FEDERAL INCOME
TAXATION
LEARNING OBJECTIVES
 Incorporate tax considerations into the
discounted cash flow analysis.
 Distinguish between active, passive, and
portfolio income.
 Explain the federal income tax treatment of
mortgage financing and depreciation.
FEDERAL INCOME
TAXATION
LEARNING OBJECTIVES
 Discuss the differential tax treatment of
ordinary versus capital gain income and
ordinary versus capital assets.
 Explain the primary methodologies employed
to defer, reduce, and/or eliminate tax liabilities.
FOUR CLASSES OF REAL
PROPERTY
 Real estate held as a personal residence.
 Real estate held for sale to others--dealer
property.
 Real estate held for use in a trade or business--
trade or business property.
 Real estate held as an investment for the
production of income - investment property.
Types of Taxable Income
 Active income (e.g., salaries, wages, bonuses, and
commissions).
 Portfolio income (e.g., interest, dividends, and
capital gains).
 Passive income (e.g., rents from real estate, and
royalties from oil and gas rights).
General Tax Formula for
Individuals
Item
Salaries and Wages
+ Business Income (Sch. C)
+/- Capital Gains and Losses
+ Interest Income
+ Dividend Income
+/- Rents, Royalties, and Partnerships
+/- Adjustments
= Adjusted Gross Income (AGI)
- Personal Deductions (Itemized or Standard)
- Personal Exemptions
= Federal Taxable Income
PASSIVE ACTIVITY LOSS
RESTRICTIONS
 Passive losses cannot be used to reduce active or
portfolio income. (TRA ’86)
 Passive losses may be used to reduce other passive
income. (REITs)
 Passive losses not used may be used in future years or
at the time of sale.
 Active participants may deduct up to $25,000 in
passive losses against other non-passive income,
subject to limitations.
TAX ON OPERATIONS
Item
Net Operating Income
Symbol
(NOI)
-
Depreciation
(DEP)
-
Interest Expense
(INT)
=
x
=
Amortized Financing Costs
Taxable Income
Tax Rate
Tax Liability
(AFC)
(TI)
(TR)
(TAX)
AFTER TAX CASH FLOW
FROM OPERATIONS
=
=
Item
Net Operating Income
Interest Expense
Principal Amortization
Before-Tax Cash Flow
Tax Liability
After-Tax Cash Flow
Symbol
(NOI)
(INT)
(PA)
(BTCF)
(TAX)
(ATCF)
Tax Shelter
 Partial Tax Shelter: NOI is positive but taxable
income of asset reduced due to depreciation and costs
of financing
 Deep Tax Shelter: NOI is negative (tax loss) due to
depreciation and costs of financing
 Tax losses may be used to reduce the taxes due on
 other passive income
 ordinary and portfolio income of qualified active participants
Interest Expense and
Amortized Financing Costs
 Interest and Prepaid Interest
 Costs of Financing
 Financing costs amortized over the term of the
loan.
 Unused balance taken in the year sold.
Depreciation Basis
 The original cost basis includes all costs associated
with acquiring the property and transferring the title
 Land value cannot be depreciated
 The depreciable basis is the total value that can be
depreciated over the recovery period
Depreciable Basis = Cost Basis - Land Amount
Annual Depreciation Deduction
 Annual Depreciation =
Depreciable Basis / Recovery Period
 mid-month convention
Cost Recovery Period
 Residential Income Property (27.5 years)
 Other Commercial Income Property (39 years)
 Personal Property (3-15 years)
Original Cost Basis and
Depreciation
 The original cost basis
is affected by
depreciation and
substantial (capital)
improvements
Original Cost Basis
- Total Annual Depreciation
+ Total Capital
Improvements
TAX DUE ON SALE
Item
Symbol
= Net Sale Proceeds
(NSP)
- Adjusted Basis
(AB)
= Total Taxable Gain
(TG)
- Depreciation Recapture
(DR)
= Capital Gain
(CG)
Capital Gain Tax
+ Depreciation Recapture Tax
= Tax Due on Sale
(CGTAX)
(DRTAX)
(TDS)
AFTER TAX CASH FLOW FROM
SALE
Item
Symbol
Gross Sale Price
(GSP)
- Selling Expenses
(SE)
= Net Sale Proceeds
(NSP)
- Remaining Mortgage Balance
(RMB)
= Before-Tax Equity Reversion
(BTER)
- Tax Due on Sale
= After-Tax Equity Reversion
(TDS)
(ATER)
Net Effects of Annual Depreciation
 Defers taxes
 If annual tax incidence transferred from period of
operation to period of sale
 Reduces taxes
 If capital gains rate less than ordinary tax rate
 If tax losses can be used to offset passive income
 If tax losses can be used to offset other income
Ordinary versus Capital
Gain Income
 Definition of a Capital Asset
 Tax Treatment for Capital Assets
 Tax Treatment for Section 1231 Assets
METHODS OF DEFERRING
TAXES ON DISPOSITION
 Installment Sale
 Like-Kind Exchange
TAX FACTORS AFFECTING
HOME OWNERS
 Preferential Tax Treatment of Home Owners
 Capital gains of $250,000 are excluded from income for
individuals ($500,000 for couples filing joint returns)
 Home owners allowed to deduct mortgage interest and
local property taxes.