CH 17 - Income Tax in RE Transactions

Depreciation cont'd

- Another important element of tax depreciation is that the owners are permitted to recover their cost of an asset over the period of the asset's useful life. - STRAIGHT LINE DEPRECIATION - *For income producing residential property, anything that is not owner occupied, the building and improvements are depreciable over a 27.5 year period of time. The depreciable basis/27.5 yrs = determines the property's allowance for each year. *For income producing non-residential properties, aka commercial properties, the properties depreciate during a 39 year depreciable schedule. *Ex: Property Depreciable Basis- $2,750,000 $2,750,000/27.5 = $100,000 (yearly allowable depreciation). The tax payer would be eligible to take an annual depreciation allowance of $100,000 and they would take that uniform amount under the straight line method each and every year ($100,000 each and every year for the 27.5 years of useful life) assuming they had ownership during that whole period of time. - Investors can benefit from depreciation when they own a property but it may be a liability when they have to sell it. *EX. DEPRECIATION AT SALE OF PROPERTY Sales price: $1,500,000 - Property Purchase Price: $1,000,000 = Deducted Depreciation (400,000) Property Purchase Price: $1,000,000 - Deducted Depreciation ($400,000) = Adjusted Basis: $600,000 steps: (1. sales price - property purchase price = deducted depreciation. 2. purchase price-deducted depreciation=Adjusted Basis) GAIN CALCULATION: Sales Price: $1.5M Adjusted Basis: $600,000 Gain (taxable): $900,000 If an investor buys a property for $1M and then later sells it for $1.5M, they must calculate their adjusted basis in the property by backing out the depreciation they've taken over time. So if they've taken $400,000 of depreciation over their ownership period then they would be removing that from the $1 million dollar cost figure which would then result in a $600,000 adjusted basis. Determining your gain, you are actually taking 1.5 million, subtracting the $600,000 that is how you will derive at the gain of $900,000. So it is important to realize that the depreciation is recaptured upon the sale. - COMPONENT DEPRECIATION- the difference between a lower selling price & a higher selling price, resulting in a financial loss to the seller. For tax purposes, allocating a portion of the total cost of renovation to each component of the renovation (roof, plumbing, foundation, electricity, etc.) and then depreciating the cost of each of that separately. This method focused on building systems, and accelerated depreciation. - Cost segregation- focuses on land and interior improvements, which nearly have a shorter depreciation period and/or economic life. The IRS has developed a manual guide regarding the theory and application of cost segregation, it defines which items qualify for five, seven and 15-year depreciation lives. A well-prepared cost segregation report will delineate 35 to 100 items which qualify for short-life depreciation. Each of these items increases tax deductions. This allows investors to increase the profitability of their investment by accelerating their appreciation and deductions & increasing their yr to yr profits. Conversely, a component depreciation analysis might have only identified five to 10 systems. *http://www.poconnor.com/component_depreciation.asp

Medical Surtax

- In 2010 Congress passed the Healthcare and Education Affordability Reconciliation Act which went into effect in January 2013 with the main effect being that there was now a new Medicare surtax that certain real estate investors were subject to. It imposed a 3.8% tax on the net investment income joined filed with adjusted gross income of $250,000, single filers with adjusted gross income of over $200,000. So the tax also applies to dividends, royalties, interest, except for municipal bond interest, short and long term capital gains, the taxable portion of payments and income from the sale of a personal residence above the $250,000 and $500,000. - Bottom line is that the impact that this act had is that when you are calculating the gain on the sale of either a personal residence beyond the 121 exemption amounts ($250,000 for single filer, $500,000 for a married filer) or if you have a non-owner occupied property that you are subject to capital against, you now have to add this Medicare Surtax. You now have the capital gains rate of 20% on a federal level plus the 3.8% = 23.8%.

Low Income Housing Incentives

- Tax Reform Act of 1986 established the low income program referred to as LIHC. It also caused the bottom rate to be raised from 11% to 15% while the top tax rate was brought down from 50% to 28%. Its purpose was to promote private sector involvement in the reduction of housing for the low income households. The program provided a dollar for dollar reduction in federal taxes for the project owners who developed low income housing that serves low income households. - Low income households are actually defined as households that have an income 60% or less of the area's medium level. The income is adjusted for household size. -The New York State division of housing and community renewal which is the DHCR is the lead housing credit agency for New York that oversees this program.

Taxpayer Relief Act of 1997

- This act reduced several federal taxes in the US and had a significant impact on real estate. - it took the top marginal long term capital gains rates from 28% down to 20% and for the 15% bracket brought it down to 10%. So that had a major impact on everybody that was selling an asset that was subject to capital gains. - The act also exempted from taxation the profits from the sale of a personal residence. So now when a personal residence was sold then depending on the tax filings status ($250K for single, $500K for married), you had anywhere from $250,000 exemption to a $500,000 exemption - This exemption only applies to residences that the taxpayer has lived in for at least 2 years for the last 5, it doesn't have to be the last two years before you sell the property; just any two years within a 5 year span - 59 1/2 rule- act actually allows the tax payer to use some of their IRA funds towards the purchase of their new home. It's called the age 59 and ½ rule and what it allows is (for what they consider a first time home buyer) to use up to $10,000 from their traditional IRA account without being subject to the normal early withdrawal penalty. Therefore, allows them to avoid that 10% early withdrawal penalty and actually have use of those funds and contribute towards the down payment on the purchase. - to qualify that and actually use this 59 and ½ age exemption the buyer must have had no present ownership interest in a principal residence during the two year period ending on the date they acquire the new residence. You can't be living in your personal residence and about to buy another home so you move into another personal residence and then try to use this provision. It has to really be what is considered a first time home purchase.

Depreciation

- the periodic expensing of an asset over the property's theoretical economic life. It's the loss of utility and thus value caused by physical deterioration, functional/economical obsolescence, or both. So if you have an asset that qualifies as a capital asset you are not actually able to expand or recover the cost of that asset in one year. - Two types of depreciation that are relevant to real estate: 1. economic and 2. tax depreciation. *ECONOMIC DEPRECIATION- the physical deterioration of a property while you are owning it *TAX DEPRECIATION- an accounting concept; it permits a property owner to take a business deduction for the annual depreciation expense. So it is actually the systematic deduction of a property owner over time. - DEPRECIATION is the deductible allowance from the net income of the property that helps you calculate the taxable income number. - TAX CREDIT- a dollar for dollar reduction in your tax liability or the taxes that you would owe - TAX DEDUCTION- you take that amount that you are eligible for as a deduction, you apply your tax rates and that would actually solve for you what amount you could reduce from that possible income or from the taxes that are due. Land is also not depreciable primarily in theory because it will not ware out over time. What is good with condominiums from depreciation standpoint is that condos do not have a land element so 100% of the purchase price can be depreciated as long as it's not used personally. EX: So if the condominium you are buying is for investment purposes then it would be eligible for the depreciation deduction. - NON-DEPRECIABLE ASSETS: land, personal use assets -DEPRECIABLE ASSETS: buildings, equipment, machinery, other business items that produce income or are held for an investment - Because land is not depreciable it is important to separate the land value from the building value of the property, before determining the depreciable basis.

Terms

-STRAIGHT-LINE DEPRECIATION - A method of calculating the depreciation of an asset which assumes the asset will lose an equal amount of value each year. -TAX DEPRECIATION - An income deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property. -CAPITAL GAIN - A profit that results from a the sale of a property where the amount realized from the sale exceed the purchase price. -CAPITAL LOSS - The difference between a lower selling price and a higher purchase price, resulting in a financial loss to the seller. -BASIS - A major accounting method that recognizes revenues and expenses at the time physical cash is actually received or paid out. -RECAPTURED DEPRECIATION - When real property is sold at a gain and accelerated depreciation has been claimed, the owner may be required to pay a tax at ordinary (non-accelerated) rates to the extent of the excess accelerate depreciation. -Adjusted Basis - The original cost of a property minus depreciation and sales of portions thereof plus allowable additions such as capital improvements and certain carrying costs and assessments. A bookkeeping rather than appraisal term. -BOOT - Cash received in a tax-deferred exchange. However, It's difficult to find an equal exchange (in a 1031) and, in many cases, one party ends up kicking in some extra cash to make the deal fair. This additional property or cash received is known as "boot", and this gain is taxed up to the amount of the boot received. - TAX -DEFERRED EXCHANGE - Under Section 1031 of the US Internal Revenue Code, the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due. -APPRECIATION - Monetary gain resulting from the increase in the market value of an investment, excluding additions of capital. For example, a house which is sold five years after it was purchased for 50% more than the purchase price. - CASH FLOW - The net result when income from an investment property is subtracted from the expenses. The result is used to determine the rate of return on an investor's money. -PASSIVE ACTIVITY INCOME - Earnings an individual derives from a rental property in which he or she is not actively involved. -ACTIVE INCOME - Income for which services have been performed. - TAX SHELTER - Any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments.

Property Types and the Capital Gain

-Section 121 of the tax code does allow for an exemption every 2 yrs of gains pertaining to sale of one's primary residence. So long as you live in the property two years out of the last 5 years, the tax payer is eligible for an exemption: for a single tax payer ($250,000 exemption) & for a married couple ($500,000 exemption). - The tax payer can only have only one primary residence at a time, so if the tax payer owns multiple properties, second home, they can only claim one primary residence to a given tax year - The taxpayer can qualify for a partial exclusion in certain extenuating circumstances i.e. divorce, job relocation, death, health related. They receive a pro-rata portion of the exemption. If the taxpayer has lived in the property only one year out of the last 5 but they have these extenuating circumstances they may then qualify for 50% of the primary residence exemption. Just keep in mind this exemption is an exemption of gain. *EX: CAPITAL GAINS (married couple) Sales price: $800K Purchase price: $500K Capital gain: $300K Exemption: $500K Gain to be taxed: $200K The taxpayer is selling their primary residence for $800,000 & they are a married couple. They purchased the property for $500,000, so they have a $300,000 gain in the property. As a married couple assuming that they lived in it for 2/5 years they will qualify for the $500,000 exemption which is more than enough to cover the exemption of the gains since the gain would be equal to $300,000 (the difference between the sales price of $800,000 and what they originally bought it for $500,000). - REALIZED GAIN- a gain that's not necessarily taxed. In a successful exchange, the gain is realized but not recognized & therefore not taxed. In the above ex, the $300K is the realized gain. - RECOGNIZED GAIN- amount of gain subject to tax when property is disposed of at a gain or profit in a taxable transfer. -BASIS- a major accounting method that recognizes revenues & expenses at the time physical cash is received or paid out: Basis = original purchase price + capital improvements - depreciation = adjusted basis (When you are putting money into the asset or capital improvements into the property; you are increasing your basis). Once you have that adjusted basis number you are going to look at the sales price of the property, deducting any selling cost, things like transfer taxes or closing fee and look at the difference between that net sales price and your adjusted basis and then it will give you your realized gain. - RECAPTURED DEPRECIATION- when real property is sold at a gain and accelerated depreciation has been claimed, the owner may be required to pay a tax at ordinary (no-accelerated) rates to the extent of the excess accelerate depreciation. - If applicable, you may very well also have capital gains rate on not just federal but also state and city level taxes that could be due upon the sale of the property. So that is what makes up that tax rate on the capital gain portion on the sale of the property.

Tax Strategies

-Two tax strategies that tax payers are using to mitigate some of that tax liability: 1. INSTALLMENT SALE- where a tax payer will sell their property and take back a note from a full purchase price or a portion. - INSTALLMENT NOTE is another section of the tax code, (section 453) and basically, as the tax payer receives the money they pay the prorated portion of the tax over the period of time that they receive the funds. *EX: INSTALLMENT SALE STRATEGY Sales Price: $1M Down payment: $500,000 10 year note (loan) @ 6%- $500,000 (payments of $50K/yr) You sell a property for $1M and you receive $500,000 upfront as well as $500,000 note. Basically it's a note from the buyer saying I will pay you the remaining $500,000 plus interest. So what the tax payer is doing in that situation is they are basically stepping into the shoes of the lender. So they are taking back basically a mortgage on that property. Let's just assume that the note is structured at 6% interest and it's payable in payments of $50,000 a year for the next 10 years. In year one when the taxpayer sells the property they receive a check for $500,000 which is essentially the down payment. The tax payer would pay tax on a pro-rata portion of that money received, so part of that tax liability paid in year one. Then in each of the next subsequent years the taxpayer received payments of $50,000 of principal payments, the taxpayer will pay the remaining liability spread out over the next 10 years. Also you are obviously getting a 6% interest on that money. That interest income is ordinary income just like you would receive, if you received interest dividend or interest income from money held in the bank. - On that portion you would pay your ordinary income tax rate. But what we are focused on is the principal portion because that is really the capital gain portion of the sale. So the installment sale is one structure that taxpayers would use as a means of mitigating some of that tax liability.

Federal Income Tax Treatment

-Under IRS Regulations certain items can be deducted on your tax returns. These deductions include the property tax deductions and the deductions you can receive on mortgage interest. Property taxes are deductible for any type of real property. This includes personal residences, a second home, time share, vacant land, even inherited property. - The taxes paid on non-investment real property are deducted as an itemized deduction on the tax return, but it's important to keep in mind that you can only take advantage of the deduction if you itemize your taxes. So you have to be eligible to actually file Schedule A on your return. If you are taking the standard deduction on your taxes then any property taxes that you paid over the course of the year you will not be able to take advantage of that. - Taxes paid on rental properties are deducted on a taxpayer's Schedule E. - To deduct home mortgage interests off your taxes: 1. you must itemize on Schedule A 2. tax payers must be legally liable for the loan. The tax payer cannot deduct the payments they make on behalf of someone else if they are not legally liable for the payments. For ex: as a parent if you actually held a son or daughter by a residence and even though they are on the mortgage you are actually helping them with the payments. At the end of the year you would not be qualifying for that interest deduction on those taxes. It is actually on their taxes because they are legally liable for the loan. - A qualified home is a taxpayer's main home or second home. Mortgage interest is deductible on both the main home and the second home. A home may be a house, a condominium, a co-op, a mobile home, a house trailer, a boat, anything that is considered a dwelling where you have sleeping, cooking and toilet facilities. So all of those would qualify if you were then to take a mortgage out on those properties and a mortgage interest would be deductible. The loan can also be for construction, home improvement, a line of credit or even a line of equity loan. The interest paid in a mortgage debt, other than the tax payer's main home or a second home may still be deductible if the loan proceeds are for the business investment or other deductible purposes.

Federal Tax Rules on Acquisition

-When purchasers acquire a mortgage they must follow certain IRS rules in deducting interests, points, and closing costs - Home acquisition financing is considered the debt that you will incur to buy, build, or greatly improve a qualified home (primary or 2nd home) *Home Acquisition Financing (Interest Deductions): -Can't be more than $1M (married) -Can't be more than $500,000 (single) -Limit is reduced but never below zero (grandfathered debt- defines 'grandfather debt' as a mortgage that was taken out, on, or before October 13th 1987) *REFINANCING RULES AND LIMITATIONS: -any secure debt used to refinance home acquisition debt or the original mortgage is treated as home acquisition debt for tax purposes. -new debt disqualifies the remaining balance debt *Home Equity Financing (Interest Deductions) - Mortgage that uses qualified home as collateral - Smallest of either: $100,000 (married) or $50,000 (single) OR - Property Value - acquisition debt - Grandfathered debt = Home Equity debt *Home Improvement Loans (Interest Deductions): -Can deduct interest as long as it fulfills the IRS requirements *Construction Financing (Interest Deductions): - Can treat the home as a qualifying home for up to 24 months. - Must become a qualified home when ready for occupancy *POINTS - describes certain charges that a borrower pays to obtain a mortgage. Points are called origination fees, maximum loan charges, loan discounts or discount points. The term point includes loan placement, fees that the seller pays to the lender to arrange financing for the buyer. The general IRS rule for points is that the buyer cannot deduct the full amount of points in the year they are paid. They are required to be deducted over the life of the mortgage. So they are added to the mortgage principle and then amortized out over the life of the payment plan. *CLOSING COSTS- not interest and not tax deductible *PREPAYMENT PENALTIES- If the homeowner pays off the whole mortgage before the time set out in the mortgage contract he may have to pay a penalty to the lender. According to the IRS the home owner can deduct that penalty as home mortgage interest if the penalty is not for a specific service performed, or cost incurred in connection with the mortgage loan. If penalties are incurred for investment property they are added to the basis to the property purchased.

Tax Strategies cont'd

2. 1031 Exchange/Tax Deferred Exchange- the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due. - If you sell a business or investment property and follow this process and acquire a replacement property within a 180 days you are able to defer the tax. So what is important under these installment structures and the 1031 structure it's a deferral of tax. -The tax code requires that you require 'like kind' property exchange. For the most part any real property defined by state law qualifies like kind with any other real property so long as it's held for business or investment purposes & it can be anywhere in the US. You can change the asset class i.e. exchange a multi-family for an office building; 1031 Exchange Process- goal of 180 days: (3 steps) 1. Sale of the property- an escrow account is established after sale to pay for transfer taxes, closing costs, etc. during the exchange process 2. Identification of property- taxpayer has 45 days to i.d. a property. Taxpayer has 2 options for this: *3 property rule- can id any 3 properties *200% rule- the taxpayer can identify more than 3 properties, as many as they want, the catch is the total value of the identified properties cannot exceed 200% of a property that was sold. A form is submitted then listing the addresses. Once you are outside those 45 days, your identification is locked in. That's why identifying a second and third property can be very valuable to the taxpayer, to give them some fallback options. 3. Acquisition of new property- Generally to get the maximum tax deferral on the 1031 Exchange, you want to try and buy property of equal and greater value so if I sell for a million I would like to buy replacement property of a million dollar or greater. The IRS wants you to replace the debt that you paid off. I you sell for a million you pay off the mortgage of $400,000 and that leaves $600,000 of proceeds. You still have to buy for a million dollar or greater to maximize the 1031. So what the IRS wants you to do is carry forward the $600,000 of equity and they either want you to take out a new mortgage on a new property or contribute additional cash to the purchase of the new property. - REVERSE EXCHANGE- The taxpayer acquires the replacement property and then within 180 days sells off & they relinquish the property. -FORWARD EXCHANGE- same 1031 process but a very transparent process - Improvement Exchange- That starts out like a traditional exchange where the taxpayer sells their property, let's say for a million dollars. Then they go out and they buy a replacement property for $800,000. Well there is a trade down amount. You sold for one million, you purchased for $800,000. What you can do is you can structure an improvement exchange whereby you use $800,000 of proceeds to acquire that property and then you utilize the remaining $200,000 to make improvements to that property.

Operations Income and Capital Gains

In the ownership of real estate, only two types of income or gain that will be applicable to the ownership of real estate: - The first would be the income from operations, - The second being capital gains associated with the sale of the property. A profit that results from a sale where the amount realized from the sale exceeds the purchase price. - Income from operations: 3 classifications of this income: (1) ACTIVE INCOME- earned through salaries or earned in the business activities (2) PORTFOLIO INCOME- includes dividends, interests, annuities, as well as royalties. (3) PASSIVE INCOME- income that is generated from invested funds i.e. rental properties -INCOME FROM CAPITAL GAINS: the gain associated with the sale and disposition of the property 2 types: (the differentiation between the two types besides the tax rate, they are determined based on the period of ownership of the property) 1. SHORT TERM- refers to assets held < 12 mths; subject to the ordinary income tax rate 2. LONG TERM- refers to assets held > 12 mths; long term capital gains tax rate (about 23.8%) -CAPITAL LOSSES- the difference between a lower selling price and a higher purchase price, resulting in a financial loss to the seller. Capital losses are not deductible against the taxable income.

Section 121 & 1031 of the Tax Code

http://www.irs.gov/irb/2005-07_IRB/ar10.html http://www.investopedia.com/terms/s/section1031.asp