©2011 Cengage Learning
Jan 17, 2016
©2011 Cengage Learning
Chapter 17
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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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