Chapter 16

Federal Taxation and Real Estate Finance

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Chapter 16 Learning Objectives

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Understand how the rules and regulations of federal income taxation affect both the value of real estate investments and financing decisions

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Understand how changes in the tax rules can alter the return on real estate investment

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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)

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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

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Property Held as Principal Residence

  Cannot depreciate  Mortgage interest and property taxes are tax deductible; maintenance costs are not 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

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Property Held for Investment

  Generally unimproved land and net leases  Held strictly for income or investment and owner has no participation in operations Limitations on interest deductibility  Limitations of capital Loss write offs

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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

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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

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Tax Shelters

  Real estate has the potential of a tax shelter  A tax shelter is an investment whose value is enhanced by tax rules and regulations Tax rules may create value that otherwise would not exist

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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

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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

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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

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Methods of Depreciation

Pre-1981    Straight-line (SL) method – depreciation is given by: 𝐷 𝑡 = 𝐶 𝑛 Double-declining method Sum-of-the-years’ digit method 1981-1986  SL depreciation and accelerated depreciation  The accelerated cost recovery system (ACRS) provided accelerated depreciation over a shorter time period (15-19 years) 1986-1993  Modified accelerated cost recovery system (MACRS) – eliminated accelerated depreciation  Residential properties depreciated SL over 27.5 years; commercial properties depreciated SL over 31.5 years

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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)

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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

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Taxes and Interest Payment

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

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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

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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

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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

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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

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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

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Tax-Deferred (1031) Exchanges

  Properties exchanged must be of like kind  Property must be held for use in trade or business or for investment, owner-occupied residences do not qualify The exchange must occur; cannot sell for cash and immediately purchase  Properties adjusted basis will be equal

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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

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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

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Installment Sale

  Imputed interest rule applies  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. Any down payment amount is allowed  Debt amortization vs. installment period

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