Real Estate Investment Chapter 6 Property Taxes and Income Taxes © 2011 Cengage Learning

Key Terms Active income Ad valorem Adjusted basis Allocation ARRA Capital gain income Cost recovery period Depreciation FIRREA

© 2011 Cengage Learning Key Terms Investment interest Mill Millage Negative amortization Passive activity income Portfolio income RTC Tax assessment Tax Reform Act

© 2011 Cengage Learning Kinds of Taxes That Affect Real Estate Property taxes—sometimes called ad valorem taxes, which are levied on the value of taxable property. Income taxes—taxes on individuals and corporations based on the amount of taxable income.

© 2011 Cengage Learning Property Taxes Determination of Property Taxes Budget Requirements Appraisal Assessment Collection of Property Taxes Property Tax Exemptions

© 2011 Cengage Learning Other Property Tax Considerations Special Assessments Tax Revenue Bonds Deductibility of Property Taxes Homeowner Business Mortgagee Back Taxes Paid by the Buyer

© 2011 Cengage Learning Federal Income Taxes Economic Recovery Tax Act of 1981 (ERTA) Tax Reform Act of 1986 Depreciation schedules changed Component depreciation reintroduced Reduction in marginal tax rate

© 2011 Cengage Learning FIRREA The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was passed in 1989 The Resolution Trust Corporation (RTC) was established by FIRREA mission is to close the failed thrifts, dispose of the seized assets (primarily real estate) and return the funds to the new insurers of the thrift industry. RTC completed its mission by 1995

© 2011 Cengage Learning More Legislation Economic Growth and Tax Reconciliation Act of 2001 Jobs and Growth Tax Relief Reconciliation Act of 2003 American Recovery and Reinvestment Act (ARRA) of 2009

© 2011 Cengage Learning Business Income Business income has many sources, and the IRS identifies a few in the following general categories for reporting purposes: 1. Gross receipts less cost of goods sold and/or cost of operations 2. Interest and dividends 3. Rental and royalty income 4. Net capital gain or loss

© 2011 Cengage Learning Deductions from Income Salaries and wages Management expenses Property taxes Repairs and maintenance Insurance Utility costs Depreciation Interest

© 2011 Cengage Learning Deductions from Income Capitalizing an expense If the capitalized item is non-tangible the recovery of the cost is amortized. If the capitalized item is tangible property its recovery is taken as depreciation. Problem Areas of Deductions Repairs and Maintenance Repairs vs. Improvements Replacement vs. Maintenance

© 2011 Cengage Learning Interest Expense Prepaid Interest Investment Interest Interest on Rollover Loans Accrued Interest Loan Discount

© 2011 Cengage Learning Types of Income for Tax Purposes Active Income Passive Activity Income Limited Partners and Limited Liability Corporations Real Estate Rental Activity Exception for Real Estate Professionals Portfolio Income Capital Gain Income

© 2011 Cengage Learning Determining Capital Gain Basis of value Purchased property Property purchased with other property Property exchanges Inherited property Gift Property Property purchased for services rendered Foreclosed property

© 2011 Cengage Learning Adjustments to the Basis of Value Additions to the basis of value Reductions to the basis of value Depreciation Method of calculating depreciation Cost recovery period Residential property defined Midmonth convention Excluded real estate

© 2011 Cengage Learning Realized Selling Price Consideration Received All cash received The fair market value of any property used as consideration or services rendered in payment Any liabilities of the seller assumed by the buyer Permitted selling costs

© 2011 Cengage Learning Allocation of Land Costs and Building Costs The purchase contract may specify the prices for major components of the property. An appraisal by a professional gives good evidence of a proper allocation. The taxpayer may use a property tax (ad valorem tax) assessment of the property.