Chapter 18 - Real Estate Investment

Question 1

Liquidity:

Answer 1

The degree to which an investment is readily marketable, or convertible to another form of asset. If immediately salable, an investment is liquid; the longer it takes to sell, the more illiquid the investment. Real property is relatively illiquid in comparison with other types of investment.

Question 2

Leverage:

Answer 2

You may pledge the value of your resource to borrow funds in order to make an investment that is larger than your own resource permits you to do directly. The small resource is used as a lever to make a larger investment, and thus increases your opportunity to benefit from income, appreciation, and the other rewards of investment.

Question 3

Non-income property:

Answer 3

A residential property used as the investor’s primary residence. The basic reward, beyond the enjoyment of use, comes in the form of appreciation. There may also be tax benefits, depending on how the purchase is financed.

Question 4

Income Property:

Answer 4

A property owned specifically for the investment rewards it offers. Examples are multi-family residential properties, retail stores, industrial properties, and office buildings. Rewards come in any or all of the forms mentioned earlier: income, appreciation, leverage and tax advantages.

Question 5

Opportunity Cost:

Answer 5

The return that an investor could earn on capital invested with minimal risk. If the real estate investment, with all its attendant risk, cannot yield a greater return than an investment elsewhere involving less risk, then the opportunity cost is too high for the real estate investment.

Question 6

Syndicate:

Answer 6

A group of investors who combine resources to buy, develop, and/or operate a property.

Question 7

General and Limited Partnerships:

Answer 7

General: A syndicate in which all members participate equally in managing the investment and in the profits or losses it generates. The group designates a trustee to hold title in the name of the syndicate.

Limited: A syndicate in which a general partner organizes, operates and is generally responsible for the partnership’s interests in the property. Limited partners invest money in the partnership but do not participate in operating the property. These limited partners are passive investors.

Question 8

REIT:

Answer 8

(Real Estate Investment Trust). Investors buy certificates in the trust, and the trust in turn invests in mortgages or real estate. Investors receive income according to the number of shares they own. A trust must receive at least 75% of its income from real estate to qualify as a REIT, and if certain other conditions are met, the trust does not have to pay any corporate income tax.

Question 9

REMIC:

Answer 9

(Real Estate Mortgage Investment Conduit). A kind of partnership entity formed to hold a fixed pool of mortgages that are secured by real property. The entity issues two kinds of interest. Holders of residual interests are treated, for tax purposes, as partners. Holders of regular interests are regarded as owning debt instruments. Income (or loss) received by regular or residual interest holders is treated as portfolio income or loss, and is not included in determining losses from passive activities.

Question 10

Cost Recovery:

Answer 10

Allows the owner of income property to deduct a portion of the property’s value from gross income each year over the life of the asset. The “life of the asset” and the deductible portion are defined by law.

Question 11

Capital Gain:

Answer 11

When real estate, whether non-income or income, is sold, a taxable event occurs. If the sale proceeds exceed the original cost of the investment, subject to some adjustments, there is a capital gain that is subject to tax.

Question 12

Passive Activity:

Answer 12

Business activities in which the taxpayer does not materially participate. Included are interests in limited partnerships and rental activities.

Question 13

Appreciation:

Answer 13

The increase in value of an asset over time.

An increase in the value of a property generally owing to economic forces beyond the control of the owner.

Question 14

Adjusted Basis:

Answer 14

The beginning basis, or cost, of a property plus the costs of capital improvements, minus all depreciation expense.

The basic formula for adjusted basis is:
    Beginning basis
\+  capital improvements
-   exclusions, credits or other amounts received
     adjusted basis

Question 15

Gain on Sale:

Answer 15

The gain on sale of a primary residence is represented by the basic formula:

amount realized (net sales proceeds)
- adjusted basis
gain on sale

Gain on sale, if it does not qualify for an exclusion under current tax law, is taxable.

Question 16

Cash Flow:

Answer 16

The remaining positive or negative amount of income an investment produces after subtracting all operating expenses and debt service from gross income.

Question 17

Tax Liability:

Answer 17

The owner’s tax liability on taxable income from the property is based on taxable income rather than cash flow. Taxable income and tax liability are calculated as follows:

   net operating income (NOI)
\+ reserves
-  interest expense
-  cost recovery expense
= taxable income
x tax rate
= tax liability

Question 18

Amount realized.

Answer 18

The amount realized, also known as net proceeds from sale, is expressed by the formula:

sale price - costs of sale = amount realized

The sale price is the total amount the seller receives for the home. This includes money, notes, mortgages or other debts the buyer assumes as part of the sale.

Costs of sale include brokerage commissions, relevant advertising, legal fees, seller-paid points and other closing costs. Certain fixing-up expenses, as discussed further below, can be deducted from the amount realized to derive an adjusted sale price for the purpose of postponing taxation on gain.

Question 19

Gain on sale.

Answer 19

The gain on sale of a primary residence is represented by the basic formula:

amount realized (net sales proceeds) - adjusted basis = gain on sale

Gain on sale, if it does not qualify for an exclusion under current tax law, is taxable.