In view of the importance of the taxation
subject, we are developing an e-course called Taxation of Income Property
that will cover this subject in considerable detail. In this lesson
we will provide only a brief discussion of the subject.
Rules of Special Interest
to Investors
Most tax law applies to both the average
taxpayer and to real estate investors, but there are a number of rules
that are particularly, some even only, applicable to real estate investors.
Depreciation
In addition to the benefit of leverage, another
important advantage associated with investing in real estate is depreciation. Depreciation
is an accounting procedure that provides a tax deductible loss, whether or not
there is really any loss in value. The Internal Revenue Service assumes
that a building loses its value (depreciates) over time, so at the very minimum,
a $150,000 residential rental property, depreciated over 27.5 years will produce
approximately $4,800 in tax shelter a year. For commercial property the
IRS requires depreciation be extended over 35 years. The numbers are a
bit ambiguous because the IRS allows depreciation for improvements only, not
the land. Therefore, investors want to assign the lowest possible percentage
of the purchase price to the land. The rule of thumb is 10 to 20%, however
if you can substantiate a lower number by checking the allocation on the property
tax rolls, or obtaining an appraisal showing similar building lots are selling
for less, by all means use that lower number.
The tax shelter number can also be enhanced significantly
by structuring the purchase to assign as much of the value as possible to personal
property which can be depreciated over a much shorter period.
The really good tax benefits come through special
government programs that reduce tax burden in order to promote prevailing policy. For
example: historical buildings and low income housing tax-credits.
We will utilize the above principles in the next
lesson when we discuss the pre-offer analysis and determination of the price
you will offer.
The Alternative Minimum Tax
ATMT was adopted in the 1980s as a
part of tax reform. It has since had a depressing effect on overall investment
in depreciable real estate by not allowing many property owners to take
adequate deductions for depreciation on their tax returns. This, of course,
leads to lower values for existing investment property and less incentive
to invest in new construction of affordable rental housing.
The so-called check on the rich has become a middle-class
headache because while incomes have risen with inflation, the AMT's exemptions
of $45,000 for married couples and $33,750 for single taxpayers have been the
same since 1993.
At-Risk Rule
Real estate debt that a partnership
or limited liability company (LLC) is personally liable for could be
treated as qualified non-recourse financing under the at-risk rules if
no other person in liable for the debt, according to proposed IRS rules.
Under the proposed regulations, the ban on personal liability would not
disqualify debt for which a partnership or LLC is personally liable if
the entity's only assets are either real property used in the activity
of holding real property, or such real property and other property incidental
to the activity of holding real property, and if no other person is liable
for the debt.
The regulations also provide that if a person
is liable for a portion of the debt, the remainder could be treated as qualified
non-recourse financing if it meets the other requirements.
Capital Gains
There is little doubt that the present
capital gains tax is regressive to the U.S. economy. The rate, as it
applies to real estate, penalizes gains that have come solely as a result
of inflation. That tax on gain in value often deters owners from selling
existing properties to new investors who would normally invest vital
new capital for up-grades and modernization of America's deteriorating
urban rental housing. There is more reason than ever before to
utilize the 1031 exchange, rather than sell investment property outright.
Most real estate and
investment groups are pushing for legislation that would replace
the present capital gains tax with a straight 50 percent exclusion
and index both new and existing assets for inflation. That would
certainly be a good initial step toward encouraging investment in
productive assets like rental housing. Most economists also believe
that depreciation recapture provisions for real estate should not
be added to the tax code.
Tax Relief Act of 1997
The tax Act provided some relief on
real estate investments by reducing capital gains from 28% to 20% if
assets have been held for 18 months or longer. (28% tax-bracket.) However
the rate would be 25% on any recapture of deprecation when there is a
gain on a sale.
Homeowners, (spell that v o t e r s) had
taxes eliminated on capital gains of up to $500,000 for the principal residence
of a married couple filling jointly. Single taxpayers enjoy a $250,000
exemption. There may be an upside for rental property owners, however. Millions
of homeowners who have been locked into their present home by the prospect of
high capital gain taxes on the sale of a home, may now choose to sell, invest
their equity somewhere else and become tenants.
Tax-Deferred Exchanges
There is no such thing as a free anything. The
famous "1031 tax free exchange" is actually just a temporary tax deferment. However,
like the draft deferments of old, if you can delay the inevitable long enough,
the war may be over before they get to you.
In general, no gain or loss shall be recognized
on the exchange of property held for productive use in a trade or business or
for investment if such property is exchanged solely for property of like kind
which is to be held either for productive use in a trade or business or for investment.
Present tax law allows for a liberal IRS interpretation
of like-kind exchanges so that property of one kind can be exchanged for property
of another kind without creating a taxable event. These exchanges encourage and
enable an orderly transfer of property ownership which usually results in fresh
new management ideas and attitudes.
Exchanging up, defers capital
gains taxes until the eventual sale of the asset and can increase tax
shelter by the amount of the new depreciable value difference. All of
the principals of using leverage to amass wealth apply.
Exchanging down,
offers many interesting opportunities to the creative real estate investor.
For example:
- Trade one large for two small. Sell one on an installment sale and
keep the other for income production and tax shelter.
- Trade down to get a free and clear property. Re-finance the
property and pocket the proceeds, tax free.
Requirements
have been eased for some like-kind exchanges, or sales where investment
property is replaced. Replacement property may now be
bought before you sell the property you wish to exchange under
the new 1031 rule. That means capital gains taxes can be deferred
even if replacement property is bought first.
Until now, currently owned property had to be
sold first in order to clearly defer capital gains. Now, IRS guidelines preserve
tax deferral in some carefully structured deals where replacement property is
purchased fewer than 180 days ahead of the existing property sale.
However, the property can't be directly purchased
in advance; instead, an unrelated titleholder must temporarily acquire it.
Property Exchange
Resources
Many companies provide service related to 1031
exchanges. The following are listed as examples, but we have no direct
knowledge or experience with these particular companies and you should check
with local title insurance or or escrow companies for recommendations.
- Asset Preservation, Inc.,
a leading national IRC 1031 "Qualified Intermediary", has facilitated
over 45,000 tax deferred exchanges and provides the highest level experience,
expertise and security. One call to our trained Exchange Counselors
is all that is needed to structure a delayed exchange or more complex
improvement or reverse exchange.
- Exchange Partners Inc.
- Real Estate Exchange Services
Online. REES makes exchanging easy and affordable. With
one phone call, we provide intermediary and consulting services for
1031 tax deferred exchanges, including reverse and construction transactions.
Low-Income Housing Tax Credit
(LIHTC) The 1986 tax reform act took
away most incentives for investing in low-income rental housing by changing
depreciation from fifteen to twenty seven and a half years. Many investment
analysis professionals concluded that the act reduced the value of new
investments in rental housing by about eighteen percent.
The feds responded by creating temporary Low-Income
Housing Tax Credits to soften the effects on new or rehabilitated low-income
housing. Essentially the act allows investors in properly set-up and
registered low-income projects to take nine percent a year of their adjusted
basis as a tax credit. Investors receive the annual credit of up to their
tax bracket times $25,000. The credit must be spread out over 11 years.
It results in about a seventy percent recapture of investment over that period.
In 1993 the Omnibus Budget Reconciliation act
made the Low-Income Housing Tax Credit program a permanent part of the Federal
Tax Code. This permanency led to more active involvement by both individual
and corporate investors. That increased the market demand for the credits
which are now often sold to raise equity capital for housing projects. In
fact, the price that investors pay for the credits is now twenty eight percent
higher because permanence has attracted more investor competition. The
result has been more money available to fill the "cost vs. value" gap that exists
in providing decent, safe affordable housing for low and moderate income tenants.
Historic Building Renovation Tax Credit
Program
Congress also created valuable tax
credit incentives for the rehabilitation of housing that can be used
by themselves, or in conjunction with other tax credits to enhance a
renovation project. There is a 10% credit available for most renovation
of older homes and a 20% credit if the structure qualifies under "Historic
Buildings",
Rental Income
Reporting rental income gain or loss
is reported to the IRS on Schedule E of the 1040 form of the federal
income tax return. Income from rental property, including gross
rents, coin operated laundry, vending machines, parking fees or any other
income derived from the property, is considered to be un-earned, investment
income. As a result it is not necessary to pay self employment
(FICA) or Medicare tax on the income. That is another significant
incentive to invest in income producing property.
Recent audit alerts:
- Schedule E, line 12, (Mortgage interest paid to banks, etc.) should
only contain interest information that is being reported independently
to the IRS by a lender. The Service computer compares your line
13 total
with
the total interest reported by lenders under your Social Security Number. If
there is a discrepancy you may receive a letter disallowing any excess
interest deductions.
- Schedule E, line 13 should contain any interest you paid for business
purposes connected to the rental property that was not to a traditional
lender. For example: to individuals for land contracts, trust deeds
or personal notes.
Tax Help Links
- Nationwide
Tax Negotiators A vehicle
for delinquent IRS taxpayers to settle their IRS tax liability
for pennies on the dollar by mail.
- The
Tax Profit Embark on a cyber-journey
with the Tax Prophet, as he deciphers the Internal Revenue
Code for U.S. and foreign taxpayers, and professionals
alike. Watch as he stills the swirling pool of tax obfuscation
with a touch of his magic wand.
Estate Taxes
Not only does one have to consider income taxes
while alive, but one should also be concerned about what the government will
take from their estate after they die.
You spend your entire life searching out CDs that
pay an extra 15 basis points, trading stocks on the cheap with a discount broker,
watching the management fees on your no-load mutual funds like a hawk, and pinching
pennies in managing your income real estate. Then you die and the Internal Revenue
Service takes an obscenely large bite out of your estate. For every dollar more
than $1 million you leave behind, Uncle Sam will take at least 41 cents. The
marginal tax rate hits 49% for a $2 million estate, at $2.5 million it climbs
to 50%. And, remember that some states levy additional estate taxes.
Currently scheduled changes will increase the
amount an individual can leave to heirs tax-free from $675,000 in 2001 to $1
million in 2002 and 2003; and eventually to $3.5 million in 2009. You may
be aware of the 2001 law change that calls for complete repeal of the federal
estate tax in 2010. Believe it when you see it. Estate tax planning remains extremely
important until repeal actually occurs — if it ever does. Politicians sometimes
do change their minds.
There is some relief from what Congress called
the "Unified Credit" (also known as the Unified Federal Gift and Estate Tax Credit).
The Unified Credit allows every American citizen to pass a certain amount of
their estate to heirs tax-free. This credit can be used during one's lifetime
(e.g. a gift of $250,000 to each of your four children), but is usually used
after someone has died and the estate is being distributed.
With the Taxpayer Relief Act of 1997 and the Tax
Relief Act of 2001, the Unified Credit has gradually been increasing.
Most people think that if all of their assets
are jointly held with their spouse that their estate is properly planned. This
is not always the case, especially if the marital estate is more than the exemption,
currently $1,000,000 at the federal level. And, some states also want a
share of your estate.
There are a variety of estate planning techniques
to reduce or avoid estate taxes such as gifting, life insurance, and trusts. By
utilizing some straight forward estate planning techniques, hundreds of thousands,
even millions of dollars of estate taxes can be avoided and the fruits of your
labor can be enjoyed by your heirs rather than by the Internal Revenue Service
and the state tax authorities. We will likely cover this subject in greater
detail in a future e-course.
Filing Tax Returns
If you have an accountant
prepare your income tax returns, you only have to provide adequate information
to him. If, however, you prepare your own returns, then some of
the following benefits of modern technology will be of interest to you..
Tax Return Software
Today there are a number of tax return
preparation programs that are easy to use and relatively inexpensive.
The most popular consumer tax preparation program is TurboTax by Intuit,
the same company that makes the Quicken family of accounting software.
On Line Tax Returns
You can now do your income taxes on
line rather than using a program installed on your own computer. SecureTax takes
you through an interview, much like Turbotax, and allows you to fill
out both federal and state tax forms using a secure Internet connection.
You then print out the completed forms, attach W-2s and 1099s, sign and
mail. There is no charge for the service unless you also want them to
file your return electronically. The cost for E-filing from SecureTax
is very low. Intuit, the maker of TurboTax also provides an online
version of their product, WebTurboTax, that brings
you all the benefits, functionality and content of their #1-selling software,
including support for all states that impose an income tax. Using the
new Smart Interview System, you can work on your taxes safely and securely
anytime and from any place where you have a Web connection. State-of-the-art
encryption technology and security procedures protect your personal information
at all times.
Forms on the IRS Web site
The IRS
web site provides all tax forms as well as all instructions
and other publications. Most items are available in a variety of
file formats, including the Adobe Acrobat PDF format. Forms are
also provided in the fill-in PDF format, meaning that you can save the
forms to your hard-drive, fill them out at your convenience, modify them
as often as necessary, and print the completed form for mailing in. The
same services are provided by many states and availability is increasing
all the time.
File Electronically
In 1998, 900,000 taxpayers
did their own returns on a personal computer and sent them directly to
the IRS electronically. That might seem like a lot, but it amounts to
less than one percent of the 100 million-plus individual returns the
feds received. The total number of returns funneled $792.6 billion into
the federal government, and $169.2 billion into state and local governments,
according to the Tax Foundation.
The percentage of taxpayers filing electronically increases each year.
Exchanging Up
Exchanging Down
Property Exchange Resources
