REE3043 Exam 2 Study Guide Study For Exam Chapter 4 Federal Income Taxation Four Classes of Real Property 1 Personal Residence An owner occupied housing unit 2 Dealer Property Real estate held for sale to others 3 Business Property Real estate held for use in a trade or business Most income property investments are classified as held for use in a trade or business Business property also applies to the owner who hires a property manager for the day to day operations as well as the owner operator of a restaurant This includes apartments 4 Investment Property Real estate held as an investment for the production of income Investments in unimproved land and property subject to a net lease are termed investment property Passive investments in real estate may be deemed investment property Passive Income Income generated from trade and business activities in which the tax payer does not materially participate The Most Popular form of PASSIVE Real Estate investment today is LLC Three Types of Taxable Income 1 Active Income Income earned from salaries wages bonuses fees and commissions 2 Portfolio Income Income earned from investments in securities e g interest dividends and capital Poor People Line 7 of 1040 gains Rich People Lines 8 9 and 13 of 1040 Smart Rich People Line 17 of 1040 3 Passive Income e g rents from real estate and royalties from oil and gas rights Tax treatment of passive activity income includes several passive loss restrictions and exemptions Depreciation Deductions o Cost Recovery Period The cost recovery period is the period over which real property improvements and personal property can be depreciated Since 1993 residential income property currently placed in service could be recovered depreciated over 27 5 years and nonresidential income property over no less than 39 years Personal property is any tangible property not permanently attached to the building structure Personal property may be depreciated over shorter periods o Allowances that are deductible directly from the taxes owed This DECREASES THE TAX tax credits are available to individuals investing in historic rehabilitation and low income housing Rehabilitation Tax Credits What is a Tax Shelter o A tax shelter occurs when the cash received is not taxed due primarily to mortgage interest and depreciation deductions to the taxable income Page 1 of 12 A Partial Shelter occurs when the taxable income is less than the before tax cash flow A Deep Tax Shelter occurs when the taxable income is negative This reduction in tax is currently usable if the investor is an active participant or has sufficient passive income from other sources to shelter Ordinary versus Capital Gain Income o All recognized gains and losses must eventually be classified as either Capital or Ordinary Capital gains under current tax rules are subject to a maximum 23 5 rate Currently 23 5 headed towards 28 Ordinary income is subject to a 39 6 tax rate Gains due to recaptured depreciation are taxed at a maximum rate of 25 Methods of Deferring Taxes On Disposition o Installment Sale Under this method of sale the seller allows the buyer to pay the purchase price over a number The buyer makes periodic payments to the seller The IRS allows the seller to of years recognize the taxable gain over a number of years usually matched to the installment sale period Section 1031 of IRS Tax Code Like Kind 1031 Transfer Under this method owners may exchange their properties and avoid paying capital gains at the o Like Kind Exchange time of transaction Three Requirements The properties must be business or investment properties The properties must be like kind properties both real estate Any cash or personal property used to equalize the transaction is defined as boot o This results in partial taxation Tax Factors Affecting Home Owners o Preferential Tax Treatment of Home Owners Home owners are allowed to deduct mortgage interest and local property taxes Single Homeowners are permitted to exclude from taxable income up to 250 000 of the capital gains realized on the sale of their principle residence For married couples who are filing joint returns the exclusion is 500 000 The tax exclusion is allowed each time a taxpayer sells a principle residence and meets the eligibility requirements but generally no more than once every 2 years This tax exclusion only works on the Permanent Residence not vacation homes Schedule E Supplemental Income and Loss o Designed for those who have Rental Real Estate Land Lords royalties partnerships S Corporations Estates Trusts etc o May deduct expenses related to Advertising auto and travel cleaning and maintenance commissions insurance legal professional fees management fees mortgage repairs supplies taxes and utilities etc Page 2 of 12 Chapter 5 Real Estate Investment Trusts and LLC s A Real Estate Investment Trust REIT is a corporate form of ownership engaged in real estate investment However it avoids taxation at the corporate level if specific requirements are satisfied o REIT s get foreign investors to invest in Real Estate o REIT s are basically a mutual fund for real estate Basic Operations o REIT s invest primarily in real property and mortgage loans o REIT s raise equity capital through the sale of shares to investors and may borrow funds from lending institutions Primary Ownership Restrictions o REIT s can be small and privately held or large and traded on public stock exchanges o Must have 100 or more shareholders o Cannot have 5 or fewer SH holding more than 50 of the shares o More than 90 of REIT taxable income must be distributed each year in the form of dividends o More than 75 of the REIT s assets must be real estate assets cash and government securities o More than 75 of an REIT s gross income must come from real estate Advantages o Not subject to double taxation o SH have same limited liability as a C corporation o Property Assets can be managed by a Property Management Firm o REIT s provide liquidity diversification and the ability to purchase relatively small amounts of real property divisibility Disadvantages o Tax losses from a REIT do not pass through to shareholders Income is classified as Portfolio Income REIT s must meet substantial operating restrictions to avoid taxation at the corporate level Limited Liability Companies LLC o If the Limited Liability Company LLC lacks at least 2 of the four standard corporate characteristics the IRS has ruled that the LLC should be taxed as a partnership However LLC