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Taxation of Real Estate Investments I
- Introduction to Taxes
a) Many types of taxes must be paid on real estate investments: Real property taxes (ad valorem taxes) Special assessments
Income taxes on the operation of the property Federal income taxes State & local income taxes
Capital gains taxes on the disposition of the property
Our focus is on the federal income and capital gains tax treatment of real property investments.
b) The “tax world” vs. the “real world” Cash flows from operations
Real World Tax World
Net Operating Income Net Operating Income
Annual Debt Service Mortgage Interest
Before-tax Cash Flow Depreciation
Taxes from Operations Amortized Expenses
After-tax Cash Flow Taxable Income
Marginal Tax Rate
Taxes from Operations
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Cash flows from the sale of the property
Real World Tax World
Sale Price Sale Price
Costs of Sale Costs of Sale
Net Sale Price Net Sale Price
Mortgage Balance Adjusted Basis
Before-tax Equity Reversion Total Gain from Sale
Capital Gains Taxes SL Cost Recovery
Depreciation Recapture Gain from Appreciation
+ Unclaimed Amortization
After-tax Equity Reversion Gain from Appreciation
Cap. Gains Tax Rate
Capital Gains Taxes
SL Cost Recovery
Dep. Recapture Rate
Depreciation Recapture
c) Ownership Structures
Most real estate investments are held in an ownership structure that eliminates double taxation and yet still provides limited liability for the investors Limited Partnerships Limited Liability Corporations Limited Liability Partnerships REITs
Our focus, therefore is on the individual income tax treatment of real estate investments.
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Methods for allocating basis:
Tax assessor’s ratio of land value to total value
Professional appraisal
Values explicitly stated in the purchase contract
As long as the values are legally defensible, you may pick the one that gives you the highest value to improvements, and thus the most tax benefits.
Example: A property is acquired with a down payment of $625,000 cash plus a mortgage of $1,875,000. The following values were assigned by the tax assessor and the property appraisal: Tax Assessor Appraisal Land $400,000 $390, Improvements 1,600,000 2,210, Total $2,000,000 $2,600,
What is the total basis in this property, and what is the proper allocation between the land and improvements?
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- Calculating Taxable Income
a) Depreciation allowances
All real estate is depreciated using a straight line method with a mid-month convention.
Residential real estate improvements are depreciated over 27. years
Example: Suppose the property in the example on the last page is a residential property, and is put in service July 1. It will be in service for 4.5 years, being sold on December 31 st^. What is the depreciation allowance for years 1 through 5?
Commercial real estate improvements are depreciated over 39 years.
Example: Suppose instead that the property from before is a commercial property. What will be the depreciation allowance in each of the five years of the expected holding period?
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Example Suppose to purchase the property from the previous exapmles ($2,500,000 purchase price) you pay 2 points on a 75 percent LTV, 10-year balloon mortgage, amortized over 25 years with an 8.5 percent interest rate. If the first payment on the mortgage is due July 1, how much may you deduct in the first year?
What are your amortized expenses in the second year?
What are your amortized expenses for the final year (when it is sold on Dec. 31 st^ )?
Unamortized points may be deducted in full from taxable income in the year the loan is repaid
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c) Interest expenses
Interest is based on the amortization schedule from the loan.
Example: In the loan from the last example, the monthly payment is:
Interest paid in each of the first five years will be:
d) Example of calculating taxable income and after-tax cash flow:
Suppose that the property from before is a residential property that you have purchased at a 10 percent cap rate. Suppose also that NOI is expected to remain constant in the future. What is the taxable income for each of the first five years?
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Portfolio income This includes interest, dividends, royalties, and gains or losses attributable to the disposition of portfolio property (e.g., stock and bond investments).
Passive income Income from trade or business in which the taxpayer does not materially participate.
Rental real estate has been specifically identified as passive, regardless of management participation.
A limited partner’s income is passive by definition.
c) Passive loss rule: No losses from passive activities may shelter active or portfolio income. Net positive income from all three baskets is added together and taxed at the ordinary income tax rate.
Income and loss generated within the active and portfolio baskets can be netted against each other. For example, short-term losses on the sale of stocks from the portfolio basket can be netted against salary income or other active income.
Income within each basket may be offset by losses within that basket
Net losses from the passive basket can be carried forward to shield taxes on passive income in future years. Cumulative losses generally are allowed in full against any gain to be reported on the sale of the property, or are reported as additional losses if the property is sold at a loss.
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Examples:
Active Income $100, Portfolio Income $50, Passive Income $50, Total income
Active Income $100, Portfolio Income ($3,000) Passive Income $50, Total income
Active Income $175, Portfolio Income $75, Passive Income $50,000 & ($10,000) Total income
Active Income $175, Portfolio Income $75, Passive Income ($100,000) & $50, Total taxable income
The key importance for our purposes is whether or not you can claim a tax credit for negative taxable income from a property: If the property generates positive taxable income, this is taxed at the investor’s marginal tax rate. If the property generates negative taxable income, whether you can claim the loss depends on whether you have other passive income against which to offset this loss: If you have other real estate or other passive activities that are generating positive income, you can use the loss to shield this income If you do not have any other passive income, you must defer this income into the future until you have positive passive income to use it against.
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Note that this can change from year-to-year based on other passive income that you may have.
Thus in one year you may have to defer your losses because you have no other passive income, but in the following year you may be able to claim your losses.
e) Rental Real Estate Loss Allowance. Individual taxpayers (only) that “actively participate” in the management of a real estate activity may use up to $25,000 of passive losses to offset active or portfolio income.
This exception is phased out for single and married-filing-jointly taxpayers with more than $100,000 in AGI, not including net negative passive income. The phase out is $0.50 per $1.00 income over $100,000, so the $25,000 exception is completely phased out for income over $150,000.
Suppose an individual investor has active income of $100,000, portfolio income of $20,000 and losses on a real estate investment totaling $25,000. What is the investor’s taxable income in that year if he qualifies for the rental real estate loss allowance?
