©2011 Cengage Learning. Chapter 17 ©2011 Cengage Learning INCOME TAX ASPECTS OF INVESTMENT REAL ESTATE

©2011 Cengage Learning

Chapter 17


INCOME TAX ASPECTS OF INVESTMENT REAL ESTATE

Income tax advantages for income-producing real estate

Interest on loans used to purchase or improve rental real estate is fully deductible.

Operating expenses are deductible.Depreciation (cost recovery) is a non-cash

deduction.Favorable capital gain treatment.May use installment sale reporting when seller

carries a note and deed of trust.Exchange can defer all gain and taxes if the

investor follows the rules of IRS Section 1031.


Major Income Tax Advantages

Dealers do not get the following income tax benefits:

Depreciation

Capital Gains

Installment Sales


Basis refers to the property owner’s cost

Initial basis is determined by the method of acquisition.

Depreciation is based on purchase price not value.

Land and improvements must be allocated.Straight-line depreciation is used.


Basis and Depreciation

According to the Tax Reform Act of 1986, income is classified as:

Active Income - wages, commissions, profits from owner-managed business, etc.

Portfolio Income - interest on savings, divided on stocks, bonds, etc.

Passive Income - limited partnerships, business ventures with no active role, rents from rental real estate, etc.


Passive Loss Rules

The General RuleA passive loss can offset only passive income.Passive losses cannot normally be used to

offset active or portfolio income.


Exception to Passive Loss RuleExemption is known as the $25,000 real

estate exception to the passive loss rule. To qualify for this $25,000 exception, the

taxpayer must meet the following tests:must own 10% or more of property.must be active in management. modified adjusted gross income must be

$100,000 or less.


Qualified Real Estate ProfessionalsWho spend:

at least 750 hours and more than one-half of all business time per

year in real estate activities. Can use real estate losses to offset any

business or personal income.


Tax on Capital Gains

Sell for cash & pay the taxOwner Finance & defer tax1031 exchange & defer tax


Calculating and Deferring Gain


Calculating Gain and Taxes Owed on Income Property

Step 1: Calculate Adjusted Cost Basis

Initial (original) basis

Plus: Buyer’s capitalized closing costs

Plus: Capital improvements, if any

Minus: Depreciation for term of ownership

Equals: Adjusted cost basis on date of resale


Step 2: Calculate Gain

Resale price

Less: Seller closing costs

Less: Adjusted cost basis from Step 1

Less: Carry-forward passive losses,

if any

Equals: Gain on sale

Step 3: Apply capital gain treatment to the gain to calculate the tax owed

Installment Sale• Advantages

• Method of sale for a slow real estate market• Lower the tax owed immediately• Tax can be paid in the future with inflated

(cheaper) dollars.

• Disadvantages• Not all money is received up front• May pay more in taxes depending on future

income• Buyer could default


Sale of Principle ResidenceNo tax on gain

Up to $250,000 if singleUp to $500,000 for married

Principal residence for at least two out of the last five years


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©2011 Cengage Learning. Chapter 17 ©2011 Cengage Learning INCOME TAX ASPECTS OF INVESTMENT REAL ESTATE