Unit 3: Income Taxes and the Investor in Florida

Debt service

Interest and principal payments for loans on the property

Which four activities shown here are the responsibility of a qualified intermediary (QI)? 1. Place proceeds of the first sale with escrow, with instructions. 2, Handle transactional paperwork with escrow. 3. Provide a list of possible exchange properties to the investor. 4. Provide transfer documents for the exchange. 5. Submit a 1099 to the taxpayer and IRS for any gross proceeds paid out. 6. Change or back date exchange paperwork for the investor.

1, 2, 4, 5

Net operating income

= effective gross income - operating expenses

What is an installment sale?

A contractual agreement in which the buyer pays the seller the purchase price over time in a series of installments until the buyer has paid the contract in full, and the seller turns over the deed to the buyer.

What is another name for an installment sale contract? A land contract A traditional mortgage An equitable lien A pro-rated sales plan

A land contract

Vacancy and credit loss

Actual gross potential income is offset by this, which occurs when units are not rented or tenants do not pay their full obligation

Cash flow

Amount of money that remains after debt service is subtracted from net operating income

Any profits investors have earned are only realized after they sell their investments. These profits are called capital gains, and taxes are owed on capital gains. To calculate the capital gain or loss on an investment, an investor must first calculate the adjusted basis for the property. Which of these formulas is used to calculate the adjusted basis?

Basis + improvement costs made during ownership - accrued depreciation

Operating costs Purchasing costs Financing costs

Deductible as current expenses Depreciated Amortized over the life of the loan

Which of the following could an investor who sells an apartment house buy using a 1031 exchange? Duplex only Office building only Warehouse or office building only Duplex, office building, or warehouse

Duplex, office building, or warehouse

Miscellaneous income

Examples include coin-operated laundry equipment, vending machines, pay phones, and late fees

Effective gross income

Gross potential income plus expense reimbursements plus miscellaneous income, minus vacancy and credit loss

Both of these terms are "gross." Which one refers to the total income possible? Effective gross income Gross potential rental income

Gross potential rental income

Expense reimbursements

Income received when tenants pay for some or all of the property's operating expenses

Net operating income

Income that remains after operating expenses are subtracted from effective gross income (this is a measure of the property's ability to pay its bills)

Coin-operated laundry equipment, vending machines, and late fees are all examples of ______. Property income Operating income Miscellaneous income Side income

Miscellaneous income

What is the formula used to calculate taxable income for income-producing activities?

Net operating income + reserves - mortgage interest -annual depreciation -carryover of losses ( if any) = taxable income

Once an investor has calculated the adjusted basis, the capital gain or loss can be determined. Which of these formulas is used to calculate the capital gain or loss for an investment property?

Net sales proceeds - adjusted basis

What costs are associated with purchasing property: match with operating costs, financing costs, purchasing costs title charges lender fees purchase of tools surveys property maintenance hazard insurance

Operating costs: -Hazard insurance -Purchase of tools -Property maintenance Financing costs: -Lender fees Purchasing costs: -Title charges -Surveys

Costs associated with running and maintaining a property are called ______. Property expenses Operating expenses Landlord expenses Profit loss

Operating expenses

Property expense reimbursements are paid to the ______. Property owner Tenant Property manager Landlord

Property owner

Gross potential rental income

The maximum amount of income a property can generate from all sources when fully occupied and when rents are fully collected

adjusted basis

The original cost of a property reduced by depreciation deductions and increased by capital expenditures

Which of the following is a reason a seller might consider selling his property through an installment contract rather than a traditional sale? The buyer in an installment transaction is likely to have better credit than a buyer in a traditional sale. The seller is not subject to fair housing requirements if he sells the property through an installment sale. The seller owes no property taxes as long as the property is under an installment sale contract. The seller may pay less in capital gains taxes if he receives the proceeds from the sale over time rather than in a lump sum.

The seller may pay less in capital gains taxes if he receives the proceeds from the sale over time rather than in a lump sum.

Actual gross potential income is offset by ______. Vacancy and credit loss Operating expenses Capital improvements Cash flow

Vacancy and credit loss

external obsolescence

a loss in property value due to external factors such as declining neighborhood, rezoning, etc.

tax-deferred exchange

an exchange of one property for another (a sale and purchase) for tax deferment purposes

appreciation

rise in value of a property

Jen and Charley are buying a piece of property. They haven't been able to save much for a down payment, so they don't qualify for traditional financing. The seller, Lorraine, has agreed to an installment sale method—or land contract—with a $1,000 down payment. This situation benefits Jen and Charley, as well as Lorraine. Connect each statement to its corresponding advantage or disadvantage. 1. The $1,000 down payment Jen and Charley are making on the property is much less than it would be for a traditional mortgage loan. 2. Lorraine can avoid paying federal capital gains all at once and can pay them through percentage payments each year. 3. If Jen and Charley are unable to make the payments, Lorraine can keep all of the proceeds received and repossess the property. 4. Jen and Charley don't have ownership in the property until it is completely paid off.

1. Advan for buyer 2. Advan for seller 3. Adv. seller/ Dis. buyer 4. Disadv for buyer

1. Money left to spend 2. Max income minus vacancy 3. Max income possible 4. Income minus operating costCash flow

1. Cash flow 2. Effective gross income 3. Gross potential rental income 4. Net operating income

Closing costs on an investment property will fall into one of three tax categories. What are those three categories?

1. Deductible in the year they're paid 2. Amortized over the life of the loan 3. Depreciated (added to the cost basis)

1. Active income 2. Passive income 3. Portfolio income

1. Income derived from employment; examples include salaries, tips, and commissions; also called earned income 2. Income derived from activities not directly related to active participation in a business or earnings from wages; example: rental income 3. Income derived from investments; examples include income from capital gains, interest, and dividends

1. Like-kind 2. Basis doesn't change 3. Equal or greater debt load 4. Qualified intermediary 5. 45 calendar days 6. Disclose intent to exchange

1. The investor must be buying and selling property that is used for investment or business purposes and is similar. 2. The cost basis of the original property carries over to the new property. It includes new assumed debt and cash paid out. 3. The new property must come with the same or greater debt load for the investor. The investor is liable for the gains on the difference. 4. An individual who facilitates the exchange between the parties and their attorneys or agents. 5. The time period during which investors have to identify and commit in writing to the property that's being acquired. 6. At the time of the sale and at the time of the purchase, investors must say if they're doing a like-kind exchange.

What tax-related term with the correct stage of property ownership life cycle 1. acquisition 2. ownership 3. reversion

1. tax credits points deduction closing points depreciation 2. property tax deductions mortgage interest deductions expense write-offs depreciation 3. 1031 tax exchange depreciable basis 3.8% investment income tax net loss/income

What's the difference between recaptured depreciation and capital gains? Review each statement about recaptured depreciation and capital gains and determine if the statement is true or false. A Recapture is the process of investors getting money back on the amount they have depreciated on their investment property over the years. B Recaptured depreciation on property is taxed at 25% at the time of the sale. C For investors in higher tax brackets, capital gains on property are taxed between 15% and 20%. D Taxes owed on capital gains cannot be deferred. E When calculating capital gains, the investor can deduct the costs of the sale. F Recaptured depreciation and capital gains are different terms for the same thing.

A. False; Recapture is the process of investors repaying at the tine of the sale any depreciation they've taken over the years, which has reduced their tax liability B. True C. True D. False; taxes owed on capital gains can be deferred E. True F. False

Do you know how points are handled for tax purposes when an investor acquires property? Review each statement below about how points are handled for tax purposes when an investor acquires property, and determine if the statement is true or false. A Points paid to reduce the interest rate are deductible in the year they're paid. B Provided the investor follows a few rules, the deduction of points can be taken equally over the life of the loan. C One of the requirements for being able to deduct points for an acquired investment property is that the property must secure the loan. D One of the requirements for being able to deduct points for an acquired investment property is that the investor must use the cash method of accounting. E If the loan for an investment property is more than $200,000, the points can't be more than four for a 15-year or under loan, or more than six if the loan period is more than 15 years.

A. False; points paid to reduce the interest rate can be tax deductible, but not in the year they're paid B. True C. True D. True E. False

In a nutshell, cash flow is the sum of the money coming in (income) and the money going out (expenses). Identify which of these have a positive effect on the bottom line, and which have a negative effect on the owner's bottom line. A Debt service B Expense reimbursements C Miscellaneous income D Vacancy E Operating expenses

A. Negative B. Positive C. Positive D. Negative E. Negative

Review each statement about capital gains and net investment income tax and then determine if the statement is true or false. A A short-term gain is taxed as ordinary income. B A long-term gain is taxed at a maximum of 15% unless the taxpayer falls into the lowest tax brackets of 10-15%, in which case long-term gains are zero. C A long-term gain is taxed at a maximum of 15% unless the tax payer falls into the highest tax bracket, in which case the long-term capital gains are taxed at 25%. D As of 2013, there is a 3.8% tax on net investment income that impacts investors whose adjusted gross income exceeds a specified threshold. E The net investment income tax applies to the gain from the sale of investment real estate, which includes the gain from the sale of a second home that's not a primary residence. F The net investment income tax income threshold for a couple filing separately is $200,000.

A. True B. True C. False D. True E. True F. False

Let's consider the differences between the identify and exchange time periods for 1031 exchanges. Review each statement about the identify and exchange time periods for 1031 exchanges and determine if the statement is true or false. A Any cash an investor receives from the proceeds of a sale is called boot, and it's taxable. B The 45-day identification period doesn't include Saturdays and Sundays. C An investor can revoke and submit a new property for exchange within the 45-day identification period. D An investor must identify a property within 45 days. If the deal falls through, a new property must be identified within the 45-day window or the chance to complete a 1031 exchange is lost. E An investor has 180 calendar days following the close of the relinquished property, or the due date of the investor's federal income tax return, to complete the 1031 exchange.

A. True B. False C. True D. True E. True

Review each statement below about how the sales price is handled for tax purposes when an investor acquires property, and determine if the statement is true or false. A The sales price must be depreciated after separating the cost of the land. B With investment property, the land, as well as the improvements to the land, can be depreciated. C The amount an investor allocates to the land is normally between 10% and 15% of the purchase price. D Other closing costs (the appraisal fee, the credit report, the lender's inspection fee, the mortgage insurance application fee, any assumption fee) must be amortized over the life of the loan. E Purchased personal property, such as tools and equipment, cannot be depreciated.

A. True B. False; land cannot be depreciated, only the improvements upon the land C. True D. True E. False; If the investor is also buying personal property, such as tools and equipment, this can be depreciated

Review each statement about tax deferred exchanges and determine if the statement is true or false. A A tax-deferred exchange for properties used for investment or business purposes is also referred to as the like-kind or 1031 exchange. B The 1031 tax exchange is used to defer paying taxes when there is an almost immediate repurchase of what's called a "like-kind" property. C A 1031 exchange can also be applied to a primary residence—similar to the capital gains exclusion. D Investors can defer capital gains using the 1031 exchange for real estate exchanges only; personal property, such as equipment, cannot be tax-deferred. E Incoming-producing residential, commercial, and industrial, as well as hotels and motels, can qualify for an exchange. F Leased property can also qualify for an exchange, as long as the lease is for 25 years or more.

A. True B. True C. False; the property has to be bought and sold for investment or business purposes D. False E. True False; leased property can also qualify for an enhance as long as the lease is for 30 years or more

Key Points

At the time of reversion (sale), tax considerations are the depreciable basis, tax-deferral through 1031 exchanges, net loss/income, and the 3.8% investment income tax. During the ownership period, tax considerations include deductions for mortgage interest, property tax, and expenses, as well as depreciation. The acquisition phase involves tax write-offs such as points, possible tax credits, and closing costs depreciation. To determine depreciable amount of a property, the land value must be deducted; the amount deducted is generally 10-15 percent. Land is not depreciable. To be able to deduct points, the loan for which the points are paid must be secured by the property itself. Recaptured depreciation on an investment property is taxed at 25% at the time of sale. When selling an investment property, to calculate capital gain/loss, subtract adjusted basis from net sales proceeds. To calculate adjusted basis in a property, add the basis plus capital improvements and subtract accrued depreciation. An installment sales contract is a contractual agreement in which the buyer pays the seller the purchase price over time in a series of installments until the contract has been paid in full. With an installment sale, the seller retains legal rights to the property while the buyer has equitable rights. To calculate taxable income on an income-producing investment, add reserves to net operating income and subtract mortgage interest, annual depreciation, and carryover of any losses. Portfolio income is income derived from investments, such as capital gains, interest, and dividends. Passive income is income derived from rental activities or a business in which the taxpayer did not materially participate. Active income is income derived from employment. Examples include salaries, tips, and commissions. This is also called earned income. An investor doing a 1031 tax exchange who closes on a replacement property before closing on the old property will have to do a reverse exchange to qualify for tax deferment. To qualify for a 1031 exchange, the new property must be identified with the qualified intermediary within 45 days of the sale of the prior property and must close within 180 days of that sale. "Boot" is any cash proceeds an investor receives from a 1031 tax exchange; it is taxable and may not be deferred. A qualified intermediary must perform the 1031 tax-deferred exchange. This means it cannot be done by the exchanger, or their attorney or real estate agent. With a 1031 tax exchange, the basis from the first property transfers over to the second. A 1031 tax exchange can also be used to defer taxes on business equipment. A tax-deferred exchange for properties used for investment or business purposes is also referred to as a like-kind exchange or a 1031 exchange. Cash flow is the income left over after expenses have been paid. Net operating income minus debt service = cash flow. Total income minus vacancy and credit loss = effective gross income.

Operating expenses

Costs associated with running and maintaining a property

boot

excess cash after a property exchange

depreciation

functional obsolescence

Effective gross income

is the total of all income, minus vacancy and credit loss

passive income

non-earned income such as rental income

capital gain

profit realized from the sale of real estate or other assets