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Federal Taxation and Real Estate: Valuation, Classifications, and Tax Law Changes

Learn how federal income tax rules and regulations impact the value of real estate investments and financing decisions. Understand the different classifications of real property and how tax shelters, depreciation, and interest payments affect taxation. Explore the changes in tax law that have altered the return on real estate investment.

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Federal Taxation and Real Estate: Valuation, Classifications, and Tax Law Changes

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  1. Chapter 16 Federal Taxation and Real Estate Finance

  2. Chapter 16Learning Objectives • Understand how the rules and regulations of federal income taxation affect both the value of real estate investments and financing decisions • Understand how changes in the tax rules have altered the return on real estate investment

  3. VALUATION OF REAL ESTATE • The value of an income-producing asset is a function of the income accruing to the asset • Income for valuation purposes is generally measured as cash flow either before-tax or after-tax

  4. VALUATION OF REAL ESTATE • Factors affecting valuation: • Financial leverage • Tax shelters such as depreciation • Tax treatment of the asset

  5. CLASSIFICATIONS OF REAL PROPERTY • Property Held for Principal Residence • Property Held for Investment • Property Held for Resale to Others • Property Held for Use in Trade or Business

  6. CLASSIFICATIONS OF REAL PROPERTY • Property Held as Principal Residence • Mortgage interest and property taxes are tax-deductible; maintenance costs are not • Cannot depreciate • Capital losses are not tax-deductible • Capital gains exclusion of $250,000 ($500,000 for married filing jointly) for one sale every two years • Owned and occupied two out of the last five years

  7. CLASSIFICATIONS OF REAL PROPERTY • Property Held for Investment • Held strictly for income or investment and owner has no participation in operations • Generally unimproved land and net leases • Limitations on interest deductibility • Limitations of capital Loss write offs

  8. CLASSIFICATIONS OF REAL PROPERTY • Property Held for Resale to Others • Viewed as inventory • Income is taxed as ordinary income (not capital gains) • Owners treated as dealers • Cannot depreciate • Losses are operating losses

  9. CLASSIFICATIONS OF REAL PROPERTY • Property Held for Use in Trade or Business • Section 1231 asset • Generally the most favorable classification • Owned for the purpose of deriving income • Can depreciate • Operating expenses and mortgage interest are tax-deductible • Capital losses are tax-deductible

  10. TAX LAW CHANGES AFFECTING REAL ESTATE • Changes in marginal tax rates • Changes in depreciation allowance • Length of recovery period • Accelerated versus straight-line • Tax treatment of capital gains (losses) • Ability to write off losses

  11. TAX SHELTERS IN REAL ESTATE • A tax shelter is an investment whose value is enhanced by tax rules and regulations • Real estate has the potential of a tax shelter • Tax rules may create value that otherwise would not exist

  12. DEPRECIATION IN REAL ESTATE • Depreciation is a noncash outlay but a tax-deductible expense • The value of depreciation is the depreciation amount times the investor’s marginal tax rate • Real estate is a physical asset that is considered to “wear out” and deteriorate to a value of zero over time

  13. COMPONENTS OF REAL ESTATE DEPRECIATION • Depreciable Basis • The Original Cost Basis is the purchase price (of land and improvements) plus acquisition costs • Land and the portion of acquisition costs attributable to the land are not depreciable

  14. COMPONENTS OF REAL ESTATE DEPRECIATION • Depreciable basis is the original cost basis minus the value of the land and land portion of acquisition costs • Value of the land may be determined by independent appraisal or by property appraiser’s office

  15. COMPONENTS OF REAL ESTATE DEPRECIATION • Cost Recovery Period • Is the period over which depreciation can be taken • Congress periodically alters the recovery period for depreciation • Recovery period is currently 27.5 years for residential income property and 39 years for non-residential income property

  16. METHODS OF DEPRECIATION • Straight-line and accelerated • Currently only the straight-line method is allowed • Previously the accelerated cost recovery system (ACRS) was allowed which provided accelerated depreciation over a shorter time period (15-19 years)

  17. CALCULATING DEPRECIATION • The depreciation deduction can be calculated by multiplying the depreciable basis by the depreciation rate • Mid-month convention assumes that the asset is put into service (and sold) on the 15th day of the month regardless of the actual day of occurrence

  18. TAXES AND INTEREST PAYMENTS • Original Issue Discount Rates • Debt that is issued at a discount from the face value • Incentive to convert ordinary income to capital gains income when tax rates are different • Recourse vs. nonrecourse debt

  19. INTEREST RATE RULES • Adequacy-of-Interest Test • Rate charged must be comparable to an applicable federal rate based on Treasury obligations • Time Value of Money Test • Even though payments may not be made annually the interest must be calculated and reported annually

  20. INTEREST RATE RULES • Imputed Interest Rule • For properties exempted from previous rules such as sale of farms for less than $1 million and residences under $250,000 • Requires a fair interest rate to be charged or imputed

  21. CAPITAL LOSS LIMITATION • Allows capital losses to be written off only against capital gains • Capital losses in excess of capital gains can be written off against other income up to $3,000 annually • Unused balance can be carried forward

  22. PASSIVE LOSS LIMITATION • Instituted by the the 1986 Tax Reform Act • Three categories of income: • Active income: Earnings, etc. • Portfolio income: Stocks, bonds, etc. • Passive income: Real estate • Losses are restricted to each category

  23. PASSIVE LOSSES • Passive losses cannot be used to offset income from REITs and REMICs • Includes non-active real estate activity, specifically limited partnerships • Loophole to be treated as active: AGI less than $100,000 can deduct up to $25,000 in losses from other income • Is phased out at AGI of $150,000

  24. TAX-DEFERRED EXCHANGE • Property must be held for use in trade or business or for investment, owner-occupied residences do not qualify • Properties exchanged must be of like kind • The exchange must occur; cannot sell for cash and immediately purchase • Properties adjusted basis will be equal

  25. TAX-DEFERRED EXCHANGE • Third-Party Exchanges • Delayed Exchanges • Boot • Property that is not like kind such as cash or debt relief • Identification period is 45 days • Exchange period runs for 180 days

  26. INSTALLMENT SALE • Seller takes back a promissory note from the buyer • Installment sale vs. outright sale • Sale price is paid in installments • Gross profit percentage is the proportion of capital gain that is taxed each year

  27. INSTALLMENT SALE • Related persons rule • If an installment sale is made to a related person who sells the property within a two-year period, the original seller must recognize the balance of the gain at the time the related person makes the sale. • Imputed interest rule applies • Any down payment amount is allowed • Debt amortization vs. installment period

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