Income Tax Aspects of Real Estate Flashcards
Okay! On to tax benefits of owning a home!
The mortgage interest deduction (MID) is the biggie. Amortized loans are structured so that borrowers pay mostly interest at the beginning of the loan, slowly increasing the amount of principal they pay as the years go by. Being able to deduct the interest on a mortgage is a big tax break for most borrowers.
Before the TCJA, homeowners could deduct the interest on a mortgage up to $1,000,000 (filing jointly) or $500,000 (filing singly). After 2018, those numbers dropped to:
$750,000 (for people filing jointly)
$375,000 (for people filing separately)
Anything beyond that is no longer tax-deductible.
Eligibility for MID
To be eligible for this tax deduction:
The taxpayer must be legally responsible for the debt. (So for example, you can’t deduct rent, even though your landlord is probably using it to pay their mortgage.)
The loan must be a secured debt, with the home as collateral.
The loan must be for a primary residence.
Mortgage Interest Deduction
There’s more to say about the tax aspects of real estate for homeowners. For example…
Home Equity Loan Interest Deduction
If you took out a loan to pay for improvements to your home, the interest paid on the loan is deductible — unless it puts your total loan balance above the MID loan amount thresholds I just shared with you.
Additionally, even if you are under those MID loan thresholds, if the home equity loan is used to pay off personal expenses rather than home improvements, the interest is NOT deductible.
Property Tax Deduction
Before 2018, all money paid toward state income taxes, city income taxes, and property tax was tax-deductible. After the passage of the TCJA, homeowners can only deduct a total of $10,000 combined of state, city, and property taxes.
Home Equity Loan Interest & Property Tax Deduction
Points Deduction
Remember points? You remember points. Just in case you’re fuzzy:
Discount points are upfront interest that a borrower pre-pays on their loan to lower their interest rate.
Origination points are fees associated with getting a loan.
Each point is 1% of the total value of the loan.
Now here’s the good news: Most points are tax-deductible in the year they’re paid! Hooray for points!
MID Threshold Warning!
The only thing to keep an eye on with deducting points is that if you have exceeded the limit for the mortgage interest deduction on your loan, you can’t deduct all of your points, either. You can only deduct for the amount of total points that would be proportional to the first $750,000 in loan value.
For instance, if you took out a $1,000,000 loan with 2 points, only the interest based on $750,000 of that loan would be tax-deductible.
In this example, $750,000 represents 75% of the total loan. Therefore, you would only be able to deduct 75% of the total points you paid (which would come to 1.5 points).
Mortgage Pre-Payment Penalty Deduction
If you are penalized for pre-paying your mortgage (which is pretty rude, if you ask me), that penalty is tax-deductible.
Points & Mortgage Prepayment Penalty Deductions
Before we get into this final tax deduction, known as capital gains exclusions, I want to cover the meaning of a couple of relevant and related terms.
Note: Some say exemption while others prefer exclusion. Makes no difference, they both refer to the same tax deduction.
Capital Gain
A capital gain is simply the increase in the value of an asset from the time a property is purchased to the time that property is sold.
They are the profits made from selling an item of value, whether that’s real estate, stocks, bonds, or suitcases full of diamonds. 💎
Capital gains are the result of appreciation or the increase in value of property. At its core, a capital gain is the profit created when property is sold after it appreciates.
Capital Loss
Conversely, a capital loss refers to the loss incurred from selling an asset that has depreciated in value.
Capital Asset
Capital assets include all of a taxpayer’s tangible property, such as real estate, investment properties, and equipment. (This does NOT include property that is held for regular sale to consumers.)
Capital Gains Tax
For most people, a home is their biggest capital asset.
Capital gains tax used to cause homeowners big problems when they sold their property. If the home appreciated in value, as most real estate eventually does, they’d be stuck with a big tax bill.
That made it harder for people to afford to “move up the real estate ladder” and invest their money in another, larger or more expensive home.
The Taxpayer Relief Act of 1997
Enter the Taxpayer Relief Act of 1997, which created certain exclusions from capital gains taxes for homeowners.
Under the capital gains exemption, single homeowners may exclude up to the first $250,000 on the sale of a primary residence. Married homeowners may exclude up to the first $500,000.
This exclusion is reusable every two years. It can be found in Section 121 of the Internal Revenue Code.
The capital gains exemption is also called the $250,000/$500,000 rule.
A single homeowner stands next to her home with a for sale sign. Married homeowners stand next to their home, also for sale. The exemptions differ.
A study by the Federal Reserve suggests the capital gains exemption caused 17% more home sales from 1998 to 2008. When this exemption was introduced, it touched off a real estate bull market that careened right into 2008’s housing crash. 😳
Capital Gains Exemption Eligibility
Taxpayers must meet ownership and use requirements to be eligible for the capital gains exemption.
The taxpayer must have owned and occupied the home as a principal residence for at least two of the five years preceding the sale. The two years may be an aggregate amount of time, and need not be continuous.
For married couples, both spouses must have occupied the residence for at least two years out of the prior five years. Only one spouse needs to have owned the property for at least two out of five years.
Also, neither spouse can have used a capital gains exemption in the past two years (as they are reusable every two years).
Next Up: A Quick Review
In a moment, you’re going to learn how to calculate the capital gain for a primary residence. First, though, let’s review some of the tax incentives for homeownership.
Capital Gains Exemptions
Now on to calculating capital gain, Anthony! The formula:
Realized gain - Adjusted basis = Capital gain
In order to understand that… well, I have to give you more terms and formulas. Sorry ‘bout that.
Adjusted Basis
To find the adjusted basis for a primary residence, you take the property’s sale price (or basis) when purchased, add qualified closing costs from that initial purchase, and add the cost of any capital improvements made during ownership.
A capital improvement, by the way, is any upgrade or improvement to a property that falls outside the scope of normal repair and maintenance, usually with the intention of increasing value. It’s basically a renovation.
The formula:
Basis + Cost of improvements + Qualified closing costs = Adjusted basis
Note: This is true for capital gains calculations on a primary residence.
Realized Gain
The realized gain is how much the homeowner makes when they sell. It’s the sales price, minus any closing costs and commissions they pay at the sale. The formula:
Sales price - Selling costs = Realized gain
Scenario 1: Harry and Louis
I promise, it’s not as complicated as it seems. Let’s look at a typical scenario.
Harry and Louis are a married couple who bought their primary residence three years ago for $650,000. They just got an all-cash offer for $900,000. Their qualified closing costs when they bought the house were $50,000. The cost of the sale was only $10,000. They’ve both lived in the home for the last three years. How much capital gain will they pay tax on?
Step 1: Find the adjusted basis
There’s no capital improvements mentioned, so:
$650,000 + $50,000 = $700,000
Step 2: Find the realized gain
$900,000 - $10,000 = $890,000
Step 3: Find the capital gain
$890,000 - $700,000 = $190,000
Final answer: Since both spouses owned and lived in the home as a primary residence for at least two years, they qualify for the full $500,000 exemption. And since $190,000 is well under the $500,000 exemption, they owe no capital gain taxes.
Whew!
Scenario: Liam’s Lovely Condo
Let’s look at another scenario.
Liam is a single gentleman who has never settled down with a partner, though he did make a commitment to a condo thirteen years ago.
He paid $200,000, plus another $10,000 in closing costs. The condo was his primary residence for seven of the years he owned it (he spent some time in Berlin), including three of the last five.
He’s finally decided to pack it in, sell his place, and move to Europe for good.
Liam was delighted to find that his adorable, exposed-brick one-and-a-half bedroom with a balcony is now worth $1,300,000 (it’s to die for). It cost him $90,000 to sell the place. How much, if any, capital gain will he pay taxes on?
Step 1: Find the adjusted basis
There’s no capital improvements mentioned, so:
$200,000 + $10,000 = $210,000
Step 2: Find the realized gain
$1,300,000 - $90,000 = $1,210,000
Step 3: Find the capital gain
$1,210,000 - $210,000 = $1,000,000
Final answer: Because Liam only qualifies for a $250,000 capital gain exclusion, he is subject to $750,000 in taxable capital gains. Ouch.
(Final answer math: $1,000,000 – $250,000 = $750,000)
Calculating a Capital Loss
Sadly, Anthony, life isn’t all rainbows, cupcakes, and capital gains. Sometimes, you take a capital loss. But the silver lining here is that you may be able to write off some of that loss at tax time or use it to offset a non-exempt capital gain.
How do you calculate the amount of capital loss? Essentially the same way you calculate a capital gain, only you end up with a negative number.
Calculating Capital Gain for a Primary Residence
So, that’s how to calculate a capital gain.
Once you know that number, you either don’t have to pay taxes on it (if within the exemption threshold), or, eh, you do.
And if you do, just how are taxes on capital gains calculated? Good question!
Holding Periods
Capital gains can be taxed as either a short-term or a long-term gain.
This is determined by the length of time the property is held (the amount of time that passes between the purchase and the sale). This is called the holding period.
If the holding period was less than one year, the capital gain is a short-term gain.
If the holding period was greater than or equal to one year, the capital gain is considered a long-term gain.
Short-Term Capital Gains
Short-term capital gains are taxed as ordinary income*, according to federal income tax rates. This means that in most cases, short-term gains are taxed at a much higher rate than long-term gains.
*Ordinary income is derived from wages and interest and is taxed at rates up to 37%.
Long-Term Capital Gains
Long-term capital gains are currently taxed at 0%, 15%, 20%, 25%, or 28%, based on the overall income the taxpayer earns. The more money you make, the more capital gains tax you pay.
Sometimes taxpayers also have to pay an additional 3.8% net investment income tax (NIIT).
Luckily, with the big exemptions available to people selling a primary residence, most non-investors won’t have to worry about paying capital gains tax.
Why 25%?
The 25% rate applies to depreciated properties, which we will get to in a bit. The tax rate is higher here because investors received previous tax deductions from depreciating the property over its useful life. It’s called a depreciation recapture tax.
Why 28%?
The 28% rate is only for people selling high-end collectibles like art, jewels, wine, or other rich-people baubles OR investors in small businesses who held their stock for at least five years. These capital gainers can exclude half of their profits, then they must pay a 28% capital gains tax on the other half. (This is not relevant to real estate and you probably don’t need to know it, but just in case you’re planning to sell your Picasso this year.)
Capital Gains Holding Period
So, we’re pretty much done with tax deductions and benefits that come from homeownership.
But before we move on to a discussion about deductions and benefits for investment properties, let’s briefly turn to a law I like to call FIRPTA.
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) regulates the purchase of real property in the U.S. from foreign sellers.
Essentially, the law requires that if you buy property from a foreign seller, you must withhold 15% of the sales price for taxes. This way, the IRS ensures that they get taxes owed by foreign sellers.
The foreign seller may ask the IRS to reduce this 15% to the amount of tax estimated to be due. The IRS usually quickly approves these requests.
FIRPTA does not apply if you are buying a residence for $300,000 or less.
The Foreign Investment in Real Property Tax Act
Now, for everyone’s favorite question: Are there tax implications to real estate investment? You betcha!
First, remember that the capital gains exemption is only available for individuals selling their primary residence. Investors are locked out of that topic.
So, what are investors supposed to do? Just sit there and pay taxes out the wazoo without any recourse?
Tax Shelters to the Rescue
No, Anthony. Investors also have tax strategies they can utilize to their benefit. These maneuvers, known as tax shelters, might not get the shrewd investor completely out of paying taxes, but they provide some relief.
A tax shelter is any method used to reduce taxable income and, consequently, reduce the amount of taxes paid to the government.
Note: Mortgage interest and property taxes on investment properties are fully tax-deductible, with no upper limit.
Taxable Income on Investment Properties
Time to talk about taxable income on an investment property.
This refers to the income that can be taxed after all deductions and permissible adjustments have been made.
Here’s what you need to know:
Certain operating expenses (money spent on running and maintaining the property) are deductible in the year they are paid.
Property taxes are considered a fixed operating expense and are deductible from gross income.
A cash reserve for replacements is not deductible. However, replacement expenses paid during the tax year may be deducted.
EXAMPLE
Investor Ida has a reserve account of $200,000. She cannot deduct this amount when she is calculating her taxable income. However, she can deduct the $10,000 she spent from that reserve during the tax year on re-painting the units in the complex.
Taxes & Real Estate Investment
Two concepts to know when talking about investment income are debt service and cash flow.
Debt Service
Debt service is the amount of money needed for a specific time period in order to cover the payment of principal and interest portions on a loan. If you were an individual, you’d probably just call this your “mortgage payment,” but serious business-doers need serious business words. The investor will need to calculate the annual or monthly debt service that each loan requires.
Cash Flow
Cash flow refers to the cash that an investment generates after accounting for the operating expenses, debt service, and taxes associated with the enterprise.
Cash flow can be calculated before or after taxes. Cash flow before taxes is an important number for real estate investors when determining whether or not a property is worth investing in.
Review of Types of Income
We learned this pretty recently, but let’s review the types of income for investment properties:
Potential Gross Income (PGI)
Potential gross income (PGI) is the total rental income a property would receive if the property was 100% leased.
Here’s the formula you learned for that:
Contract rent + Projected rent = Potential gross income
Effective Gross Income (EGI)
Effective gross income (EGI) is the estimated total annual income that a property produces. Effective gross income does not account for any expenses; it only accounts for the total income produced by a property.
Here’s the formula you learned for that:
Potential gross income + Other income - Vacancy cost = Effective gross income
Net operating Income (NOI)
Net operating income (NOI) is a property’s annual income that remains after paying its operating costs. Net operating income shows property owners and potential buyers the profit that a property produces.
Here’s the formula you learned for that:
Effective gross income + Operating expenses = Net operating income
Debt Service, Cash Flow, & Types of Income
Depreciation is super important when it comes to investment properties. It is a type of tax shelter for investors. Tax depreciation is a way to recapture the loss in value of an asset over time by writing off a portion each year.
There are three major events in investment property ownership:
Acquisition (when you buy it)
Holding period (when you own it)
Reversion (when you sell it) and it reverts back to the natural state of the investment, meaning the cash you used to buy it
Depreciation is something that happens during the holding period. It doesn’t start at acquisition, however — it starts when the property is “placed in service.”
An investment property is placed in service when you start using it for its intended, income-producing purpose. So if you buy an apartment building and spend two months renovating it before the tenants move in, you start depreciating it when it’s done being renovated.
You stop depreciating either when the property is fully depreciated (more on that later), or when it is retired from service (sold or converted to non-income producing property).
Retirement parties for buildings are not tax-deductible but would be adorable. 🎉
What Can Depreciate?
Only investment properties depreciate — you can’t claim depreciation on a primary residence.
Generally, property (including items like computers) used for business purposes are depreciable. Here are the rules about what can depreciate, according to the IRS:
It must be property you own.
It must be used in your business or income-producing activity.
It must have a determinable useful life.
It must be expected to last more than one year.
Land Doesn’t Depreciate
The biggest thing in the non-depreciable category is land. Land does NOT depreciate, because land doesn’t have a determinable useful life or lose value over time.
Like your Uncle Jimmy always says, “They’re not makin’ any more of it!”
Other Things That Don’t Depreciate
Other things that can’t be depreciated include:
Equipment used to build capital improvements
Personal property, including clothes
Property placed into service and disposed of in the same year
Stocks and bonds
Intangible property
Depreciation Station
There are three things that cause property to depreciate. (We talked about this a bit earlier in the level.):
Physical deterioration is stuff getting old and breaking. It’s a gradual process — a roof damaged in a hailstorm is not physical deterioration, but a roof that wears out over time is. It’s considered curable because things like damaged roofs can be repaired or replaced.
In an investment property, physical deterioration becomes incurable when the cost of fixing it is higher than the value of having it fixed. In that case, just throw it right in the trash.
Functional obsolescence is when something loses value because it becomes outdated. It could be an aesthetic issue, like ugly pink bathroom tile, or an engineering issue, like an older house not having enough electrical capacity for modern appliances. It can be curable or incurable, depending on the cost of fixing it.
External obsolescence is a loss of value from factors external to the property, like a change in zoning or a highway being built through a neighborhood.
Depreciation Is Not a Choice
Depreciation is sort of confusing because it’s not actually related to what is going on with your property. It’s just a construct that the IRS uses for business tax purposes. It doesn’t matter if your building is in great shape or increasing in value: In the eyes of the tax authority, it is depreciating.
What Is Causing All This Depreciatin’ Anyway?
Straight-line depreciation (or straight-line cost recovery) is an accounting method used to figure depreciation that allows the taxpayer to deduct the same amount every year of the asset’s useful life.
Another depreciation method, called the modified accelerated cost recovery system (MACRS), is how the IRS requires depreciation of investment property to be calculated. (In case it ever comes up at a cocktail party, it’s pronounced like “makers.”)
MACRS is very similar to straight-line depreciation, so we’ll use that for our examples. (The differences involve picky things about when the property was placed in service and are best left to the tax pros.)
Recovery Periods for Depreciable Assets
The IRS has determined “recovery periods” for depreciable assets. Your asset will fully depreciate by the end of the recovery period.
Here are the two recovery periods you will want to know:
The recovery period for residential income-producing property is 27.5 years. This includes apartment buildings, vacation rentals rented out more than 14 days a year, rental homes, and any other property people rent to live in.
The recovery period for commercial investment property is 39 years. Commercial investment property includes things like office buildings, shopping centers, industrial parks, and professional buildings.
How did the IRS come up with these extremely specific cost recovery periods? There are lots of theories. None of them pretty.
Straight-Line Depreciation
So now we know that property depreciates over either 27.5 or 39 years. But how do you know how much you can claim each year?
Here’s the formula for the straight-line method:
Depreciable basis ÷ Useful life = Annual IRS depreciation deduction
Essentially, you divide what’s known as your “depreciable basis” by either 27.5 or 39 to get your annual “depreciation allowance.” (No depreciation allowance until you do your depreciation chores, Anthony!)
Depreciable Basis
The depreciable basis is essentially the total value of the property that is eligible to be depreciated.
Remember how we said that land can’t depreciate? For that reason, the property (land) value is taken out of the equation when finding the depreciable basis.
Also, any acquisition costs or renovations a person makes before putting the investment property “into service” — the IRS’s way of saying “starting to make money from it” — can be included in the depreciable basis.
In the end, the depreciable basis is the purchase price of the property, plus the cost of acquiring it (expenses like broker fees, appraisal fees, title insurance, and other closing costs), plus any improvements you made to it before putting it in service, minus the value of the land.
Here’s what that formula looks like:
Purchase price + Acquisition costs + Renovations - Land value = Depreciation basis
Finding the annual depreciation deduction amount that can be reported each year has its own little formula:
Depreciation basis ÷ Recovery period = Annual depreciation deduction
Improvements vs. Repairs
The IRS makes a big deal about the difference between “improvements” and “repairs.” Essentially, improvements increase your basis in the property and must be depreciated. Repairs just fix stuff and can be deducted in the year they’re made.
If you make an improvement before a property is placed in service, the cost of that improvement can be added to your depreciable basis. If you make an improvement after you start using the property, that improvement is depreciated separately and NOT as part of the property.
Scenario: Catelyn’s Depreciation Allowance
Let’s look at an example.
Catelyn buys a commercial building for $800,000. Her closing costs are $60,000. She figures out that her land is worth $200,000. What is her annual depreciation allowance?
A fancy building with a glass exterior.
Step 1: Find the depreciable basis
We find her depreciable basis by adding the closing costs to the cost of the property, then subtracting the value of the land.
$800,000 + $60,000 - $200,000 = $660,000
Step 2: Insert recovery period
Since it is a commercial building, its recovery period is 39 years.
$660,000 ÷ 39 = $16,923.08
Final answer: Every year, Catelyn would depreciate her building by $16,923.08. This means that she can deduct $16,923.08 from her taxes every year.
Depreciation Recapture Tax
Warning, Anthony. Depreciation tax deductions are only half the story. When you go to sell your investment property, depreciation recapture tax comes due.
Depreciation recapture is taxed at 25% of the total allowable depreciation deductions. It is not 25% of the deductions you actually take. It is 25% of the deductions you could have taken.
Even if a taxpayer doesn’t claim depreciation on a property, they still have to pay the depreciation recapture tax when they sell it. 😳
How to Find the Annual Depreciation Allowance
Ok, we have one more calculation to learn for this level. Let’s power through!
Calculating the capital gain (or loss) on an investment property is really similar to calculating capital gain for a primary residence. The main difference is that you have to remember to deduct any claimed depreciation from your adjusted basis.
It would look like this:
Basis + Cost of improvements + Qualified closing costs - Realized depreciation = Adjusted basis
Don’t forget our other formulas for realized gain and capital gain:
Sales price - Selling costs = Realized gain
Realized gain - Adjusted basis = Capital gain
Scenario: Maria’s Investment
Maria is buying up investment properties. She snags an old building for $500,000 and puts $200,000 worth of work into it. Her closing costs are $10,000.
She rents it out to tenants for five years, claiming $20,654.55 per year in depreciation.
Five years on, she sells it for $1.3 million. It costs her $100,000 to sell it, including a 6% commission and closing costs.
What is her capital gain?
A row of older apartment buildings.
Step 1: Find the adjusted basis
To calculate Maria’s capital gains, we need to first find her adjusted basis.
We will use this formula:
Basis + Cost of improvements + Qualified closing costs - Realized depreciation = Adjusted basis
Note: We have to multiply $20,654.55 by five ($103,272.75) to get the realized depreciation figure for the formula because Maria rented out the property for five years.
The formula with numbers plugged in looks like this:
$500,000 + $200,000 + $10,000 - $103,272.75 = $606,727.25
Step 2: Find the realized gain
To find realized gain, we will use this formula:
Sales price - Selling costs = Realized gain
With the numbers plugged in:
$1,300,000 - $100,000 = $1,200,000
Step 3: Find the capital gain.
Finally, we need to find the capital gain, using this formula:
Realized gain - Adjusted basis = Capital gain
With the numbers plugged in:
$1,200,000 - $606,727.25 = $593,272.75
Final answer: The capital gain is therefore $593,272.75.
Wowee, that’s a lotta gain! Maria’s gotta get a tax shelter, as, remember, capital exemptions are only for when you sell your primary residence.
Calculating Capital Gains on Investment Property
Though investors can’t use the capital gains tax exemption, there are strategies they can employ to limit their tax exposure. As previously mentioned, these are called tax shelters, because they shelter your money from the roaring winds of the tax code.
One of the better-known tax shelters is the 1031 exchange, also called a tax-deferred exchange or like-kind exchange.
1031 Exchange: Like for Like
A like-kind exchange is the tax-deferred sale or exchange of one investment property for another similar one. It’s used when an investor wants to sell an asset and acquire a similar one while avoiding the capital gains tax.
Basically, a 1031 exchange lets an investor sell a property, reinvest the proceeds in a brand new property, and defer all capital gain taxes. This is a totally-legal-yet-kinda sneaky way to defer paying capital gains taxes when you sell an investment property.
It’s called a like-kind exchange because you’re exchanging a property for another property (or properties) like it.
How It Works
A taxpayer who sells an investment property and buys another within a stipulated time limit does not have to pay tax on the first sale. They will have to pay tax upon the sale of the second property… unless another like-kind exchange is done. In that case, the tax payment will be deferred again.
You’ll still have to pay eventually. Well, unless you die first, I guess. In that case, the IRS can pry those bucks from your cold dead hands.
Deferral of Depreciation Recapture
A like-kind exchange doesn’t only have tax-deferral benefits. It also allows the seller to defer that depreciation recapture tax. Remember, when you go to sell your investment property, depreciation recapture tax comes due. Not if you’re participating in a like-kind exchange, though!
Like-Kind Exchanges: The Basics
