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 contractor • Includes Construction Interest • Will not necessarily include developer’s profit 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 Less: 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 insurance) • 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 $520,528.21 (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 Adjusted 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% $520,528 Equals: Long–Term Gain* (@15%) $2,187,600 • 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% Recapture 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 3rd Party is Much more One get 1031 Third Party Deferral and the Common! 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 years • 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 FIRPTA • Taxation of Foreign Investors – Foreign Investors Real Property Tax Act – AKA FIRPTA • 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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