Chapter 16
Federal Taxation and Real
Estate Finance
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Chapter 16 Learning Objectives
 Understand how the rules and regulations of federal
income taxation affect both the value of real estate
investments and financing decisions
 Understand how changes in the tax rules can alter the
return on real estate investment
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Tax Regulations and Their Effect on the
Value of Real Estate Investment
 Definition of income for tax purposes differs from BTCFs
 Non cash expenses are allowed (e.g. deduct depreciation)
 Interest payments on debt can be expensed
 The actual amount of taxes paid affected by:
 Differential tax rates on income and capital gains
 Offset of losses against other sources of income
 Providing for alternative minimum tax (AMTs)
 Establishing favorable classes of real estate investment (lowincome housing, historical structures)
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Classification of Real Property
 Property Held for Principal Residence
 Property Held for Investment
 Property Held for Resale to Others
 Property Held for Use in Trade or Business
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Property Held as Principal Residence
 Mortgage interest and property taxes are taxdeductible; maintenance costs are not
 Cannot depreciate
 Capital losses are not tax-deductible
 Capital gains exclusion of $250,000 ($500,000 for
married filing jointly) for one sale every two years
 Owned and occupied two out of the last five years
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Property Held for Investment
 Held strictly for income or investment and owner has
no participation in operations
 Generally unimproved land and net leases
 Limitations on interest deductibility
 Limitations of capital Loss write offs
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Property Held for Resale to Others
 Viewed as inventory
 Income is taxed as ordinary income (not capital gains)
 Owners treated as dealers
 Cannot depreciate
 Losses are operating losses
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Property Held for Use in Trade or Business
 Section 1231 asset
 Generally the most favorable classification
 Owned for the purpose of deriving income
 Can depreciate
 Operating expenses and mortgage interest are taxdeductible
 Capital losses are tax-deductible
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Tax Shelters
 A tax shelter is an investment whose value is
enhanced by tax rules and regulations
 Real estate has the potential of a tax shelter
 Tax rules may create value that otherwise would not
exist
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Real Estate Tax Regulations –
Definition of Income
 Taxable income differs from BTCF in the treatment of
depreciation and interest as expense
 Depreciation is a noncash outlay but a tax-deductible
expense
 The value of depreciation is the depreciation amount
times the investor’s marginal tax rate
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Depreciation - Depreciable Basis
 The Original Cost Basis is the purchase price (of land
and improvements) plus acquisition costs
 Land and the portion of acquisition costs attributable
to the land are not depreciable
 Depreciable basis is the original cost basis minus the
value of the land and land portion of acquisition costs
 Value of the land may be determined by independent
appraisal or by property appraiser’s office
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Depreciation - Cost Recovery Period
 Is the period over which depreciation can be taken
 Congress periodically alters the recovery period for
depreciation
 Recovery period is currently 27.5 years for residential
income property and 39 years for non-residential
income property
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Methods of Depreciation
 Pre-1981
 Straight-line (SL) method – depreciation is given by: 𝐷𝑡 =
𝐶
𝑛
 Double-declining method
 Sum-of-the-years’ digit method
 1981-1986
 SL depreciation and accelerated depreciation
 The accelerated cost recovery system (ACRS) provided accelerated
depreciation over a shorter time period (15-19 years)
 1986-1993
 Modified accelerated cost recovery system (MACRS) – eliminated
accelerated depreciation
 Residential properties depreciated SL over 27.5 years; commercial
properties depreciated SL over 31.5 years
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Methods of Depreciation
 1993-1997
 Top marginal tax rate of 39.6%; Max. CG tax rate of 28%; 39 years SL
depreciation for commercial real estate
 1997-2003
 Increased holding period for LT gains to 18 months; Max cap. gain rate of 20%
 Post 2003
 Max. marginal income tax rate lowered to 35%
 Max. tax rate for depreciation capture for section 1250 properties of 25%
 Max. capital gain rate of 15%
 2013
 Bush tax cuts from 2003 expired – maximum marginal income tax rate of 39.6%
 Max. capital gain tax rate of 20% (for 39.6% tax bracket)
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Calculating Depreciation
 The depreciation deduction can be calculated by
multiplying the depreciable basis by the depreciation
rate
 Mid-month convention assumes that the asset is put
into service (and sold) on the 15th day of the month
regardless of the actual day of occurrence
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Taxes and Interest Payment
 Original Issue Discount (OID) Rates
 Debt that is issued at a discount from the face value
 No coupons or payments over its life
 Incentive to convert ordinary income to capital gains
income when tax rates are different
 Use of large amounts of nonrecourse debt to sell
properties at inflated prices
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Interest Rate Rules
 Adequacy-of-Interest Test
 If the stated interest is less than 110% of the applicable
federal rate, an interest rate will be imputed at 120 percent
of the applicable federal rate
 Time Value of Money Test
 Even though payments may not be made annually the
interest must be calculated and reported annually
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Imputed Interest Rule
 Properties exempted from OID rules: sales of farms by
individuals for less than $1 million; residences under
$250,000; and transactions between related parties
under $500,000
 For properties exempted from OID rules imputed
interest rule applies
 Requires a fair interest rate to be charged or imputed
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Capital Loss Limitation
 Allows capital losses to be written off only against
capital gains
 Capital losses in excess of capital gains can be written
off against other income up to $3,000 annually
 Unused balance can be carried forward
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Passive Loss Limitation
 Instituted by the the 1986 Tax Reform Act
 Three categories of income:
 Active income: Earnings, etc.
 Portfolio income: Stocks, bonds, etc.
 Passive income: Real estate
 Losses are restricted to each category
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Passive Losses
 Passive losses cannot be used to offset income from
REITs and REMICs
 Includes non-active real estate activity, specifically
limited partnerships
 Loophole to be treated as active: AGI less than
$100,000 can deduct up to $25,000 in losses from
other income
 Is phased out at AGI of $150,000
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Tax-Deferred (1031) Exchanges
 Property must be held for use in trade or business or
for investment, owner-occupied residences do not
qualify
 Properties exchanged must be of like kind
 The exchange must occur; cannot sell for cash and
immediately purchase
 Properties adjusted basis will be equal
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Tax-Deferred (1031) Exchanges
 Types of 1031 exchanges
 Direct Exchanges
 Third-Party Exchanges
 Delayed Exchanges
 Boot - Property that is not like kind such as cash or debt
relief
 Identification period is 45 days
 Exchange period runs for 180 days
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Installment Sale
 Seller takes back a promissory note from the buyer
 Installment sale vs. outright sale
 Sale price is paid in installments
 Gross profit percentage is the proportion of capital
gain that is taxed each year
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Installment Sale
 Related persons rule
 If an installment sale is made to a related person who sells
the property within a two-year period, the original seller
must recognize the balance of the gain at the time the
related person makes the sale.
 Imputed interest rule applies
 Any down payment amount is allowed
 Debt amortization vs. installment period
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