Topic 18.5: Federal Income Taxes
Learning Objectives
After successfully completing this topic, you will be able to
- describe the tax advantages of home ownership,
- explain how to determine taxable income of investment real estate, and
- distinguish between installment sales and like-kind exchange.
Sale of Real Property
Real property is a capital asset. The sale of real property is a taxable event. To calculate the taxes due on the sale, it will depend on
• the amount realized from the sale,
• the adjusted basis of the property,
• whether it was a gain or a loss, and
• the length of time the property was owned.
Amount realized from the sale
This is the sale price minus any commissions or fees paid.
Adjusted basis
The basis is what the owner paid for the property. The adjusted basis adds acquisition costs, any capital improvements, less allowable depreciation (if this is an investment property).
Capital Gain (Loss)
Subtract the adjusted basis (what you paid) from the realized amount (how much you sold it for) to determine the difference.
• If you sold your assets for more than you paid, you have a capital gain.
• If you sold your assets for less than you paid, you have a capital loss.
Length of time the property was held
If you held the property for less than one year, the IRS considers that a short-term gain. You’ll have to pay taxes at your normal tax rate.
If you held the property for one year or more, it is a long-term capital gain. The tax rates are lower, with a maximum rate of 20% or the gain.
If the property has been your personal residence for at least two years, all or part of the gain is excluded from taxation (see below).
Principal Residence
There are many tax advantages to owning a personal residence. Before any of deductions are considered, the owner should understand that a married couple filing jointly has an automatic “standard deduction” of $24,800 for 2020. Persons taking the standard deduction cannot “itemize” other deductions, so the individual will need to weigh the best option. The following is a list of other deductions.
• Mortgage interest deduction on principal residence and second home with a total value of up to $750,000.
• Deduction of up to $10,000 in property taxes on principal residence and second home.
• IRA withdrawal of up to $10,000 for first time home buyers without having to pay a penalty.
• Exclusion of up to $250,000 gain from sale of principal residence ($500,000 for married couples filing jointly). The property must have been the principal residence for at least two of the previous five years. Any gain above those limits are taxed as capital gains.
• Interest on home equity loans used to pay for home improvements is deductible. Home equity loans used for other purposes are not deductible.
• Loan origination fees and points made to purchase a principal residence are deductible in the year they are paid.
Disposition of Real Property by Foreign Sellers
When a person who is not a U.S. citizen sells property, the Foreign Investment in Real Property Tax Act (FIRPTA) may require the buyer to withhold up to 15 percent of the amount realized on the sale. The buyer, title closing agent, and the real estate licensee should seek professional advice.
Investment Real Estate
Federal tax laws are generous to real estate investors who employ competent tax professionals or keep up with tax law changes themselves. Purchases and sales of real property should be planned to generate the best returns from favorable tax treatment.
Types of Income and Cash Flows
Potential gross income is the income that might be generated if the entire property were rented for the full rental amount during the entire year. This is unrealistic because of vacancies and rental discounts.
Effective gross income is the actual income collected by the owner after deducting for vacancies, and adding other income from parking fees or vending income.
Net operating income is the amount left to the owner after paying operating expenses from the effective gross income. Examples of operating expenses include property taxes, maintenance, supplies, trash removal, and employee salaries.
Tallahassee Villas Apartments Operating Statement
Purchase Price: $1,000,000 / Mortgage $800,000
| Potential gross income 25 units @ $425/mo. 12 units @ $500/mo. Less: Vacancy and Coll. Losses @ 5% Effective gross income | $127,500 72,000 (9,975) 189,525 |
| Operating Expenses Property Taxes Garbage collection Pest Control Insurance Maintenance Management @ 5% Resident Manager Apt. Reserves for replacements Total Operating Expenses | 8,700 2,800 4,500 3,500 9,600 9,476 4,200 30,000 72,776 |
| Net operating income | $116,749 |
We’ll add a little more information to the statement so we can calculate the taxes.
• Annual debt service is $68,777, of which interest is $47,419.
• The property cost $1,000,000. The building value is 75%, and land is 25%.
• Assume that the owner’s income tax rate is 25%.
Determining taxable income
Reserves for replacements is NOT deductible; $30,000 must be added back to NOI.
Interest of $47,419 is deductible, but principal payments are not.
Depreciation is deductible. Residential property improvements are depreciated over 27.5 years; non-residential property is depreciated over 39 years. The property is residential. The improvements are $750,000, so depreciation deduction is $27,273 ($750,000 ÷ 27.5 years).
| Start with: Net Operating Income | $ 116,749 |
| Add back Reserves for Replacements | + 30,000 |
| Deduct Interest | (47,419) |
| Deduct Depreciation | (27,273) |
| TAXABLE INCOME | $ 72,057 |
| Investor’s Tax Rate (25%) | x .25 |
| TAX ON PROPERTY OPERATIONS | $ 18,014 |
Capital Gain (Loss)
If you held the property for less than one year, the IRS considers that a short-term gain. You’ll have to pay taxes at your normal tax rate. If you held the property for one year or more, it is a long-term capital gain. The tax rates are lower, with a maximum rate of 20% or the gain.
Capital losses can be used to offset capital gains. For example, assume an investor has sold two properties in the year; one for a capital gain of $28,000, and one for a capital loss of $22,000. So, the investor has a capital gain of $6,000 to report if the investor does not sell another property.
However, if the investor sells another property with a loss of $14,000, the net loss is $8,000. The tax law limits the amount of capital loss that is deductible to $3,000 per year; the balance is carried over to future years. The investor can deduct $3,000 this year, $3,000 next year, and $2,000 in the following year.
Installment Sales Method
Sometimes investors sell properties and finance the sale, receiving payments over several years. The tax law allows the seller to pay taxes as the payments are received, rather than in the year of sale. A portion of each payment is interest income. The principal portion of the payment is divided into the seller’s basis in the property, and into the seller’s profit.
| Example of installment sale taxation Assume that an investor purchased vacant land ten years ago for $300,000. The investor sold it this year for $500,000 and financed $400,000 with annual payments at 10% over ten years. The annual payments will be $65,098. In the first year, the interest is $40,000, and the principal payment is $25,098. The seller will pay taxes on the interest collected and will also have to pay taxes on the portion of the principal that represents profit. The profit percentage is .66667 ($200,000 profit ÷ $300,000 cost). So, the seller has a long-term capital gain on the first year’s principal payment in the amount of $16,740 ($65,098 x .66667). |
Like-Kind Exchange
Most savvy investors don’t pay capital gains taxes unless they just want to “cash out.” If the investor will be reinvesting, a better move is to do a Section 1031 tax-deferred like-kind exchange. To qualify for a tax-deferred exchange, investment real property must be exchanged for like-kind investment property.
What is like-kind? For example, an owner of an office building might exchange the property for a multifamily apartment property. The owner could not make a like-kind exchange of the office property for a personal residence or for shares of stock, or for a yacht.
If the owner of the office property receives cash or any other asset in the exchange, it is called “boot” and is taxable. Like-kind exchanges can be complicated and must be carefully structured to get favorable tax treatment, so a CPA or attorney should be engaged early in the transaction.