1. Real Estate Principles and Practices Chapter 16 Investment and Tax Aspects of Ownership © 2010 by South-Western, Cengage Learning

2. Key Terms Adjusted basis Basis Cash flow Corporations Depreciation Gain General partnership Installment sale Joint venture Leverage Limited partnership Negative cash flow Partnership Passive income Prospectus Real Estate Investment Trust (REIT) S Corporation

3. © 2010 by South-Western, Cengage Learning Key Terms Salvage value Securities and Exchange Commission (SEC) Straight-line depreciation Syndication Tax-free exchange Tax shelter Useful life

4. © 2010 by South-Western, Cengage Learning Overview Investing in a residence Advantages of homeownership as an investment Investing in income-producing real estate Benefits to the real estate investor

5. © 2010 by South-Western, Cengage Learning Homeownership as an Investment Itemized deductions on taxes, mortgage interest for 1 st and 2 nd homes 2 nd home: annual occupancy for at least 14 days or 10% of useful rental period Equity loans Tax Reform Act of 1986

6. © 2010 by South-Western, Cengage Learning Calculating the Benefits of Homeownership Married couple, filing jointly, will pay 28% income tax $70,000mortgage X.08 interest rate $5,600 annual interest X.28 tax savings tax bracket $1,568 $1,568 ÷ 12 = $130.66 per month $669.20 PITI – $130.66 = $538.54

7. © 2010 by South-Western, Cengage Learning Calculating the Benefits of Homeownership $1800 property tax per year Building equity Appreciating in value $1,800 X 28% = $504.00 per year $538.54 – $42.00 = $796.54 $504.00 ÷ 12 = $42.00 per month

8. © 2010 by South-Western, Cengage Learning Appreciation and Homeownership Rising construction and land cost Supply of funds and market conditions Demand for housing Needs of each generation

9. © 2010 by South-Western, Cengage Learning Depreciation of a Residence Depreciation not allowed for a residence Exception: portion allowed for in home office

10. © 2010 by South-Western, Cengage Learning How Tax Provisions Affect Sale of Principal Residence Excluded amount $500,000 married filing jointly $250,000 single return May be claimed every 2 years Death of spouse results in 2 year limit to maintain the $500,000 exclusion

11. © 2010 by South-Western, Cengage Learning How Tax Provisions Affect Sale of Principal Residence Eligibility requirements:. Ownership: 1. Ownership: minimum 2 of the last 5 years Use: 2. Use: principal residence for at least 2 of the last 5 years Waiting period: 3. Waiting period: exclusion may not have been used for any sale during the past 2 years

12. © 2010 by South-Western, Cengage Learning How Tax Provisions Affect Sale of Principal Residence Loss on sale is not deductible Gain which exceeds the excluded amount is taxed as a capital gain Rate of tax: 20% (10% for taxpayers in 15% bracket) 1. Assets sold after 7/28/87: 18 month holding period 2. Deprecation recapture: 25% rate 3. Maximum rate after 12/31/2000:18%

13. © 2010 by South-Western, Cengage Learning How Tax Provisions Affect Sale of Principal Residence Basisadjusted: Basis is adjusted: gain Cost of new residence minus gain on old residence $65,000 1990 Purchase price 1992 added family room 8,500 $73,500 Adjusted basis 88,000 2008 sale price 6,330 Less selling expenses $81,670

14. © 2010 by South-Western, Cengage Learning How Tax Provisions Affect Sale of Principal Residence Basisadjusted: Basis is adjusted: gain Cost of new residence minus gain on old residence 73,500 Less adjusted basis Gains from sale 8,170 $95,000 New purchase price 8,170 Less gain from sale Adjusted basis $86,830 $81,670

15. © 2010 by South-Western, Cengage Learning How Tax Provisions Affect Sale of Principal Residence Calculate the purchase price Rollover (IRS Form 2119: Sale of Your Home”) Capital improvements are deductible Costs of sale are deductible Not tax deductable Determining the Basis for Measuring Gain Selling at a Loss

16. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment Reasons for investing in real estate Appreciation Cash flow Equity buildup Tax shelter Primary purpose: Generate income Long term capital growth without risk Purchasing Real Estate vs. Fixed Income Investment

17. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment “the higher the risk the greater the return” Net proceeds after all expenses Risk and Return Cash Flow Income from office building $44,000 Expenses17,000 Debt service 18,000 Cash flow $9,000

18. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment Negative cash flow Negative cash flow: tax deductible expenses are greater than income Tax Shelter: Tax Shelter: book loss Income$44,000 Expenses22,000 Interest deduction 18,000 Depreciation deduction $44,000 8,000 $46,000 $2,000 book loss

19. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment Passive income: Passive income: not containing the taxpayers’ active involvement 3 Classifications of income Active income Portfolio income Passive activity income Losses up to $25,000 may be used to offset salaries and active business income

20. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment Value is determined by income produced Value = annual net income divided by desired rate of return Rate of Return $15,000 Net annual income 12% Desired rate of return = $125,000 Property value with 12% return

21. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment Future income is converted to present value Greater risk = higher cap rate = lower value Property depreciates as the economic life is depleted Rate of Return $15,000income 16% rate of return = $93,750 Property value to investor

22. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment Accounting concept for tax purposes Estimates future decreases in value Useful life: Useful life: economic life Salvage value: Salvage value: value after useful life Depreciation

23. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment 1981 – Tax Recover Act: “recovering the cost” straight line depreciation TRA 86: straight line depreciation over 27 ½ years Properties deprecate in equal installments over a predetermined period of time Land does not depreciate Depreciation

24. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment Annual depreciation of a single family residential rental Depreciation Land Value: $ 32,000 Improvements: $ 88,000 Assessed value: $120,000 Improvements: $ 88,000 ÷ 27.5 $ 3,200 = Annual depreciation

25. © 2010 by South-Western, Cengage Learning Real Estate as an Income- Producing Investment 2. Investment financed: $125,000 investment $93,750 mortgage = $31,250 equity invested subtract one year’s interest at 10% from $15,000 income: $15,000 - $9,375 = $5,625 net income $15,000 - $9,375 = $5,625 net income $5,625 ÷ 31,250 = 18% annual return Leverage

26. © 2010 by South-Western, Cengage Learning Investment Opportunities Types of investments Holding power needed for land investments Income Purchase price: $75,000 $450 @ 12 mos. = $5,400.00 $500 @ 12 mos. = 6,000.00 Gross Income = $11,400.00

27. © 2010 by South-Western, Cengage Learning Investment Opportunities Expenses Insurance policy $340.00 Supplies & materials 280.00 Taxes 900.00 Maintenance 320.00 Mortgage payments 7,030.80 Net Income $8,870.80 $2,529.20

28. © 2010 by South-Western, Cengage Learning Real Estate Offerings as Securities Real estate purchased for investment is considered a security Securities Act of 1933 – 4 elements of an “investment contract” 1. Investment of money 2. Common enterprise 3. Undertaken for prospect of a profit 4. Profit derived from management efforts of others

29. © 2010 by South-Western, Cengage Learning Real Estate Offerings as Securities Purpose of Securities Act: full and fair disclosure Prospectus: Prospectus: disclosure of basic information of the enterprise interstate Exception for interstate Blue sky laws: Blue sky laws: securities license required