Ch. 17 - Tax Consequences

Sam purchased an apartment building in April 2009. His initial tax basis on the building, less the land value, is $395,250. What is his monthly depreciation allowance?

$1,197.73

What accelerated technique does the IRS allow for the cost recovery of land improvements?

150% declining balance method

What is the cost recovery period for residential structures?

27.5 years

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.

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 is the most important consideration when choosing an investment ownership type?

Maintaining decision-making control over the operations

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 15% of the gross sales price.

A special provision that applies only to real estate allows an investor to offset up to how much a year in passive activity rental real estate losses against otherwise taxable income?

$25,000.00

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.)

Which of the following statements is not true about Limited Liability Companies?

An LLC gives investors the income tax advantages of a corporation.

Define depreciation allowance.

An amount an investor can deduct from his or her taxable income to recover some of his or her investment capital.

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.

What determines eligibility for a depreciation allowance?

An investor must purchase the investment property with the intent of producing income.

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.

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.

Which investment ownership type is taxed twice?

Corporation

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.

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.

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.

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.

A loss on which of these properties can never be claimed on income taxes?

Personal residence

Which of the following is not an example of a like-kind exchange?

Recreational vehicle for motel

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.

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. Click here if you would like to open this summary as a pdf, which you can then print or save to your device: Chapter 17 Summary

Which statement is not true about money borrowed for rental real estate?

When an investor borrows money, his or her tax liability is increased.