Federal Taxation and Real Estate Finance

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Chapter 16

• Federal Taxation and Real Estate Finance

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Chapter 16Learning 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 have
  altered the return on real estate investment

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VALUATION OF REAL ESTATE

• The value of an income-producing asset is a
  function of the income accruing to the asset
• Income for valuation purposes is generally
  measured as cash flow either before-tax or
  after-tax

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VALUATION OF REAL ESTATE

• Factors affecting valuation
• Financial leverage
• Tax shelters such as depreciation
• Tax treatment of the asset

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CLASSIFICATIONS 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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CLASSIFICATIONS OF REAL PROPERTY

• 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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CLASSIFICATIONS OF REAL PROPERTY

• 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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CLASSIFICATIONS OF REAL PROPERTY

• 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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CLASSIFICATIONS OF REAL PROPERTY

• 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 LAW CHANGES AFFECTING REAL ESTATE

• Changes in marginal tax rates
• Changes in depreciation allowance
• Length of recovery period
• Accelerated versus straight-line
• Tax treatment of capital gains (losses)
• Ability to write off losses

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TAX SHELTERS IN REAL ESTATE

• 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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DEPRECIATION IN REAL ESTATE

• Depreciation is a noncash outlay but a
  tax-deductible expense
• The value of depreciation is the depreciation
  amount times the investors marginal tax rate
• Real estate is a physical asset that is
  considered to wear out and deteriorate to a
  value of zero over time

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COMPONENTS OF REAL ESTATE 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

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COMPONENTS OF REAL ESTATE DEPRECIATION

• 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 appraisers
  office

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COMPONENTS OF REAL ESTATE 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

• Straight-line and accelerated
• Currently only the straight-line method is
  allowed
• Previously the accelerated cost recovery system
  (ACRS) was allowed which provided accelerated
  depreciation over a shorter time period (15-19
  years)

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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 PAYMENTS

• Original Issue Discount Rates
• Debt that is issued at a discount from the face
  value
• Incentive to convert ordinary income to capital
  gains income when tax rates are different
• Recourse vs. nonrecourse debt

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INTEREST RATE RULES

• Adequacy-of-Interest Test
• Rate charged must be comparable to an applicable
  federal rate based on Treasury obligations
• 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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INTEREST RATE RULES

• Imputed Interest Rule
• For properties exempted from previous rules such
  as sale of farms for less than 1 million and
  residences under 250,000
• 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 EXCHANGE

• 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 EXCHANGE

• 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