Chapter 16Chapter 16

Federal Taxation Federal Taxation and Real Estate and Real Estate

FinanceFinance

Chapter 16Chapter 16Learning ObjectivesLearning Objectives

Understand how the rules and Understand how the rules and regulations of federal income regulations of federal income taxation affect both the value of real taxation affect both the value of real estate investments and financing estate investments and financing decisions decisions

Understand how changes in the tax Understand how changes in the tax rules have altered the return on real rules have altered the return on real estate investmentestate investment

VALUATION OF REAL VALUATION OF REAL ESTATEESTATE

The value of an income-producing The value of an income-producing asset is a function of the income asset is a function of the income accruing to the assetaccruing to the asset

Income for valuation purposes is Income for valuation purposes is generally measured as cash flow generally measured as cash flow either before-tax or after-taxeither before-tax or after-tax

VALUATION OF REAL VALUATION OF REAL ESTATEESTATE

Factors affecting valuation:Factors affecting valuation:– Financial leverageFinancial leverage– Tax shelters such as depreciationTax shelters such as depreciation– Tax treatment of the assetTax treatment of the asset

CLASSIFICATIONS OF CLASSIFICATIONS OF REAL PROPERTYREAL PROPERTY

Property Held for Principal Property Held for Principal ResidenceResidence

Property Held for InvestmentProperty Held for Investment Property Held for Resale to OthersProperty Held for Resale to Others Property Held for Use in Trade or Property Held for Use in Trade or

BusinessBusiness

CLASSIFICATIONS OF CLASSIFICATIONS OF REAL PROPERTYREAL PROPERTY

Property Held as Principal ResidenceProperty Held as Principal Residence– Mortgage interest and property taxes are tax-Mortgage interest and property taxes are tax-

deductible; maintenance costs are notdeductible; maintenance costs are not– Cannot depreciateCannot depreciate– Capital losses are not tax-deductibleCapital losses are not tax-deductible– Capital gains exclusion of $250,000 Capital gains exclusion of $250,000

($500,000 for married filing jointly) for one ($500,000 for married filing jointly) for one sale every two yearssale every two years

– Owned and occupied two out of the last five Owned and occupied two out of the last five yearsyears

CLASSIFICATIONS OF CLASSIFICATIONS OF REAL PROPERTYREAL PROPERTY

Property Held for InvestmentProperty Held for Investment– Held strictly for income or investment Held strictly for income or investment

and owner has no participation in and owner has no participation in operationsoperations

– Generally unimproved land and net Generally unimproved land and net leasesleases

– Limitations on interest deductibilityLimitations on interest deductibility– Limitations of capital Loss write offsLimitations of capital Loss write offs

CLASSIFICATIONS OF CLASSIFICATIONS OF REAL PROPERTYREAL PROPERTY

Property Held for Resale to OthersProperty Held for Resale to Others– Viewed as inventoryViewed as inventory– Income is taxed as ordinary income Income is taxed as ordinary income

(not capital gains)(not capital gains)– Owners treated as dealersOwners treated as dealers– Cannot depreciateCannot depreciate– Losses are operating lossesLosses are operating losses

CLASSIFICATIONS OF CLASSIFICATIONS OF REAL PROPERTYREAL PROPERTY

Property Held for Use in Trade or Property Held for Use in Trade or BusinessBusiness– Section 1231 assetSection 1231 asset– Generally the most favorable classificationGenerally the most favorable classification– Owned for the purpose of deriving incomeOwned for the purpose of deriving income– Can depreciateCan depreciate– Operating expenses and mortgage interest Operating expenses and mortgage interest

are tax-deductibleare tax-deductible– Capital losses are tax-deductibleCapital losses are tax-deductible

TAX LAW CHANGES TAX LAW CHANGES AFFECTING REAL AFFECTING REAL

ESTATEESTATE

Changes in marginal tax ratesChanges in marginal tax rates Changes in depreciation allowanceChanges in depreciation allowance

– Length of recovery periodLength of recovery period– Accelerated versus straight-lineAccelerated versus straight-line

Tax treatment of capital gains Tax treatment of capital gains (losses)(losses)

Ability to write off lossesAbility to write off losses

TAX SHELTERS IN REAL TAX SHELTERS IN REAL ESTATEESTATE

A tax shelter is an investment A tax shelter is an investment whose value is enhanced by tax whose value is enhanced by tax rules and regulationsrules and regulations

Real estate has the potential of a Real estate has the potential of a tax sheltertax shelter

Tax rules may create value that Tax rules may create value that otherwise would not existotherwise would not exist

DEPRECIATION IN REAL DEPRECIATION IN REAL ESTATEESTATE

Depreciation is a noncash outlay but a Depreciation is a noncash outlay but a tax-deductible expensetax-deductible expense

The value of depreciation is the The value of depreciation is the depreciation amount times the depreciation amount times the investor’s marginal tax rateinvestor’s marginal tax rate

Real estate is a physical asset that is Real estate is a physical asset that is considered to “wear out” and considered to “wear out” and deteriorate to a value of zero over deteriorate to a value of zero over timetime

COMPONENTS OF REAL COMPONENTS OF REAL ESTATE DEPRECIATIONESTATE DEPRECIATION

Depreciable Basis Depreciable Basis – The Original Cost Basis is the The Original Cost Basis is the

purchase price (of land and purchase price (of land and improvements) plus acquisition costsimprovements) plus acquisition costs

– Land and the portion of acquisition Land and the portion of acquisition costs attributable to the land are not costs attributable to the land are not depreciabledepreciable

COMPONENTS OF REAL COMPONENTS OF REAL ESTATE DEPRECIATIONESTATE DEPRECIATION

– Depreciable basis is the original cost Depreciable basis is the original cost basis minus the value of the land and basis minus the value of the land and land portion of acquisition costsland portion of acquisition costs

– Value of the land may be determined Value of the land may be determined by independent appraisal or by by independent appraisal or by property appraiser’s officeproperty appraiser’s office

COMPONENTS OF REAL COMPONENTS OF REAL ESTATE DEPRECIATIONESTATE DEPRECIATION

Cost Recovery PeriodCost Recovery Period– Is the period over which depreciation Is the period over which depreciation

can be takencan be taken– Congress periodically alters the Congress periodically alters the

recovery period for depreciationrecovery period for depreciation– Recovery period is currently 27.5 Recovery period is currently 27.5

years for residential income property years for residential income property and 39 years for non-residential and 39 years for non-residential income propertyincome property

METHODS OF METHODS OF DEPRECIATIONDEPRECIATION

Straight-line and acceleratedStraight-line and accelerated Currently only the straight-line Currently only the straight-line

method is allowedmethod is allowed Previously the accelerated cost Previously the accelerated cost

recovery system (ACRS) was recovery system (ACRS) was allowed which provided allowed which provided accelerated depreciation over a accelerated depreciation over a shorter time period (15-19 years)shorter time period (15-19 years)

CALCULATING CALCULATING DEPRECIATIONDEPRECIATION

The depreciation deduction can be The depreciation deduction can be calculated by multiplying the calculated by multiplying the depreciable basis by the depreciation depreciable basis by the depreciation raterate

Mid-month convention assumes that Mid-month convention assumes that the asset is put into service (and sold) the asset is put into service (and sold) on the 15th day of the month on the 15th day of the month regardless of the actual day of regardless of the actual day of occurrenceoccurrence

TAXES AND INTEREST TAXES AND INTEREST PAYMENTSPAYMENTS

Original Issue Discount RatesOriginal Issue Discount Rates– Debt that is issued at a discount from Debt that is issued at a discount from

the face valuethe face value– Incentive to convert ordinary income Incentive to convert ordinary income

to capital gains income when tax to capital gains income when tax rates are differentrates are different

– Recourse vs. nonrecourse debtRecourse vs. nonrecourse debt

INTEREST RATE RULESINTEREST RATE RULES

Adequacy-of-Interest TestAdequacy-of-Interest Test– Rate charged must be comparable to Rate charged must be comparable to

an applicable federal rate based on an applicable federal rate based on Treasury obligationsTreasury obligations

Time Value of Money TestTime Value of Money Test– Even though payments may not be Even though payments may not be

made annually the interest must be made annually the interest must be calculated and reported annuallycalculated and reported annually

INTEREST RATE RULESINTEREST RATE RULES

Imputed Interest RuleImputed Interest Rule For properties exempted from For properties exempted from

previous rules such as sale of previous rules such as sale of farms for less than $1 million and farms for less than $1 million and residences under $250,000residences under $250,000

Requires a fair interest rate to be Requires a fair interest rate to be charged or imputedcharged or imputed

CAPITAL LOSS CAPITAL LOSS LIMITATIONLIMITATION

Allows capital losses to be written Allows capital losses to be written off only against capital gainsoff only against capital gains

Capital losses in excess of capital Capital losses in excess of capital gains can be written off against gains can be written off against other income up to $3,000 other income up to $3,000 annuallyannually

Unused balance can be carried Unused balance can be carried forwardforward

PASSIVE LOSS PASSIVE LOSS LIMITATIONLIMITATION

Instituted by the the 1986 Tax Instituted by the the 1986 Tax Reform ActReform Act

Three categories of income:Three categories of income:– Active income: Earnings, etc.Active income: Earnings, etc.– Portfolio income: Stocks, bonds, etc.Portfolio income: Stocks, bonds, etc.– Passive income: Real estatePassive income: Real estate

Losses are restricted to each Losses are restricted to each categorycategory

PASSIVE LOSSESPASSIVE LOSSES

Passive losses cannot be used to offset Passive losses cannot be used to offset income from REITs and REMICsincome from REITs and REMICs

Includes non-active real estate activity, Includes non-active real estate activity, specifically limited partnershipsspecifically limited partnerships

Loophole to be treated as active: AGI Loophole to be treated as active: AGI less than $100,000 can deduct up to less than $100,000 can deduct up to $25,000 in losses from other income$25,000 in losses from other income

Is phased out at AGI of $150,000Is phased out at AGI of $150,000

TAX-DEFERRED TAX-DEFERRED EXCHANGEEXCHANGE

Property must be held for use in trade or Property must be held for use in trade or business or for investment, owner-business or for investment, owner-occupied residences do not qualifyoccupied residences do not qualify

Properties exchanged must be of like kindProperties exchanged must be of like kind The exchange must occur; cannot sell for The exchange must occur; cannot sell for

cash and immediately purchasecash and immediately purchase Properties adjusted basis will be equalProperties adjusted basis will be equal

TAX-DEFERRED TAX-DEFERRED EXCHANGEEXCHANGE

Third-Party ExchangesThird-Party Exchanges Delayed ExchangesDelayed Exchanges BootBoot Property that is not like kind such Property that is not like kind such

as cash or debt reliefas cash or debt relief Identification period is 45 daysIdentification period is 45 days Exchange period runs for 180 daysExchange period runs for 180 days

INSTALLMENT SALEINSTALLMENT SALE

Seller takes back a promissory Seller takes back a promissory note from the buyernote from the buyer

Installment sale vs. outright saleInstallment sale vs. outright sale Sale price is paid in installmentsSale price is paid in installments Gross profit percentage is the Gross profit percentage is the

proportion of capital gain that is proportion of capital gain that is taxed each yeartaxed each year

INSTALLMENT SALEINSTALLMENT SALE

Related persons ruleRelated persons rule– If an installment sale is made to a related If an installment sale is made to a related

person who sells the property within a two-person who sells the property within a two-year period, the original seller must year period, the original seller must recognize the balance of the gain at the recognize the balance of the gain at the time the related person makes the sale. time the related person makes the sale.

Imputed interest rule appliesImputed interest rule applies Any down payment amount is allowedAny down payment amount is allowed Debt amortization vs. installment periodDebt amortization vs. installment period