Highlights • Chapter 7  1

Chapter 7: INCOME TAXES

Chapter Highlights

  1. How are taxes used?

The federal government, most state governments, and many local governments use income taxes to raise revenue to finance various activities, such as road construction, education, and national defense.

  1. What is the difference between tax evasion and tax avoidance?

Tax evasionoccurs when a party reduces their tax liability in violation of the Code. It is illegal to evade taxes and penalties for doing so include fines and prison time. Tax avoidanceoccurs when a party reduces their tax liability in accordance with the Code. Not only is tax avoidance legal, it is encouraged by the Code.

  1. Explain progressive and regressive tax.

The theory behind a progressive tax is that each taxpayer’s tax liability should be positively related to the taxpayer’s ability to pay. Other taxes, such as a sales tax, are said to be regressive. Regressive taxes tend to fall more heavily on the poor; that is, they represent a larger share of lower-income taxpayer’s income.

  1. What is a tax shelter?

The term tax shelteris a phrase used to describe a tax advantage that allows a taxpayer to eliminate or postpone the payment of income tax. Some tax shelters come in the form of a deduction, so called because certain amounts may be deducted from the taxpayer’s gross income in calculating taxable income. Examples of items that real property owners may be able to deduct from gross income include other taxes, mortgage interest paid during the tax year, and depreciation.

  1. Explain the three categories all incomes are required to be classified into.

Active incomeis income derived from salaries, wages, fees for services, bonuses, and income from a trade or business in which the taxpayer materially participates. The Code defines material participation as “involvement in the operations of the activity on a regular, continuous, and substantial basis.” As a general rule, if a taxpayer devotes at least 500 hours per year attending to a particular activity it will qualify as material participation.

Passive incomeis income derived from a trade or business in which the taxpayer does not materially participate. However, even if a taxpayer materially participates, income from most real estate rental activity is classified as passive income.

Portfolio incomeis income derived from securities such as dividends on stocks and interest on bonds. Portfolio income derived from real estate activity includes dividends received on shares in a real estate investment trust, as well as income received on ground leases and long-term net leases.

  1. What is PALL?

Passive Activity Loss Limitation requires that passive losses be used first to offset passive income, and only passive income, earned during the tax year. If any unused passive losses remain after all passive gains have been offset; the excess can be carried forward indefinitely to offset passive income in future years, or to offset any gain resulting from the sale of the investment.

  1. Explain the Omnibus Budget Reconciliation Act.

The Omnibus Budget Reconciliation Act of 1993 allows real estate professionals to offset real estate rental losses (excluding prior year losses) against other income if the following three conditions are met: more than 50 percent of the taxpayer’s personal services are performed in real property trades or businesses in which the taxpayer is a “material” participant; the taxpayer spends at least 750 hours per year in real estate activities; and the taxpayer owns more than 5 percent of the activity if the personal services are performed as an employee.

  1. What exception to PALL benefits many rental property owners?

An exception to PALL benefits many rental property owners (other than limited partners) who actively participate in the management of the property. Active participation requires less personal involvement than is required for material participation. An individual is deemed to be an active participant if the individual owns at least a 10 percent interest in the activity and is involved in management decisions, such as rent determination and tenant selection. If passive losses for the year exceed passive income from other activities, such individuals may use up to $25,000 of passive losses to offset active income. The $25,000 exception is reduced, however, by fifty percent of the amount of the individual’s adjusted gross income in excess of $100,000.

  1. How is real estate classified for income tax purposes?

For federal income tax purposes, real estate is classified into one of the following categories: personal residence, investment property, trade or business property, or dealer property. A personal residence is property used as the taxpayer’s home. Investment property is real estate held as an investment for income production. Trade property or business property is real estate held for use in a trade or business, and dealer property is real estate held for sale to others.

  1. What are some deductions homeowners may take?

Each year, homeowners may deduct any mortgage interest paid during the year for both their principal residence and second home. In addition, when purchasing a home, points representing interest are deductible in the year paid. Points representing interest charged on a home improvement loan or a refinance may not be deducted in full in the year in which the loan is obtained. Instead, for tax purposes, the cost of such points must be spread over the life of the loan. Finally, each year, homeowners may deduct, in full, the amount of property taxes on their home paid during the year.

  1. How do you calculate the realized gain or loss on the sale of a personal residence?

To calculate the realized gain or loss on the sale of a personal residence, the owner’s adjusted basis in the property is subtracted from the amount realized. Initially, an owner’s basisin their home is the purchase price plus any closing costs associated with the purchase, paid for and not previously deducted by the owner. The basis may be increased by an amount equal to any expenditures made for improvements to the property. For this reason, it is important for homeowners to keep records of the cost of any major improvements made to the property. The amount realized is the gross sales price reduced by any selling expenses associated with the sale paid for by the owner/seller (e.g., brokerage commission, interest rate buydown, title insurance premium, recording fees).

  1. What is the installment sale method?

The installmentsalemethod allows property owners who either use an installment land contract to convey their property or provide seller financing for a “regular” sale of their property to defer paying income tax on any gain until the year in which they receive payment. To calculate the tax due each year, the product of the amount of principal received during the year and the seller’s gross profit margin is multiplied by the seller’s marginal tax rate. For investment property, gross profit margin is the adjusted sales price (the gross sale price, less the selling and fixing-up expenses) less the seller’s adjusted basis in the property, divided by the adjusted sale price. However, for a personal residence, any gain on the sale that is exempt from income tax is not included in calculating the gross profit margin.

  1. Describe some different tax shelters for owners of investment property.

Like homeowners, investment property owners may claim deductions for mortgage interest and property taxes paid. In addition, they may deduct expenditures for operating costs, property insurance premiums, and depreciation. Owners of investment property may also defer income taxes on gains resulting from the disposition of the property using the installment method, or by exchanging the property for other real property. In some cases, owners of investment property may be entitled to tax credits.

  1. What is a tax credit?

A tax creditis an amount that directly reduces one’s tax liability. Tax credits are generally more valuable to taxpayers than a deductible item. Tax credits are designed to provide incentives for socially desirable private sector activities. Currently, federal income tax credits may be claimed for three real-estate-related reasons: for providing low income housing, for rehabilitating older and historic structures, and for business and commercial projects in low-income and moderate-income areas.

  1. Describe the low-income housing tax credit.

The Tax Reform Act of 1986 introduced the low-income housing tax credit. One who makes low-income housing available may claim the low-income housing credit annually for a period of ten years. The maximum annual credit is equal to either 4 percent of the acquisition cost of existing housing, or 9 percent of new construction or rehabilitation costs. Two special features are associated with the low-income housing credit. First, the credit may be used to offset taxes due on all types of income (passive, active, and portfolio) whether or not the owner materially participates in the management of the property. Second, taking the credits does not reduce the property’s depreciable basis. To qualify for the credit the project must meet both a cost test and a use test. To pass the cost test, construction or rehabilitation expenditures must exceed $2,000 per low-income unit. The use test requires that either at least 25 percent of the units in the project be occupied by households with incomes no greater than 50 percent of the median income for the area (as determined by the U.S. Census), or at least 40 percent of the units be occupied by households with incomes no greater than 60 percent of the median income for the area.

  1. What is the rehabilitation tax credit?

The rehabilitation tax credit was implemented to provide investors with a financial incentive to preserve architectural history. Two tax credit programs are available to encourage the preservation of older structures. One entitles the taxpayer to a credit equal to 10 percent of the rehabilitation expenditures on nonresidential structures constructed before 1936. The other entitles the taxpayer to a tax credit equal to 25 percent of the rehabilitation expenditures on residential or nonresidential structures that are either on the National Register of Historic Places or are nominated for placement on the register.

  1. What are the differences between the rehabilitation tax credit and the low-income housing credit?

There are two important differences between this credit and the low-income housing credit. First, the depreciable basis of the historic property is reduced by the full amount of the credit in the year the credit is taken. This means that when the property is sold, a larger taxable gain will be realized. Second, the rehabilitation investment tax credit is taken in the year the rehabilitation expenditures occur, rather than being spread over several years.

  1. What are the stipulations of the rehabilitation tax credit?

Because the tax credit was designed to encourage the preservation of still useful and historically significant structures, developers must comply with a number of restrictions including the use of materials, construction methods, and building redesign. For example, at least 75 percent of a historic building’s internal structural framework and external walls must be retained as either interior or exterior walls, and at least 50 percent of the external walls must remain as external walls. In addition, the rehabilitation costs must exceed the greater of $5,000 or the adjusted basis of the property prior to the rehabilitation. If the rehabilitation tax credit was taken and the property is disposed of within five years after the rehabilitation, the Code requires some of the credit to be recaptured.

  1. Explain the New Markets Tax Credit.

The New Markets Tax Credit is the newest federal real-estate-related tax credit. It is designed to spur $15 billion in new capital for business development in economically underserved communities. It will give investors an income tax credit for new investments in eligible business and commercial projects in low-income and moderate-income areas. The credit is equal to 39 percent of the investment spread over seven years. Almost any type of business, community facility, or commercial real estate project located in nearly 40 percent of all census tracts in the country (containing one-third of the U. S. population), will qualify for the credit.

  1. What is the depreciation allowance?

In recognition of this fact, the Code requires that the cost of a long-lived asset be written off over a time period that, theoretically, approximates the asset’s useful life. Unlike other deductions, the depreciationallowancerequires no cash outlay in the year the allowance is taken. It is merely an allocation of the asset’s cost over its estimated life. According to the theory upon which depreciation allowances were originated, the allowance serves two purposes. First, it results in a book value that approximates the property’s market value, and second, it thereby encourages the asset owner to accumulate the tax savings provided by the allowance and eventually use them to replace the property. Regarding real property, only property held as an investment or for use in trade or business is depreciable; personal residences and dealer property may not be depreciated. The amount of the permissible depreciation deduction is prescribed in the Code, and depends on three factors: the method of depreciation, the life of the asset, and the asset’s depreciable basis.

  1. Explain depreciable basis.

The total amount that may be depreciated by a property owner is referred to as the depreciablebasis. It is important to note that only the original cost of improvements plus the cost of any additions to the improvements may be depreciated. The depreciable basis is usually determined in one of two ways. First, the relative values of the land and improvements as recorded in the property tax assessor’s office can be used. Second, if the property tax assessment is not current, an appraisal of the property, conducted by an independent real estate appraiser, may increase the amount allocated to the depreciable basis and, therefore, the tax shelter.

  1. What were some of the methods of depreciation available to real property owners?

Historically, several methods of depreciation were available to real property owners. One was straight-line, wherein the depreciable basis is written off uniformly over the estimated life of the asset. Several accelerated depreciation methods, which allowed for faster write-offs than straight-line, were also available and, for tax purposes, owners of depreciable assets elected to use these methods whenever possible. A problem under the former system was that both real property owners and the government wasted resources as the IRS challenged many depreciation claims. In 1981, these disputes were eliminated with the introduction of the Accelerated Cost Recovery System (ACRS).

  1. How do you determine the gain or loss on the sale of investment property?

The determination of the gain or loss on the sale of investment property is similar to that previously demonstrated for a personal residence. The primary difference is that the basis of an investment property will be reduced by an amount equal to any depreciation or rehabilitation tax credits the owner claims. Thus, a larger taxable gain (or smaller loss, which may be used to offset other passive income) results than if the owner had not claimed depreciation. Investment property owners may postpone the payment of income tax on gains by using the installment method (when applicable), or by exchanging the property for other real estate.

  1. What is a like-kind exchange?

Owners of investment real property (or property held for use in a trade or business) are afforded a tax shelter, known as a like-kind exchange, if the property is traded for other real property. In essence, no gain is recognized upon the exchange, and under no circumstances may a loss resulting from an exchange be used as a deduction. For real property to qualify for a tax-free exchange, it must be traded for other real property, although not necessarily real property put to the same use as the original property.

  1. How does property qualify for a like-kind exchange?

To qualify as a like-kind exchange, the property to be received in the “trade” must be identified within 45 days after the transfer of the relinquished property, and title to the second property must actually be acquired within 180 days after the transfer of the relinquished property. It is also important that the exchanger not use the proceeds from the sale of the original property, keeping it in a separate account earmarked for the acquisition of the second property. Part of the exchange may be taxable if other assets, referred to as boot, are included in the deal.

  1. What are some quantitative factors in the rent/purchase decision?

Factors include but are not limited to: Monthly rent, payment of principle and interest, income tax shield on mortgage interest, property tax, income tax shield on property tax, property insurance premiums, and incremental utility and maintenance costs.