B428 Real Estate Day 5 Leases, Income Tax, 1031 Exchanges, Lending and Borrowing

Environmental Warning Responsible parties liable: Parties who arranged disposal Parties who transported Prior owner Current owner Liability All costs of removal, restoration costs of private parties damages health costs related to contamination

Mechanics Liens Who? Who? How? How? Duration? Duration?

Income Tax Issues Purchase and Sale of Property Purchase and Sale of Property Capital asset?Capital asset? Gain or loss?Gain or loss?

Income Tax continued Ownership Ownership DepreciationDepreciation Passive incomePassive income Passive lossPassive loss

Review of Income Tax Aspects Real estate must qualify as a capital asset to get capital gains treatment. Real estate must qualify as a capital asset to get capital gains treatment. Sales by dealers do not get capital gains treatment. Sales by dealers do not get capital gains treatment. Inventory and real estate used in taxpayer’s trade or business aren’t capital assetInventory and real estate used in taxpayer’s trade or business aren’t capital asset Possible tests: frequency of sales, subdividing, promotional activitiesPossible tests: frequency of sales, subdividing, promotional activities Holding period is one year. Holding period is one year.

Intro to Leases Lease Durations: How long do they last? Lease Durations: How long do they last? Houses and apartments, month to month, annualHouses and apartments, month to month, annual Office space, 3 – 5 years (What about renewals)Office space, 3 – 5 years (What about renewals) Retail, small- 1-2 years, malls 10 to 20 yearsRetail, small- 1-2 years, malls 10 to 20 years Industrial, 3 -5 yearsIndustrial, 3 -5 years Ground LeasesGround Leases

Income Tax Matters Taxable Income NOI-Interest-Depreciation Cash Flow does not equal Taxable Income

Sale of Property Sales Price LESS Adjusted Basis = Taxable Gain

Passive Loss Limitations Taxpayer may not offset passive losses against other income. Exceptions for RE Investors Individual rental property owners RE professionals, material involvement

Material Involvement Defined More than ½ of all personal services during the year are for real property trades or businesses in which they materially participate. More than ½ of all personal services during the year are for real property trades or businesses in which they materially participate. AND AND Perform more than 750 hours of service per year in those RE activities Perform more than 750 hours of service per year in those RE activities

Tenant Deposits RENTORSECURITY

Common Area Charges Charged for the use of space “in common” with others Charged for the use of space “in common” with others Examples: Hallways, parking, recreation, landscaping, reception areas Examples: Hallways, parking, recreation, landscaping, reception areas

Lease Provisions Base Rent Base Rent Step-up Provisions Step-up Provisions Increase in costs (management, maintenance…)Increase in costs (management, maintenance…) Specific IndexSpecific Index Most commonly, the CPI (Consumer Price Index)

Lease Provisions Continued… Percentage Rents Percentage Rents Net Lease Net Lease Limitations on Assignment and Subletting Limitations on Assignment and Subletting Destruction of Premises Destruction of Premises Insurance of Premises and Contents Insurance of Premises and Contents Options to renew Options to renew Options to purchase Options to purchase

What Smart Landlords Put in Their Leases Require sufficient advance payment of rent Require sufficient advance payment of rent Require adequate security deposit Require adequate security deposit Prohibit assignment or subletting without permission Prohibit assignment or subletting without permission Retain permission to enter the premises for inspection at reasonable times Retain permission to enter the premises for inspection at reasonable times Secure permission to show the property to new tenants toward the end of the lease Secure permission to show the property to new tenants toward the end of the lease Use rent escalation clauses Use rent escalation clauses Limit the number of persons permitted to use the apartment Limit the number of persons permitted to use the apartment

Smart Landlords continued… Use percentage leases on commercial property to permit participation in profits of the tenant Use percentage leases on commercial property to permit participation in profits of the tenant Require the tenant to make repairs and do maintenance Require the tenant to make repairs and do maintenance Have regulations or rules for the benefit of all tenants Have regulations or rules for the benefit of all tenants Avoid exclusion clauses which limit the L’s ability to lease remainder of the property Avoid exclusion clauses which limit the L’s ability to lease remainder of the property

Termination of Leases Expiration of Lease Expiration of Lease Mutual Agreement Mutual Agreement Breach of the Lease (Default) Breach of the Lease (Default) Eviction (Unlawful Detainer) Eviction (Unlawful Detainer) Constructive Eviction Constructive Eviction Is there a statute?Is there a statute? Rent abatementRent abatement

Unlawful Detainer The Basics The Basics Definition Definition Procedure Procedure Three day noticeThree day notice Service of noticeService of notice Action for possessionAction for possession EnforcementEnforcement

Tax Deferred Exchange Section 1031 IRC Section 1031 IRC Both properties (relinquished and acquired) must be held for business or investment purposes.Both properties (relinquished and acquired) must be held for business or investment purposes. Must be like-kind.Must be like-kind. Exchange must actually occur.Exchange must actually occur. Basis in acquired property equal to basis in relinquished property plus any “boot.”Basis in acquired property equal to basis in relinquished property plus any “boot.”

BOOT Boot is a general term for property in an exchange which is not like-kind. Boot is a general term for property in an exchange which is not like-kind. Boot is taxableBoot is taxable Boot is not limited to cashBoot is not limited to cash

Two Variations Three Party Exchanges Three Party Exchanges Delayed Exchanges Delayed Exchanges Owner of relinquished property identifies replacement property within 45 days of transfer.Owner of relinquished property identifies replacement property within 45 days of transfer. Exchange is completed using a third party specialist within 180 days or due date of tax return, whichever soonerExchange is completed using a third party specialist within 180 days or due date of tax return, whichever sooner Owner of relinquished property must not receive the proceeds from the relinquished property.Owner of relinquished property must not receive the proceeds from the relinquished property.

The Final Test Issue Issue Rule Rule Analysis Analysis Conclusion Conclusion