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Lesson 12
Taxation
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. You will find more information and a look at the code
on the RHOL Tax page.
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.
RHOL provides additional information on our Exchange
page as well as in our
new Real Estate Investor's Web.
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", We have much more information in our new Real
Estate Investor's Web.
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.
IRS
Guidelines
Defer
Capital Gain
1231
property
Exchanging
Up
Exchanging
Down
Property
Exchange Resources
Real
Estate Investor's Web
Estate
Planning
Federal
Housing Acts
Federal
Income Tax
Low-Income
Housing Tax Credit Summary
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