FEDERAL INCOME TAXATION

LEARNING OBJECTIVESIncorporate tax considerations into the

discounted cash flow analysis.

Distinguish between active, passive, and portfolio income.

Explain the federal income tax treatment of mortgage financing and depreciation.

FEDERAL INCOME TAXATION

LEARNING OBJECTIVES

Discuss the differential tax treatment of ordinary versus capital gain income and ordinary versus capital assets.

Explain the primary methodologies employed to defer, reduce, and/or eliminate tax liabilities.

FOUR CLASSES OF REAL PROPERTY

Real estate held as a personal residence.

Real estate held for sale to others--dealer property.

Real estate held for use in a trade or business--trade or business property.

Real estate held as an investment for the production of income - investment property.

Types of Taxable Income

Active income (e.g., salaries, wages, bonuses,

and commissions).

Portfolio income (e.g., interest, dividends, and

capital gains).

Passive income (e.g., rents from real estate, and

royalties from oil and gas rights).

General Tax Formula for Individuals

Item

Salaries and Wages

+ Business Income (Sch. C)

+/- Capital Gains and Losses

+ Interest Income

+ Dividend Income

+/- Rents, Royalties, and Partnerships

+/- Adjustments

= Adjusted Gross Income (AGI)

- Personal Deductions (Itemized or Standard)

- Personal Exemptions

= Federal Taxable Income

PASSIVE ACTIVITY LOSS RESTRICTIONS

Passive losses cannot be used to reduce active or portfolio income. (TRA ’86)

Passive losses may be used to reduce other passive income. (REITs)

Passive losses not used may be used in future years or at the time of sale.

Active participants may deduct up to $25,000 in passive losses against other non-passive income, subject to limitations.

TAX ON OPERATIONS

Item Symbol

Net Operating Income (NOI)

- Depreciation (DEP)

- Interest Expense (INT)

- Amortized Financing Costs (AFC)

= Taxable Income (TI)

x Tax Rate (TR)

= Tax Liability (TAX)

AFTER TAX CASH FLOW FROM OPERATIONS

Item Symbol

Net Operating Income (NOI)

- Interest Expense (INT)

- Principal Amortization (PA)

= Before-Tax Cash Flow (BTCF)

- Tax Liability (TAX)

= After-Tax Cash Flow (ATCF)

Tax Shelter

Partial Tax Shelter: NOI is positive but taxable

income of asset reduced due to depreciation and costs

of financing

Deep Tax Shelter: NOI is negative (tax loss) due to

depreciation and costs of financingTax losses may be used to reduce the taxes due on

other passive income

ordinary and portfolio income of qualified active participants

Interest Expense and Amortized Financing Costs

Interest and Prepaid Interest

Costs of Financing

Financing costs amortized over the term of the loan.

Unused balance taken in the year sold.

Depreciation Basis

The original cost basis includes all costs associated

with acquiring the property and transferring the title

Land value cannot be depreciated

The depreciable basis is the total value that can be

depreciated over the recovery period

Depreciable Basis = Cost Basis - Land Amount

Annual Depreciation Deduction

Annual Depreciation =

Depreciable Basis / Recovery Period

mid-month convention

Cost Recovery Period

Residential Income Property (27.5 years)

Other Commercial Income Property (39 years)

Personal Property (3-15 years)

Original Cost Basis and DepreciationThe original cost basis

is affected by depreciation and substantial (capital) improvements

Original Cost Basis - Total Annual Depreciation + Total Capital

Improvements

TAX DUE ON SALE Item Symbol

= Net Sale Proceeds (NSP)

- Adjusted Basis (AB)

= Total Taxable Gain (TG)

- Depreciation Recapture (DR)

= Capital Gain (CG)

Capital Gain Tax (CGTAX)

+ Depreciation Recapture Tax (DRTAX)

= Tax Due on Sale (TDS)

AFTER TAX CASH FLOW FROM SALE

Item Symbol

Gross Sale Price (GSP)

- Selling Expenses (SE)

= Net Sale Proceeds (NSP)

- Remaining Mortgage Balance (RMB)

= Before-Tax Equity Reversion (BTER)

- Tax Due on Sale (TDS)

= After-Tax Equity Reversion (ATER)

Net Effects of Annual Depreciation

Defers taxesIf annual tax incidence transferred from period of

operation to period of sale

Reduces taxesIf capital gains rate less than ordinary tax rate

If tax losses can be used to offset passive income

If tax losses can be used to offset other income

Ordinary versus Capital Gain Income

Definition of a Capital Asset

Tax Treatment for Capital Assets

Tax Treatment for Section 1231 Assets

METHODS OF DEFERRING TAXES ON DISPOSITION

Installment Sale

Like-Kind Exchange

TAX FACTORS AFFECTING HOME OWNERS

Preferential Tax Treatment of Home Owners

Capital gains of $250,000 are excluded from income for

individuals ($500,000 for couples filing joint returns)

Home owners allowed to deduct mortgage interest and

local property taxes.