Chapter 17: Income Tax in Real Estate Transactions

Three Classifications of Income

Active income, Passive income, and Portfolio income

Active income

Money earned through salaries or in a business in which the taxpayer actively participates.

(Example: a typical full-time job).

Passive income

Money earned from investing in a business venture or partnership.

(Example: income earned from a rental property).

Portfolio income

Money earned from Interest, annuities, dividends, and royalties.

(Example: income earned from investing in stocks, bonds, mutual funds).

Tax shelters

Any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments.

One of the advantages that real estate offers to investors

a tax shelter

tax shelter

which allows investors to only pay income taxes on a portion of their properties cash flow (or pay no taxes at all).

A 1031 tax-deferred exchange

an individual to defer capital gains taxes on real estate bought and sold for investment purposes.

In order to qualify for a tax-deferred exchange (1031 Exchange),

the properties must be “like-kind”.

example of “'like-kind” properties for 1031 Exchange

for example, commercial properties must be exchanged for other commercial properties.

This may be an office building for a shopping mall, an apartment building for a tract of land, or an office building for an apartment building

Depreciation

a paper loss required for estimated wear, tear, and obsolescence of a property.

who allows real estate investors to depreciate their investment properties?

the IRS

Residential buildings and improvements

are depreciable over 27.5 years using straight-line depreciation.

Commercial buildings and improvements

depreciate over 39 years using straight-line depreciation.

Straight-line depreciation

means that the portion allocated to the building is divided by 27.5 to determine an equal amount of depreciation allowance each year.

Adjusted Basis

the original cost or other basis plus certain additions and minus certain deductions such as depreciation and casualty losses.

Capital Gain

the profit realized from the sale of any capital investment including real estate.

Capital Gain

occurs when an investor sells the property for more than the adjusted basis.

Capital Gain Tax Break

A special exclusion in the IRS law gives home sellers a tax break on capitals gains when they are selling their home.

Capital Gain Tax Break

Home sellers may be eligible to exclude up to $250,000 if single or up to $500,000 if married of the capital gain on the sale of the residence.

The IRS allows homeowners certain deductions on their income taxes that include:

1) Property taxes: this applies to property taxes paid on a primary resident and second homes/vacation homes.

2) Mortgage interest

The following closing costs are NOT tax deductible:

1) Appraisal fees

2) Notary fees

3) Preparation costs for the mortgage

4) Mortgage insurance premiums

5) VA funding fees

Certain qualified individuals may be eligible for a partial exemption in their property taxes. These include:

– Veterans

– Senior Citizens

– Disabled

the STAR program

allows qualified owner-occupied, primary residences to be exempt from school property taxes.