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Real EstateReal Estate Principles and Practices Principles and Practices
Chapter 16Chapter 16
Investment and Tax Aspects Investment and Tax Aspects of Ownershipof Ownership
© 2014 OnCourse Learning
© 2014 OnCourse Learning
Key TermsKey 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
© 2014 OnCourse Learning
Key TermsKey Terms
Salvage value
Securities and Exchange Commission (SEC)
Straight-line depreciation
Syndication
Tax-free exchange
Tax shelter
Useful life
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OverviewOverview
Investing in a residenceAdvantages of homeownership as an investment
Investing in income-producing real estateBenefits to the real estate investor
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Homeownership as an Homeownership as an InvestmentInvestment
Itemized deductions on taxes, mortgage interest for 1st and 2nd homes
2nd home: annual occupancy for at least 14 days or 10% of useful rental period
Equity loans
Tax Reform Act of 1986
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Calculating the Benefits of Calculating the Benefits of HomeownershipHomeownership
Married couple, filing jointly, will pay 28% income tax
$70,000$70,000 mortgagemortgage
X .08X .08 interest rateinterest rate
$5,600$5,600 annual interestannual interest
X .28X .28
tax savingstax savings
tax brackettax bracket
$1,568$1,568
$1,568 ÷ 12 = $1,568 ÷ 12 = $130.66 per month$130.66 per month
$669.20 PITI – $669.20 PITI – $130.66$130.66 = $538.54 = $538.54
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Calculating the Benefits of Calculating the Benefits of HomeownershipHomeownership
$1800 property tax per year
Building equity
Appreciating in value
$1,800 X 28% = $1,800 X 28% = $504.00 per year$504.00 per year
$538.54 – $538.54 – $42.00 $42.00 = $796.54= $796.54
$504.00 ÷ 12 = $504.00 ÷ 12 = $42.00 per month$42.00 per month
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Appreciation and Appreciation and HomeownershipHomeownership
Rising construction and land cost
Supply of funds and market conditions
Demand for housing
Needs of each generation
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Depreciation of a ResidenceDepreciation of a Residence
Depreciation not allowed for a residence
Exception: portion allowed for in home office
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How Tax Provisions Affect How Tax Provisions Affect Sale of Principal ResidenceSale 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
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How Tax Provisions Affect How Tax Provisions Affect Sale of Principal ResidenceSale of Principal Residence
Eligibility requirements:
1. Ownership: . Ownership: minimum 2 of the last 5 years
2. Use: Use: principal residence for at least 2 of the last 5 years
3. Waiting period: Waiting period: exclusion may not have been used for any sale during the past 2 years
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How Tax Provisions Affect How Tax Provisions Affect Sale of Principal ResidenceSale 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%
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How Tax Provisions Affect How Tax Provisions Affect Sale of Principal ResidenceSale of Principal Residence
BasisBasis is adjusted:adjusted:Cost of new residence minus gaingain on old residence
$65,000$65,000 1990 Purchase price1990 Purchase price
1992 added family room1992 added family room8,5008,500
$73,500$73,500 Adjusted basisAdjusted basis
88,00088,000 2008 sale price2008 sale price
6,3306,330 Less selling expensesLess selling expenses
$81,670$81,670
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How Tax Provisions Affect How Tax Provisions Affect Sale of Principal ResidenceSale of Principal Residence
BasisBasis is adjusted:adjusted:Cost of new residence minus gaingain on old residence
73,50073,500 Less adjusted basisLess adjusted basis
Gains from saleGains from sale8,1708,170
$95,000$95,000 New purchase priceNew purchase price
8,1708,170 Less gain from saleLess gain from sale
Adjusted basisAdjusted basis$86,830$86,830
$81,670$81,670
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How Tax Provisions Affect How Tax Provisions Affect Sale of Principal ResidenceSale 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 Determining the Basis for Measuring Gain
Selling at a LossSelling at a Loss
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Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing Investment
Reasons for investing in real estateAppreciation
Cash flow
Equity buildup
Tax shelter
Primary purpose: Generate income
Long term capital growth without risk
Purchasing Real Estate vs. Fixed Income InvestmentPurchasing Real Estate vs. Fixed Income Investment
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Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing Investment
“the higher the risk the greater the return”
Net proceeds after all expenses
Risk and ReturnRisk and Return
Cash FlowCash Flow
Income from office buildingIncome from office building $44,000$44,000
ExpensesExpenses 17,00017,000
Debt serviceDebt service 18,00018,000
Cash flowCash flow $9,000$9,000
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Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing Investment
Negative cash flowNegative cash flow: tax deductible expenses are greater than income
Tax Shelter: Tax Shelter: book lossIncome Income $44,000$44,000
ExpensesExpenses 22,00022,000
Interest deductionInterest deduction 18,00018,000
Depreciation deductionDepreciation deduction
$44,000$44,000
8,0008,000
$46,000$46,000
$2,000 book loss$2,000 book loss
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Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing Investment
Passive income: Passive income: not containing the taxpayers’ active involvement
3 Classifications of income
Active incomeActive income
Portfolio incomePortfolio income
Passive activity incomePassive activity income
Losses up to $25,000 may be used to offset salaries and active business income
© 2014 OnCourse Learning
Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing Investment
Value is determined by income produced
Value = annual net income divided by desired rate of return
Rate of ReturnRate of Return
$15,000$15,000 Net annual Net annual incomeincome
12%12% Desired rate Desired rate of returnof return
= $125,000= $125,000Property value Property value with 12% returnwith 12% return
© 2014 OnCourse Learning
Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing 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 ReturnRate of Return
$15,000$15,000 incomeincome
16%16% rate of returnrate of return= $93,750= $93,750
Property value Property value to investorto investor
© 2014 OnCourse Learning
Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing 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
DepreciationDepreciation
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Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing Investment
1981 – Tax Recover Act: “recovering the cost”
TRA 86: straight line depreciation straight line depreciation over 27 ½ years
Properties deprecate in equal installments over a predetermined period of time
Land does not depreciate
DepreciationDepreciation
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Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing Investment
Annual depreciation of a single family residential rental
DepreciationDepreciation
Land Value: Land Value: $ 32,000$ 32,000
Improvements:Improvements: $ 88,000$ 88,000
Assessed value:Assessed value: $120,000$120,000
Improvements:Improvements: $ 88,000 ÷ 27.5$ 88,000 ÷ 27.5
$ 3,200 = Annual depreciation$ 3,200 = Annual depreciation
© 2014 OnCourse Learning
Real Estate as an Income-Real Estate as an Income-Producing InvestmentProducing Investment
2. Investment financed:
$125,000 investment$125,000 investment
$93,750 mortgage = $31,250 equity $93,750 mortgage = $31,250 equity invested invested
subtract one year’s interest at 10% from subtract one year’s interest at 10% from $15,000 income:$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$5,625 ÷ 31,250 = 18% annual return
LeverageLeverage
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Investment OpportunitiesInvestment Opportunities
Types of investments
Holding power needed for land investments
IncomeIncome
Purchase price: $75,000Purchase price: $75,000
$450 @ 12 mos. = $5,400.00$450 @ 12 mos. = $5,400.00
$500 @ 12 mos. = 6,000.00$500 @ 12 mos. = 6,000.00
Gross Income = $11,400.00Gross Income = $11,400.00
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Investment OpportunitiesInvestment Opportunities
ExpensesExpensesInsurance policy $340.00Insurance policy $340.00
Supplies & materials $280.00Supplies & materials $280.00
TaxesTaxes $ $900.00900.00
Maintenance $320.00Maintenance $320.00
Mortgage payments $7,030.80Mortgage payments $7,030.80
Net IncomeNet Income
$8,870.80$8,870.80
$2,529.20$2,529.20
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Investment OpportunitiesInvestment Opportunities
The Investment Scenario
Rehabilitation Tax Credit
Refinancing vs. Selling
Tax-Deferred Exchanges
Installment Sales
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Group Business VentureGroup Business Venture
General partnership
Limited partnership
Corporation
S Corporation
Syndication
REITs
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Real Estate Offerings as Real Estate Offerings as SecuritiesSecurities
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
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Real Estate Offerings as Real Estate Offerings as SecuritiesSecurities
Purpose of Securities Act: full and fair disclosure
Prospectus: Prospectus: disclosure of basic information of the enterprise
Exception for interstateinterstate
Blue sky laws: Blue sky laws: securities license required
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