©2011 Cengage Learning

Chapter 17 ©2011 Cengage Learning INCOME TAX ASPECTS OF INVESTMENT REAL ESTATE

Income tax advantages for income-producing real estate Interest on loans used to purchase or improve rental real estate is fully deductible. Operating expenses are deductible. Depreciation (cost recovery) is a non-cash deduction. Favorable capital gain treatment. May use installment sale reporting when seller carries a note and deed of trust. Exchange can defer all gain and taxes if the investor follows the rules of IRS Section ©2011 Cengage Learning Major Income Tax Advantages

Dealers do not get the following income tax benefits: Depreciation Capital Gains Installment Sales ©2011 Cengage Learning

Basis refers to the property owner’s cost Initial basis is determined by the method of acquisition. Depreciation is based on purchase price not value. Land and improvements must be allocated. Straight-line depreciation is used. ©2011 Cengage Learning Basis and Depreciation

According to the Tax Reform Act of 1986, income is classified as: Active Income - wages, commissions, profits from owner-managed business, etc. Portfolio Income - interest on savings, divided on stocks, bonds, etc. Passive Income - limited partnerships, business ventures with no active role, rents from rental real estate, etc. ©2011 Cengage Learning Passive Loss Rules

The General Rule A passive loss can offset only passive income. Passive losses cannot normally be used to offset active or portfolio income. ©2011 Cengage Learning

Exception to Passive Loss Rule Exemption is known as the $25,000 real estate exception to the passive loss rule. To qualify for this $25,000 exception, the taxpayer must meet the following tests: must own 10% or more of property. must be active in management. modified adjusted gross income must be $100,000 or less. ©2011 Cengage Learning

Qualified Real Estate Professionals Who spend: at least 750 hours and more than one-half of all business time per year in real estate activities. Can use real estate losses to offset any business or personal income. ©2011 Cengage Learning

Tax on Capital Gains Sell for cash & pay the tax Owner Finance & defer tax 1031 exchange & defer tax ©2011 Cengage Learning Calculating and Deferring Gain

©2011 Cengage Learning Calculating Gain and Taxes Owed on Income Property Step 1: Calculate Adjusted Cost Basis Initial (original) basis Plus: Buyer’s capitalized closing costs Plus: Capital improvements, if any Minus: Depreciation for term of ownership Equals: Adjusted cost basis on date of resale

©2011 Cengage Learning Step 2: Calculate Gain Resale price Less: Seller closing costs Less: Adjusted cost basis from Step 1 Less: Carry-forward passive losses, if any Equals: Gain on sale Step 3: Apply capital gain treatment to the gain to calculate the tax owed

Installment Sale Advantages Method of sale for a slow real estate market Lower the tax owed immediately Tax can be paid in the future with inflated (cheaper) dollars. Disadvantages Not all money is received up front May pay more in taxes depending on future income Buyer could default ©2011 Cengage Learning

Sale of Principle Residence No tax on gain Up to $250,000 if single Up to $500,000 for married Principal residence for at least two out of the last five years ©2011 Cengage Learning