Chapter 20. Federal Income Taxation. IRS Tax Classifications. IRS Tax Classifications. Taxation of Individuals & Corporations

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1 Fedeal Income Taxation Chapte 20 Income Taxation and Value Whethe you like it o not, you have a silent patne who shaes in you entepise If RE investos ae successful, fedeal (& usually state) govenment shaes in that success If RE investos lose, fedeal govenment may not shae in losses In any event, income taxes have a significant effect on etuns that can ultimately be consumed o invested by investo/taxpaye Result? Maket values/pices significantly affected by tax law McGaw-Hill/Iwin Copyight 200 by The McGaw-Hill Companies, Inc. All ights eseved Taxation of Individuals & Copoations The double taxation of income endes C copoations a less desiable fom of owneship than flowthough entities such as LLCs and LPs We theefoe focus on the taxation of individuals whose investment in RE via flowthough entities Fo IRS guidance on Special Allocations see p---audit-technique-guide---chapte-6---patneship- Allocations-%28Revised %29 IRS Tax Classifications fo Real Estate RE held as a pesonal esidence RE held fo sale to othes (deale popety) E.g. Homebuilde (teated as inventoy) RE held fo use in tade o business (section 23 assets) E.g. most investment eal estate (NOI) RE held fo investment E.g. Raw land (capital appeciation) IRS Tax Classifications Impotant because they: Detemine if depeciation is allowed Pesonal esidences & deale popety can t be depeciated May affect taxes due on sale Net gains fom sale of tade o business popety (held fo a yea) ae taxed at capital gain tax ates Net losses on tade o business popety ae deductible w/o limit against odinay income IRS Tax Classifications Investment popety Losses on sales of investment assets ae geneally limited Geneally can t be depeciated Is ental RE investment popety p o tade o business (Section 23) popety? In geneal - Section 23 IRS website

2 Income Subject to Taxation Active Basket Potfolio Basket Passive Basket + Salay Income + Consulting Income + Sales Commissions = Net Active Income Taxed at odinay ates + Inteest + Dividends + Annuities + Cap Gains on Stocks - Inteest incued in Poducing Income = Net Potfolio Income Taxed at odinay o capital gain ates + Taxable Income fom Business in which no Mateial Paticipation + Any Rental Income - Any Expenses fom Poducing Rental Income = Net Passive Income Odinay, capital gain, and/o ecaptue ates Passive Activity Loss Restictions Taxable income & losses on all passive activities ae fist netted If net passive income is negative, it cannot be used to offset active o potfolio income Passive losses not used ae caied fowad until taxpaye has sufficient passive income to deduct defeed losses To use losses fom one passive investment, taxpaye needs othe passive activities that ae poducing positive taxable income i.e., PALs need PIGs Impotant Exemptions Tax Rates on Single Taxpayes $25,000 exemption fo taxpayes with AGI < $00,000 Copoations not subject to PAL estictions If taxpaye s pimay business is eal estate (at least 750 hous pe yea), net tax losses fom RE ental activities may be used to offset income fom poviding the following RE sevices: Development, Constuction, Acquisition, Management, Bokeage, Leasing, and othes Tax Rates on Maied Taxpayes Aveage vs. Maginal Tax Rates If a single taxpaye has $50,000 in taxable income, total fedeal tax = $4, ($50,000-$33,950) = $8, Maginal Rate: = 25% Aveage Rate: $8,697.50/$50,000 = o 7.4%

3 Estimating Tax Liabilities fom Opeations: Exhibit 20-3 Investos ae concened with CFs, but tax calculations ae equied to get to the net CFs eceived by investo Any eseves (i.e., non-cash set asides) fo CAPX would also be added back in the cash calculations 20-3 Cost of Motgage Financing Motgage inteest is geneally deductible in the yea in which it is paid Repayment of loan pincipal is not Up-font financing costs on tade o business popeties o investment popeties ae amotized ove life of loan If loan is pepaid befoe up-font costs ae fully deducted, emaining costs can be deducted in yea of sale 20-4 Witing off investments ove time Depletion Depeciation Amotization Calculating Tax Depeciation What is "conceptual" basis fo tax depeciation? What detemines amount of tax depeciation?. Oiginal depeciable basis 2. Cost ecovey peiod 3. Method of depeciation Depeciable Basis of Existing Popety Stating point is oiginal cost basis, which is equal to total acquisition pice of popety: Land, building, & pesonal popety Oiginal depeciable basis fo existing popety: Oiginal cost basis - land value Depeciable basis of the eal popety: Oiginal depeciable basis minus value of pesonal popety Cost Recovey Peiods Cost ecovey peiods fo eal (not pesonal) popety: 27.5 yeas fo "esidential" income popety 39.0 yeas fo "non-esidential" income popety (3.5 if placed in sevice befoe May 3, 993) Distinction between esidential & nonesidential income popety? Does not apply to hotels and motels Eighty pecent ule if 80% of goss ents ae esidential, the building qualifies as esidential

4 Methods of Depeciation Staight-line method Staight line ate Fo 27.5 yea esidential: Staight lineate 27.5 cost ecovey peiod , o 3.636% Methods of Depeciation Declining balance methods (i.e., acceleated) Acceleated ate % facto x cost ecovey peiod Fo 50% declining balance & 5-yea ecovey peiod: 50% declining ate.50 x Depeciation of Pesonal Popety Depeciation Ceates Tax Shelte Cost ecovey peiods fo pesonal (not eal) popety: Capeting & dapeies: 3 yeas, 200% declining balance. Office equipment & fixtues: 7 yeas, 200% declining i balance. Landscaping & sidewalks: 5 yeas, 50% declining balance What is cost segegation? Owne s view IRS view Rental Income Owne s Cash Flow Loan Payments (Inteest only Loan) Opeating Expenses Yea Taxable Cash Flow Depeciation Loan Payments Opeating Expenses Yea Othe Taxing Issues Opeating expenses vs. capital expenditues Substantial impovements Capital expenditues made afte initial puchase ae teated as a sepaate building o impovement Cente Point Office Building Assumptions contained in Exhibit % of $885,000 pice (oiginal cost basis), o $708,000, is allocated to depeciable eal popety 20% allocated to land (i.e., no pesonal popety) Investo in 30% tax backet Total up-font financing cost of $9,92.5 ($663,750 x 0.03) is amotized ove loan tem (30 yeas)

5 Cente Point Office Building: Estimated Taxes Fom Opeations Cente Point Office Building Assuming, fo simplicity, that CAPX ae added to tax basis but not depeciated Estimating Tax Liabilities fom Sale Fully Taxable Sale Fully taxable tansactions When selle eceives full payment in yea of sale Tax-defeed tansactions Installment sales Section 03 like-kind exchanges Impotant!! Includes land Total gain/loss (TG) is NOT equal to BTER!!! Types of Income Geneated by a Sale All taxable income fom popety sales must eventually be classified as eithe: Odinay income 35% maximum ate Capital gain income 5% maximum ate Depeciation ecaptue income 25% maximum ate Good News and Bad News at Sale of Investment Real Estate Acquisition Cost Appeciation Acquisition Cost: Pice plus othe acquisition expenses Net Sale Pice Net Sale Pice: Pice less expenses of sale Long-tem Capital Gain Taxed favoably Total Depeciation Claimed Taxed unfavoably Depeciated Value Yea

6 Tax Rates on Income Fom Sale Adjusted Tax Basis: Cente Point Odinay Rates (203) Capital Gain Depn Recaptue Taxes Due on Sale: Cente Point Afte-Tax Equity Revesion: Cente Point Note: Total Taxable Gain is $37,465, which is less than the BTER!!! Components of Taxable Gain on Sale Effects of Debt & Taxes on IRR & NPV Why.2% afte-tax discount ate?.2% = 6.0% ( 0.30) Afte-tax oppotunity cost always < befoe-tax

7 203 Tax Rate Change Two pimay effects fo wealthy eal estate investos Sutax of 3.8% fo Obamacae Highe ates on odinay income and capital gains % Incease Max Odinay Max Cap Gain Max Depn Recaptue Tax Cedits Tax law allows taxpayes to take cedits fo ehabilitation of olde & histoic stuctues constuction & ehabilitation of qualified lowincome housing Unlike a deduction, a cedit is a dolla-fo- dolla eduction in tax liability (not taxable income) A $ deduction fo investo in a 30% tax backet saves $0.30 in taxes A $ cedit save $.0 in taxes Rehabilitation Tax Cedits. 0% one-time cedit may be taken on qualified ehab expenditues on nonesidential stuctues put in sevice befoe % one-time cedit may be taken fo ehab expenditues on esidential o nonesidential stuctues so long as they ae at least 50 yeas old, and listed on National Registe of Histoic Places o located in a egisteed histoic distict Cedit educes $ fo $ the depeciable basis Low Income Housing Tax Cedits LIHTC is a fedeal tax cedit povided to taxpayes who develop o acquie affodable ental housing Cedits ae allowed each yea fo 0 yeas and ae in addition to egula depeciation deductions Ceated by Congess in 986, what did the LIHTC eplace? HUD website on LIHTC LIHTCs: How Ae They Administeed? LIHTC is govened by fedeal tax code but administeed by state housing authoities Maximum amount of fedeal tax cedits each state could appove in 2005 = $.85 x state population Pe capita allocation fo LIHTC = $2.00 in 2008 Amount is indexed to inflation LIHTC: How is it Calculated? Fo new constuction not eceiving othe fedeal subsidies Cedit is 9% of qualified basis Fo acquisition of existing buildings o new constuction cti n eceiving in othe fedeal subsidies Cedit is 4% of qualified basis PV of cedits can be as much as 70% of total acquisition costs

8 Methods of Defeing Taxes on Disposition Installment sale Selle allows buye to pay puchase pice ove a numbe of yeas Selle collects down payment & then loans buye emainde of puchase pice Because selle eceives poceeds ove a # of ys, IRS allows selle to pay taxable gain ove an equal # of ys Speading tax payments ove seveal ys usually educes PV of tax liability Downside? Selle s oppotunity cost of waiting fo the sale poceeds Methods of Defeing Taxes on Disposition Like-kind exchange Sections 03 of Intenal Revenue Code allows ownes of RE, unde cetain conditions, to exchange popety fo othe popety & avoid paying taxes at the time of tansaction Note: taxable gain is defeed, not eliminated Like-kind exchanges have become commonplace in ecent yeas Tax Factos Affecting Homeownes Deduction of Motgage Inteest: Benefit is popotional to owne s maginal tax backet Afte-tax cost of pmt = pmt - tax savings = pmt - (inteest x tax ate) Tax Advantages of Home Owneship: Motgage Inteest Deduction Pincipal Monthly Loan Payment Inteest Note: The itemized deductions of uppe income household ae phased out Reduction of inteest cost though income tax deduction Tax Factos Affecting Homeownes Deduction of Popety Taxes: Assume: 2,000 in taxes; 28% maginal tax ate Afte-tax cost of pmt = pmt - tax savings = $2,000 - ($2,000 x 0.28) = $,400 Tax Advantages of Home Owneship: Popety Tax Deduction Annual Popety Tax Payment Reduction of popety tax cost though income tax deduction

9 Tax Factos Affecting Homeownes Exclusion of Capital Gains Tax fo Homeownes Individuals can exclude $250,000 ($500,000 fo maied filing jointly) of taxable gain ealized on sale of pesonal esidence To qualify, taxpaye must have owned & used popety as his/he/thei pesonal esidence fo at least two yeas duing pio five yeas befoe sale Tax Factos Affecting Homeownes Discount Points Paid at Oigination Fully deductible in yea paid Discount Points Paid on Motgage Refinancing Amotized ove life of loan Oh Othe "Closing Costs" Chaged by the Lende Added to tax basis (i.e, not deductible) Examples: Oigination fee, cedit checks, popety appaisal, lende's attoneys fees Costs Associated with Acquiing Popety (Not the Motgage)? Deduction of Motgage Inteest is Not Pimay Homeowne Tax Benefit Assume household has $400,000 in wealth invested at aveage ate of 7%, geneating $28,000 in investment income. Household puchases $200,000 home with all cash Tax effect? TI educed by $4,000 (0.07 x $200,000) 2. Household puchases $200,000 home with $40,000 cash & $60,000, 7% motgage Tax effect? TI educed by $4,000 $ 2,800 = decease in invest. income (0.07 x $40,000) $,200 = int. deduction (0.07 x $60,000) $4,000 = Total eduction in taxable income Deduction of Motgage Inteest is Not Pimay Homeowne Tax Benefit So.if cost of motgage is appoximately = boowe's oppotunity cost of invested equity (a easonable assumption), eplacing equity financing with moe debt financing does NOT educe tax liabilities Moeove, phase-out of itemized deductions fo highe income households may actually cause, at some LTV, equity financing to be pefeed to debt financing So.What is Pimay Tax Benefit of Owne- Occupied Housing? The nontaxation of etun on equity. Peiodic implicit ental income is not taxed if you own a home & ent it to youself Capital gains ae, effectively, not taxed End of Chapte