Kap Real Estate Chapter 18: Federal Income Taxation of Real Property Ownership

Question 1

Tax-Deductible Loan Expenses

Answer 1

• Loan discount points. Those that are prepaid interest to reduce the loan interest rate when acquiring a residence, not a refinance, are deductible in the year of purchase.
• Mortgage prepayment penalties. Rare in North Carolina.
• Mortgage insurance premiums. If certain income requirements are met.
• Some loan origination fees. If they are quoted as a percent of the loan amount and if paid to obtain the loan. (Brokers and buyers should check with their tax advisers before assuming that such fees may or may not be deductible.)
• Mortgage interest payments on a principal residence and second homes. As of 2018, for a principal residence, a second residence, or both, the total amount of acquisition debt for which interest can be deducted cannot exceed a total of $750,000.

Question 2

Real Property Taxes

1) when are they deductible?
2) deductions for real property taxes can be taken on

Answer 2

are deductible in the year paid

Deductions for real property taxes can be taken on a principal residence as well as on a second home; however, effective in 2018, the total of state and local taxes will be limited to a $10,000 deduction per year.

Question 3

Mortgage interest, property taxes, and repairs are tax-deductible items for homeowners. (t/f)

Answer 3

false

Mortgage interest and property taxes are tax-deductible, but homeowners cannot take a deduction for repairs.

Question 4

There are no limits on the amount of mortgage interest and property tax deductions for homeowners. (t/f)

Answer 4

false

There are limits on the amount of mortgage interest and property tax deductions for homeowners. Homeowners cannot write off the interest on more than a $750,000 loan amount and no more than $10,000 of property tax (and other state and local taxes)

Question 5

What is Capital gain?

Answer 5

the profits realized from the sale or exchange of property

If a person sells a painting for $10,000 that was acquired for $6,000, that person has recognized a gain, that is, income, of $4,000, and that income is taxable (unless specifically excluded by the tax code). So it is with the buying and selling of real property.

Question 6

short-term capital gain

Answer 6

profits from assets owned for 12 months or less

Question 7

long-term capital gain

Answer 7

A gain on a capital asset that has been held for more than one year, resulting in a more favorable capital gains tax rate is currently 20% (not the ordinary 39.6%)

Question 8

Cost Basis

Answer 8

is the owner’s initial cost for the real estate (purchase price plus allowable closing expenses)

Question 9

Adjusted Basis

Answer 9

The owner of a property can add to the cost basis, the cost of any physical capital improvements that add value to the property or prolong its life

Question 10

Amount Realized

Answer 10

(sales price minus allowable closing expenses) exceeds the property’s adjusted basis is the capital gain subject to taxation.

Question 11

capital loss

Answer 11

If the amount realized is less than the adjusted basis, a capital loss has occurred

Question 12

Purchase price + Allowable closing costs + Capital improvements =

Answer 12

Adjusted Basis

Question 13

Tax-Free Gains from Sale of Principal Residence

Answer 13

-capital gains—up to $500,000 for a married couple filing jointly and up to $250,000 for a single person or a married person filing singly—from the sale of a principal residence are excluded from taxation.

If a seller has gains that exceed the $500,000 or $250,000 limit, those gains will be currently taxed at the maximum 20% long-term capital gains rate.

Question 14

Tax-Free Gains From Sale of Principal Residence restrictions on this tax benefit (2)

Answer 14

(1) the seller must have occupied the property as a primary residence for two of the previous five years (residency does not have to be continuous)
(2) the exclusion is available only once every two years. Because of the first restriction, this exclusion of gain does not apply to vacation properties or second homes

Question 15

Residential homeowners who have sold their primary residence at a loss cannot write off the loss on their income tax the year following the sale. (t/f)

Answer 15

true

Residential property owners are eligible for capital gains tax benefits but cannot write off the loss on the sale of their residences

Question 16

To calculate the gain on a home, a property owner should determine its purchase price, the monies expended for improvements to the home, its sales price and any expenses associated with the sale. (t/f)

Answer 16

true

Question 17

installment sale

Answer 17

When a seller finances the sale of the seller’s property (as with the use of a contract for deed or purchase money mortgage), or when the seller is to receive all or some portion of the sales price in a year or years other than the year of sale. With an installment sale, the taxpayer is taxed on a pro rata portion of the total gain as each installment actually is received.

For example, if a taxpayer received a gain of $10,000 on a $100,000 contract price, her profit percentage would be 10%. If during the tax year she received $5,000 in principal payments, 10% of those payments would be taxable that year. Ten percent of $5,000 is $500. She would have to report a taxable gain of $500 in that tax year.

Question 18

Vacation Homes

Answer 18

But if the owner personally uses the property for more than 14 days per year, or for more than 10% of the number of days for which the property is rented, whichever is greater, certain deductions will be disallowed

Question 19

Tax Deferred Exchange

Answer 19

offers significant tax advantages because no matter how much a property has appreciated since its initial purchase, it may be exchanged for another property and the taxpayer may be able to defer taxes on the entire gain

Question 20

The requirements for a tax-deferred exchange (Section 1031 Exchange)

Answer 20

there must be a property transferred (relinquished property) and a property received (replacement property). These properties must be exchanged—they cannot be sold. Both the property transferred and the property received must be held for productive use in a trade or business or for investment

Finally, the properties must be like-kind properties. Essentially, the like-kind requirement is met when real estate is exchanged for real estate. An apartment building can be exchanged for an office building or gas station, and the exchange will still qualify as like-kind. The apartment building real estate does not have to be exchanged for an apartment building to qualify

Question 21

boot

Answer 21

Sometimes, a property is exchanged for another property that is worth substantially more or less money. When this happens, cash or personal property may be included in the transaction to even out the value of the exchange. The party receiving boot is taxed on the value of the boot at the time of the exchange.

Question 22

Depreciation (tax)

Answer 22

allows an investor to recover the cost of an income-producing asset by taking tax deductions over the period of the asset’s useful life

Question 23

Cost recovery deductions may be taken only on

Answer 23

personal property and improvements to land and only if they are used in a trade or business or for the production of income. Cost recovery deductions cannot be claimed on a principal residence or on land (technically, land never wears out or becomes obsolete).

Question 24

The amount of loss that may be deducted depends on the following factors per the Tax Reform Act of 1986:

Answer 24

• Whether an investor actively participates in the day-to-day management of the rental property or makes management decisions
• The amount of the loss
• The source of the income against which the loss is to be deducted

Question 25

Investors who do not actively participate in the management or operation of the real estate are considered

Answer 25

passive investors, which prevents them from using a loss to offset active income.

Question 26

The IRS rules permit residential property owners to depreciate a part of their homes that may be used for home offices. (t/f)

Answer 26

True

Question 27

Installment sales are a method of deferring the payment of capital gains taxes and is often used by owners of investment property. (t/f)

Answer 27

True

Question 28

If a homeowner itemizes deductions when filing a federal income tax return, which of the following expenses can probably be deducted?

A)
Depreciation, if taken on a straight-line basis

B)
Maintenance and improvement costs

C)
Principal payments on the home loan

D)
Interest payments on the home loan

Answer 28

D)
Interest payments on the home loan

Interest payments on the home loan. Depreciation, principal payments, and maintenance costs cannot be deducted on a federal income tax. Interest payments on a home loan may usually be deducted

Question 29

In 1992, a family purchased their house for $126,500. They made no major improvements during the time they owned the property. Recently, they sold the property for $162,275. What was their percentage of gross profit?

A)
77.95%

B)
28.3%

C)
128.3%

D)
49.7%

Answer 29

B)
28.3%

$162,275 sales price - $126,500 cost = $53,775 profit

$53,775 ÷ $126,500 = 0.283 = 28.3%

Question 30

Serena owns a vacation home and wants to deduct some of the expenses on her taxes. Which of these situations could disallow certain deductions?

A)
There are no expenses that may be deductible for tax purposes on a vacation rental.

B)
Serena uses the vacation property for one week every year for her personal use.

C)
Serena never uses the vacation property.

D)
Serena uses the vacation property for six weeks every year for her personal use

Answer 30

D)
Serena uses the vacation property for six weeks every year for her personal use.

If the owner personally uses the property for more than 14 days per year, or for more than 10% of the number of days for which the property is rented, whichever is greater, certain deductions will be disallowed.

Question 31

In North Carolina, the North Carolina Real Estate Commission (NCREC) suggests which of these regarding brokers giving advice on the eligibility of properties in a tax-deferred exchanges?

A)
Brokers are to advise all clients regardless of their experience with tax-deferred exchanges.

B)
Clients should be counseled to consult a tax adviser or attorney who has experience with such exchanges.

C)
Brokers are to advise clients in all aspects of a real estate transaction including tax-deferred exchanges.

D)
Brokers must ensure that the client conducting a tax-deferred exchange is exchanging like-kind real estate with like-kind. For example, exchanging an apartment building for an apartment building and not an apartment building for an office building.

Answer 31

B)
Clients should be counseled to consult a tax adviser or attorney who has experience with such exchanges

NCREC cautions brokers not to give advice about tax-deferred exchanges or the eligibility of property for such an exchange and instead have clients refer to a tax adviser or an attorney who has experience with such exchanges.

Question 32

To determine the adjusted tax basis of a principal residence,

A)
add the purchase price and the cost of improvements and special assessments.

B)
add money received for a casualty loss and depreciation.

C)
add the purchase price, the cost of improvements, and depreciation.

D)
subtract the costs of the survey, the appraisal, and repairs.

Answer 32

A)
add the purchase price and the cost of improvements and special assessments.

The owner of a property can add to the cost basis the cost of any physical capital improvements that add value to the property or prolong its life. This is the property’s adjusted basis. (Note that the cost of ordinary repairs or maintenance does not increase the adjusted basis.)

Question 33

The depreciation that is allowable on investment property as a tax deduction is

A)
straight-line depreciation.

B)
determined by appraisers using the cost approach.

C)
variable depreciation.

D)
determined by the owner

Answer 33

A)
straight-line depreciation.

The owner of an investment property gets a depreciation credit to recover the cost of the building. They do not get to depreciate, or cost recover the value of the land. The depreciation is straight-line depreciation on a schedule determined by the IRS, which means an equal amount of depreciation credit each year of ownership.

Question 34

An investor is selling a commercial property that is free and clear for a price of $875,000. The investor is planning on doing a 1031 tax-deferred exchange and acquiring another investment property. The investor decides to reinvest $800,000, but to keep $75,000 of the proceeds for other purposes. Which of these is TRUE?

A)
The investor may keep all or any portion of the funds. The portion the investor keeps and does not reinvest will be called “boot” and is taxable.

B)
The investor must still invest the $75,000 into real estate.

C)
If the investor keeps any funds from the sale, the entire amount of $875,000 may become taxable as a capital gain.

D)
The investor may not keep any of the proceeds and must reinvest the entire amount that he realizes from the sale.

Answer 34

A)
The investor may keep all or any portion of the funds. The portion the investor keeps and does not reinvest will be called “boot” and is taxable

Boot is the amount of proceeds that an investor does not reinvest in the replacement property. An investor may keep any portion she desires, but the portion kept will be taxed as a capital gain.

Question 35

A buyer purchased a home for $150,000 and financed $100,000. The equity has increased by $20,000. What is the percentage of gain in equity?

A)
25%

B)
40%

C)
20%

D)
30%

Answer 35

B)
40%

Amount received = base × rate

150,000 − 100,000 = 50,000 original equity

20,000 = 50,000 × rate

20,000 ÷ 50,000 = 0.40 or 40%

Question 36

The profit homeowners receive from the sale of their principal residence may be

A)
taxed at a lower rate because depreciation is deductible from each annual income tax return.

B)
subject to long-term federal income tax if the profit exceeds the excluded limits.

C)
excluded from taxation every year up to a statutory limit of $500,000 per married couple filing jointly.

D)
rolled over into the purchase of a more expensive property without any tax liability once every 24 months.

Answer 36

B)
subject to long-term federal income tax if the profit exceeds the excluded limits.

Under current tax law, capital gains—up to $500,000 for a married couple filing jointly and up to $250,000 for a single person or a married person filing singly—from the sale of a principal residence are excluded from taxation. If a seller has gains that exceed the $500,000 or $250,000 limit, those gains will be currently taxed at the maximum 20% long-term capital gains rate.

Question 37

When filing a federal tax return, capital improvements adjust

A)
the price.

B)
the basis.

C)
the market value.

D)
the assessed value.

Answer 37

B)
the basis

The owner of a property can add to the cost basis the cost of any physical capital improvements that add value to the property or prolong its life. This is the property’s adjusted basis

Question 38

An investor who does not want to pay capital gains tax when selling an investment property should consider

A)
claiming the investment property as his primary residence.

B)
using a 1031 tax-deferred exchange.

C)
not filing an itemized return.

D)
moving into the property for a year to get a primary residence exclusion.

Answer 38

B)
using a 1031 tax-deferred exchange

A 1031 tax-deferred exchange would allow the investor to defer paying capital gains until a later date

Question 39

Which expense is NOT tax deductible for homeowners?

A)
Property taxes paid for the home

B)
Mortgage interest paid on a home loan

C)
Repairs to the home

D)
Depreciation taken for a home office

Answer 39

C)
Repairs to the home

Repairs to the home are not tax deductible. Consult with a tax expert before claiming any costs of a home office

Question 40

Capital gain

A)
is calculated based on inflation.

B)
is taxable, but taxes can be avoided under some circumstances for homeowners.

C)
considers the mortgage balance of the property owner.

D)
is not taxable on investments.

Answer 40

B)
is taxable, but taxes can be avoided under some circumstances for homeowners

Under current tax law, capital gains—up to $500,000 for a married couple filing jointly and up to $250,000 for a single person or a married person filing singly—from the sale of a principal residence are excluded from taxation. There are restrictions on this tax benefit: (1) the seller must have occupied the property as a primary residence for two of the previous five years, and (2) the exclusion is available only once every two years.

Question 41

What is the maximum allowable gain from the sale of their long-time primary residence that may be claimed as tax exempt by a husband and wife filing jointly?

A)
$100,000

B)
$500,000

C)
$250,000

D)
$750,000

Answer 41

B)
$500,000

Taxpayers who sell their principal residences can take advantage of tax laws that took effect in May 1997. Under current tax law, capital gains—up to $500,000 for a married couple filing jointly and up to $250,000 for a single person or a married person filing singly—from the sale of a principal residence are excluded from taxation.

Question 42

Sally purchased a home for $150,000. A recent appraisal of her home shows it to be worth only $125,000 because of a recession in the area. What is her rate of loss if she sells her home today for $125,000?

A) 167%

B) 8.33%

C) 83%

D) 17%

Answer 42

D) 17%

$150,000 − $125,000 = $25,000 loss received

Amount received = base × rate

$25,000 = $150,000 × rate

$25,000 ÷ $150,000 = 0.1666 or 16.67%, rounded to 17%

Question 43

A 40-acre tract was sold for $2,200 per acre. The seller realized a 14.5% profit from the sale. What was the original cost of the tract?

A) $100,760.00

B) $75,240.00

C) $102,923.98

D) $76,855.90

Answer 43

D) $76,855.90

40 acres × $2,220 SP = $88,000 sales price (present value)

100% + 14½% = 114.5 = 1.145

$88,000 ÷ 1.145 = $76,855.895 = $76,855.90

Question 44

Five lots were bought several months ago for $20,000 each. During the next few months, the lots were surveyed and redivided into nine lots that sold for $17,000 each. What was the percent profit?

A) 53%

B) 65%

C) 47%

D) 33%

Answer 44

A) 53%

$20,000 × 5 lots = $100,000 original value; $17,000 × 9 lots = $153,000 present value - $100,000 =

$53,000 profit ÷ $100,000 original value = 0.53 = 53% profit

Question 45

When preparing an annual income tax return, a homeowner may be able to deduct all of the following EXCEPT

A) real estate taxes.

B) mortgage interest on a first home.

C) mortgage interest on a third home.

D) mortgage interest on a second home.

Answer 45

C) mortgage interest on a third home

Mortgage interest on a third home. While a homeowner may be able to deduct the mortgage interest on a first or second home, the Internal Revenue Service will not permit a deduction on mortgage interest on additional properties.

Question 46

Which of the following is not a tax deductible loan expense?

A) Loan discount points

B) Mortgage prepayment penalties

C) Mortgage interest payments on a principal residence

D) Interest paid on overdue taxes

Answer 46

D) Interest paid on overdue taxes

Interest paid on overdue taxes is not deductible.

Question 47

The effective gross income from an office-building property is $73,500, and the annual operating expenses total $52,300. If the owner expects to receive an 11% return on his investment, what is the value of the property?

A) $125,800

B) $668,181

C) $475,454

D) $192,727

Answer 47

D) $192,727

73,500 (EGI) − 52,300 (expenses) = 21,200 (NOI)

NOI = value × cap rate

21,200 = ? × 11%

21,200 ÷ 11% (0.11) = 192,727

Question 48

A couple sold their vacation home for $412,500. If they made a profit of 10%, what was the original cost of the property?

A) $371,250

B) $375,000

C) $453,750

D) $360,000

Answer 48

B)

$375,000

$375,000. $412,500 SP ÷ 1.10 [100% + 10% profit] = $375,000 original price

Question 49

Which of these regarding tax-deferred exchanges is FALSE?

A) Owners of a principal residence can use that residence in a tax-deferred exchange.

B) The tax is deferred, not eliminated, so whenever the investor actually sells the newly acquired property without the use of an exchange, the capital gain will be taxable.

C) Real estate investors can defer taxation of capital gains by exchanging property versus selling it and receiving taxable profit.

D) There must be a property transferred and a property received; these properties cannot be sold.

Answer 49

A) Owners of a principal residence can use that residence in a tax-deferred exchange

A 1031 tax-deferred exchange never applies to a principal residence. It is a tool to allow investors to sell investment property and replace it with another investment property and defer the capital gains tax that would normally be due and payable.

Question 50

Homeowners will be able to avoid capital gains tax on the sale of their residence if they

A) are 55 years old or older.

B) have owned and occupied the home for two years or more.

C) have owned the home for two years or more.

D) are married.

Answer 50

B) have owned and occupied the home for two years or more

IRS regulations exempt homeowners who have owned and occupied a home for two years or more from capital gains taxes on the sale of that home

Question 51

Federal income tax regulations allow a homeowner tax deductions for

A) real estate taxes.

B) hazard insurance premiums.

C) repairs and maintenance.

D) principal and interest.

Answer 51

A) real estate taxes

Real property taxes paid by a homeowner are deductible in the year paid. Deductions for real property taxes can be taken on a principal residence, as well as on a second home; however, effective in 2018, the total of state and local taxes will be limited to a $10,000 deduction per year

Question 52

What real estate-related charges can be deducted from income taxes?

A)
Points, insurance, taxes, annual interest

B)
Taxes, points, insurance

C)
Points, interim interest, HOA dues

D)
Origination fee, monthly interest, taxes

Answer 52

D)
Origination fee, monthly interest, taxes

Remember POIT: points, origination fees, interest, and taxes can be deducted. HOA dues and principal payments are not deductible from income taxes.

Question 53

Which of the following statements is TRUE about tax-deferred exchanges?

A)
Any boot that is received will be taxable.

B)
A taxpayer’s personal home can be used as an exchange property.

C)
The properties being exchanged must be of equal value.

D)
A retail property must be exchanged for another retail property.

Answer 53

A)
Any boot that is received will be taxable

Sometimes, a property is exchanged for another property that is worth substantially more or less money. When this happens, cash or personal property may be included in the transaction to even out the value of the exchange. This cash or personal property is called boot. The party receiving boot is taxed on the value of the boot at the time of the exchange.

Question 54

Anne purchased an office building for $490,000. She borrowed $400,000 and paid the balance in cash at closing. Six months later, she sold the office building for $690,000. What is her rate of return on equity?

A)
766.7%

B)
2.22%

C)
222.2%

D)
140.8%

Answer 54

C) 222.2%

$490,000 − $400,000 = $90,000 original equity

$690,000 − $490,000 = $200,000 profit received

Amount received = base × rate

$200,000 = $90,000 × rate

$200,000 ÷ $90,000 = 2.222 or 222.2%

Question 55

A building is valued at $100,000 using a capitalization rate of 8%. If an investor demands a capitalization rate of 10%, the value of the building will

A)
increase by less than 20%.

B)
decrease less than $10,000.

C)
increase by 20%.

D)
decrease more than $10,000.

Answer 55

D) decrease more than $10,000.

Rate × value = NOI

0.08 × $100,000 = $8,000

NOI ÷ rate = value

$8,000 (NOI) ÷ 0.10 (10%) = $80,000 value; a decrease of $20,000

Question 56

An unmarried man, age 38, sells his home of eight years and realizes a $25,000 gain from the sale. Income tax on this gain may be

A)
excluded from taxation.

B)
reduced by the amount of mortgage interest paid over the life of the
property’s owner.

C)
excluded from taxation if the man purchases a property with a value equal to or exceeding the adjusted basis of the previous residence.

D)
reduced by subtracting the depreciation of the property when compared to the reproduction cost of a like-kind improvement.

Answer 56

A)
excluded from taxation

Under current tax law, capital gains—up to $500,000 for a married couple filing jointly and up to $250,000 for a single person or a married person filing singly—from the sale of a principal residence are excluded from taxation

Question 57

A homeowner listed her real estate for sale at $100,000. If her cost was 80% of the listing price, what will her percentage of profit be if her real estate is sold for the listing price?

A)
25%

B)
15%

C)
10%

D)
20%

Answer 57

A)
25%

$100,000 SP ‒ $80,000 original price = $20,000 profit ÷ $80,000 original price = 0.25 = 25%