Income Taxes by 63QLrX


									Income Taxes – THE CODE!

 The Joys of dealing with the IRS, tax
      attorneys and accountants!
   Disclaimer: Things CHANGE
         3 Sets of Books!
• GAAP Statements
• Cash Statements
• And TAX
   Tax Basis

Every Asset Has One
                The Tax Basis
• The Tax Basis is the amount reflecting your
  “capital investment” in a property
• The Initial Basis is the purchase price, or the
  value at inheritance or gift
   – Includes commission, and other costs incurred that
     can’t be expensed
• Over time, the tax basis is adjusted for:
   – Capital contributions, depreciation, casualty and other
   Example of Initial Tax Basis
Shopping Center
• Purchase Price        $5,000,000
• Commission 1% (if        $50,000
  buyer pays)
• Legal Fees               $20,000
• Title Policy              $5,000
• Other closing costs        $150
      Initial Basis     $5,075,150
       Initial Tax Basis – Newly
           Constructed Basis
• Basis for Developer
• Will equal total cost including profit if to
• Includes Construction Interest
• Will not necessarily include developer’s
           Allocation of Basis
• Two Issues
  1. Between Land and Improvements
     • Because can’t depreciate land
     • Acceptable Rule of Thumb?
  2. Multiple Properties – one contract
• Acceptable methods
  – Prices specified in contract
  – Based on Tax Assessed Values
  – Based on an Appraisal
   Why do we need the basis? To calculate depreciation!
          Depreciable Life
• Currently:
  Apartments – 27.5 Years
  Other Commercial – 39 years
  Land Improvements – 15 years
  Tenant Improvements – varies
  Equipment - varies
          Depreciation Example
• Apartments                    • Industrial
• $5,075,150 Price
                                • All the same except
• 15% is land value
• Depreciable Amount=             now the denominator
   – $5,075,150*.85 or            is 39 on annual basis!
          $4,313,877.50            or $110,612.24 per year
   Divide by 27.5 Years            and $9,217.69 per month*
     =$156,868.27 per year or
     by 330 months
   =$13,072.35 per month        * part year do monthly, part month is
                                    half rate no matter the date of
                                    purchase or sale
   Calculating Taxable Income
• IRS Allows deduction of some non-operating
  expenses so:
      Net Operating Income (not forecasted but actual)
      Less: Interest Expense
      Less: Depreciation
      Equals: Taxable Income

NOTE: Interest during construction is capitalized
 and Point are amortized over the life of the loan!
  Example: Calculating Income
     Tax or (Tax Savings)
                             Year 1    Year 2   Year 3   Year 4   Year 5   Year 6

Net Operating Income         759,200 873,000 933,800 928,700 969,100 1,010,600
Interest *                   410,443 401,356 391,514 380,856 369,312       356,811
Depreciation **              215,273 215,273 215,273 215,273 215,273       215,273

Taxable Income               133,484 256,371 327,013 332,571 384,515       438,516
Tax Rate               35%
Income Tax (savings)          46,719   89,730 114,455 116,400 134,580      153,481

* (Loan $5,180MM @8% 20 Yrs)

** (Value $7,400M, 20% Land)

    PV 5,180,000, I = 8%/12,n=20*12, Solve for PMT
    1st years interest enter 12 <f> amort gives interest
    Switch x&y and get amortization
               After Tax Cash Flow
                            Year 1    Year 2    Year 3    Year 4    Year 5

Effective Gross Income     1,500,000 1,636,200 1,718,000 1,741,000 1,802,000

Total Operating Expenses    740,800   763,200   784,200   812,300   832,900

Net Operating Income        759,200   873,000   933,800   928,700   969,100

Debt Service                519,900   519,900   519,900   519,900   519,900

Before Tax Cash Flow        239,300   353,100   413,900   408,800   449,200

Income Tax (savings)         46,719    89,730   114,455   116,400   134,580

After Tax Cash Flow         192,581   263,370   299,445   292,400   314,620
       What is “Tax Savings”
• Amount you can credit against future taxes
  – See Table 10.2 Line 21

• Not necessarily real savings but a deferral
  of future tax payments. We don’t
  distinguish on NPV basis.
       Disclaimer Reminder
• The Tax Code is always changing

• Example: What if Congress decided to
  change depreciation to 10 years?
         Capital Gains
             Rules of Thumb:
a) On sale
b) None if assets held for resale as part
   of business
c) On recapture of depreciation
d) Short term < 1 year otherwise Long
       IRS Class of Real Estate
• Personal Residence
   – Can’t depreciate but no capital gains taxes!
• Dealer Property – for sale to others
   – Considered inventory and no depreciation
   – No gain on sale all ordinary income
   – Home builders/lot developers
• Trade or Business Property (sec 1231)
   – Almost all property and depreciate

  Some get a depreciation deduction and some don’t!
Calculating Gain (Loss) on Sale

   The Initial Basis does not stay static
         with rental real estate!
             Adjusting the Basis
• The Basis is Reduced for:
   – Accumulated Depreciation
   – Partial Sale of Asset
   – Partial Destruction of Asset      (offset by any compensation from
• The Basis in Increased for:
   – Capital Expenditures that increase value or useful life
      • If deductible not a capital item
      • Has own depreciation schedule
      • Transaction costs at upon sale
         Example of Adjusted Basis
Shopping Center – Initial Basis        Shopping Center – Adjusted Basis
• Purchase Price      $5,000,000       Calculate Accumulated Depreciation
                                            $5,075,150 * .8 / 39= $104,105.64 /yr * 5 yrs=
   Commission 1%          $50,000
    (if buyer pays – zero if seller)
                                       Deduct from Initial Basis
•   Legal Fees           $20,000
                                          Initial Basis      $5,075,150
•   Title Policy          $5,000          Acc. Dep.            $520,528
•   Other closing costs    $150                              $4,554,622
•   Initial Basis     $5,075,150       Add ALL
                                       Purchase (Sale) Costs     $87,250
• What is the adjusted basis after     Adjusted Basis =     $ 4,641,872
  5 years assuming 80%
  depreciable (land is 20%) and
  sales costs are $87,250?
      TAXABLE Realized Gain
•   Adjusted Basis used in calculating Gain NOT Initial Basis

Sales Price              $7,500,000
Selling Costs               150,000
Basis                     4,641,872
Realized Gain            $2,708,128

    *Sale occurring at end of 5th year
  Gain Split into Different Types
Total Gain                                      $2,702,128
Less: Unrecaptured Depreciation (@25%
Equals: Long–Term Gain* (@15%)
• Accumulate Depreciation = Unrecaptured Depreciation
        Calculation of Taxes
Unrecaptured Depreciation (@25%)
     $520,528 * .25 =              $130,132
Long – Term Gain (@ 15%)
      $2,187,600 * .15=             328,140
Total Taxes Due                    $458,272
    After-Tax Cash Flow from Sale
•   Sales Price            $7,500,000
•   Less: Selling Costs 2%     150,000
•   Less: Taxes                458,272
•   Less: Mortgage Balance $ 4,533,825*
•   Equals: ATCF           $ 2,357,903

    *pv=$5,180,000, I=8%/12,n=20*12,PMT then 60 <f>amort,
    X/Y= total amortization. PV-amortization= Balance
  Taxes Rates – Why it matters

Ordinary Rates 10% 15% 25% 28% 33% 35%

Rates on gains
               10% 15% 25% 28% 33% 35%
held <12mo.
Rates on gains
               10% 10% 15% 15% 15% 15%
held >12mo.
Rate on
Depreciation   10% 15% 25% 25% 25% 25%
 IRS Categories: Income & Loss
• Active
   – Salaries, wages, fees but not Rental RE
   – Income from hotel or nursing home
• Passive
   – Rental Real Estate! Even if materially participate!
   – Limited Partnership income
• Portfolio
   – Stock dividends and bond interest
   – Some net leases where don’t materially participate

 Generally speaking similar losses offset similar gains
       Casualty Loss Example
     Shopping Center – tenants have fire

Current Tax Basis         $3,000,000
Fire Damage (50%)         (1,200,000)*
Insurance Payment after    1,100,000*
    deductible $100,000
Adjusted Basis            $2,900,000

                          *Cost to rebuild may have no relation
                             to value or historical cost – all
                             depends terms of policy
Other Notable Tax Issues

   See Appendix D for help!
         Like Kind Exchanges
• Used VERY frequently by investors
• Why? Mechanism that allows the DEFERRAL
  (not avoidance) of taxes
• AKA 1031 Exchanges
• Tax basis of sold property essentially carries over
  to acquired property

Cash Sale – Gain is recognized and realized or due
  in the year of the transaction
1031 – Gain may be realized in year of transaction,
  but not recognized until a later date.
     Tax Basis on Simple Trade
• Sam Student has a             • Basis is:
  property with adj. tax        Old Basis          $45k
  basis of $45k. He will        Other Consideration –0-
  receive property worth        Costs                1k
  $60k and costs are $1k:       New Basis          $46k
   MV of New $60k
                                • Alternatively:
   Less: Tran Cost 1k
                                MV of new            $60k
   Less: Basis     45k
                                Less: Realized Gain 14k
   Realized Gain 14k
   Recognized -0-!              Plus: Recognized Gain –0-
                                New Basis            $46k
         Note: Only difference is
         cost to get deal done!
Two vs. Three Party Exchanges
           Direct Swap Between Two Owners
                     X’s property
       Owner X       Y’s property    Owner Y

         Two-Way Exchange w/ 3rd Party Buyer
                   Y’s property
       Owner X     X’s property
                                    Owner Y

                          Cash          X’s property
   Party is
 Much more                                  One get 1031
                     Third Party            Deferral and the
                                            Other does not!
Typical Like Kind Activity
         1031 Exchange Rules
• Only investment property or that used in trade or
  business can qualify
• A real trade must take place
   – Does not have to be simultaneous
      • Find substitute property within 44 days & complete in 179
• Real Property for Real Property and nothing else!

   OK                               Not OK
   Ranch for Mall                   Mall for Stock
   Mineral Interest for Land        Mineral Interest for Cattle
     Example of Tax Effect #1
• LeBraun will trade A       • Farve will trade B
Property Value $650k         Property Value $900k
Cash            250k         Cash               -0-
Equity Value $900k           Equity Value $900k
Brett Favre has to pay taxes on $250k – why?
Cash is not like-kind asset and is taxable (The taxable part
of a 1031exchange is called Boot – no idea why.)
LeBraun James pays no tax at this time.
After the transaction, what is LeBraun’s basis in Property
B and Farve’s Basis in Property A?
LeBraun = $900k and Farve = $650k – see next slide for help!
           Basis on a 1031
• Basis of Old Property
• Plus:
  – Additional Consideration Paid
  – Transaction Cost
• Less: Additional Consideration Received
• Equals: New Basis
     Example of Tax Effect #2
• LeBraun                    • Farve

Property Value $650k         Property Value $900k
Mortgage        100k         Mortgage        350k
Equity Value $550k           Equity Value $550k

Agree to swap since value is the same. Each agrees to
assume the respective mortgages.
Farve has to pay taxes…why?
      Example of Tax Effect #3
• LeBraun                      • Farve
Property Value $650k           Property Value $900k
Mortgage        100k           Mortgage        450k
Equity Value $550k             Cash            100k
                               Equity Value $550k

To “even out” this trade, Farve agrees to pay 100k.
Farve pays on $250k, why?
What does LeBraun pay on?
       Tax Basis in New Property
•    Mr. Trader has:                  MV of Prop. Rec. $975k
Property value $850,000               Less: Basis Old    450k
Mortgage       (300,000)              Less: Cash         100k
Equity         $550,000
                                      Less: Debt Relief 25k
•    Mr. Trader receives:
                                      Less: Tran. Cost    25k
Property      $975,000
Mortgage      (325,000)               Realized Gain      375k
Equity        $650,000                New Basis:
1.   What cash is he likely to pay    MV of Prop. Rec. $975k
     to “even out” trade?             Less: Realized Gain 375k
2.   If transaction costs are $25k,   Basis               $600k
     & his adj. Tax basis is $450k,       Or think of it this way
     what is realized gain?               Old Basis:             $450
                                          Plus: Increase in debt 25
3.   What is new basis?                   Transaction Cost         25
                                          Cash                    100
   What about Capital Losses?
• In 1031 Exchange, can’t recognize
• Any losses are added to the new property’s
  tax basis
And Finally….
            Installment Sales
• Payments for a property occur over a number of
• Allows seller to “finance” a property without
  incurring a liability in the first year
• Allows for deferral of taxes to future years
• Simplistically recognize gain in proportion to
  payments received each year
• Can be complicated depending on depreciation
  methods utilized.
        Inheritance and Gifts
• Inheritance – may be inheritance taxes
  – Property tax basis is “stepped-up” to the
    market value at the time of death.
• Gifts – limitations on the amount of gift
  each year ~ $13,000 per person
  – Property tax basis is either the same as the
    giver’s or the giver’s basis plus gift tax paid
• Taxation of Foreign Investors
   – Foreign Investors Real Property Tax Act
• When active in trade or business foreigners are
  taxed in home county
• FIRPTA is attempt to collect some taxes
• Note: BUYER must withhold 10% of sales
  proceeds or you could be liable so always make
  sure you seller is not foreign!
(Strong Lobbying to Eliminate at the moment)
              Bottom line!
• Always consult with an accountant to
  determine your best tax strategy
• And don’t forget your attorney either.

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