RFINANCE17: Tax Consequences

Foreign Investors' Taxes:

- Because of the surge in United States real estate investments by foreign investors in the 1970s, the Treasury Department became worried that somehow these foreign investors would escape paying taxes on their capital gains. To ensure that would not happen, Congress passed the Foreign Investment Real Property Tax Act of 1980 (FIRPTA). - The act requires that any person who purchases property from a seller who is not a US citizen must withhold and send to the Internal Revenue Service 10% of the gross sales price. If the buyer fails to withhold the correct amount of tax, he or she may be liable for the tax, plus interest and penalties. There are some exceptions, but for the most part, the withholding is mandatory unless any of the following circumstances exist: The property is worth less than $300,000 and the purchasers are buying it as personal residence. The transaction is not subject to tax because of a US tax treaty with another country, and the buyer and seller are not related. The seller or buyer gets a "withholding certificate" from the IRS, which decreases the amount to be withheld.

Check Your Understanding-Answers:

- Explain the difference between realized and recognized gains or losses. A gain or loss is realized at the time the property or asset is sold. A recognized gain or loss is the amount incurred that must be reported on income taxes for a specific year (either the year of the transaction or later) and is determined by how the transaction is structured. - Which kinds of assets are considered Section 1231 assets and which are not? Assets used in a trade or business are Section 1231 assets. Assets held for investments or personal use are not Section 1231 assets. - What is the potential important advantage to a seller who uses the installment sales method when selling a property? The seller may be able to defer the taxes on the gain until he or she is in a lower tax bracket. - What is the definition of a like-kind exchange? One property can be exchanged for another property regardless of the property type, as long as it is held as an investment or for use in a trade or business.

Gifts of Property:

- If a person owns a property free and clear and gives the property to someone else, no money or other payment changes hands in the transaction so there is no realized gain or loss. Because there is no realized gain or loss, there is no recognized gain or loss. However there may be a gift tax. - All legitimate gifts and all property passed down due to death are subject to a unified and graduated gift and estate tax. The tax is paid by the giver or by the deceased person's estate. How ever, there are some exemptions and exclusions: Starting in 2006, taxpayers could give up to $12,000 per person per year to as many people as they wanted to without having to pay a gift tax. The person who receives the gift must have immediate access to the gift, unless he or she is a minor. If that's the case, the gift can be held in trust until the minor reaches adulthood. The annual exclusion amount was indexed for inflation and has increased to $14,000 for 2013. If spouses jointly make gifts, they are permitted to give up to $28,000 per person per year without having to pay the gift tax, but they must file an information gift tax return in the year they have given the gift. A person has an unlimited exemption for gifts to his or her spouse, provided the spouse is a US citizen at the time he or she receives the gift. If the spouse is not a US citizen, the tax-exempt gift is limited to a specific yearly amount. (Note: This annual exclusion is indexed for inflation and will gradually increase in $1,000 increments.) There is an unlimited exception for payment of tuition and medical expenses for others, as long as the payments are made directly to the educational institution or healthcare provider. Gifts to a political organization for its own use are not taxable. Gifts to charities are not taxable. All other gifts are subject to the unified, graduated tax, which has been gradually decreasing over the past several years. The estate tax was repealed for 2010 but returned in 2011. For the current gift and estate tax rates go to http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Estate-and-Gift-Taxes.

Like-Kind Exchanges:

- If an investor participates in an exchange of a like-kind asset, any taxable gain or tax-deductible loss is not recognized in the year the transaction takes place. Rather, the investor can defer those gains or losses until a future taxable transaction occurs involving a substitute property. - Like-kind exchanges are sometimes wrongly called tax-free exchanges. They are not tax free; they are tax deferred. The legislation that deals with like-kind exchanges is contained in Section 1031 of the IRS code. Because of this, these exchanges are sometimes called Section 1031 exchanges. - To qualify under Section 1031, there must have been a legitimate exchange of the assets involved. Therefore, it is important for investors to make certain that all proper steps are taken by all parties involved in the transaction so that the transaction can be documented as a bona fide exchange. - To qualify as a like-kind exchange, the property being transferred must have been held for productive use in a trade or business or held as an investment and must be exchanged for property that will also be used in a trade or business or be held as an investment. Qualifying properties can fall into either of these categories. In other words, a property that is used in a trade or business may be exchanged for an investment property and vice versa.

Gifts of Property:

- If the gift property is transferred with a mortgage, there will be both sale and gift aspects to the transfer. Even though the person giving the property is liable for the debt, the person receiving the property must pay the debt to maintain control the mortgaged property. If the balance on the mortgage is greater than the donor's adjusted tax basis, the difference will be a realized gain. The difference between the property's market value and the mortgage balance is a gift and could be subject to the gift tax. - The tax basis of the receiver's interest in the property will be the same as the donor's, unless the donor had to pay a gift tax. In that case, the receiver's tax basis will increase by an amount equal to the portion of the gift tax that was a result of the property's appreciation while it was owned by the donor.

Like-Kind Exchanges: Definition

- Only like-kind property qualifies for tax-deferred exchange treatment. The idea of like kind refers to the nature of the property, not to its quality. Real estate investors must realize that one property can be exchanged for another property regardless of the property type, as long as it is held as an investment or for use in a trade or business. Also, a single property can be exchanged for several properties. Here are some examples: Trade or business property, together with cash, for other trade or business property Metropolitan property for a farm or ranch Improved investment property for unimproved investment property A leasehold, with at least 30 years to run, for a freehold Mineral interest in land for a fee title in real estate Note: Property in the United States and property in foreign countries are not considered like-kind under Section 1031. - Tax Consequences of Like-kind Exchanges If all the property involved in an exchange qualifies as like-kind, then no person involved in the exchange may recognize any gain or loss on the transaction. This is a mandatory rule and not an option. If an investor realizes any gain or loss in an exchange but that gain or loss is not recognized for income tax purposes, it will be reflected in the tax basis of the newly-acquired property. If some of the property involved in an exchange fails the like-kind test, the investor must recognize some portion of the gain in the year the transaction takes place. The investor can defer the remainder of the realized gain and it will be reflected in the adjusted basis of the acquired property.

Capital Gain or Loss Rules:

- Property held for longer than 12-months is considered a "long-lived" asset. Any gain realized on a long-lived asset is considered a long-term gain. Any gain realized on an asset held for less than 12 months would be considered a short-term gain. - Special rules apply to the sale of assets used in a trade or business as opposed to those held for investment purposes or for personal use. Assets used in a trade or business are called Section 1231 assets (after the IRS code section that applies to these assets). Gains on the sale of Section 1231 assets are treated as capital gains to the extent that the gain is greater than the losses on the sale of other 1231 assets during the same taxable year. Any losses are treated as reductions in ordinary income for the year. - Similarly the gain on the sale of a personal residence is also considered a capital gain. However, unlike Section 1231 assets, a loss on the sale of a personal residence has no income tax consequences whatsoever - meaning the owner cannot claim a loss on his or her income taxes.

The Alternative Minimum Tax:

- The Alternative Minimum Tax (AMT) was passed in 1969 to ensure that upper-income taxpayers paid at least some income taxes. Up to that point, taxpayers skilled at finding enough in itemized deductions, income exclusions and tax credits would sometimes manage to avoid paying any income taxes. - The AMT is a modified "flat-rate" tax that coexists within the regular income tax system. After a taxpayer figures his or her taxable income and how much he or she owes in income tax using the regular process for computing tax, he or she must compute an alternative minimum taxable income and alternative minimum tax. After both computations are done, the taxpayer must pay the larger of the alternative tax or the regular tax. - Many taxable and tax deductible items receive stricter treatment under the alternative minimum tax computation than under the regular tax computation. For example, there is a difference in the cost recovery allowance in that the costs are recovered over a greater number of years. Also, certain gains on the sale of property that can be deferred or that receive preferential treatment under the regular tax computation method are considered regular taxable income under the alternative method. - Because of this, some of the tax advantages usually associated with the real estate investment might be taken away by the alternative minimum tax. Therefore, it's important for cautious investors to look at the alternative minimum tax consequences of their investments before deciding to invest.

Tax Consequences of Selling Property:

- The tax consequences of selling property depend in part on: The amount and nature of the gain or loss (if there is one) How the transaction is structured - The consideration of a property consists of everything of economic value that is received for that property, including any remaining balance due on the mortgage, whether or not the buyer assumes personal liability. Any other property or services the seller receives as part of the deal must also be included at their fair market value. The realized gain or loss on a transaction is the difference between the consideration received and the adjusted tax basis at the time the transaction takes place. - Realized gain may be treated as ordinary income or as capital gain. Capital gain gets special tax treatment. By the same token, a loss may result in a decrease in ordinary income taxable for the year, or it may be a capital loss and be able to offset ordinary taxable income by only a limited amount. - Investors realize a gain when a property is sold at a price that is higher than its adjusted tax basis. As we saw earlier, yearly depreciation allowances that investors can take on their taxes reduce the adjusted tax basis. Reducing the adjusted tax basis increases the potential for a gain when the property is sold.

Realized Versus Recognized:

- There is a difference between realized and recognized gains or losses. A gain or loss is realized at the time the property or asset is sold. However, how the transaction is structured actually determines whether or not the gain or loss is recognized and incurred for income tax purposes in the year of the transaction. - If the transaction is a cash sale and the seller realizes a gain, that gain will be recognized in the year of the transaction. However, if the sale results in a loss, it may be that a portion will have to be carried forward and recognized in future taxable years. - If the seller takes back a promissory note as part payment for the sale or gets assets of "like kind" as in a trade of real estate, the investor may be able to defer all or a part of the gain or loss. The deferral is sometimes compulsory and sometimes elective.

Exception for Small Investors:

- There is a special provision that applies only to real estate. This provision allows an investor to offset up to $25,000 a year in passive activity rental real estate losses against otherwise taxable income, such as wages and profits from business activities. This exception is phased out proportionally as the investor's adjusted gross income moves from $100,000 to $150,000. There are two exceptions to this phase-out rule: If the passive activity tax credits are attributable to the rehabilitation tax credit that we talked about earlier, the exception is phased out proportionally as the investor's adjusted gross income moves from $200,000 to $250,000. If the passive activity tax credits are attributable to low-income housing credits, there is no adjusted gross income limitation. To qualify for the exception, the taxpayer must have at least a 10% ownership interest in the property and must actively participate in the rental operation. The active participation requirement doesn't apply to the pass-through of low-income housing or rehabilitation credits.

Check Your Understanding-Answers

- What is a property's initial tax basis? Everything of value that was given in exchange for the property, including any commissions, legal fees, title insurance and other items that the purchaser had to pay to complete the purchase that are not deductible as a current operating expense. - Define depreciation allowance. An amount an investor can deduct from his or her taxable income to recover some of his or her investment capital. - Glenda purchased a nonresidential building in June 2004. Her initial tax basis on the building is $480,500. What is her monthly depreciation allowance? $480,500 ÷ (12 X 39) = $480,500 ÷ 468 = $1,026.71 (Remember: Nonresidential buildings have a cost recovery period of 39 years.) - What kind of circumstance would decrease the tax basis of a property and what type of circumstance would increase the basis? Damage to the property would result in a decrease in the tax basis, while money spent to increase the property's value or useful life would increase the tax basis.

Computing Capital Gains or Losses:

- When a Section 1231 asset is sold, the sale is recorded as to whether it resulted in a gain or a loss. Capital gains and losses are then subdivided according to whether they are long-term or short-term. The gains and losses are offset against one another within each category. That means that Section 1231 gains and losses are offset against one another, short-term gains and losses are offset against one another, and long-term gains and losses are offset against one another. The final tax consequences of each category depend on which is greater -- the gains or the losses. - If there is a net loss on a Section 1231 asset, it is offset against ordinary income. If there is a net gain on a Section 1231 asset, it is treated as ordinary income to the extent that the investor has used Section 1231 net losses to offset ordinary income during the previous five years. If there is any remaining gain, it is treated as a long-term capital gain. - When one category shows net capital losses, either long-term or short-term, and the other category shows net capital gains, the two are offset against one another. If there is a remaining net capital loss, it is offset against ordinary income, but only up to $3000. The investor must carry forward any remaining net capital loss to the next taxable year. The losses that are carried forward maintain their identity as short-term or long-term in the next taxable year. If there is a remaining net short-term capital gain, it is taxed as ordinary income for the year. If the net long-term capital gains surpass the offsetting short-term capital losses, what remains is identified as net capital gains.

Installment Sales Method:

- When a seller sells a property and gets only a partial payment for it during the year of the sale, he or she can report the transaction under the installment sales method. Using this method allows the seller to defer a part of the income tax liability until the he or she collects the balance of the cash. The investor will incur tax liability on a pro rated basis with each year's collection of the sales proceeds. Advantages of Installment Sales Reporting The IRS code provisions dealing with installment sales make it possible for sellers to provide significant financing for buyers without the unfortunate side effect of having income tax liability surpass their cash collections in the year the property sells. A possible result of the installment sales method is that the seller may be able to defer the taxes on the gain until he or she is in a lower tax bracket. For example, a seller could sell a property during his or her peak income earning years with the payments spread over his or her retirement years. The amount of taxable gain on the sale and the nature of that gain are determined at the time of the actual transaction. However, the applicable tax rate is the rate that is in effect when the taxes become due. A seller pays income tax only on the profit portion of each installment payment. Only the portion of the principal that represents gain is taxable; the portion of the principal that represents the return of capital (basis) is not taxable. As with most notes, an installment sale contract usually provides for periodic payments on the note, plus interest payments on the unpaid balance. The principal portion of the payment is considered part of the purchase price. However, the interest payments are considered additional income to the seller and are taxable.

Check Your Understanding-Answers;

-What is the most important consideration when choosing an investment ownership type? Maintaining decision-making control over the operations - Under what circumstances would the joint tenancy form of ownership be a bad idea? Because of the right of survivorship, joint tenancy is not a good idea unless the other joint tenant or tenants are people to whom the investor intended to leave the property to anyway. - Explain the difference between a tax deduction and a tax credit. A tax deduction reduces a person's taxable income. A tax credit reduces the actual tax liability dollar for dollar, after the tax due amount has been computed. - What does the Foreign Investment Real Property Tax Act of 1980 require? The act requires that any person who purchases property from a seller who is not a US citizen must withhold and send to the IRS 10% of the gross sales price.

Limited Liability Companies:

A limited liability company, LLC, gives investors the income tax advantage of a partnership and the limited liability benefits of a corporation. This type of ownership is fairly new, but most states now allow it. Instead of shareholders or partners, an LLC has members. The LLC typically has an operating agreement that is similar to corporate bylaws. The person or persons who manage an LLC do not have to be members. Neither the members nor the persons doing the management of an LLC have personal liability, which makes this ownership type more like a corporation than a partnership. If the LLC meets the IRS guidelines for how it is structured, the LLC members will be taxed in essentially the same way as a partnership. That is, they will file a return that is informational, but the tax liability will pass through to the individual members for reporting on their personal income tax returns.

Limitations on the Deductibility of Losses:

According to Section 469 of the IRS Code, taxpayers must report separately their income and losses from activities distinguished as passive. Except in a small number of circumstances, net losses from passive activities cannot be offset against income from other sources. Instead, the taxpayer must carry the losses forward and offset them against passive income in future years. The taxpayer can deduct any passive loss carryovers that remain when the investor sells or otherwise divests himself or herself of the property to which the losses apply. Passive activities include ownership interests in most rental property and in any trade or business that the taxpayer does not have a hand in managing year-round, on a regular, continuous and substantial basis. - Limited partners' income and expenses are always passive. Section 469 of the IRS Code also specifically includes limited partnership interests as passive activities. The Code says "Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates." The Code goes on to say, "No interest as a limited partner in a limited partnership shall be treated as an interest with respect to which the taxpayer actively participates." When viewed together, these two provisions eliminate any possibility that limited partnership interests might not be considered passive activities. - Real estate rental income and expenses are sometimes passive. Section 469 of the IRS Code says, "The term passive activity includes any rental activity." However, other wording in the section excludes the following: Rental income that is supplementary to the primary business activity or where considerable personal service is involved. This would include hotels, motels and resorts. Other parts of the code have special provisions that would exempt other rental real estate under certain circumstances. Rental income when the taxpayer is actively engaged in real property trade or a business such as brokerage, development or management. In order for the term "actively engaged" to apply, the taxpayer must have at least a 5% ownership interest in the business. In addition, more than 50% of the taxpayer's working hours must be devoted to the activity, which must take up more than 750 hours a year.

Adjustment of the Basis for Cost Recovery:

An investor can deduct an allowance from otherwise taxable income to recover some of his or her investment capital. The allowance is called a depreciation allowance. It is enough to recover the cost of buildings and land improvements, such as roads and walkways, but it must be deducted according to a time schedule that is specified in the Internal Revenue Code. Only assets held for business or income purposes are eligible for the depreciation allowance. However, eligibility for the allowance is determined by the intent to produce income, rather than actually producing it. What this means is that an owner of rental property may claim the depreciation allowance, regardless of whether the owner has a tenant actually living on the property. But the Internal Revenue Service may require the owner to provide proof of the intent to produce income. For example, if an owner has previously occupied a property, then moved out, left it vacant and then tried to sell it, the property will not qualify for a deduction. The IRS will consider it income property and permit the depreciation allowance only if the owner actively seeks to rent it after he or she has moved out.

Computing the Allowance:

An investor recovers the tax basis of a building in equal annual increments over the allowable recovery period. If the investor owns the property for less than 12 months of a specific taxable year, the investor can take the depreciation allowance only for those number of months during that year that he or she owned the property. The investor can take half a month allowance for the first month the property was put into service, regardless of how many days during that month the property actually was in service. The investor can claim another half month allowance in the month he or she sells the property, again regardless of the actual number of days he or she owned the property that month. This half month allowance is called the mid-month convention.

Summary/Review:

An investor's tax basis in a property is of major significance to the outcome of the investment. From the time a property is first purchased, owners have a tax basis in the property. Selling or exchanging a property generates a gain or loss equal to the difference between the sales price and the adjusted basis of the property at the time it is sold. The initial basis in property that is purchased is what it cost to make the purchase, including any commissions, legal fees, title insurance and other items that the purchaser had to pay to complete the purchase that are not deductible as a current operating expense. If a buyer purchases two or more assets in a single transaction, the initial tax basis must be distributed among them according to their relative market values. An investor can deduct an allowance from otherwise taxable income to recover some of his or her investment capital. The allowance is called a depreciation allowance. Only assets held for business or income purposes are eligible for the depreciation allowance. However, eligibility for the allowance is determined by the intent to produce income, rather than actually producing it. The recovery period for qualifying residential structures is 27.5 years. The recovery period for nonresidential buildings purchased after May 12, 1993, is 39 years. The recovery period for land improvements, such as walks, roads, sewers, gutters, and fences, is 15 years. An investor recovers the tax basis of a building in equal annual increments over the allowable recovery period. When a property sells or is damaged or destroyed by a disaster such as a fire, flood or storm, the tax basis is reduced. Any money spent on the property that substantially increases the value or useful life of the property gets added to the tax basis.

Accelerated Recovery Periods:

As we mentioned earlier, the recovery period for improvements to land is 15 years. However, the IRS allows taxpayers to use an accelerated technique called the 150 percent declining balance method. This method allows an investor to take larger depreciation amounts during the earlier years, balanced by smaller depreciation allowances in later years. The investor can change to the straight-line method for the remainder of the 15-year period if doing so at some point along the way will generate a higher annual allowance.

Table:

Cash down payment $100,000 Second mortgage note $50,000 First mortgage note $400,000 $550,000 Attorney fee $1,500 Owner's title policy $300 Recording fee $50 Initial tax basis $551,850 All the other money Jim paid out represents his costs of obtaining financing or is incidental to the purchase and cannot be included in the calculation of the initial basis.

Corporate Ownership:

Corporations are themselves legal bodies. A corporation's identity is separate and distinct from that of its shareholders. Just like individuals, corporations can buy or sell property, enter into contracts, sue and be sued, and transact all types of business. Corporations can also be taxed. They must file corporate income tax returns and pay taxes on their net earnings. If the corporation distributes earnings in the form of cash dividends to the stockholders, the stockholders must pay tax on the dividends as regular income. Because the corporation pays taxes on the earnings and the stockholders pay taxes on the dividends, the corporation's distributed earnings are taxed twice. Should the corporation refuse to declare a cash dividend to try to avoid the double taxation, it could result in even higher tax on accumulated earnings that exceed the corporation's justifiable needs. This excess accumulated earnings tax, when added to the regular tax, can be viewed as a penalty. Even though there appears to be several disadvantages to holding title as a corporation, corporations do offer several advantages. These are the most important. Limited shareholder liability Stockholders are not liable for the corporation's debts, unless they sign an agreement that says they are. So shareholders carry risk only to the extent of their investments in the corporation. Liquidity Corporations can issue fractional interests in the form of one or more shares of stock that can be used to transfer small pieces of ownership. Easier transactions Shares in a corporation are considered personal property rather than real property. Transferring ownership of personal property is much less complex than transferring ownership of real property. Easier estate settlement When an investor owns real property in more than one state, it's possible that both states will try to collect the taxes based on the property's value. Because corporate shares are personal property rather than real property, holding title as a corporation avoids this problem.

Income Tax Credits for Property Rehabilitation:

Even though tax shelter benefits have been significantly reduced by legislation since 1986, some benefits are still available to investors who are involved in property renovation and rehabilitation. Not all of these shelter opportunities are equal however. If the investments conform to a set of very comprehensive criteria, costs to renovate low-income housing or special nonresidential properties qualify for tax credits rather than tax deductions. Tax credits for rehabilitating certified historic structures can be even greater. - How Tax Credits Work Tax credits are not the same as tax deductions. Tax credits give a dollar-for-dollar reduction in tax liability, which is subtracted from the total tax due after the amount of income tax has been computed. For example, a taxpayer in the 35% income tax bracket would have his or her income tax reduced by one dollar for every dollar of tax credits, but only $.35 for every dollar of tax deductions.

Allowable Cost Recovery Periods:

Every so often, legislators change the allowable recovery periods for depreciation without seeming to take into consideration the actual useful life of an asset. Their decision to make the change seems to hinge on the need to get more tax revenue or encourage investments. Currently, the recovery period for qualifying residential structures, which are defined as buildings that get 80% of their gross rents from residential tenants, is 27.5 years. The recovery period for nonresidential buildings purchased after May 12, 1993, is 39 years. The recovery period for land improvements, such as walks, roads, sewers, gutters and fences, is 15 years.

Limited Partnerships:

In many situations, investors contribute funds to the investment, but they don't want to be involved in the day-to-day operations. Because of this, they do not want to be personally liable for the project's financial obligations. Limited partnerships provide an option which gives investors no personal liability, but also avoids the double taxation found with corporations. As we discussed in an earlier unit, limited partnerships have one or more general partners who conduct the business and do have unlimited personal liability for partnership obligations. Then there are one or more limited partners who have no personal liability but who share in the profits and losses of the partnership just like partners in a general partnership do.

Subchapter S Corporations:

In some cases, the owners of certain corporations may choose to have the corporation's income be taxable directly to the shareholders rather than to the corporation. In this situation, any losses are also passed through to the shareholders, but only to the extent of the shareholders' adjusted tax basis in the stock. The stockholder would have to carry forward any additional losses until such time as he or she makes further contributions to the corporation. Corporations that qualify and choose this option are called S corporations or tax option corporations. The qualification process for this Subchapter S entity type can be very complex and will only be successful in companies that have a good understanding of the statutes and regulations.

Tax Basis:

Income tax issues are vitally important to real estate investors. The investor's tax basis in a property is of major significance to the outcome of the investment. So let's talk first about the nature and significance of the tax basis. From the time a property is first purchased, owners have a tax basis in the property. During the time the property is owned, the basis may be adjusted to reflect a reduction in capital investment or the addition of capital to the investment. This tax basis is the primary determining factor of the tax consequences during the time the property is held. Selling or exchanging a property generates a gain or loss equal to the difference between the adjusted sales price and the adjusted basis of the property at the time it is sold. The adjusted sales price is the sales price plus selling expenses associated with the sale such as commissions. The adjusted basis of the property is the original tax basis, minus all accumulated depreciation, plus any capital additions to the property. The initial tax basis in a newly purchased property depends in part on how it was purchased. If the property was received as a gift, its initial tax basis will be the same as the adjusted tax basis of the person who donated the property, unless the donor is subject to gift tax liability. If there was gift tax liability, the initial tax basis will include the part of the gift tax liability the donor had to pay because the property increased in value while the donor owned it. The initial tax basis in property that someone inherits is its market value as determined for estate tax purposes. We'll talk about gift and estate taxes a little later on in this unit.

Tax Consequences by Ownership Type:

Investors have a variety of ownership entity choices. These ownership forms include ownership by: Individuals Corporations Subchapter S Corporations General Partnerships Limited Partnerships Limited Liability Companies It's important for investors to know that how they choose to take title to a property can critically affect the outcome of the business enterprise. The question of entity type is particularly pressing if there is some consideration being given to involving a number of investors in a pooling-of-capital arrangement. Outside investors generally want an entity arrangement that will limit their personal financial liability. The choice of ownership entity can significantly affect how quickly an asset or property can be liquidated. Investors are much more willing to enter into an investment with others if they will have the ability to liquidate quickly whenever they want to. For this reason, cooperative ventures tend to choose an ownership entity that will allow investors to transfer their investment shares in relatively small increments. The chief consideration when choosing an ownership type is the importance of maintaining decision-making control over operational matters. If a cooperative venture sacrifices control in order to persuade associates to contribute additional funds, the effort could prove to be self-defeating if the associates end up being incompetent managers.

Summary/Review::

Investors have a variety of ownership entity choices. These ownership forms include ownership by: Individuals Corporations Subchapter S Corporations General Partnerships Limited Partnerships Limited Liability Companies The chief consideration when choosing an ownership type is the importance of maintaining decision-making control over operational matters. Ownership by one individual is known as tenancy in severalty. The most common co-tenancy arrangements are tenancy in common and joint tenancy. Even though there appears to be several disadvantages to holding title as a corporation, corporations do offer several advantages. These are the most important. Limited shareholder liability Liquidity Easier transactions Easier estate settlement Unlike corporations, partnerships are not taxable entities. The individual partners handle the taxes for income and losses. A limited liability company, LLC, gives investors the income tax advantage of a partnership and the limited liability benefits of a corporation. When an investor borrows or repays money, his or her tax liability is neither increased nor decreased. However, the interest on money borrowed for rental real estate is usually deductible in the taxable year that it is paid. Costs to renovate low-income housing or special nonresidential properties qualify for tax credits rather than tax deductions. Tax credits are not the same as tax deductions. Tax credits give a dollar-for-dollar reduction in tax liability which is subtracted from the total tax due after the amount of income tax has been computed. Limited partners' income and expenses are always passive. Real estate rental income and expenses are sometimes passive. The Alternative Minimum Tax is a modified "flat-rate" tax that coexists within the regular income tax system. After a taxpayer figures his or her taxable income and how much he or she owes in income tax using the regular process for computing tax, he or she must compute an alternative minimum taxable income and alternative minimum tax. After both computations are done, the taxpayer must pay the larger of the alternative tax or the regular tax.

Ownership by Individuals:

Joint Tenancy Tenants in Common

Joint Tenancy:

Joint tenancy has essentially the same characteristics as tenancy in common, except that: Joint tenants always have an equal interest in the property. If one of the joint tenants dies, that tenant's interest in the property goes to the other joint tenant or tenants instead of to his or her heirs. Because of the right of survivorship, joint tenancy is not a good idea unless the other joint tenant or tenants are people to whom the investor intended to leave the property to anyway. Joint tenancy requires one deed for all owners, who must take title at the same time.

Computation for Cost Recovery:

Let's look back at our earlier example of Jim's apartment building purchase. Let's assume that Jim purchased the building on June 20, 2003 and sold the building on December 31, 2005. If you recall, we calculated Jim's tax basis on the building to be $551,850. Let's see how much of the cost Jim will be able to recover. Because it's a residential property, the recovery period is 27.5 years. To identify the allowance, let's assume a land-to-building ratio of 25%. Here are the formulas to figure Jim's monthly depreciation allowance: Tax basis x land's percent of total value = land value (Tax basis - land value) / recovery period = annual depreciation allowance Monthly Depreciation Amount = Annual depreciation / 12 Therefore, in the example: ($551,850 x 25% = $137,962.50 land value ($551,850 - 137,962.50) / 27.5 = $15,050.45 annual depreciation allowance $15,050.45 / 12 = $1,254.20 monthly depreciation allowance In 2003, Jim will be able to claim six months' full depreciation (July-December) and a half month's allowance for June. Months in Use X Monthly Allowance = Yearly Depreciation 6.5 X $1,254.20 = $8,152.33 Depreciation Allowance for 2003 For each of the years 2004 and 2005, Jim will be able to claim a full year of depreciation, or $15,050.45 each year. Total cost recovery is thus ($8,152.33 + $15,050.45 + $15,050.45), or $38,253.23.

More Ownership Types:

Ownership in General Partnerships Subchapter S Corporations Limited Partnerships Limited Liability Companies

Allocation of the Initial Tax Basis between Land and Buildings:

Since land is not depreciable for tax purposes, its value must be separated from the value of the improvements in order to be able to set up a depreciation schedule for the improvements portion of the investment. This land-building value allocation can be accomplished through the expertise of an appraiser or other party recommended by tax counsel.

Ownership by Individuals:

Taking title to a property as an individual is the least involved option. This individual ownership is known as tenancy in severalty. If more than one investor takes an equity position, it would be a co-tenancy arrangement. Co-tenancies are not themselves taxpaying entities. Any profits and losses accrue to the individual co-tenants, and they must be reported on the investors' personal tax returns. The co-tenants divide the profits and losses according to their relative ownership interests in the property. So each investor is in the same tax position as he or she would be if he or she took title to a portion of the property as a sole owner. The most common co-tenancy arrangements are tenancy in common and joint tenancy. Each state has its own version of the deed which creates joint tenancy as opposed to tenancy in common. But either way, co-tenants have the flexibility to decide how they wish the property to be operated. The agreement the co-tenants reach should be in writing and signed by all parties to avoid misunderstanding. The written agreement can also serve as a guide for settling any disagreements that might arise. The agreement should be written with the help of an attorney to make sure that it can be enforced if needed.

Initial Tax Basis:

The initial basis in property that is purchased is what it cost to make the purchase. This includes everything of value that was given in exchange for the property. It also includes all costs that may have been paid to obtain and defend the title. Therefore, cost includes any commissions, legal fees, title insurance and other items that the purchaser had to pay to complete the purchase that are not deductible as a current operating expense. These items can be added to the acquisition cost to get the initial tax basis. Here is an example of how a purchaser's initial tax basis could be determined. Jim purchases an apartment building on the following terms: $100,000 in cash at closing, with Jim taking the title subject to an existing mortgage note, which has a remaining balance of $400,000, and signing a note and second mortgage for $50,000 and $50 for document recording. He also pays $1500 for legal representation and $300 for an owner's title insurance policy. Jim's initial tax basis is $551,850. Here's how we determine it: Purchase price: $550,000

Summary/Review:

The tax consequences of selling property depend in part on the amount and nature of the gain or loss and how the transaction is structured. The realized gain or loss on a transaction is the difference between the consideration received and the adjusted tax basis at the time the transaction takes place. Realized gain may be treated as ordinary income or as capital gain. Capital gain gets special tax treatment. By the same token, a loss may result in a decrease in ordinary income taxable for the year, or it may be a capital loss and be able to offset ordinary taxable income by only a limited amount. If a transaction is a cash sale and the seller realizes a gain, that gain will be recognized in the year of the transaction. However, if the sale results in a loss, a portion of it may have to be carried forward and recognized in future taxable years. When a seller sells a property and gets only a partial payment for it during the year of the sale, he or she can report the transaction under the installment sales method. Using this method allows the seller to defer a part of the income tax liability until he or she collects the balance of the cash. If an investor participates in an exchange of a like-kind asset, any taxable gain or tax-deductible loss is not recognized in the year the transaction takes place. Instead, the investor can defer those gains or losses, until a future taxable transaction occurs involving a substitute property. The legislation that deals with like-kind exchanges is contained in Section 1031 of the IRS code. Because of this, these exchanges are sometimes called Section 1031 exchanges. To qualify as a like-kind exchange, the property being transferred must have been held for productive use in a trade or business or held as an investment and must be exchanged for property that will also be used in a trade or business or be held as an investment. If a person owns a property free and clear and gives the property to someone else, no money or other payment changes hands in the transaction, so there is no realized gain or loss. However there may be a gift tax. Taxpayers can give up to $14,000 per person per year to as many people as they want to without having to pay a gift tax. If spouses jointly make gifts, they are permitted to give up to $28,000 per person per year without having to pay the gift tax.

Other Adjustments to the Tax Basis:

There are a number of other factors besides the depreciation allowance that can affect the tax basis. Some of these factors decrease the basis, while others increase it. When a property sells or is damaged or destroyed by a disaster such as a fire, flood or storm, the tax basis is reduced. If only a portion of the property is sold, the tax basis will be reduced by the portion of the tax basis that corresponds to the part that was sold. In the situation of loss through disaster, the basis is reduced to account for any loss deductions the investor can take in the year of the loss, plus any loss for which the investor received compensation. Any money spent on the property that substantially increases the value or useful life of the property gets added to the tax basis. Normally, this includes any expenses that are not deductible as current expenses. A new central heating or cooling system, a new roof, and new wall-to-wall carpeting are good examples of such costs. A US Treasury regulation helps investors distinguish between what would be considered a capital expenditure and what is considered currently deductible repairs and maintenance. The cost of any improvements, alterations or additions that are added to the tax basis can be depreciated and recovered in the same way as the initial costs. But the investor must depreciate the new costs using an entirely separate recovery schedule. The new, separate schedule starts with the month that the improvements, alterations or additions are placed in service. If you remember, when purchasing property, the investor can add certain transaction costs to the adjusted basis. By the same token, the investor can also add to the adjusted basis qualified transaction costs resulting from the sale.

Allocation of the Initial Tax Basis:

Tom purchased a property for $1,000,000. It includes land and two buildings. Here are the values given by an independent appraiser. Appraiser Land $200,000 Building 1 $500,000 Building 2 $300,000 Total: $1,000,000 If Tom uses the appraisers' allocations, here's how the allocation will look as a percentage. Percent of Total Land 20 Building 1 50 Building 2 30 Total: 100 Tom's property in this scenario has an initial tax basis of $1,000,000, and a depreciable basis of $800,000 for tax purposes. The land-to-building ratio here is 20-80. Again, remember that land cannot be depreciated for tax purposes.

Ownership in General Partnerships:

Unlike corporations, partnerships are not taxable entities. The individual partners handle the taxes for income and losses. Partnerships must file tax returns, but only to provide information to the IRS. The return shows the amount of the income, where the income came from, the expenses and deductions. The return also indicates how each item is divided among the partners. Then the partners must report the individual items on their personal income tax returns. General partners share profits and losses equally and have equal authority over the partnership business, unless there is a written agreement that states otherwise. They are jointly and severally liable for all partnership obligations, even if a particular obligation was created by a partner who exceeded his or her authority. Because all partners share authority and all are liable for the decisions of any one partner, general partnerships have very limited appeal as real estate ownership entities. Because of the inherent problems, most general partnerships are limited to business associates who know one another well and have a good deal of confidence in and respect for each another

Tax Consequences of Financial Leverage:

When an investor borrows or repays money, his or her tax liability is neither increased nor decreased. However, the interest on money borrowed for rental real estate is usually deductible in the taxable year that it is paid. There are a few exceptions to this general rule involving: Prepaid interest Construction-period interest Deduction limitations - Prepaid Interest Typically, a borrower cannot deduct prepaid interest until that interest is actually earned by the lender. Therefore discount points and loan origination fees must be amortized over the term of the loan. However, if a borrower gets a loan to purchase a personal residence or to finance improvements to a personal residence, that loan is exempt from the amortization rule. - Construction-Period Interest Any interest that accrues during the construction of improvements to real estate is considered a part of the construction cost. So it is part of the initial tax basis of the improvements and becomes part of the cost recovery allowance. - Limits on the Deductibility of Interest Any interest that an investor incurs as a result of purchasing and carrying assets such as stocks or bonds can be deducted only in an amount that is equal to the income that was earned by the portfolio. If interest accrues that is more than the portfolio income, that interest must be carried forward and claimed as offsets against the portfolio's income in later years. There are also limits on the amount of real estate net losses that an investor can offset against his or her income from other sources. Because of these limitations, an investor may not be able to deduct some interest expense in the year it was incurred. If that happens, the investor must carry that interest expense forward and treat it as interest expense incurred the next year. Fortunately at this time, there is no limit on the number of years that an investor can carry forward the interest expense in this way. - Implications of Investment Strategy A property's equity is the difference between the market value of the property and the remaining balance on the mortgage loan. When an investor sells a property, he or she converts the equity to cash, which could result in having to pay income taxes. However, borrowing on the property, which also converts the equity to cash, does not result in a taxable event. So often, an investor will benefit from choosing to borrow instead of sell.

Tenants in Common:

When property is titled as a tenancy in common, each of the investors' names is listed on the deed, and each holds an undivided interest in the whole property. This means that, even though they may hold unequal shares of the property itself (for example, one person might hold a 10% interest, another person a 35% interest, and yet another person a 55%), each tenant in common has the use of the whole property, unless there is a specific agreement that states otherwise. Substantial changes or improvements to the property will need agreement among all the owners. This ensures that no one owner has too much control over the property. Usually the agreement will state that one owner can operate the property under a limited power of attorney from the other owners.