Real Estate Investment: Real Estate as an Investment

Carol has a basis of $30,000 in a rental house. She sells the house for $45,000. The broker's commission was 6.5 percent, and other selling expenses amounted to $400. What is Carol's gain on this transaction? $11,500. $14,025. $11,675. $11,450.

$45,000 x 6% = $2,925 commission. So, $45,000 - $2,925 commission - $400 other selling expenses - $30,000 basis = $11,675 capital gain.

Two main factors affect appreciation:

*Inflation* is the increase in the amount of money in circulation. When more money is available, its value declines. When the value of money declines, wholesale and retail prices rise. This is essentially an operation of supply and demand. The *intrinsic value* of real estate is the result of a person's individual choices and preferences for a given geographic area. For example, property located in a pleasant neighborhood near attractive business and shopping areas has a greater intrinsic value to most people than similar property in a more isolated location. As a rule, the greater the intrinsic value, the more money a property commands on its sale.

Disavantages of Real Estate

-Unlike stocks and bonds, real estate is not a liquid asset. -Real estate investment is expensive. -Real estate requires active management. Sweat equity (physical improvements accomplished by the investor personally) may be required to make the asset profitable. Many good investments fail because of poor management. -real estate investment is far from a sure thing.

Capital Improvement

A capital improvement is a permanent improvement that adds value to the property, such as a new roof on the building or new kitchens in the rental units.

Installment Sales

A taxpayer who sells real property and receives payment on an installment basis pays tax only on the profit portion of each payment received. Interest received is taxable as ordinary income. Many complex laws apply to installment sales, and a competent tax adviser should be consulted. *"Year of sale"* is usually the year in which title passes. Payments during the year of sale would include the down payment (in whatever form) and the principal portion of installment payments received during the year. In the event that the property is sold subject to a mortgage that exceeds the seller's basis, the difference between the principal amount of the mortgage and the adjusted basis of the seller would be treated as a payment made during the year of sale. The taxpayer's use of the installment sale method under IRC Section 453 provides a way to spread tax on the profit from the sale of an asset over a number of years. This avoids paying tax on the entire gain in the year of sale.

Advantages of Real Estate Investment

Appreciation

Depreciation

Depreciation taken periodically in equal amounts over an asset's useful life is called *straight-line depreciation*. This is the only type of depreciation allowed today. For certain property acquired before 1987 it was also possible to use an accelerated cost recovery system (ACRS) to claim greater deductions in the early years of ownership, gradually reducing the amount deducted in each year of useful life. The Taxpayer Relief Act of 1997 established specific rules governing the holding period and taxation of depreciation for real property. According to the IRS Code, the useful life is now 27-1/2 years for residential property and 39 years for nonresidential property.

Tax Classifications of Real Estate

For tax purposes, real estate can be classified into the following types of holdings: Real Estate Held for Investment or for Production of Income Real Estate Held for Use in Trade or Business Real Estate Held as a Personal Residence Real Estate Held Primarily for Sale to Customers

Real Estate Held as a Personal Residence

HomeWhen a personal residence is sold or exchanged, any resulting profit is treated as capital gain, but losses cannot be deducted against income. If a personal residence has been converted to income-producing property, it may become trade or business real estate and, as such, qualifies for capital gain or ordinary loss treatment upon disposition. Special rules apply to calculation of losses in this situation. Profit derived from the sale of a personal residence is treated as a capital gain and is taxable only to the extent that it exceeds the exclusion limits and only if the home was NOT used as a personal residence for at least 2 of the immediately preceding 5 years; Loss resulting from the sale of a personal residence IS NOT deductible; Depreciation deductions are NOT allowed; and Only mortgage interest, real property taxes, loan origination fees and discount points are deductible.

Passive Investors.

Investors who do not actively participate in the management or operation of the real estate

Rates of Return and Leverage

Other real estate investments have shown above-average rates of return, generally greater than the prevailing interest rates charged by mortgage lenders. In theory, this means an investor can use the leverage of borrowed money to finance a real estate purchase and feel relatively sure that if held long enough, the asset will yield more money than it cost to finance the purchase. Risks are directly proportionate to leverage. A high degree of leverage translates into greater risk for the investor and lender because of the high ratio of borrowed money to the value of the real estate. Lower leverage results in less risk. When values drop in an area or vacancy rates rise, the highly leveraged investor may be unable to pay even the financing costs of the property.

Tax Reform Act of 1986

Prior to 1986, investors would purchase real estate investments even if they were losing money purely for the tax write-offs. But the Tax Reform Act of 1986, which implemented prohibitions on the ability to write off losses from "passive investments," changed all of that. In recent years, the "Taxpayer Relief Act of 1997" has had the most noticeable effect on the residential housing market.

Tax Deferred Exchanges

Real estate investors can defer taxation of capital gains by making property exchanges. Even if property has appreciated greatly since its initial purchase, it may be exchanged for other property. A property owner will incur tax liability on a sale only if additional capital or property is also received. Note, however, that the tax is deferred, not eliminated. Whenever the investor sells the property, the capital gain will be taxed. Internal Revenue Code Section 1031 states, "No gain or loss shall be recognized (taxable) on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment." Real property of like kind includes improved and unimproved property, fixtures and leaseholds with a remaining term of at least 30 years. In other words, an investor could trade an apartment building for a farm of equal or greater value. Any additional capital or personal property included with the transaction to even out the value of the exchange is called boot. The IRS requires tax on the boot to be paid at the time of the exchange by the party who receives it. The value of the boot is added to the basis of the property for which it is given. Tax-deferred exchanges are governed by strict federal requirements and competent guidance from a tax professional is essential. NOTE: It is important that the documents be drawn properly so that the transaction does not appear to be merely a sale and a purchase. The listing agreement and any offer to purchase needs to clearly state that it is the seller's intention to create an IRC Section 1031 Tax Deferred Exchange. The exchange documents should be drawn by an experienced real estate or tax practitioner and not by the broker. Brokers involved in an exchange should recommend that experienced real estate or tax counsel represent their clients. *Multiple Exchanges.* It is highly unlikely that two property owners will wish to exchange their properties with each owner retaining the property received from the other. The usual situation arises when a taxpayer, owning Property A, wishes to make a tax-deferred exchange for Property B, owned by a seller who is not interested in Property A. The taxpayer may enter into an exchange agreement with the owner of Property B, conditioned upon the sale at a specified price of Property A to a third party within a period acceptable to the owner of Property B. *Delayed Exchanges.* Occasionally a property owner wishes to effect a tax-deferred exchange, but finds a buyer for the relinquished property before a replacement property can be found. In such a situation, the owner may sell the property and close on the sale prior to finding the replacement property. In order to qualify as an exchange, the rules contained in the Internal Revenue Code must be followed. These rules are outlined in three basic steps: The exchangor finds a cash buyer for the smaller like kind property. When the sale closes, *a third-party qualified intermediary must hold the cash.* (If the seller has access to that cash, called constructive receipt, the sale proceeds are taxable to the seller). *Within 45 days of closing the sale,* the exchangor must designate the property to be acquired, with the sales proceeds being held by the intermediary (plus any cash to be added). The purchase of the designated property must be completed *within 180 days* after closing on the sale of the relinquished property.

Real Estate Held Primarily for Resale to Customers

Real estate under this classification can be compared to merchandise on a dealer's shelf. Taxpayers who deal in real estate so classified are called dealers. Gains or losses resulting from the disposition of dealers' realty are ordinary gains or ordinary losses. Rules as to whether a taxpayer is classified as a dealer have evolved from court decisions. Among the factors considered by the courts in the classification of taxpayers as dealers are the following: The degree of activity in the purchase and sale of real estate. Merely reducing the frequency of real estate turnover is not sufficient to remove the dealer status once the taxpayer has been so classified. The intent of purchasing and holding the property as an investment or as part of an inventory held for resale. It is important to make the intent of a matter of record at the time of acquisition and to act consistently with such intent during the term the property is held. The length of time the property is held. The extent of involvement in real estate activity by the owner, such as promotion, advertising, listing the property with a real estate broker and so forth. The reason for purchasing or selling the property; whether the purchase or sale was voluntary or involuntary (because of a drop in rents, increase in maintenance costs, sudden rise in land values, etc.). Undeveloped real estate is subdivided. The extent to which income from real estate sales compares with income from another full-time occupation. Real estate brokers, builders and subdividers need additional evidence to establish that any of their real estate holdings are investments and not inventory. It should be noted that nonprofessional investors are not protected from being classified as dealers by the IRS, even though they are in an entirely different business.

Liquidity

Refers to how quickly an asset can be converted into cash. *Real estate is not a liquid asset

Basis

The basis is the initial price you paid for the real estate, not just the cash you put in. The basis can change over time, because the costs of capital improvements are added to it. Basis is increased by: additions and improvements (as distinguished from repairs); the cost of insuring, perfecting and defending the title and other purchase expenses; and special assessments.

Short and Long Term Tax Rates

The current *short-term* (assets held for less than 12 months) *capital gains tax rate is equal to the taxpayers ordinary income tax rate* which has a maximum rate of 39.6%. The current *long-term capital gains tax rates* are as follows: Single Taxpayers whose ordinary income is: $0 - $$37,450: 0% $37,450 - $413,200: 15% $413,200 and up: 20% Married and Filing Jointly Taxpayers whose ordinary income is: $0 - $74,900: 0% $74,900 - $464,850: 15% $464,850 and up: 20% NOTE: Gains due to recapture of depreciation are taxable at 25%.

Cash Flow

The object of directing funds into income property is to generate spendable income, usually called cash flow. Cash flow is the total amount of money remaining after all expenditures have been paid.

Real Estate Held for Use in a Trade or Business

This category includes real property used by the taxpayer in his or her trade or business. Generally, rental property falls into this category as the property is used in the trade or business of producing rental income. Real estate in this category falls outside the definition of capital asset and qualifies for tax treatment that is especially advantageous. If in any one-year gains exceed losses on trade or business property, all gains or losses are treated as gain or loss from the sale of a capital asset, resulting in a net capital gain; If in any one-year losses exceed gains, all such gains and losses are treated as arising from the sale of noncapital assets, resulting in a fully deductible ordinary loss; Depreciation deductions are allowed and Expenses are deductible.

Capital Gains

When you sell a property for more than you paid for it, you have made what, for tax purposes, is called a capital gain. That gain is taxable, but because the government wants to encourage people to make long-term (usually more than a year) investments over time, it treats capital gains more favorably than regular income for tax purposes.

Tax Credit

a direct reduction in the tax due rather than a deduction from income before tax is computed. Tax credits encourage the revitalization of older properties and the creation of low-income housing.

The Taxpayer Relief Act of 1997

brought good news to homeowners! A new exclusion rule became effective on May 7, 1997, which allows homeowners to exclude up to $250,000 of gain ($500,000 for married couples filing jointly) realized on the sale of exchange of a principal residence.

Homeowners may deduct from their gross income

mortgage interest payments on most first and second homes, real estate taxes (but not interest paid on overdue taxes), certain loan origination fees, loan discount points (whether paid by the buyer or the seller) and loan prepayment penalties.

According to the IRS, income may be classified as:

ordinary income, which includes wages, salaries, tips, interest income, income from the sale of "dealer" property, etc. portfolio income, which includes dividends and distributions on stock and bond investments passive investment income, which is income from a business activity in which the taxpayer does not "materially participate," like rental income capital gains, which are the profits from the sale or exchange of capital assets.

Capital Gains Tax Computation

original cost + capital improvements = basis basis - depreciation = adjusted basis. Next subtract selling expenses, such as commission expenses and closing costs, from the selling price of the property. That total is called the net selling net selling price - adjusted basis =capital gain Finally, the adjusted basis is subtracted from the net selling price, and the result is the capital gain. The calculations that follow show the amount of capital gain for a property initially purchased for $ 50,000. $ 50,000 (purchase price, or basis) + $ 8,000 (capital improvements) - $ 4,000 (depreciation) = $ 54,000 (adjusted basis) $ 90,000 (selling price to the new buyer) - $ 5,000 (commission expense) - $ 1,000 (closing costs) = $ 84,000 (net selling price) $ 84,000 (net selling price) - $ 54,000 (adjusted basis) = $ 30,000 (capital gain)

With real property held for investment or for production of income:

profits derived from the sale of the property are taxed as capital gains; losses derived from the sale of the property may only be used to offset capital gains (they are "capital losses") and unused losses may be carried forward to future years in which the taxpayer has a capital loss; depreciation ("cost recovery") deductions are allowed and expenses (such as advertising, insurance, maintenance and repairs, etc.) are deductible.

Debt Service

refers to the amount paid for the principal and interest payments on mortgage loans.

Pyramiding

the process of using one property to drive the acquisition of additional properties. Two methods of pyramiding can be used: pyramiding through sale and pyramiding through refinance.