SALE

15 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Net Effects of Annual Depreciation Defers taxes –If annual tax incidence transferred from period of operation to period of sale Reduces taxes –If capital gains rate less than ordinary tax rate –If tax losses can be used to offset passive income –If tax losses can be used to offset other income

16 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Ordinary versus Capital Gain Income Definition of a Capital Asset Tax Treatment for Capital Assets Tax Treatment for Section 1231 Assets

17 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin METHODS OF DEFERRING TAXES ON DISPOSITION Installment Sale Like-Kind Exchange

18 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin TAX FACTORS AFFECTING HOME OWNERS Preferential Tax Treatment of Home Owners –Capital gains of $250,000 are excluded from income for individuals ($500,000 for couples filing joint returns) –Home owners allowed to deduct mortgage interest and local property taxes.