1. Chapter 16 Federal Taxation and Real Estate Finance © OnCourse Learning

2. Chapter 16 Learning 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 can alter the return on real estate investment © OnCourse Learning 2

3. Tax Regulations and Their Effect on the Value of Real Estate Investment  Definition of income for tax purposes differs from BTCFs  Non cash expenses are allowed (e.g. deduct depreciation)  Interest payments on debt can be expensed  The actual amount of taxes paid affected by:  Differential tax rates on income and capital gains  Offset of losses against other sources of income  Providing for alternative minimum tax (AMTs)  Establishing favorable classes of real estate investment (low- income housing, historical structures) 3 © OnCourse Learning

4. Classification 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 © OnCourse Learning 4

5. 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 © OnCourse Learning 5

6. 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 © OnCourse Learning 6

7. 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 © OnCourse Learning 7

8. 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 © OnCourse Learning 8

9. Tax Shelters  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 © OnCourse Learning 9

10. Real Estate Tax Regulations – Definition of Income  Taxable income differs from BTCF in the treatment of depreciation and interest as expense  Depreciation is a noncash outlay but a tax-deductible expense  The value of depreciation is the depreciation amount times the investor’s marginal tax rate © OnCourse Learning 10

11. 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  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 appraiser’s office © OnCourse Learning 11

12. 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 © OnCourse Learning 12

13. Methods of Depreciation © OnCourse Learning 13

14. Methods of Depreciation  1993-1997  Top marginal tax rate of 39.6%; Max. CG tax rate of 28%; 39 years SL depreciation for commercial real estate  1997-2003  Increased holding period for LT gains to 18 months; Max cap. gain rate of 20%  Post 2003  Max. marginal income tax rate lowered to 35%  Max. tax rate for depreciation capture for section 1250 properties of 25%  Max. capital gain rate of 15%  2013  Bush tax cuts from 2003 expired – maximum marginal income tax rate of 39.6%  Max. capital gain tax rate of 20% (for 39.6% tax bracket) 14 © OnCourse Learning

15. 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 © OnCourse Learning 15

16. Taxes and Interest Payment  Original Issue Discount (OID) Rates  Debt that is issued at a discount from the face value  No coupons or payments over its life  Incentive to convert ordinary income to capital gains income when tax rates are different  Use of large amounts of nonrecourse debt to sell properties at inflated prices © OnCourse Learning 16

17. Interest Rate Rules  Adequacy-of-Interest Test  If the stated interest is less than 110% of the applicable federal rate, an interest rate will be imputed at 120 percent of the applicable federal rate  Time Value of Money Test  Even though payments may not be made annually the interest must be calculated and reported annually © OnCourse Learning 17

18. Imputed Interest Rule  Properties exempted from OID rules: sales of farms by individuals for less than $1 million; residences under $250,000; and transactions between related parties under $500,000  For properties exempted from OID rules imputed interest rule applies  Requires a fair interest rate to be charged or imputed © OnCourse Learning 18

19. 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 © OnCourse Learning 19

20. 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 © OnCourse Learning 20

21. 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 © OnCourse Learning 21

22. Tax-Deferred (1031) Exchanges  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 © OnCourse Learning 22

23. Tax-Deferred (1031) Exchanges  Types of 1031 exchanges  Direct Exchanges  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 © OnCourse Learning 23

24. 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 © OnCourse Learning 24

25. 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 © OnCourse Learning 25