©2011 Cengage Learning. Chapter 17 ©2011 Cengage Learning INCOME TAX ASPECTS OF INVESTMENT REAL ESTATE.

©2011 Cengage Learning

Chapter 17

©2011 Cengage Learning

INCOME TAX ASPECTS OF INVESTMENT REAL ESTATE

Income tax advantages for income-producing real estate

Interest on loans used to purchase or improve rental real estate is fully deductible.

Operating expenses are deductible.Depreciation (cost recovery) is a non-cash

deduction.Favorable capital gain treatment.May use installment sale reporting when seller

carries a note and deed of trust.Exchange can defer all gain and taxes if the

investor follows the rules of IRS Section 1031.

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Major Income Tax Advantages

Dealers do not get the following income tax benefits:

Depreciation

Capital Gains

Installment Sales

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Basis refers to the property owner’s cost

Initial basis is determined by the method of acquisition.

Depreciation is based on purchase price not value.

Land and improvements must be allocated.Straight-line depreciation is used.

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Basis and Depreciation

According to the Tax Reform Act of 1986, income is classified as:

Active Income - wages, commissions, profits from owner-managed business, etc.

Portfolio Income - interest on savings, divided on stocks, bonds, etc.

Passive Income - limited partnerships, business ventures with no active role, rents from rental real estate, etc.

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Passive Loss Rules

The General RuleA passive loss can offset only passive income.Passive losses cannot normally be used to

offset active or portfolio income.

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Exception to Passive Loss RuleExemption is known as the $25,000 real

estate exception to the passive loss rule. To qualify for this $25,000 exception, the

taxpayer must meet the following tests:must own 10% or more of property.must be active in management. modified adjusted gross income must be

$100,000 or less.

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Qualified Real Estate ProfessionalsWho spend:

at least 750 hours and more than one-half of all business time per

year in real estate activities. Can use real estate losses to offset any

business or personal income.

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Tax on Capital Gains

Sell for cash & pay the taxOwner Finance & defer tax1031 exchange & defer tax

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Calculating and Deferring Gain

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Calculating Gain and Taxes Owed on Income Property

Step 1: Calculate Adjusted Cost Basis

Initial (original) basis

Plus: Buyer’s capitalized closing costs

Plus: Capital improvements, if any

Minus: Depreciation for term of ownership

Equals: Adjusted cost basis on date of resale

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Step 2: Calculate Gain

Resale price

Less: Seller closing costs

Less: Adjusted cost basis from Step 1

Less: Carry-forward passive losses,

if any

Equals: Gain on sale

Step 3: Apply capital gain treatment to the gain to calculate the tax owed

Installment Sale• Advantages

• Method of sale for a slow real estate market• Lower the tax owed immediately• Tax can be paid in the future with inflated

(cheaper) dollars.

• Disadvantages• Not all money is received up front• May pay more in taxes depending on future

income• Buyer could default

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Sale of Principle ResidenceNo tax on gain

Up to $250,000 if singleUp to $500,000 for married

Principal residence for at least two out of the last five years

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