Basic Income Tax Issues

1
Chapter 10

• Basic Income Tax Issues

2
Nature and Significance of the Tax Basis

• Newly acquired propertys initial tax basis is
  starting point in determining income tax
  consequences of operating the property and,
  ultimately, the tax consequence of disposal
• During holding period, tax basis is adjusted to
  reflect disinvestment or additional capital
  investment

3
Nature and Significance of the Tax Basis

• Selling or exchanging a property generates a gain
  or loss equal to the difference between the sales
  price and the adjusted basis of the property at
  the time of disposal

4
The Initial Tax Basis

• Property acquired as gift, initial tax basis the
  same as donors, unless donor incurs gift tax
  liability
• Property acquired by inheritance, initial tax
  basis is market value as determined for estate
  tax purposes
• Property acquired by purchase, cost forms buyers
  initial tax basis

5
Allocating the Initial Tax Basis

• Two or more assets acquired together, initial tax
  basis must be allocated between them using ratio
  of their relative market value
• Specify price of each in original purchase
  contract
• Use ratio of land value to building value
  estimated by tax assessor
• Have independent appraiser estimate relative
  value of land and buildings

6
Adjusting the Basis in Cost Recovery

• Depreciation allowance An allowance of capital
  invested in improvements of property held for
  business or investment purposes.
• Does not apply to property held for personal use
  or primarily for resale
• Land, considered virtually indestructible, is not
  included in depreciation allowance computation

7
Adjusting the Basis in Cost Recovery

• Claiming tax deduction for cost recovery
  allowances reduces a propertys tax basis
• Lower the adjusted tax basis when property is
  sold, the greater the taxable gain on disposal

8
Recovery of Building and Other Improvements

• 27.5 years for buildings intended for residential
  rental purposes
• 39 years for buildings intended for other
  allowable purposes
• 15 years for land improvements such as walks,
  roads, sewers, and fences

9
Recovery of Building and Other Improvements

• Allowance for buildings are computed using
  straight-line method
• Allowances for improvements on and to the land
  may be computed using the 150 percent declining
  balance method

10
Other Adjustments to the Tax Basis

• Basis is reduced when portion of asset is sold or
  destroyed by casualties such as fire, flood, or
  storm
• Owners tax basis is increased by expenditures
  that materially increase the propertys value or
  useful life
• Transaction costs are added to the tax basis

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Table 10.2
12
Tax Consequences of Ownership Form

• Title may vest in owners as individuals
• Title may vest in a corporation
• Tax Option Corporations
• Investors may form a general partnership
• Limited partnership may hold title
• Limited liability company

13
Tax Consequence of Property Sales

• Adjusted tax basis at time of sale is the initial
  tax basis plus all additional capital
  investments, minus cumulative depreciation
  allowances, plus-or-minus certain other
  adjustments that may sometimes apply
• Gain or loss on propertys sale is difference
  between the value of consideration received and
  the adjusted tax basis at the time of the
  transaction

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Tax Consequences of Financial Leverage

• Borrowing or repaying debts are not taxable
  events
• Interest expense is usually tax-deductible in the
  year the interest is paid
• Exception--prepaid interest is not deductible
  until actually earned by the lender

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Tax Consequences of Financial Leverage

• Construction period interest is special
  exceptionmust be capitalized reflected in
  annual depreciation allowances
• Deductibility of mortgage interest is limited by
  passive asset loss limitation rules
• Strategyborrow against equity rather than
  selling, as selling will trigger a taxable gain

16
Income Tax Credits for Property Rehabilitation

• Tax credits direct, dollar-for-dollar offsets
  against ones income tax obligation
• Expenditures to rehabilitate certain buildings
  qualify for a 10 percent rehabilitation tax credit

17
Limitations on Deductibility of Losses

• Limited partners income and expenses from a
  partnership are always considered passive asset
  items
• Real estate held for rental purposes is passive
  unless it is incidental to the primary business
  activity
• Special exception for real estate investors who
  are not actively engaged in a real estate trade
  or business to deduct up to 25,000 of passive
  asset losses each year

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Figure 10.1
19
Taxation of Foreign Investors

• Taxpayer who acquires a U.S. real estate interest
  from a foreign owner must withhold and remit to
  the IRS 10 percent of the gross sales price,
  unless
• Property is worth no more than 300,000 and is to
  be used by purchaser as personal residence
• Transaction is protected from taxation pursuant
  to a U.S. tax treaty
• Seller or buyer obtains a certificate form the
  IRS that reduces the amount to be withheld

20
Taxation of Foreign Investors

• Buyer who fails to withhold the correct amount
  may be liable for the under-withheld amount, plus
  interest and penalties

21
Alternative Minimum Tax

• After figuring tax liability the regular way,
  taxpayers must perform an alternative
  computation, and pay taxes on whichever
  computation method results in the greater
  liability
• Alternative computation tax credits, and many tax
  deductions, that are permitted in the regular
  computation must be excluded