Chapter 16

Federal Taxation and Real Estate Finance

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Chapter 16 Learning Objectives

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

Understand how changes in the tax rules can alter the return on real estate investment

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Tax Regulations and Their Effect on the Value of Real Estate Investment Definition of income for tax purposes differs from BTCFs

Non cash expenses are allowed (e.g. deduct depreciation) Interest payments on debt can be expensed

The actual amount of taxes paid affected by: Differential tax rates on income and capital gains Offset of losses against other sources of income Providing for alternative minimum tax (AMTs) Establishing favorable classes of real estate investment (low-

income housing, historical structures)3© OnCourse Learning

Classification of Real Property

Property Held for Principal Residence

Property Held for Investment

Property Held for Resale to Others

Property Held for Use in Trade or Business

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Property Held as Principal Residence

Mortgage interest and property taxes are tax-deductible; maintenance costs are not

Cannot depreciate

Capital losses are not tax-deductible

Capital gains exclusion of $250,000 ($500,000 for married filing jointly) for one sale every two years

Owned and occupied two out of the last five years

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Property Held for Investment

Held strictly for income or investment and owner has no participation in operations

Generally unimproved land and net leases

Limitations on interest deductibility

Limitations of capital Loss write offs

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Property Held for Resale to Others

Viewed as inventory

Income is taxed as ordinary income (not capital gains)

Owners treated as dealers

Cannot depreciate

Losses are operating losses

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Property Held for Use in Trade or Business

Section 1231 asset

Generally the most favorable classification

Owned for the purpose of deriving income

Can depreciate

Operating expenses and mortgage interest are tax-deductible

Capital losses are tax-deductible

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Tax Shelters

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

Real estate has the potential of a tax shelter

Tax rules may create value that otherwise would not exist

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Real Estate Tax Regulations – Definition of Income Taxable income differs from BTCF in the treatment of depreciation and

interest as expense

Depreciation is a noncash outlay but a tax-deductible expense

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

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Depreciation - Depreciable Basis

The Original Cost Basis is the purchase price (of land and improvements) plus acquisition costs

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

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

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

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Depreciation - Cost Recovery Period

Is the period over which depreciation can be taken

Congress periodically alters the recovery period for depreciation

Recovery period is currently 27.5 years for residential income property and 39 years for non-residential income property

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Methods of Depreciation Pre-1981

Straight-line (SL) method – depreciation is given by:

Double-declining method

Sum-of-the-years’ digit method

1981-1986 SL depreciation and accelerated depreciation

The accelerated cost recovery system (ACRS) provided accelerated depreciation over a shorter time period (15-19 years)

1986-1993 Modified accelerated cost recovery system (MACRS) – eliminated accelerated

depreciation

Residential properties depreciated SL over 27.5 years; commercial properties depreciated SL over 31.5 years

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Methods of Depreciation 1993-1997

Top marginal tax rate of 39.6%; Max. CG tax rate of 28%; 39 years SL depreciation for commercial real estate

1997-2003 Increased holding period for LT gains to 18 months; Max cap. gain rate of

20%

Post 2003 Max. marginal income tax rate lowered to 35% Max. tax rate for depreciation capture for section 1250 properties of 25% Max. capital gain rate of 15%

2013 Bush tax cuts from 2003 expired – maximum marginal income tax rate of

39.6% Max. capital gain tax rate of 20% (for 39.6% tax bracket)

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Calculating Depreciation

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

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

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Taxes and Interest Payment

Original Issue Discount (OID) Rates Debt that is issued at a discount from the face value

No coupons or payments over its life

Incentive to convert ordinary income to capital gains income when tax rates are different

Use of large amounts of nonrecourse debt to sell properties at inflated prices

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Interest Rate Rules

Adequacy-of-Interest Test If the stated interest is less than 110% of the applicable federal rate, an interest rate will be

imputed at 120 percent of the applicable federal rate

Time Value of Money Test Even though payments may not be made annually the interest must be calculated and

reported annually

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Imputed Interest Rule

Properties exempted from OID rules: sales of farms by individuals for less than $1 million; residences under $250,000; and transactions between related parties under $500,000

For properties exempted from OID rules imputed interest rule applies

Requires a fair interest rate to be charged or imputed

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Capital Loss Limitation

Allows capital losses to be written off only against capital gains

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

Unused balance can be carried forward

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Passive Loss Limitation

Instituted by the the 1986 Tax Reform Act

Three categories of income: Active income: Earnings, etc.

Portfolio income: Stocks, bonds, etc.

Passive income: Real estate

Losses are restricted to each category

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Passive Losses

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

Includes non-active real estate activity, specifically limited partnerships

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

Is phased out at AGI of $150,000

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Tax-Deferred (1031) Exchanges

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

Properties exchanged must be of like kind

The exchange must occur; cannot sell for cash and immediately purchase

Properties adjusted basis will be equal

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Tax-Deferred (1031) Exchanges

Types of 1031 exchanges Direct Exchanges

Third-Party Exchanges

Delayed Exchanges

Boot - Property that is not like kind such as cash or debt relief

Identification period is 45 days

Exchange period runs for 180 days

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Installment Sale

Seller takes back a promissory note from the buyer

Installment sale vs. outright sale

Sale price is paid in installments

Gross profit percentage is the proportion of capital gain that is taxed each year

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Installment Sale

Related persons rule If an installment sale is made to a related person who sells the property within a two-year

period, the original seller must recognize the balance of the gain at the time the related person makes the sale.

Imputed interest rule applies

Any down payment amount is allowed

Debt amortization vs. installment period

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