Chapter 10

Fundamental Income Tax Issues

Tax Basis: Its Nature and Significance

Newly acquired property’s initial tax basis is starting point in determining income tax consequences of operating the property and, ultimately, the tax consequence of disposal

During holding period, tax basis is adjusted to reflect disinvestment or additional capital investment

Tax Basis: Its Nature and Significance

Selling or exchanging a property generates a gain or loss equal to the difference between the sales price and the adjusted basis of the property at the time of disposal

The Initial Tax Basis

Property acquired as gift, initial tax basis the same as donor’s, unless donor incurs gift tax liability

Property acquired by inheritance, initial tax basis is market value as determined for estate tax purposes

Property acquired by purchase, cost forms buyer’s initial tax basis

Allocation of the Initial Tax Basis

Two or more assets acquired together, initial tax basis must be allocated between them using ratio of their relative market value Specify price of each in original

purchase contract Use ratio of land value to

building value estimated by tax assessor

Have independent appraiser estimate relative value of land and buildings

Adjustment of the Basis in Cost Recovery

Depreciation allowance –An allowance of capital invested in improvements of property held for business or investment purposes.

Does not apply to property held for personal use or primarily for resale

Land, considered virtually indestructible, is not included in depreciation allowance computation

Adjustment of the Basis in Cost Recovery

Claiming tax deduction for cost recovery allowances reduces a property’s tax basis

Lower the adjusted tax basis when property is sold, the greater the taxable gain on disposal

Recovery of Building and Other Improvements

27.5 years for buildings intended for residential rental purposes

39 years for buildings intended for other allowable purposes

15 years for land improvements such as walks, roads, sewers, and fences

Recovery of Building and Other Improvements

Allowance for buildings are computed using straight-line method

Allowances for improvements on and to the land may be computed using the 150 percent declining balance method

Other Adjustments to the Tax Basis

Basis is reduced when portion of asset is sold or destroyed by casualties such as fire, flood, or storm

Owner’s tax basis is increased by expenditures that materially increase the property’s value or useful life

Transaction costs are added to the tax basis

Table 10.2

Tax Consequences of Ownership Form

Ownership by individuals Corporate Ownership Subchapter S Corporations Ownership in a general

partnership Limited partnerships Limited liability company

Tax Consequence of Property Sales

Adjusted tax basis at time of sale is the initial tax basis plus all additional capital investments, minus cumulative depreciation allowances, plus-or-minus certain other adjustments that may sometimes apply

Gain or loss on property’s sale is difference between the value of consideration received and the adjusted tax basis at the time of the transaction

Tax Consequences of Financial Leverage

Borrowing or repaying debts are not taxable events

Interest expense is usually tax-deductible in the year the interest is paid

Exception--prepaid interest is not deductible until actually earned by the lender

Tax Consequences of Financial Leverage

Construction period interest is special exception—must be capitalized; reflected in annual depreciation allowances

Deductibility of mortgage interest is limited by passive asset loss limitation rules

Strategy—borrow against equity rather than selling, as selling will trigger a taxable gain

Income Tax Credits for Property Rehabilitation

Tax credits – direct, dollar-for-dollar offsets against one’s income tax obligation

Expenditures to rehabilitate certain buildings qualify for a 10 percent rehabilitation tax credit

Limitations on Deductibility of Losses

Limited partner’s income and expenses from a partnership are always considered passive asset items

Real estate held for rental purposes is passive unless it is incidental to the primary business activity

Special exception for real estate investors who are not actively engaged in a real estate trade or business to deduct up to $25,000 of passive asset losses each year

Figure 10.1

Foreign Investors’ Taxes

Taxpayer who acquires a U.S. real estate interest from a foreign owner must withhold and remit to the IRS 10 percent of the gross sales price, unless Property is worth no more than

$300,000 and is to be used by purchaser as personal residence

Transaction is protected from taxation pursuant to a U.S. tax treaty

Seller or buyer obtains a certificate form the IRS that reduces the amount to be withheld

Foreign Investors’ Taxes

Buyer who fails to withhold the correct amount may be liable for the under-withheld amount, plus interest and penalties

Alternative Minimum Tax (AMT)

After figuring tax liability the regular way, taxpayers must perform an alternative computation, and pay taxes on whichever computation method results in the greater liability

Alternative computation tax credits, and many tax deductions, that are permitted in the regular computation must be excluded