Washington Real Estate Fundamentals
Lesson 14:
Federal Income Taxation
and Real Estate
© 2011 Rockwell Publishing
Basic Taxation Concepts
Progressive tax
Progressive tax: Taxpayers with higher
incomes are taxed at higher tax rates.
 Not only must pay larger tax amount,
must also pay higher percentage of
income in taxes.
 Federal income tax is a progressive tax.
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Basic Taxation Concepts
Progressive tax
Progressive tax contrasts with two other
types:
 Proportional tax: All income levels taxed
at same rate.
 Regressive tax: Higher income levels
taxed at lower rate than lower income
levels.
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Basic Taxation Concepts
Tax brackets
Tax rates increase in uneven steps called
tax brackets.
If additional dollar earned crosses line
into higher bracket, it’s taxed at higher
rate.
 But that doesn’t increase rate charged on
dollars previously earned.

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Basic Taxation Concepts
Income
For tax purposes, income includes more than
just salary or wages.
Income: Any economic benefit realized
by a taxpayer, unless specifically excluded
from income by tax code.
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Basic Taxation Concepts
Deductions and tax credits
Deduction: Expense that may be subtracted
from income before the income is taxed.
 Example: mortgage interest deduction
Tax credit: Amount taxpayer allowed to
subtract directly from taxes owed.

Tax credit represents greater savings
than tax deduction for same amount.
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Basic Taxation Concepts
Gains and losses
Gain: Results when taxpayer sells asset for
more than amount invested in it.
 Gain is taxable income unless tax code
provides specific exception.
Loss: Results when taxpayer sells asset for
less than amount invested in it.
 Loss is deductible only if tax code
provides specific deduction.
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Gains and Losses
Deductibility of losses
Business entities can generally deduct all
losses.
Individual taxpayer may deduct losses only if
connected with:
 taxpayer’s trade or business
 transaction entered into for profit
 theft or casualty loss of taxpayer’s
property
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Gains and Losses
Capital gains and losses
Capital gain or loss: Gain or loss from sale of
capital asset, which is property held for:
 personal use, or
 investment purposes

Capital gains are taxed at lower rate than
ordinary income.

Capital losses also receive special tax
treatment.
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Capital Gains and Losses
Deductibility of capital losses
Even though loss on principal residence or
other property held for personal use is capital
loss, not deductible.
Capital losses on property held for investment
purposes are deductible.
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Capital Gains and Losses
Net gain or net loss
Capital gains and deductible capital losses
are netted against each other.
Net capital loss may be deducted.
 But annual limit on amount that can be
deducted as net capital loss.
 Net losses over limit may be carried
forward and deducted in future years.
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Gains and Losses
Tax shelters
Tax shelter: Arrangement that allows
taxpayer to reduce taxes by deducting losses
from one source from gains (income) from
another source.
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Basic Taxation Concepts
Basis
To determine gain or loss on property
transaction, you must know taxpayer’s basis.

Basis: Property owner’s investment in the
property.
 Maximum amount taxpayer could
receive without realizing a gain.
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Basis
Initial basis
Initial basis: Original cost of acquisition.
 How much owner paid to acquire the
property.
 Typically purchase price plus closing
costs.
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Basis
Adjusted basis
Initial basis may be increased or decreased to
get adjusted basis:

start with initial basis

add capital expenditures

subtract allowable depreciation
deductions
When property sold, IRS will use adjusted
basis to calculate capital gain or loss.
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Adjusted Basis
Capital expenditures
Capital expenditures: Expenditures that add
to a property’s value or extend its life.
 Examples: remodeling, new roof
Maintenance expenses are not capital
expenditures.
 Examples: painting, fixing leaky plumbing
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Adjusted Basis
Allowable depreciation deductions
For certain types of property, taxpayer’s basis
also reduced by depreciation deductions
(discussed later).
Initial basis (acquisition cost)
+ Capital expenditures
- Depreciation deductions
Adjusted basis
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Basic Taxation Concepts
Realization
Gain not taxed as income until it is realized.

For income tax purposes, increase in
property’s value not realized until owner
sells or exchanges it.

Sale or exchange separates gain from
asset.
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Realization
Amount realized
Amount realized: All benefits received by
seller, minus selling expenses (such as
broker’s commission). Also called net sales
price.
 Benefits received may include:
 cash
 property seller received in exchange
 debt buyer is assuming from seller
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Realization
Calculating gain or loss
Amount realized
- Adjusted basis
Gain or loss
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Basic Taxation Concepts
Recognition
Taxes must be paid on gain in year it is
recognized.

Usually recognized in same year realized.

But nonrecognition provisions in tax code
permit exceptions in certain transactions.
 Taxpayer allowed to defer recognition
(and taxation) of gain until a later year.
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Summary
Basic Taxation Concepts
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Income
Deduction
Tax credit
Gains and losses
Capital asset
Initial basis
Adjusted basis
Capital expenditure
Realization
Recognition
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Classifications of Real Property
Basic tax classifications of real property:
 principal residence property
 personal use property
 unimproved investment property
 property held for production of income
 property used in trade or business
 dealer property
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Classifications of Real Property
Principal residence
Principal residence property: Home owned by
a taxpayer that he lives in most of the time;
also called main home.
 Taxpayer can have only one principal
residence at a time.
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Classifications of Real Property
Personal use property
Personal use property: Real estate owned for
personal use that is not taxpayer’s principal
residence.
 Example: vacation home
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Classifications of Real Property
Unimproved investment property
Unimproved investment property: Vacant
land that is held for appreciation and
produces no income.
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Classifications of Real Property
Property held for production of income
Property held for production of income:
Any type of property (residential, commercial,
or industrial) used to generate rental income
for the owner.
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Classifications of Real Property
Property used in trade or business
Property used in a trade or business: Land
and buildings a taxpayer owns and uses in
her trade or business.
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Classifications of Real Property
Dealer property
Dealer property: Property a taxpayer is
holding primarily for sale to customers.
 Example: subdivided land available for
sale to public.
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Nonrecognition Transactions
Taxpayer generally must pay tax on gain in
the year gain is realized.
But tax code allows recognition of gain to be
deferred to a later year in:
 installment sales
 involuntary conversions
 “tax-free” exchanges
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Nonrecognition Transactions
Installment sales
Installment sale: When seller receives less
than 100% of price in year sale occurs.

Buyer pays seller rest of price in
subsequent year(s).
 Nearly
all seller-financed transactions
are installment sales.
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Installment Sales
Deferral of taxation
With installment sale, only the part of the gain
seller receives in a particular tax year is taxed
that year.

Gain basically prorated over term of
installment contract.

Installment sale reporting permitted for all
classes of property except dealer
property.
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Installment Sales
Gross profit ratio
Amount of gain seller must report each year
is based on the gross profit ratio.

Gross profit ratio: Relationship between
seller’s gross profit and contract price;
also called gross profit percentage.

Gross profit: Difference between sales
price and adjusted basis plus selling
expenses.
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Installment Sales
Gross profit ratio
To calculate gross profit:
 start with the contract price (sales price)
 subtract seller’s basis at time of sale
 subtract selling expenses
To calculate gross profit ratio:
 divide gross profit by contract price
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Installment Sales
Example
Contract price: $300,000
Seller’s adjusted basis: $248,500
Brokerage commission: $18,000
Other selling expenses: $3,500
What’s the gross profit?
$300,000 - $248,500 - $18,000 - $3,500
= $30,000 gross profit
What’s the gross profit ratio?
$30,000 gross profit ÷ $300,000 contract price
= .1, or 10% gross profit ratio
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Installment Sales
Calculating the year’s gain
Principal payments received
× Gross profit ratio
Gain to be taxed that year

Gross profit ratio not applied to interest.
 Interest always taxed in year collected.
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Installment Sales
Example, continued
Gross profit ratio: 10%
In year of sale, seller received:
$27,500 downpayment
$2,067 in principal payments
$19,725 in interest payments
What’s the taxable income from the sale for this year?
$27,500 downpayment + $2,067 principal = $29,567
$29,567 × .10 = $2,956.70 recognized gain
$2,957 gain + $19,725 interest =
$22,682 taxable income for year of sale
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Nonrecognition Transactions
Involuntary conversion
Involuntary conversion: When property
converted into cash without owner’s voluntary
action.
May occur through:
 condemnation
 destruction
 theft
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Involuntary Conversion
May result in gain
Involuntary conversion often involves gain for
owner.
 Government or insurer compensates
owner.
 Compensation is based on property’s
current replacement cost or market
value.
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Involuntary Conversion
Deferral of gain
IRS allows deferral of gain if taxpayer
replaces property within allowed replacement
period.
 Replacement period: generally lasts for 2
years.
 Any gain not applied toward replacement
property will be taxed as income.
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Nonrecognition Transactions
“Tax-free” exchanges
Tax-free exchange: When real property is
exchanged for other real property and owner
allowed to defer recognition of gain.
 Also called a 1031 exchange.
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“Tax-free” Exchanges
Eligible types of property
Eligible for tax-free exchange:
 unimproved investment property
 property held for production of income
 property used in trade or business
Not eligible:
 principal residence
 personal use property
 dealer property
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“Tax-free” Exchanges
Like-kind property
To qualify, properties exchanged must be
like-kind properties.
 Real property must be exchanged for
other real property located in the U.S.
 Like-kind property not necessarily the
same type of real property.
 Example: apartment building can be
exchanged for unimproved land.
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“Tax-free” Exchanges
Boot
Boot: Anything received in an exchange other
than like-kind property, including:
 cash
 stock
 personal property
 debt relief (difference in mortgage
balances)
Boot recognized in year exchange occurs.
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“Tax-free” Exchanges
Example
Taxpayer who owns apartment building trades it for
office building.
Apartment building: $970,000 mortgage
Office building: $880,000 mortgage
How much boot is the taxpayer receiving?
$970,000 - $880,000 = $90,000 boot (debt relief)
Only the boot will be taxed in the year of the
exchange. Taxation of any other gain (if the office
building is more valuable than the apartment
building) will be deferred.
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“Tax-free” Exchanges
Basis in new property
As a general rule, taxpayer’s basis in property
that was traded away is transferred to the
property received.
 But if exchange involved boot, then
adjustments to basis are necessary.
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“Tax-free” Exchanges
Separate transactions
Two separate transactions: taxpayer sells
property to one party, then buys like-kind
property from another party.
 Once original (relinquished) property is
sold, taxpayer has 45 days to identify
replacement property.
 Purchase of replacement must close
within 180 days of sale of relinquished
property
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Summary
Property Types and Nonrecognition
• Principal residence
• Personal use property
• Unimproved
investment property
• Property held for the
production of income
• Property used in a
trade or business
• Dealer property
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Installment sale
Gross profit ratio
Involuntary conversion
Replacement period
Tax-free exchange
Like-kind property
Boot
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Sale of Principal Residence
Taxpayer can exclude gain on sale of a
principal residence.
 Not just deferred (as in exchange or
installment sale).
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Sale of Principal Residence
Limits on exclusion of gain
Exclusion of gain on sale of principal
residence is limited:
 $250,000 for individual taxpayer
 $500,000 for married taxpayer filing joint
return
Any amount in excess of $250,000 or
$500,000 taxed as capital gain in year of sale.
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Sale of Principal Residence
Qualifying for the exclusion
Within last five years, taxpayer must have:
 owned home for at least two years, and
 lived in it as principal residence for at
least two years.
 Only
one spouse must meet ownership test,
but both must meet use test.
 Exclusion
can generally be used only once
every two years.
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Deductions for Property Owners
Deductions: Subtracted from income
before tax rate applied and taxes calculated.
Deductions available to property owners:
 depreciation
 repairs
 property taxes
 mortgage interest
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Deductions
Depreciation deductions
Depreciation deductions: Allow taxpayer to
recover cost of asset over a period of years.
Also called cost recovery deductions.

Apply only to:
 property held for production of income
 property used in a trade or business
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Depreciation Deductions
Ineligible types of property
Depreciation deductions not available for:
 principal residence
 personal use property
 unimproved investment property
 dealer property
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Depreciation Deductions
Depreciable property
Assets are depreciable only if they will
eventually wear out and need to be replaced.
 Includes structures as well as equipment
for a farm or business.
 Does not include the land, which does
not wear out.
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Depreciation Deductions
Time frame
Entire expense of acquiring depreciable asset
can’t be deducted in year incurred.
 Expense deducted over a specified
number of years, depending on type of
asset.
 For most real estate, recovery period
between 27½ and 39 years.
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Depreciation Deductions
Depreciation subtracted from basis
Depreciation deductions subtracted from
initial basis to arrive at adjusted basis.
Initial basis
+ Capital expenditures
– Depreciation
Adjusted basis

Depreciation deductions subtracted even
if taxpayer did not take them.
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Deductions
Repair deductions
Repair deductions: Property owner may
deduct expenditures made to keep property in
ordinary operating condition.
 Not available for principal residence or
personal use property.
Capital expenditures (which add to property’s
value and may prolong its life) not deductible.
 Instead, these are added to basis.
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Deductions
Property tax deductions
General real estate taxes are deductible.
Special assessments:
 deductible if for maintenance or repairs
 not deductible for improvements
 Instead, added to basis (which
generally reduces taxable gain)
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Deductions
Mortgage interest deductions
Interest paid on a mortgage loan is deductible
for all types of property.

But there are limits on this deduction for
personal residences:
 principal residence
 second home
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Deductions
Mortgage interest deductions
For personal residence, taxpayer can deduct
interest paid on:
 Loan of up to $1,000,000 used to buy,
build, or improve home.
 Home equity loan of up to $100,000.

For married taxpayer filing separately,
limits are $500,000 and $50,000.
Interest on loan amount over limits not
deductible.
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Deductions
Deductibility of points and loan costs
Buyer may deduct origination fee and discount
points for new loan.
 Treated as prepaid mortgage interest.
 Even seller-paid points (but buyer’s
basis reduced).
 Fees lender charges buyer for specific
services not deductible.
Seller’s prepayment penalty also deductible as
form of interest.
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Summary
Exclusions and Deductions
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Exclusion for sale of principal residence
Depreciation deductions
Depreciable property
Repair deductions
Property tax deductions
Mortgage interest deductions and limits
Deductibility of points
Deductibility of prepayment penalty
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