What is it? Real estate is land and the buildings and improvements on land. By definition, real estate includes natural assets, such as minerals, under the land. Because of the obvious limited supply of land, especially in “desirable” locations, real estate has long been viewed as an attractive investment alternative. Real estate can be classified into four major categories: Land Residential Commercial Industrial Copyright 2007, The National Underwriter Company

What is it? Land Residential Unimproved Farm land Recreational Ranches Subdivided lots Residential Single family dwellings Multiple family dwellings Apartments and condominiums Hotels and motels Copyright 2007, The National Underwriter Company

What is it? Commercial Industrial Residential rental Office buildings Retail stores Shopping centers Specialty buildings Industrial Factories Warehouses Industrial parks Utility facilities Copyright 2007, The National Underwriter Company

When is the use of this tool indicated? When an investor desires an investment with tax shelter potential When a long-term hedge against inflation is needed When a relatively constant cash flow is required When an investor is looking for long-term appreciation When the investor would like a tangible investment When the investor wants to make maximum use of leverage Lenders are willing to advance large sums of money on the security of real estate for long periods of time at relatively low interest because real estate is not only tangible and stationary, but is also reasonably stable in value Copyright 2007, The National Underwriter Company

Advantages Real estate has numerous different tax related advantages: Expenditures that are considered ordinary and necessary in the production or collection of income or in the preservation of its value as an investment are deductible. The cost of supplies, labor, and other components necessary to keep the property in good repair can be deducted. Real estate property taxes are deductible. A tenant leasing business property may deduct reasonable rental costs. Interest on the unpaid balance of the mortgage is deductible The full cost of buildings and real estate improvements is depreciable. Copyright 2007, The National Underwriter Company

Advantages Gain on the sale of real estate can be reported over more than one tax year. This may allow the investor to defer the payment of tax until cash proceeds from an “installment sale” of the property are received Losses incurred on the sale of real estate are deductible. One parcel of real estate can be exchanged for another without immediate recognition of income. Tax-free exchange rules Upon the “involuntary conversion” of real estate, the investor does not have to pay any tax upon the receipt of cash from insurance or condemnation award. So long as the cash is reinvested in “qualified property” having equal or greater value Copyright 2007, The National Underwriter Company

Advantages Liquidity can be obtained from real estate without paying taxes through a mortgage on the property. The cost of rehabilitating certain buildings or structures may qualify for a special investment tax credit. “Passive activity” tax rules Limit the ability to use real estate losses to offset income from other sources Copyright 2007, The National Underwriter Company

Advantages Real estate is tangible. Real estate has historically proven itself as an excellent hedge against inflation. It tends to increase in value while prices are rising and the value of the dollar is declining. Each parcel of real estate is unique. Because no two parcels can share the same location, no two can be exactly alike. The “monopoly” each real estate owner has on each individual location is itself of value. Because of its great value as security for a loan, real estate enables an investor to obtain maximum potential leverage. Copyright 2007, The National Underwriter Company

Disadvantages Real estate is almost always relatively illiquid. Difficult to convert to cash quickly Some degree of management is necessary with all real estate investments. Typically the investment in real estate is large in amount. Requires the commitment of investable funds for a long period of time. Copyright 2007, The National Underwriter Company

Disadvantages Costs related to the purchase or sale of real estate reduce its value as an investment that can produce a short-term gain. Include transfer taxes, title insurance, appraisals, financing fees and “points,” title recording and notary fees, and sales commissions May run as high as 10–15% Real estate, by definition, cannot be moved. Copyright 2007, The National Underwriter Company

Disadvantages Once land has been improved with a building, that “improvement” is often difficult and expensive to modify or remove. Referred to as “fixity” of investment. It is often difficult or impossible to assess the economic risks and projected return on a real estate investment with exactness. Because the investment return on real estate is significantly affected by the available tax benefits, such investments are most susceptible to the risk of challenge by the IRS. Copyright 2007, The National Underwriter Company

Tax Implications All the ordinary and necessary expenses paid or incurred by a real estate investor during the taxable year in carrying on a trade or business are deductible. Include costs incurred in the production or the collection of investment income, as well as expenditures for the management, conservation, or maintenance of real estate property held either to produce income or for appreciation Routine repair and maintenance expenses (those that do not appreciably add to the value of the property) are deductible in the year the outlay is incurred. The cost of improvements must be capitalized. Added to the investor’s basis in the property Recovered through depreciation deductions Copyright 2007, The National Underwriter Company

Tax Implications Amounts paid for real property taxes are deductible when paid. Construction period taxes must be capitalized and then amortized. Rental expenses for the use of business property are deductible currently. Interest paid to finance the purchase of investment real estate may be deductible currently. Rules may limit the deductibility of: Construction period interest Investment interest Prepaid interest Points Passive losses / “At risk” rules Copyright 2007, The National Underwriter Company

Tax Implications Land is not depreciable Improvements upon the land are eligible for depreciation deductions. Tax losses from depreciation deductions are subject to the “passive activity” rules. Tax on the gain upon the sale of real estate can be deferred. “Installment sale rules” permit an investor to delay reporting any gain or paying any tax until money is received. The law does not set a limit as to how long the parties can agree to extend the payment period. Tax law expects that the parties will provide for interest on the loan inherent in an installment sale. Copyright 2007, The National Underwriter Company

Tax Implications Losses on the sale of real estate held for investment or used in a trade or business are generally deductible in the year incurred. Losses incurred on the sale of personal use realty are not deductible. Real estate held purely for investment is treated as a capital asset. Subject to capital gain / loss rules Real property used in a trade or business is not a capital asset. If held for the long-term holding period before being sold, such property is called “Section 1231 Property.” Capital gain or ordinary loss Copyright 2007, The National Underwriter Company

Tax Implications “Like-kind” exchange Under certain circumstances, it is possible for an investor to trade/exchange properties with another party and postpone all or part of the gain that would normally have to be recognized on a sale. Tax deferral may also be available upon “involuntary conversion.” Involuntary conversion is the destruction of property by fire or other casualty. It may also be caused by the condemnation of property by a governmental body utilizing its right to take private property and convert it to the use of the public. Any gain realized can usually be deferred if the investor reinvests the full proceeds in similar property within three years from the end of the year in which the proceeds are received. Copyright 2007, The National Underwriter Company

Tax Implications An investor can convert part of the appreciated value of property into cash without either selling it or otherwise triggering a tax on any gain. Use property as security for a loan The cost of constructing or rehabilitating certain building or structures may qualify for a special investment credit. The properties eligible for this credit include: Qualified low income housing Certified historic structures Buildings that were first placed in service before 1936 Copyright 2007, The National Underwriter Company

Alternatives Few investments are comparable to real estate because of its unique characteristics, location, potential for significant tax shelter benefits and relatively constant cash flow, and psychological comfort. Other investments, such as stocks, do provide a long-term hedge against inflation, the possibility of substantial appreciation, and the potential to maximize the use of leverage. Copyright 2007, The National Underwriter Company

Where and How do I get it? An individual will typically purchase real estate in his own name directly from the seller or through a real estate broker or agent. Most real estate acquired for tax shelter purposes is acquired by purchasing an interest in a partnership or other investment entity. Copyright 2007, The National Underwriter Company

Where and How do I get it? Real estate may be held by an investor in any of the following forms: Outright ownership General partnership or joint venture Limited partnership Corporate (C corporation) S corporation Real estate investment trust (REIT) Copyright 2007, The National Underwriter Company

Where and How do I get it? Outright Ownership Does not protect the individual investor from full personal liability relating to the ownership and operation of the property Full management responsibility All tax benefits and costs are personal to the investor An outright owner can convey the title to all or a portion of the property at any time without restriction Death results in the termination of the individual ownership form The property will then pass through the investor’s estate to his heirs or by operation of law to his joint owners. Copyright 2007, The National Underwriter Company

Where and How do I get it? General Partnership Two or more individuals join together for investment purposes General partner jointly and severally liable for all the debts and obligations If a partner cannot pay his part of the obligation, the remaining partners are liable. Usually only a few partners are actively involved in operations Not taxed as separate entities Income, deductions, and credits flow through to the partners Losses deductible only up to basis in partnership Right to transfer interest in property is limited to the terms of the partnership agreement Death of a partner may cause termination of the partnership unless the partnership agreement provides otherwise Copyright 2007, The National Underwriter Company

Where and How do I get it? Limited Partnership Limited liability for “limited partners” Most are heavily leveraged Limited partners not at risk: may not be able to deduct partnership losses Limited partners cannot take part in management Vested solely in the general partner Income, deductions, and credits flow through to the partners according to their proportionate ownership Copyright 2007, The National Underwriter Company

Where and How do I get it? Right to transfer interest in property is limited to the terms of the limited partnership agreement More restrictive than partnership agreements Death of a partner will not cause the termination Heirs succeed in interest Syndicated partnership Syndicator-promoters Investors Copyright 2007, The National Underwriter Company

Where and How do I get it? Corporations Limited liability C or S corp Full liability stops with the corporation Corporate borrowing Personal guarantees Centralized Management Board of directors elected by shareholders Does not terminate at death of shareholder Indefinite life Enhanced transferability Shareholder can transfer any number of shares Restricted on S corp C corporation is a separate legal entity Must file its own tax return Corporate earnings paid to shareholders taxed twice Copyright 2007, The National Underwriter Company

Where and How do I get it? S Corporations Treated essentially the same as a C corporation except for taxation Taxed similarly to a partnership May not have more than 100 shareholders All individuals or trusts No nonresident aliens Not more than 1 class of stock Copyright 2007, The National Underwriter Company

Where and How do I get it? REITs (Real Estate Investment Trust) A vehicle specifically designed to facilitate large-scale public participation in real estate investments. Operates similarly to a mutual fund Having many investors, each contributing relatively small amounts of capital, enables the management of the REIT to make diversified and large-scale investments on their behalf. Copyright 2007, The National Underwriter Company

What fees or other costs are involved? Broker’s commissions Legal fees Title examination and registration fees Title insurance State and local transfer taxes Syndicated real estate venture Higher costs of investing than an investment where the owner finds, develops, and manages the property because these responsibilities are assumed by the developer/promoter. 16% to 26% of the amount invested In a private offering, total costs range from 13% to 25%. Copyright 2007, The National Underwriter Company

How do I select the best of its type? Location of the property Soundness of construction and appropriateness of design for intended use Cost of capital Financing fees The cost of operating and maintaining the property Organization and offering expenses Sales commissions Construction costs Fees paid to the general partner for managing the partnership and the underlying investment property Projected cash flow and tax results from operations Copyright 2007, The National Underwriter Company

Where can I find out more about it? Tax Facts on Investments Tax-Advantaged Investments Tax Planning for Investors The real estate industry offers many educational programs and courses: The National Marketing Institute of the National Association of Realtors The Certified Commercial Investment Member designation Member of Appraisal Institute Farm and Land Institute Graduate of Real Estate Institute Certified Residential Broker Copyright 2007, The National Underwriter Company