Washington Real Estate Fundamentals Lesson 14: Federal Income Taxation and Real Estate © 2011...

Washington Real Estate Fundamentals

Lesson 14:

Federal Income Taxation and Real Estate

© 2011 Rockwell Publishing

Basic Taxation ConceptsProgressive tax

Progressive tax: Taxpayers with higher incomes are taxed at higher tax rates.

Not only must pay larger tax amount, must also pay higher percentage of income in taxes.

Federal income tax is a progressive tax.


Basic Taxation ConceptsProgressive tax

Progressive tax contrasts with two other types:

Proportional tax: All income levels taxed at same rate.

Regressive tax: Higher income levels taxed at lower rate than lower income levels.


Basic Taxation ConceptsTax brackets

Tax rates increase in uneven steps called tax brackets.

If additional dollar earned crosses line into higher bracket, it’s taxed at higher rate.

But that doesn’t increase rate charged on dollars previously earned.


Basic Taxation ConceptsIncome

For tax purposes, income includes more than just salary or wages.

Income: Any economic benefit realized by a taxpayer, unless specifically excluded from income by tax code.


Basic Taxation ConceptsDeductions and tax credits

Deduction: Expense that may be subtracted from income before the income is taxed.

Example: mortgage interest deduction

Tax credit: Amount taxpayer allowed to subtract directly from taxes owed.

Tax credit represents greater savings than tax deduction for same amount.


Basic Taxation ConceptsGains and losses

Gain: Results when taxpayer sells asset for more than amount invested in it.

Gain is taxable income unless tax code provides specific exception.

Loss: Results when taxpayer sells asset for less than amount invested in it.

Loss is deductible only if tax code provides specific deduction.


Gains and LossesDeductibility of losses

Business entities can generally deduct all losses.

Individual taxpayer may deduct losses only if connected with:

taxpayer’s trade or businesstransaction entered into for profittheft or casualty loss of taxpayer’s

property


Gains and LossesCapital gains and losses

Capital gain or loss: Gain or loss from sale of capital asset, which is property held for:

personal use, or investment purposes

Capital gains are taxed at lower rate than ordinary income.

Capital losses also receive special tax treatment.


Capital Gains and LossesDeductibility of capital losses

Even though loss on principal residence or other property held for personal use is capital loss, not deductible.

Capital losses on property held for investment purposes are deductible.


Capital Gains and LossesNet gain or net loss

Capital gains and deductible capital losses are netted against each other.

Net capital loss may be deducted.But annual limit on amount that can be

deducted as net capital loss.Net losses over limit may be carried

forward and deducted in future years.


Gains and LossesTax shelters

Tax shelter: Arrangement that allows taxpayer to reduce taxes by deducting losses from one source from gains (income) from another source.


Basic Taxation ConceptsBasis

To determine gain or loss on property transaction, you must know taxpayer’s basis.

Basis: Property owner’s investment in the property.Maximum amount taxpayer could

receive without realizing a gain.


BasisInitial basis

Initial basis: Original cost of acquisition.How much owner paid to acquire the

property.Typically purchase price plus closing

costs.


BasisAdjusted basis

Initial basis may be increased or decreased to get adjusted basis:

start with initial basisadd capital expendituressubtract allowable depreciation

deductions

When property sold, IRS will use adjusted basis to calculate capital gain or loss.


Adjusted BasisCapital expenditures

Capital expenditures: Expenditures that add to a property’s value or extend its life.

Examples: remodeling, new roof

Maintenance expenses are not capital expenditures.

Examples: painting, fixing leaky plumbing


Adjusted BasisAllowable depreciation deductions

For certain types of property, taxpayer’s basis also reduced by depreciation deductions (discussed later).

Initial basis (acquisition cost)

+ Capital expenditures

- Depreciation deductions

Adjusted basis


Basic Taxation ConceptsRealization

Gain not taxed as income until it is realized.

For income tax purposes, increase in property’s value not realized until owner sells or exchanges it.

Sale or exchange separates gain from asset.


RealizationAmount realized

Amount realized: All benefits received by seller, minus selling expenses (such as broker’s commission). Also called net sales price.

Benefits received may include:cashproperty seller received in exchangedebt buyer is assuming from seller


RealizationCalculating gain or loss

Amount realized

- Adjusted basis

Gain or loss


Basic Taxation ConceptsRecognition

Taxes must be paid on gain in year it is recognized.

Usually recognized in same year realized.

But nonrecognition provisions in tax code permit exceptions in certain transactions.Taxpayer allowed to defer recognition

(and taxation) of gain until a later year.


SummaryBasic Taxation Concepts

• Income• Deduction• Tax credit• Gains and losses• Capital asset• Initial basis• Adjusted basis• Capital expenditure• Realization• Recognition


Classifications of Real Property

Tax code has 6 classifications of real property:principal residence propertypersonal use propertyunimproved investment propertyproperty held for production of incomeproperty used in trade or businessdealer property


Classifications of Real PropertyPrincipal residence

Principal residence property: Home owned by a taxpayer that he lives in most of the time; also called main home.

Taxpayer can have only one principal residence at a time.


Classifications of Real PropertyPersonal use property

Personal use property: Real estate owned for personal use that is not taxpayer’s principal residence.

Example: vacation home


Classifications of Real PropertyUnimproved investment property

Unimproved investment property: Vacant land that is held for appreciation and produces no income.


Classifications of Real PropertyProperty held for production of income

Property held for production of income: Any type of property (residential, commercial, or industrial) used to generate rental income for the owner.


Classifications of Real PropertyProperty used in trade or business

Property used in a trade or business: Land and buildings a taxpayer owns and uses in her trade or business.


Classifications of Real PropertyDealer property

Dealer property: Property a taxpayer is holding primarily for sale to customers.

Example: subdivided land available for sale to public.


Nonrecognition Transactions

Taxpayer generally must pay tax on gain in the year gain is realized.

But tax code allows recognition of gain to be deferred to a later year in:

installment salesinvoluntary conversions“tax-free” exchanges


Nonrecognition TransactionsInstallment sales

Installment sale: When seller receives less than 100% of price in year sale occurs.

Buyer pays seller rest of price in subsequent year(s).Nearly all seller-financed transactions

are installment sales.


Installment SalesDeferral of taxation

With installment sale, only the part of the gain seller receives in a particular tax year is taxed that year.

Gain basically prorated over term of installment contract.

Installment sale reporting permitted for all classes of property except dealer property.


Installment SalesGross profit ratio

Amount of gain seller must report each year is based on the gross profit ratio.

Gross profit ratio: Relationship between seller’s gross profit and contract price; also called gross profit percentage.

Gross profit: Difference between sales price and adjusted basis plus selling expenses.


Installment SalesGross profit ratio

To calculate gross profit:start with the contract price (sales price)subtract seller’s basis at time of salesubtract selling expenses

To calculate gross profit ratio:divide gross profit by contract price


Installment SalesExample

Contract price: $300,000Seller’s adjusted basis: $248,500Brokerage commission: $18,000Other selling expenses: $3,500

What’s the gross profit?

$300,000 - $248,500 - $18,000 - $3,500 = $30,000 gross profit

What’s the gross profit ratio?

$30,000 gross profit ÷ $300,000 contract price = .1, or 10% gross profit ratio


Installment SalesCalculating the year’s gain

Principal payments received

× Gross profit ratio

Gain to be taxed that year

Gross profit ratio not applied to interest.Interest always taxed in year collected.


Installment SalesExample, continued

Gross profit ratio: 10%

In year of sale, seller received:$27,500 downpayment$2,067 in principal payments$19,725 in interest payments

What’s the taxable income from the sale for this year?

$27,500 downpayment + $2,067 principal = $29,567

$29,567 × .10 = $2,956.70 recognized gain

$2,957 gain + $19,725 interest = $22,682 taxable income for year of sale


Nonrecognition TransactionsInvoluntary conversion

Involuntary conversion: When property converted into cash without owner’s voluntary action.

May occur through:condemnationdestructiontheft


Involuntary ConversionMay result in gain

Involuntary conversion often involves gain for owner.

Government or insurer compensates owner.

Compensation is based on property’s current replacement cost or market value.


Involuntary ConversionDeferral of gain

IRS allows deferral of gain if taxpayer replaces property within allowed replacement period.

Replacement period: generally lasts for 2 years.

Any gain not applied toward replacement property will be taxed as income.


Nonrecognition Transactions“Tax-free” exchanges

Tax-free exchange: When real property is exchanged for other real property and owner allowed to defer recognition of gain.

Also called a 1031 exchange.Not actually tax-free.

Taxation deferred indefinitely, but not avoided altogether.


“Tax-free” ExchangesEligible types of property

Eligible for tax-free exchange:unimproved investment propertyproperty held for production of incomeproperty used in trade or business

Not eligible:principal residencepersonal use propertydealer property


“Tax-free” ExchangesLike-kind property

To qualify, properties exchanged must be like-kind properties.

Real property must be exchanged for other real property located in the U.S.

Like-kind property not necessarily the same type of real property.Example: apartment building can be

exchanged for unimproved land.


“Tax-free” ExchangesBoot

Boot: Anything received in an exchange other than like-kind property, including:

cashstockpersonal propertydebt relief (difference in mortgage

balances)

Boot recognized in year exchange occurs.


“Tax-free” ExchangesExample

Taxpayer who owns apartment building trades it for office building.

Apartment building: $970,000 mortgage

Office building: $880,000 mortgage

How much boot is the taxpayer receiving?

$970,000 - $880,000 = $90,000 boot (debt relief)

Only the boot will be taxed in the year of the exchange. Taxation of any other gain (if the office building is more valuable than the apartment building) will be deferred.


“Tax-free” ExchangesBasis in new property

As a general rule, taxpayer’s basis in property that was traded away is transferred to the property received.

But if exchange involved boot, then adjustments to basis are necessary.


SummaryProperty Types and Nonrecognition

• Principal residence• Personal use property• Unimproved

investment property• Property held for the

production of income• Property used in a

trade or business• Dealer property

• Installment sale• Gross profit ratio• Involuntary conversion• Replacement period• Tax-free exchange• Like-kind property• Boot


Sale of Principal Residence

Gain on sale of a principal residence may be permanently excluded from taxation.

Not just deferred (as in exchange or installment sale).


Sale of Principal ResidenceLimits on exclusion of gain

Taxpayer may exclude entire gain on sale of principal residence, up to:

$250,000 for individual taxpayer$500,000 for married taxpayer filing joint

return

Any amount in excess of $250,000 or $500,000 taxed as capital gain in year of sale.


Sale of Principal ResidenceQualifying for the exclusion

Within last five years, taxpayer must have:owned home for at least two years, and lived in it as principal residence for at

least two years.

Only one spouse must meet ownership test, but both must meet use test.

Exclusion can generally be used only once every two years.


Deductions for Property Owners

Deductions: Subtracted from income before tax rate applied and taxes calculated.

Deductions available to property owners:depreciationrepairsproperty taxesmortgage interest


DeductionsDepreciation deductions

Depreciation deductions: Allow taxpayer to recover cost of asset over a period of years. Also called cost recovery deductions.

Apply only to: property held for production of incomeproperty used in a trade or business


Depreciation DeductionsIneligible types of property

Depreciation deductions not available for:principal residencepersonal use propertyunimproved investment propertydealer property


Depreciation DeductionsDepreciable property

Assets are depreciable only if they will eventually wear out and need to be replaced.

Includes structures as well as equipment for a farm or business.

Does not include the land, which does not wear out.


Depreciation DeductionsTime frame

Entire expense of acquiring asset can’t be deducted in year incurred.

Expense deducted over a specified number of years, depending on type of asset.For most real estate, recovery period

between 27½ and 39 years.


Depreciation DeductionsDepreciation subtracted from basis

Allowable depreciation deductions subtracted from initial basis to arrive at adjusted basis.

Initial basis+ Capital expenditures– Allowable depreciation

Adjusted basis

Depreciation deductions subtracted even if taxpayer did not take them.


DeductionsRepair deductions

Repair deductions: Property owner may deduct expenditures made to keep property in ordinary operating condition.

Not available for principal residence or personal use property.

Capital expenditures (which add to property’s value and may prolong its life) not deductible.

Instead, these are added to basis.


DeductionsProperty tax deductions

General real estate taxes are deductible.

Special assessments:deductible if for maintenance or repairsnot deductible for improvements


DeductionsMortgage interest deductions

Interest paid on a mortgage loan is deductible for all types of property.

But there are limits on this deduction for personal residences:principal residencesecond home


DeductionsMortgage interest deductions

For personal residence, taxpayer can deduct interest paid on:

Loan of up to $1,000,000 used to buy, build, or improve home.

Home equity loan of up to $100,000.For married taxpayer filing separately,

limits are $500,000 and $50,000.

Interest on loan amount over limits not deductible.


DeductionsDeductibility of points and loan costs

Buyer may deduct origination fee and discount points for new loan.

Treated as prepaid mortgage interest.Even seller-paid points (but buyer’s

basis reduced).Fees lender charges buyer for specific

services not deductible.

Seller’s prepayment penalty also deductible as form of interest.


SummaryExclusions and Deductions

• Exclusion for sale of principal residence• Depreciation deductions• Depreciable property• Repair deductions• Property tax deductions• Mortgage interest deductions and limits• Deductibility of points• Deductibility of prepayment penalty


Washington Real Estate Fundamentals Lesson 14: Federal Income Taxation and Real Estate © 2011...

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