Ch 28: Investing in Real Estate and Income Tax Aspects of Real Estate

Question 1

A commercial property was purchased for $185,000 and has depreciated to a $61,000 book value. If it is sold for $163,000, there is a:

a. $39, 000 taxable gain
b. $102,000 taxable gain
c. $22, 000 taxable loss
d. $124,000 taxable gain

Answer 1

b. $102,000 taxable gain

The book value is the tax basis as it is the original cost plus any improvements less the accumulated depreciation. The gain is computed by subtracting the book value from the sales price ($163,000 less $61,000).

Question 2

The highest price which a property should bring in a competitive and open market under the conditions existing on a certain date is:

a. Marginal value
b. Economic life
c. Market price
d. Market value

Answer 2

d. Market value

Market value is defined as an unemotional, objective price at which a seller would sell and a willing buyer would purchase, with neither party under abnormal pressure to act.

Question 3

Net cash flow equals:

a. Gross income less operating expenses
b. Gross income less operating expenses and loan payments
c. Gross income
d. Operating expenses and loan payments

Answer 3

b. Gross income less operating expenses and loan payments

Net cash flow is: Gross income less Operating Expenses and Loan Payments
Cash flow should be determined at the time an investment opportunity is evaluated.

Question 4

A broker has a problem of subdividing a 10 acre tract into 50 by 100 foot lots; after allowing 85,600 square feet for the necessary streets, how many lots will the broker realize from this subdivision?

a. 92
b. 87
c. 70
d. 16

Answer 4

c. 70

A ten-acre tract contains 435,600 square feet of land (43,560 square feet in an acre times 10 acres). Deduct 85,600 square feet from the total acreage to get the square footage of land that can be developed into lots. The answer of 350,000 square feet is then divided by the square feet of each lot (350,000 divided by 5,000). The number of lots that can be developed is 70.

Question 5

A property is valued at $200,000 using a 5 percent capitalization rate. If an investor wants an 8 percent return, he would only be willing to pay:

a. $270,000
b. $225,000
c. $125,000
d. $290,000

Answer 5

c. $125,000

The investor desires an increased return on the same projected income; therefore the investor would pay less that the valuation amount. This can be confirmed by calculation. Compute the projected income of $10,000 ($200,000 times 5%) and divide it by the 8% desired return ($10,000 divided by 8%). The computed answer is $125,000.

Question 6

A leveraged investment describes:

a. An equity investment
b. Use of other people’s money
c. Collateralized equity
d. Low-risk investment

Answer 6

b. Use of other people’s money

Leveraging means borrowing money from another source to supplement your own funds in completing the acquisition of a piece of property. Leverage can dramatically increase the return on an investment, while spreading some of the risk to others.

Question 7

A developer paid $2,450 per acre for a 125-acre tract. His costs for grading, paving and surveying totaled $625,000. He constructed 200 houses at an average cost of $150,000 each. What was the average sales price per house if the developer realized a net return of 14% on his total investment?

a. $182,134.31
b. $179,832.85
c. $154,656.24
d. $176,308.12

Answer 7

d. $176,308.12

First compute the total investment by the developer as follows:
Land cost ($2,450 times 125 acres)$306,250
Grading Paving and Surveying$625,000
Construction of houses (200 times $150,000) $30,000,000
Total Investment $30,931,250
Next, compute the total average sales price in order to realize a 14% return on the investment by multiplying the investment by 114%. The answer is $35,261,625 ($30,931,250 times 1.14)
Next, compute the sales price per house by dividing the total sales price for all of the houses by the number of houses to be built. The answer is $176,308.12 (35,261,625 divided by 200)

Question 8

Sam finances the purchase of his residence with a $75,000 first mortgage loan to be amortized over 15 years. In order to reduce the interest rate, Sam pays two points. On Sam’s income tax return, the points paid are:

a. Deductible at $50 per year over the life of the loan.
b. Deductible at $100 per year over the life of the loan
c. Deductible in the amount of $1,500 the year the points are paid
d. Not deductible

Answer 8

c. Deductible in the amount of $1,500 the year the points are paid

Since the points were paid in connection with the financing of the purchase of the home, they are deductible in the year paid.

Question 9

To be depreciated real property MUST be:

a. Your residence
b. Improved
c. Owned in fee simple
d. Paid for

Answer 9

b. Improved

For income tax and accounting purposes, the depreciation calculation does not include the cost of the land. The improvement to the land is the only portion of the total cost that is depreciated.

Question 10

On their returns, taxpayers may deduct interest expense on indebtedness related to a first and second home. The maximum combined amount of debt for which interest expense can be deducted is:

a. $1,500,000
b. $750,000
c. $1,000,000
d. $500,000

Answer 10

b. $750,000

A taxpayer can deduct interest on debt that is incurred in acquiring, constructing of substantially improving a qualified residence. This type of debt is referred to as acquisition indebtedness. Acquisition indebtedness is limited to $750,000 and can be incurred in the purchase of a maximum of two residences. Prior to enactment of the 2018 Tax Revisions the Home Acquisition indebtedness limit was $1,000,000. Home Acquisition Debt incurred before enactment of the 2018 tax revisions is still subject to the $1,000,000 debt limit.

Question 11

A taxpayer has modified adjusted gross income of $140,000 for the year and a loss of $20,000 from owned rental real estate, for which the taxpayer actively participates in the management. How much of the rental real estate loss can be deducted?

a. $10,000
b. $5,000
c. $20,000
d. None

Answer 11

b. $5,000

The total Rental Real Estate Loss allowance is $25,000 and the Allowance is reduced by 50 cents for every dollar of adjusted gross income that exceeds $100,000. In this question the adjusted gross income exceeds $100,000 by $40,000; so the loss allowance is reduced by $20,000. Therefore $5000 of the $20,000 loss from owned rental real estate can be deducted.

Question 12

In depreciating a residential property, an accountant would base the depreciation life for income tax purposes on:

a. 39 years
b. Age life tables
c. 27 1/2 years
d. The observed condition of the property

Answer 12

c. 27 1/2 years

There are two classes of real property under the 1986 Revenue Act as follows:
Residential rental property can be depreciated over 27.5 years.

Non-residential property can be depreciated over 39 years.

Question 13

Robert Sherman, the owner of a commercial building, calculates the depreciation on the plant at $25,000, the furniture and fixtures at $5,000 and the machinery at $7,500. Further he estimates that the land has declined in value by $10,000. If he is in a 30-percent tax bracket, his tax savings would be:

a. $11,250
b. $14,250
c. $37,500
d. $47,500

Answer 13

a. $11,250

The total allowable depreciation is $37,500 ($25,000 plus $5,000 plus $7,500). The tax savings would be $11,250 ($37,500 times 30%). Depreciation of land or a decline in value of land is not deductible for income tax purposes.

Question 14

The Passive Activity rules prevent all of the following EXCEPT:

a. The deduction of a passive loss from Portfolio income such as dividends
b. The deduction of a rental real estate activity loss from earned income incurred by a real estate professional who materially participates in the activity
c. The deduction of rentals that are considered by law to be a business activity when the taxpayer does not materially participate.
d. The deduction of a passive loss from Earned income such as salary

Answer 14

b. The deduction of a rental real estate activity loss from earned income incurred by a real estate professional who materially participates in the activity

Passive activities generally include any business or investment activity in which the taxpayer does not materially participate. The passive activity rules prevent an investor from deducting a passive loss from earned income or portfolio income. The rental of real or personal property is generally a rental activity under the passive activity loss rules. Rental income and losses are automatically treated as passive unless earned or incurred by a real estate professional that materially participates in the activity.

Question 15

If you own a duplex and live in half of it you MAY:

a. Deduct expenses on the rented half
b. Deduct all expenses for tax purposes
c. Depreciate expense on the land only
d. Deduct expenses on the half in which you live

Answer 15

a. Deduct expenses on the rented half

The half of the duplex that is rented is a rental income property and the operating expenses can be deducted on that half only.

Question 16

The cost basis of a home WOULD be affected by:

a. Interest paid
b. Extensive repairs
c. A room addition
d. Amortization of the loan

Answer 16

c. A room addition

Improvements or replacements and additions to a property increase the cost basis in the property. Maintenance items or interest expense do not increase the cost basis. The amortization of the loan also does not increase the amount of the investment, but it does increase an individual’s equity in the investment.

Question 17

Portfolio income is BEST described as:

a. Real estate investment actively managed
b. Yield from investments including stocks and bonds
c. Real estate held for less than 1 year
d. All securities and real estate investments.

Answer 17

b. Yield from investments including stocks and bonds

Portfolio income is income that is return on invested capital, such as interest and dividends.

Question 18

A nonresidential building was acquired and place in service in June of the tax year for $750,000, which included the cost of land in the amount of $150,000. What was the amount of depreciation in the year of acquisition?

a. $8,333.32
b. $1,282.05
c. $15,384.61
d. $19,230.76

Answer 18

a. $8,333.32

Using the half month convention for the calculation of the depreciation for the year of acquisition is; cost of improvements $600,000 divided by 39 results in the annual depreciation of $15384.61; which is dived by 12; and the answer is multiplied by 6.5. The answer is $8,333.32

Question 19

Mary, a single individual, may exclude up to $250,000 of capital gain on the sale of her residence if:

a. She has owned it for one year
b. She does not have a second residence as a vacation home
c. She has not sold a residence within the past five years
d. The residence was her principal residence for two of the preceding five years

Answer 19

d. The residence was her principal residence for two of the preceding five years

A single individual may exclude up to $250,000 of capital gain on the sale of his/her principle residence. The house must be the principal residence for two of the preceding five years in order to qualify for the exclusion. The exclusion does not apply to vacation or second home properties.

Question 20

A commercial property was purchased for $185,000 and has depreciated to a $61,000 book value. If it is sold for $163,000, there is a:

a. $102,000 taxable gain
b. $22, 000 taxable loss
c. $124,000 taxable gain
d. $39, 000 taxable gain

Answer 20

a. $102,000 taxable gain

The book value is the tax basis as it is the original cost plus any improvements less the accumulated depreciation. The gain is computed by subtracting the book value from the sales price ($163,000 less $61,000).

Question 21

Cost basis for tax purposes is NOT affected by:

a. Purchase costs
b. Mortgage interest expense
c. Broker’s commission
d. Improvements

Answer 21

b. Mortgage interest expense

Mortgage interest expense is a period cost and does not increase the cost basis.

Question 22

Capital gains are taxed at a favorable tax rate if the capital asset was held for:

a. More than one year
b. More than six months
c. More than three years
d. More than two years

Answer 22

a. More than one year

The favorable capital gains tax rate applies only to long-term capital gains, which require a holding period of more than 1 year.

Question 23

Which of the following items WOULD be taxed in a tax-deferred exchange?

a. Salvage value
b. Boot
c. Like-for-like real property
d. Assuming a mortgage of equal value

Answer 23

b. Boot

Boot is unlike property in an exchange and it is subject to capital gain tax

Question 24

Tax-deferred exchanging requires properties to be:

a. Of equal equities
b. Of “like kind”
c. Residential
d. Of equal value

Answer 24

b. Of “like kind”

“Like kind” means business or income property for other business or income property, or personal property for personal property. Real property in exchange does not need to be of the same classification. For example, an apartment complex for undeveloped land is considered “like kind”

Question 25

Boot is more closely associated with a:

a. Trade
b. Conditional sales contract
c. Tax transfer
d. Commercial bulk sale

Answer 25

a. Trade

A Section 1031 tax deferred exchange of property is often referred to as a Trade. Boot is unlike property that is included in the exchange in order to balance the trade of equity. A capital gain tax is due from the recipient of the unlike items.