Federal Income Tax Laws Affecting Real Estate
Federal Income Tax Laws Affecting Real Estate
· Know two principal tax deductions available to homeowners and list two types of home loans that qualify for a homeowner’s interest deduction
· Understand the requirements for mortgage interest deductions and understand the requirements for deducting buyer-paid points
· Explain how to use an IRA for contributing the down payment and acquisition costs of a new home
· Describe how the tax treatment of vacation home rental income properties differs from other investment property
· Know the special rules that apply for persons who deduct expenses for a home office
· Know the requirements for excluding tax on the gain on sale of a principal home sold after May 6, 1997,
· Itemize the steps required to calculate taxable income from the operations of an investment property and describe the process used to allocate the acquisition costs of property between
land and improvements
· Calculate after-tax cash flow; taxable income for an investment property; and the depreciation (cost recovery) for residential and nonresidential investment property
· Describe the tax treatment from operating losses on an investment property for small investors; the tax treatment for operating losses on an investment property for real estate professionals;
and two methods for deferring taxes
Taxpayer Relief Act, effective May 6, 1997
In 1997, President Clinton signed the Taxpayer Relief Act of 1997. The tax makes more than 800 changes to a massive tax code with changes that affect nearly everyone. Brokers need to be aware of the tax changes to help clients and staff, even though a broker is not usually an accountant.
The first major change was to the capital gains rates. When a capital asset is sold, the difference between the amounts it is sold for and the basis, which is usually what the seller paid for it, is a capital gain or loss. Capital gains and losses are reported on Schedule D, Capital Gains, and Losses, and then transferred to line 13 of Form 1040.
The top capital gain tax rate has been lowered. In 2005, the maximum capital gain rates are 5, 15, 25, or 28 percent. Capital gains are those gains on any type of investment. Short-term capital gains are for less than one year: long-term capital gain is for more than one year. If capital losses exceed capital gain, the excess is subtracted from other income on the tax return, up to $3,000 for married, filing jointly.
Capital gain can be on a number of things such as stock holdings, etc., but the capital gain most noted by brokers is on the sale of housing. The law exempts from taxation profits on the sale of a personal residence up to $500,000 for married couples filing jointly and $250,000 for singles. To qualify, sellers must have owned and used the home as their principal residence for at least two of the last five years before the sale. Effective for sales after May 6, 1997, the new provision replaces the complicated rollover provision of the one-time $125,000 exclusion from gain for those 55 and over. The rules on tax loss from the sale of property remain the same.
Capital Gain Taxes
The sale of real estate may result in capital gains taxes under certain circumstances.
To figure if any gain is taxable upon the sale of a property, first determine three things:
- It has been a principal residence for the owner for at least two years.
- If the owners who are selling their principal residence have lived there for 2 out of the past 5 years;
- If the sellers have not sold more than one home in the past 24 months.
If the seller meets these tests, he is entitled to a $250,000 exclusion as a single person or $500,000 as a couple filing jointly. This is no longer a one-time exclusion, nor is it limited to those 55 and older.
To determine the taxable amount, the amount of gain must be subtracted from the adjusted basis. To do this, the following steps are necessary:
- Know the sales price.
- Know the amount of selling expenses.
- Subtract the adjusted basis.
- Find the amount of gain or loss.
Finding the Adjusted Basis
When a home is purchased initially, the original purchase price is called the basis. The homeowner is allowed to add certain expenses to the basis. These are settlement costs such as abstract fees, charges for installing utility services, legal fees for title search and preparation of deed, recording fees, survey fees, transfer taxes, owner’s title insurance. Any charges in connection with getting a mortgage loan cannot be included.
The seller paid $75,000 for the home plus $1000 in allowable costs for closing. The basis now becomes $76,000
In addition to these items the seller may also include any:
- Additional and other improvements that have a useful life of more than 1 year;
- Special assessments for local improvements; and
- Amounts spent after a casualty to restore damaged property.
When all the additions and subtractions are complete, what remains is the adjusted basis.
The homeowners meet the requirements of the real estate exemptions of $500,000 per couple for capital gain; so there is no taxable capital gain.
Principal Residence
Introduction: Every taxpayer has the right to declare a principal residence. The 1997 Taxpayer Relief Act provided a major tax incentive when a property owner sells his or her principal residence. A married couple filing jointly can exclude up to $500,000 of gain when selling the principal residence. Individuals who file separately, whether married or single, can exclude up to $250,000 of gain upon the sale of the principal residence. In order to qualify for this exclusion, a person must live in the principal residence for at least two years out of the previous five years. There are no longer limits to the number of times a person can claim this exemption, provided all sales are at least 2 years apart.
Home Ownership
Individuals who own a principal residence, as well as a second home, have certain tax deductions that are available as well. The interest portion of the mortgage payment on a HOME ACQUISITION LOANand real estate taxes are deductible from taxable income for both the principal residence and a second home. There are limitations on interest deductions. If the mortgage loan amount is $1,000,000 or less, the interest deduction is allowable. However, if the taxpayer is married filing separately, the loan amount is limited to $500,000.
IRA
Another important tax incentive provides for first-time homebuyers to be able to use up to $10,000 of their IRA savings as a down payment and/or closing costs for the purchase of a principal residence. In order to qualify as a first-time home buyer, the individual must not have owned a residence over the past two years. A special feature of this tax code allows this benefit to be used for children or grandchildren. Because of the different types of IRA savings (Roth and Traditional), a person should consult a tax expert for the proper advice.
Property owners may also borrow against the equity in their principal residence. This is known as a HOME EQUITY LOAN. The lender will set a maximum loan-to-value ratio that will establish the amount of money that can be borrowed. The higher the loan-to-value ratio, the higher the interest rate that will be paid by the homeowner. Current tax codes allow the homeowner to deduct the interest paid on a home equity loan from the taxable income.
Special Rules
Special rules apply for tax deductions on vacation homes and for persons who deduct expenses for home offices.
Vacation Homes
If a person owns a vacation home, it may also be classified as a second home. The rules are somewhat complicated when it comes to deductions. If the home is rented for fewer than fifteen days each year and the rental income is not reported, real estate taxes and interest on the mortgage are deductible. If the home is rented for fifteen days or more, the owner must detail the number of days used for personal use and the number of days used for rental purposes. If the home is used for personal use for fewer than fifteen days, the property is categorized as an income property and taxed accordingly. If the home is used for fifteen days or more, or ten percent or more of the days it was rented, then it is considered a second home.
Office in Home
A real estate licensee who works out of his or her home should be careful when calculating deductions on income tax returns. Florida law allows a broker to use his or her home as the main office provided it is properly zoned for that activity or a business license can be obtained for the city or county in which the office is located. This is the place where negotiations take place and records are kept. Space must be used exclusively for the business of the real estate. If a broker has a main office located elsewhere, the broker may be required to show that the home office is necessary for business and the main office is not within reasonable driving distance for the home. In addition, the majority of a person’s business must take place at that location and not at the main office.
If a licensee chooses to use his or her home from which to work (home officing), consideration must be given to time spent in the home as opposed to time at the office, driving distance to the main office, and the types of activities that will take place in that office. If you are audited by the IRS, be prepared to justify any deductions that are taken.
Tax Incentives for Low Income Housing
Every community has available low-income housing for those individuals who qualify. Brokers are encouraged to participate in their development, ownership, and management. Qualifying to receive tax credits for either rehabilitating or constructing low-income housing is not easy but can be quite profitable for those who do qualify. A person who can receive a tax credit may deduct 100% of the amount of that credit from his or her income tax bill. A tax credit is far more beneficial than a tax deduction. A tax deduction is subtracted from an individual’s taxable income. This means the savings are based on the tax bracket rather than the entire amount of the deduction.
There is a non-refundable tax credit for low-income housing that can be claimed annually over a period of 10 years for low-income housing that is newly constructed, rehabilitated, or acquired (IRS). A low-income housing project is a residential rental property meeting the requirements for low-income tenant occupancy and gross rent restrictions, where the taxpayer has received a low-income housing credit allocation from a state or local housing authority that has jurisdiction over the project, and the housing has received IRS certification.
The property must be subject to MACRS depreciation. If a project fails to meet any of these requirements within 15 years after applying for the credit, then a portion of it may be recaptured. The IRS determines the applicable credit rating percentages and differs depending on whether it is for new construction or rehabilitation, whether the project is already subsidized, and whether the project was acquired. However, a taxpayer may make an irrevocable election to determine the credit percentage before the building is placed in service. The credit is not affected by the for-profit rules to determine if there was a profit motive in the project.
Home Sale Related to Change in Employment
When a sale or exchange is by reason of a change in place of employment if the change occurs during the period when the taxpayer owns and uses the property as a principal residence and the taxpayer’s or other qualified individual’s new place of employment is at least 50 miles farther from the residence sold or exchanged than was the former place of employment.
If there was no former place of employment, the distance between the qualified individual’s new place of employment and the residence sold or exchanged must be at least 50 miles. The new place of employment may be with the same or a different employer or can include the beginning or continuation of self-employment. A qualified individual is a taxpayer, the taxpayer’s spouse, a co-owner of the residence, or a person whose principal place of abode is in the same household as the taxpayer.
Home Sale Related to Health
A sale or exchange is for health reasons if it is primarily to provide medical diagnosis, treatment, or care for a qualified individual’s disease, illness, or injury or to provide personal care. Qualified individuals include those for purposes of a change of employment, plus their family members and certain other relatives. A change of residence must be more than merely beneficial to general health or wellbeing unless recommended by a physician.
Home Sale Based on Unforeseen Circumstances
Unforeseen circumstances are defined as events the taxpayer could not reasonably have anticipated before purchasing and occupying the residence. Specific-event safe harbors are the involuntary conversion of the residence; disasters or acts of war or terrorism damaging the residence; or a qualified individual’s death, unemployment (if eligible for unemployment compensation), change in employment status that results in an inability to pay housing costs and basic living expenses, divorce or legal separation under a decree of divorce or separate maintenance, or multiple births.
These, however, are hard all the common life events that can result in the sale or exchange of a home, such as marriage, adoption, or other circumstance that results in the addition of dependents to the family. Despite not being specified as safe harbor events, circumstances such as these and others may still qualify as unforeseen. Determining whether fact patterns exhibit the level of unforeseeability necessary to qualify as unforeseen circumstances require taxpayers and practitioners to exercise their best judgment.
Real Estate Investment Operations
A. Types of Cash Flow: Brokers who represent investors need to understand the various methods that are used to determine the types of cash flows that an investment property can produce. These cash flows include:
1. Potential Gross Income: The most productive income that a property can generate under the very best of conditions. Gross income can be calculated by using either contract rent or market rent. Contract rent occurs when there are long-term tenants who are under contract. Market rent can be determined by comparable properties that have similar rents.
2. Effective Gross Income (EGI): The actual income received after vacancy and collection losses are factored out.
3. Net Operating Income (NOI): The income that is generated after subtracting operating expenses (fixed, variable, and reserves) from EGI.
4. Before-Tax Cash Flow: Also known as Cash Throw Off, the income that is generated after annual debt service (principal and interest) is subtracted from a property’s net operating income.
5. After-Tax Cash Flow: The amount of revenues generated after everything has been subtracted including income taxes.
The following calculations are used to determine the various cash flows that will ultimately help determine a property’s after-tax cash flow:
B. Calculating Net Operating Income:
Potential gross income – Vacancy and collection loss + Other income
Effective gross income (or gross operating income) – Operating expense
Net operating income
C. Calculating Before-Tax Cash Flow: Net operating income can serve as the starting point for calculating before-tax cash flow and after-tax cash flow.
Net operating income – Annual debt service (mortgage principal and interest)
Before-tax cash flow (Cash Throw Off)
D. Calculating Depreciation: A taxpayer has two significant deductions that will decrease taxable income on income-producing property. Depreciation, also known as cost recovery, is a deduction that allows the property owner to recover the cost of the building over a prescribed period of time. Residential properties can be recovered over a 27.5 year period while non-residential properties can be recovered over a period of 39 years.
Depreciation contributes significantly to any tax shelters that are created. The other deduction that is allowable is the mortgage interest. To calculate the taxable income of property reserves must be added back to the net operating income since reserves are monies set aside for repair but never actually spent. The next step is to subtract interest and depreciation which leaves taxable income.
Example: An apartment building was recently purchased for $600,000 with an additional $15,000 of closing costs. According to the appraisal, the land represents 20% of the total value. The calculation would be as follows:
Allocation of Cost to Asset
Market Value Percent Basis
Total $615,000
Land $615,000 X 20% = $123,000
Building $615,000 X 80% = $492,000
The basis in the property is $492,000. Since this property is residential, the depreciation period will be for 27.5 years. Thus, the annual depreciation deduction for the apartment building investment would be:
Basis Depreciation Factor Annual Depreciation
Land $123,000 x 0 $0
Building $492,000 ¸ 27.5 $17,891
E. Calculating Taxable Income: To calculate the taxable income of a property, reserves must be added back into the net income since reserves are money set aside for repairs but never actually spent. Therefore, subtract depreciation and mortgage interest from the property’s net operating income (including reserves).
Net Operating Income + Reserves – Mortgage Interest – Depreciation
Taxable Income
To calculate a property owner’s income tax consequence, multiply the taxable income by the applicable tax rate.
After-tax cash flow is obtained by deducting taxes from operations from a property’s Before-Tax Cash Flow.
Before-tax cash flow – Income taxes
After-tax cash flow
F. Calculating Taxes from Operations: To determine income taxes from the operations of an income-producing property, one must treat the real estate income as a passive activity. Most income from rental real estate is categorized by federal tax codes as PASSIVE INCOME. Other types of incomes that an individual can earn are classified as an “ACTIVE PARTICIPANT” with income such as wages or salary, and “portfolio” income from dividends or interest from the ownership of stocks, bonds, and other investments excluding real estate. The importance of the passive income status is that taxable losses (negative taxable income) from passive investments generally cannot offset active or portfolio income.
For example, suppose an investor has a $10,000 negative taxable income from a real estate investment. Suppose also that the investor has $100,000 in other income. One might expect that the investor’s real estate loss could be combined with the other income, reducing total taxable income to $90,000. But this would be an incorrect assumption. Generally, the investor must “suspend” the passive tax loss and pay taxes on the full $100,000.
There are exceptions to this rule that could benefit some investors. An active participant who has an adjusted gross income of less than $100,000 can deduct up to $25,000 of passive losses against ordinary income. In addition, if an investor can show that he or she is actually working at least 750 hours or 50% or more of his or her work time in a particular investment property, whichever is more, he or she may deduct any losses related to that investment from other income.
In computing the amount of income that is subject to income taxes (taxable income), there are two possible scenarios. The most common and simplistic is when taxable income is positive. If the taxable income is ever negative, a tax loss will occur. Notice that all of the additional items in this column have to do with tax losses either from earlier years or during the current year. Tax losses brought forward are losses that exceed any allowable losses and, therefore, had to be suspended and carried over to the current year. The amount of tax loss suspended is the amount by which the current tax loss exceeds the current year’s tax loss allowance.
An investor can deduct up to $3,000 in net losses each year on an investment property with any balance carried forward and applied to income generated at that time. In addition, if an investor is unable to deduct losses against future gains, any and all losses can be added to a property’s adjusted basis. The amount of loss not used against gains during ownership is not taxed when the property is sold.
Calculating Taxes From Operations (with tax losses)
Net operating income (NOI) + Replacement reserves – Interest on mortgages – Depreciation deduction – Tax losses brought forward
Taxable Income
Taxable Income x Investor’s effective tax rate = Taxes from operations
Individuals who purchase investment real estate make their buying decisions based upon economic soundness and the principle of anticipation. A property should have a positive cash flow during ownership, which includes providing an acceptable return while at the same time continuing to increase in value so that when the property sells, the investor will have a profit.
Sale of Investment Real Estate
Determination of Gain or Loss
Upon the sale of an investment property, any capital gain is subject to federal income tax rules. The total gain that is realized is the difference between the net sale price and the depreciated basis of the property. Realized gain may or may not be taxable, depending on the circumstances. Recognized gain is the amount of gain upon which income taxes are paid.
The adjusted basis is calculated by taking the original basis and making adjustments as follows:
1. Plus closing
2. Plus improvements
3. Minus accumulated depreciation
Real Estate Taxes at Sale
Selling Price – Selling expenses
Net sale price – The adjusted basis
Capital gain (realized) – Gain eligible for deferral
Taxable gain (recognized) x Owner’s qualified tax rate
Income Tax at sale
Remember, at the time of sale of an income-producing property any cost recovery that was taken must be recaptured and taxed at a rate of 25%.
Any suspended losses that were not used during the ownership of a property can be subtracted from the net sales price and not be subject to taxation.
Gain or Loss Taxation
There are five steps that are required in order to estimate the standard tax liability of an investment property. Real estate licensees should be aware of this process but must be careful about giving advice on tax or other legal issues. The five steps are:
1. Determine the tax classification of the investment
2. Determine the tax status of the investor (corporate or non-corporate, active participant or non-active participant)
3. Determine the investor’s marginal tax rate
4. Estimate the taxable income that arises from operations and disposition (sale, exchange, etc.)
5. Compute the tax liability using the tax rate and expected taxable income
Real estate is classified into several categories for tax purposes. Although the classifications have some similarities, each is different and has significantly different tax consequences. Current tax codes for an investment property must establish whether or not the investor qualifies as an active participant. The different categories of real estate and their tax requirements are:
a. Principal Residence: Property owned for personal use and any expenses incurred for personal living or family purposes and expenses of repair or maintenance are not deductible. Homeowners are also prohibited from deducting depreciation. Interest paid on a mortgage loan and real property taxes incurred on a first and/or home, however, are deductible each year if the owner itemizes deductions.
If a homeowner sells his or her home, any gain is taxed at the current legal rate as a capital gain. Remember, if a homeowner has lived in his or her principal residence for two years out of the past five years, is married, and filing jointly, the first $500,000 of gain is not taxed. Individuals filing separately can exclude the first $250,000 of gain. If the home sells for a loss, the homeowner has no recourse for recovery.
b. Dealer Inventory (built for resale): When individuals buy or build properties “primarily for sale to customers, in the ordinary course of business”, they are classified as dealers. Significant tax features for those dealers in real estate that must be considered are:
i. They are not allowed a deduction for depreciation.
ii. They cannot defer recognition of gain (1031 tax-deferred exchange is not available)
c. Trade or Business: Real estate purchased for the purpose of a trade or business (i.e.: as an office or a retail store) receives the most favorable treatment. The owner is entitled to deduct all operating expenses related to the investment as well as an allowance for depreciation. Most importantly, operating losses are fully deductible. At the time of sale, capital losses are fully deductible, and capital gains can be partially deferred through either installment sale or exchange.
d. Investment: The dominant tax feature of rental real estate is a passive investment. As explained before, this severely limits the use of tax losses from operations to shelter other income except when the property is owned by an active participant.
The type of ownership affects tax treatment in several ways. If the owner is a “C” corporation, the corporation pays taxes on income from the property at corporate tax rates. In this case, individual investors are taxed only on dividends and on capital gains from the sale of the corporation (or its stock). In contrast, if the owner is any other ownership form such as individual, partnership, or tenant in common, earnings are taxed only at the individual level, at personal income tax rates.
Ownership through an “S” corporation or Real Estate Investment Trust has a special limitation when calculating income taxes. While it avoids taxation at the business level, it may limit the potential pass-through of operating losses. Dividends from a REIT are classified as portfolio income and cannot be offset by passive losses from other sources. REITs are limited to 100 members or less.
Methods of Deferring Taxes Upon Disposition (Special Rules)
Installment Sales
As has been discussed in previous chapters, the installment sale (contract for deed or land contract) can be an effective method of avoiding excessive taxation. By receiving a portion of the gain in each of several years instead of all the income in one year, the income for the investor is limited, and taxes are paid on the smaller amount.
Remember: The seller of an installment contract is the Vendor and the buyer is the Vendee.
Like-Kind Exchange:
Like-kind exchanges are also done to defer or even eliminate taxes. Generally, the tax is deferred rather than having to pay capital gains taxes at the time the property is sold.
For example, an investor can exchange real estate for real estate, an apartment house for an office building. Being a Like-Kind Exchange qualifies the sale as a tax-deferred exchange. Any additional cash or personal property is given with the property is considered boot and is taxable.
For example, Jones has an apartment building with a market value of $400,000 and an adjusted basis of $250,000. He wants to exchange it for a different apartment building owned by Carpenter which has a market value of $600,000 and an adjusted basis of $300,000. For Carpenter’s building, investor Jones exchanges his building plus a cash boot of $50,000. After the exchange, the investor’s new building adjusted basis is $300,000 (the $250,000 of the building he exchanged plus the $50,000 cash boot he paid).
Carpenter exchanged a building worth $600,000 with an adjusted basis of $300,000 for a building worth only $400,000 plus $50,000 in cash. Carpenter must pay taxes on the $50,000 boot, but the basis in the new building is the same as the building exchanging $300,000. ($250,000 + $50,000 cash) If Carpenter had sold the building outright, the capital gain tax liability would have been substantially increased.
The role of the real estate professional is to discover like-kind properties for investors and help the investor with the sale attorneys to make sure everything is completed.
Remember: Boot is taxable!
SUMMARY
The two principal tax deductions available to a homeowner are real estate taxes and interest on the mortgage up to certain limitations. A person’s principal residence and a second home qualify for the interest deduction.
The mortgage loan amount cannot exceed $1,000,000 in order to qualify for the exemption of interest on the principal residence or second home. In addition, points and pre-paid interest and can be deducted in the year in which they are paid.
A first-time home buyer may use up to $10,000 of an IRA as a down payment or for closing costs.
If the home is rented for fewer than fifteen days each year and the rental income is not reported, real estate taxes and interest on the mortgage are deductible
If the home is used for fifteen days or more, or ten percent or more of the days it was rented, then it is considered a second home.
If the home is used for personal use for fewer than fifteen days, the property is categorized as an income property and taxed accordingly.
If the home is rented for fifteen days or more, the owner must detail the number of days used for personal use and the number of days used for rental purposes.
Individuals who work out of their homes may deduct a portion of the expenses provided the portion deducted is exclusively used for real estate and the main place of business is not within a reasonable driving distance of the home.
A married couple filing jointly who have lived in their principal residence for two years of the past five years can exclude up to $500,000 of gain when sold. Individuals, either single or married filing separately, may exclude up to $250,000.
Taxable income is calculated:
Net operating income + Reserves – Interest on the mortgage – Depreciation________
Taxable Income
Closing costs are part of a property’s basis; and, therefore, the portion of the closing costs that is attributable to the building can be depreciated along with the building.
An investor can deduct up to $3,000 in net losses each year on an investment property against any net gain with the balance carried forward to the future. In the event the losses cannot be carried forward, they will be added to the basis when the property is sold.
Vocabulary List: active participant,after-tax cash flow,capital gain,home acquisition loan,home equity loan,installment sale,investment interest,like-kind exchange,passive income,qualified intermediary