Chapter 16

Generally, ownership of real estate produces two types of taxable income. Invest­ment properties/ such as stores, apartment buildings, shopping centers, and office buildings provide a current annual cash return in the form of net income. All properties, whether income producing or not, have a potential future income in the form of capital gain.

Annual net income from real estate is treated as ordinary income similar to wages and other compensation and is subject to the maximum applicable personal tax rate. A capital gain is profit realized from the sale of an asset. Prior to January 1, 1987, a long-term gain, (i.e. profit from the sale of assets held for more than six months), was 60% tax free, since only 40% was taxed. The Tax Reform Act of 1986 eliminated the distinction between ordinary income and capital gains resulting in the loss of one of the key tax incentives for investing in real estate.

FEDERAL TAXES INVOLVING A PRIMARY RESIDENCE

INCOME TAX DEDUCTIONS. An owner of a principal residence or a vacation home may take a deduction from gross income on his or her annual tax return for real estate taxes and mortgage interest. The interest is deductible so long as the debt does not exceed $1 million. Note: Deductibility of mortgage interest is a tax advantage of owner-occupied property.

Non-Deductible Items. The costs for repairs, maintenance, insurance premiums, condominium fees, utilities, and improvements are not tax deductible for first or second homes. A deduction for depreciation is not permitted.

CAPITAL IMPROVEMENTS. A permanent or capital improvement, which extends the property’s useful life or adds to the value of the property, may be used to reduce the owner’s taxable profit upon sale of a first or second home. The addition of an extra room, such as a bath or bedroom, is an example of a capital improvement. A major repair, such as a roof replacement, may be treated as a capital improvement. The cost of normal maintenance, such as painting, plastering, plumbing, heating, and electrical repairs is not a capital improvement.

GAINS AND LOSSES. The profit or capital gain realized from the sale of any type of real estate is subject to tax. Losses from the sale of income property may be used to reduce capital gains. However, losses realized from the sale of a principal residence or vacation home are not allowable since the property is not held for the production of income.

The taxable gain is the difference between the adjusted, cost basis (original cost-plus capital improvements) and the net sale price (cash plus the value of existing encumbrances taken over by the buyer), less transaction costs such as broker’s commission and closing costs. The seller’s net sale price may also be reduced by "fixing up expense," which is the cost of work performed on the dwelling within ninety days prior to the signing of the sales agreement. See Figure 16:1 for an illustration of how a net capital gain is determined on the sale of a residence.

DEFERRAL OF CAPITAL GAINS TAX ON A PRINCIPAL RESIDENCE. Even though a capital gain may be realized in the year of the sale, there are provisions in the tax law to defer, minimize, or exclude part or all of the tax liability.

Exclusion of Gain on Sale of a PRINCIPAL Residence. The Taxpayer Relief Act of 1997 eliminated the once-in-a-lifetime, over 55 exclusion and raised the amount of profit excluded from capital gains tax to $250,000 for single taxpayers and $500,000 for a married couple filing jointly. The exclusion is available repeatedly, regardless of taxpayer’s age, provided the taxpayer has lived in the home for at least two of the five years prior to the sale or exchange. There is no requirement to purchase or construct a new home within two years of the sale as required by prior law ("Rollover provision"). The new rules became effective May 1, 1997.

Installment Sale. An installment sale is a method of postponing and minimizing the capital gain tax by spreading the receipt of the purchase price over several years and reporting a pro rata share of the gain each year. It applies to the sale of all real estate. The advantage is that the taxpayer does not get pushed into a higher tax bracket by reporting all of the capital gain in the year of the sale.

FEDERAL INCOME TAXES ON INVESTMENT PROPERTY

Property held for the production of income is subject to two forms of taxation: (1) Capital gains tax and (2) Tax on the annual rental income.

CAPITAL GAINS TAX

Before 1987, a capital gain realized from the sale of real estate was given preferential treatment. If the asset had been held for more than six months, only 40% of it was subject to tax. As a result of the Tax Reform Act of 1986, all capital gains are fully taxable, regardless of how long the assets are held.

The capital gain from the sale of investment property is the difference between the adjusted cost basis (original cost-plus capital improvements) and the net sales price. The cost basis is the investor’s initial acquisition cost for the real estate. To arrive at adjusted cost basis, the investor adds to the original cost, the value of capital improvements and subtracts the amount of depreciation deducted during the time of ownership. See Figure 16:2 for illustration.

EXCHANGES. Taxation of capital gains from investment property may be deferred by making an exchange of properties of like kind, i.e. an apartment building for an apartment building. Exchanges do not eliminate taxes, but merely defer them until a later date. There will be no tax liability provided no additional capital or property is received. Any additional cash required to even out the exchange is called boot and is taxable to the party receiving it at the time of the exchange.

INSTALLMENT SALE. An installment sale is a method of postponing and minimizing the capital gain tax by spreading the receipt of the purchase price over several years and reporting a pro rata share of the gain each year. The advantage is that the taxpayer does not get pushed into a higher tax bracket by reporting all of the capital gain in the year of the sale. An installment sale is arranged by the seller taking back a mortgage, and making certain that the annual principal payments do not exceed 30% of the sale price.

TAX CREDITS. Investors who renovate older buildings for low-income housing projects are allowed to take a direct reduction in tax due, rather than a deduction from income before the tax is computed. Investors who renovate historic buildings for reuse as a place of business or rentals are also allowed a direct reduction in tax due. The tax credit is based upon a percentage of the cost of renovating.

TAX ON RENTAL INCOME

The taxable income from real estate is the net operating income less the depreci­ation (cost recovery) allowance and deduction for mortgage interest. Net operating income is what remains after deducting the operating expenses which include: property taxes, maintenance, repairs, fuel, utilities, insurance and management fees. A last month rent deposit is income during the year in which it is received. A security deposit is not income unless applied to rent. The cost of capital improvements is not an operating expense but may be used to increase the adjustable cost basis when the property is sold.

DEPRECIATION (COST RECOVERY) ALLOWANCE - TAX SHELTER

For tax purposes the owner of income property is allowed an annual deduction for the loss of value of the improvements over a designated period of time. The amount of deductible depreciation is referred to as a "paper” or artificial loss since it is not actual cash expenditure and does not actually reduce the value of the property. In terms of cash spent, it costs the owner nothing, but results in tax savings on current income, as illustrated in Figure 16:3.

In the above example, an owner in the 28% tax bracket saves $1,400 in current taxes because only half of the net operating income is subject to tax. In effect $5, 000 has been sheltered from taxation. Depending upon the amount of depreciation and the net income, it is possible to have a positive cash flow and no tax liability. The tax advantage achieved by the depreciation allowance is referred to as "tax shelter."

The depreciation or cost recovery allowance does not avoid taxes. A deduction for cost recovery postpones the tax until the property is sold. The cost basis of the property is reduced by the total amount of depreciation deduction during the years of ownership, resulting in a higher capital gain. At the time of sale, all depreciation is recaptured and taxed (currently at 25%) . The remainder of the gain is taxed at a rate depending upon how long the owner has owned the property (holding period).

DETERMINING THE AMOUNT DEDUCTIBLE FOR DEPRECIATION

In order to take an annual deduction for depreciation, three things must be determined: (1) The value of the asset, (2) the useful life (recovery period) of the improvements and (3) the method used for depreciation or cost recovery.

VALUE OF THE ASSET. Since land is not depreciable, its value must be deducted from the purchase price or acquisition cost in order to determine the depreciable basis of the buildings or improvements. This can be done by an appraiser or by using the ratio of land value to improvements as determined by the local tax assessor.

USEFUL LIFE (RECOVERY PERIOD). Prior to the tax revisions of 1981 and 1986, the IRS permitted investment property owners to determine the useful life of their buildings, so long as they stayed within published IRS guidelines. The Tax Reform Act of 1986 eliminated the guidelines and set the recovery period for residential rental property at twenty-seven and a half years for property acquired after 1986. Commercial real estate is assigned a recovery period of thirty-nine years; thirty- one years if purchase before May 12, 1993.

DEPRECIATION (COST RECOVERY) METHODS. For property acquired before 1987, the Internal Revenue Service recognized two fundamental methods of calculating depreciation: (1) Straight Line and (2) Accelerated.

Straight Line. The annual deduction for depreciation is determined by dividing the value of the building or improvement by its useful life (recovery period). For example, the annual depreciation allowed for an asset valued at $275,000, with a recovery period of twenty-seven and a half years would be $10,000, or 3.64% per year. For residential and non-residential property acquired after 1986, the only applicable method is straight-line.

Accelerated Method. The accelerated method allows assets to be depreciated more rapidly during the early years of ownership when most investors were anxious to get the largest tax write-offs possible. The methods used were known as declining balance, double declining balance and sum-of-the-year’ s-digits. Accelerated depreciation is not permissible for property acquired after 1986.

TAX SHELTER

Prior to 1987, many upper-income taxpayers invested in real estate tax shelters that purposefully lost money because the loss write-off was used to offset their taxable income from wages, salaries, and fees. These were known as passive losses, since the investor did not actively participate in the daily operation of the business. Syndications, such as limited partnerships, were popular investment vehicles since they provided loss pass-through with limited risk to the investment. PASSIVE LOSSES. Prior to 1987, an income property owner could deduct mortgage interest, depreciation, property taxes, and other expenses of rental property. Under the Tax Reform Act of 1986 these deductions are still permissible but only up to the amount of the rental income received. Any excess is a passive loss that can be used only to offset income from a similar activity. Losses from passive investments such as limited partnerships may not be used to offset income from employment or portfolio investments.

HOME OFFICE AND VACATION HOME EXPENSES

BUSINESS USE OF A HOME. A taxpayer is entitled to deduct any expenses of using his or her home for business purposes, only if the expenses are attributable to a por­tion of the home used exclusively and on a regular basis as (1) the principal place of business or (2) a place of business that is used by clients or customers for meeting or dealing with the taxpayer in the normal course of business. A specific portion of the home must be used solely for business purposes. If the portion is used for both business and personal purposes, the requirement is not met.

SECOND HOME RENTAL EXPENSES. Real estate taxes and mortgage loan interest for first and second homes are deductible for tax purposes. Losses for operating expenses and depreciation may be deductible only if the second home is an investment unit that is owner-occupied for less than two weeks per year and offered as a rental for the rest of the year. The maximum allowable loss is $25,000 for taxpayers with an adjusted gross income under $100,000.

INFORMATION REPORTING ON REAL ESTATE TRANSACTIONS - Form 1099-B

The 1986 Act requires information reporting on real estate transactions to be filed with the IRS. The person responsible for closing the transaction, such as an attorney for the lender or title company, is required to do the tax reporting.

Transactions Subject to Reporting. Reporting is required for sales or exchanges of residential real estate of four or fewer units. This includes a house, townhouse, condominium and stock in a cooperative housing corporation. It does not include a mobile home that has wheels and axles.

What Must Be Reported? The Form 1099-B must identify the seller and broker, contain a general description of the real estate, indicate the date of the closing, and disclose the gross proceeds of the sale, including any assumed mortgages.

When To File. Reports on form 1099-B for real estate transactions for the cal­endar year must be filed with the IRS Service Center after December 31 and before the following February 28, i.e. between January 1 and February 27 of the same year

KEY WORDS AND PHRASES