Notes

Taxes on Capital Gains
Capital gains are profits made from the sale or transfer of capital property. Real estate is one type of capital property; capital gains in real estate typically can be calculated by the following equation:
Gain = Sales Price - Purchase Price - Cost of Improvements - Total Expenses
Another way to express this formula follows:
Gain = Amount Realized - Adjusted Basis

Adjusted basis is:
Purchase Price + Cost of Improvements + Purchase Expenses
When dealing with investment property, depreciation is subtracted from the above equation to obtain the adjusted basis.

Amount realized is:
Sales Price - Sale Expenses

Example & Question
Assume that Owner A purchased her residence for $100,000. She had expenses of $5,000 at that time. Since then, she has made improvements that cost $50,000. Owner A recently sold the property for $300,000 and had selling expenses of $10,000.

What are the adjusted basis, the amount realized, and the capital gain?
Response
First, let's calculate the adjusted basis:

Adjusted Basis = $100,000 + $5,000 + $50,000
= $155,000
Now, let's calculate the amount realized from the sale:

Amount Realized = $300,000 - $10,000
= $290,000
Finally, we can calculate the capital gain:

Capital Gain = $290,000 - $155,000
= $135,000

Homeowner Tax Benefits When Selling Principal Residences
According to a 1997 tax law, sales of principal residences are exempt from capital gains tax for gains up to $250,000 for a person filing separately or $500,000 for spouses filing jointly ($250,000 for each spouse). Ownership and use requirements must be met for the exclusion, and only the amount of the gain in excess of depreciation adjustments can be exempted.
To qualify for the exclusion, owners must have lived in the residence for at least two years during the five-year period leading up to the sale. However, if homeowners are forced to sell their homes as a result of a change in employment or health, they can exclude a fraction of $250,000, or $500,000 for joint filers, proportionate to the fraction of two years they spent at the residence.

Exceptions to the two-year use requirement include the following:
Property acquired in rollover transactions, which are transfers of funds to investments of the same type, used to defer the payment of taxes
Property transferred by a spouse
Property owned by a spouse, former spouse or deceased spouse
Owners who have received care from a nursing home
Exemptions may only be made once every two years, again unless the sale is a result of a change in health or employment.

When homes are sold for under $250,000 (or under $500,000 for joint filers) the owners do not have to file an information return reporting the sale of their principal residence.

For principal residence sales, sellers are required to provide to the government a written assurance containing the following two components:
A statement that the entire gain made from the sale can be excluded

A statement that the property is the owner's principal residence
The law allows most people to avoid any taxes from gains on the sale of their primary residences if the gains are under $250,000 for one or $500,000 for a couple because the exclusion can be used frequently. However, these benefits do not apply to investment properties.

Penalty-Free Withdrawal from IRA
First-time homebuyers may withdraw up to $10,000 from an Individual Retirement Account (IRA) to use as the down payment for a home. The withdrawal is penalty free, but it is not tax free.


Types of Income and Cash Flows for Investment Properties

Potential Gross Income
The potential gross income (PGI) of an investment property is the amount of income that would be generated at 100% occupancy, as well as any other real estate-related income.

Effective Gross Income
Effective gross income is potential gross income minus vacancy and collections losses for expectations of losses and vacancy. This plus other expenses (from sources other than rent) equals effective gross income (EGI).

Net Operating Income
Net operating income (NOI) is the amount left after the effective gross income has been adjusted for the total operating expenses of an investment property. Operating expenses consist of fixed expenses (property taxes, insurance) and variable expenses (utilities, maintenance, management, supplies, garbage collection). Mortgage payment or annual debt service is not considered an operating expense.

Before- and After-Tax Cash Flows
After the net operating income is estimated, debt service is subtracted to obtain the cash throw off or the before-tax cash flow (BTCF). The after-tax cash (ATCF) flow is equal to the before-tax cash flow minus income taxes.

After the before tax cash flow is calculated, the Reserves for Replacement are then added to the BTCF, then minus all federal income tax due to equal the after-tax cash flow.

Determining Taxable Income
Three different kinds of deductions may be made from the taxable income of an investment property. Depreciation expense, discussed later in this lesson, may be taken. Also, operating expenses and interest are deductible.

Operating Expenses
Operating expenses include regular cash expenses, such as maintenance and real property taxes. Reserve for replacements can be deducted to determine net operating income, but it is not deducted from taxable income.

Interest
The interest portion of mortgage payments is deductible, but the principal portion is not. In addition to interest expense, any costs associated with obtaining a loan are deductible over the life of the loan.

Depreciation
Investors can use depreciation, sometimes called cost recovery, as a tax shelter on investment property to recover costs. The term deprecation generally refers to the allocation of the cost of an asset over its useful life. Only improvements to a parcel of real estate may be depreciated: the land itself is considered to be indestructible and therefore may not be depreciated. An improvement, such as the construction of a home, can only be depreciated and deducted from income when it is being used to generate income, such as a rental house. Improvements may be depreciated regardless of the physical damage and deterioration the property suffers. Tax deductions from depreciation lower the adjusted tax basis of a property.

Straight-Line Method
Real estate investors use the straight-line method to calculate depreciation on investment properties. Under this method, depreciation expense is taken for the same amount of money each year. Depreciation is taken over the economic life or useful life of an asset: the useful life is defined by the Internal Revenue Service as 27.5 years for residential properties and 39 years for non-residential properties.

Example & Question
Assume that an investor purchases a residential investment property for $150,000.
If the land is worth $50,000, what is the annual depreciation rate for this property?

Response
First let's calculate the value of the improvements on this property:
Cost of Improvements = $150,000 - $50,000 = $100,000

Because the property is a residential property, the asset may be depreciated over a useful life of 27.5 years. To calculate the annual depreciation rate, we must divide the cost of improvements by this period of time:
$100,000 / 27.5 years = $3,636.36
The investor can annually deduct this amount of money from income until the property has been fully depreciated.

Age-Life Method
Appraisers also take into account the observed condition of the structure. Age-Life or observed condition breakdown method is often used to estimate depreciation of residential structures. It is the ratio of the property's effective age to its economic life. For example: If a home is 5 years old but has been well maintained its effective age could only be 2 years. The formula using the age-life method is Effective Age ÷ Economic Life x Cost New = Estimated Total Accrued Depreciation. Appraisers always use the effective age of a structure and not the chronological age. Economic life is the total number of years that a structure should be able to contribute to the property's value.

Capital Gains and Losses on Investment Properties
If an investment property is sold for an amount greater than the adjusted basis, then a capital gain in generated; if the property is sold for an amount less than the adjusted basis, then a capital loss has been generated (the adjusted basis of investment properties incorporates any depreciation). The first $3,000 of total capital losses may be deducted from income each year. Gains and losses offset one another: if an investor sells two properties for a capital gain of $20,000 and a capital loss of $30,000, there is a net loss of $10,000 dollars, so no capital gains taxes are paid for the gain.

Holding Period
Whether a capital gain is taxed as a short-term or long-term gain is determined by the length of time the property is held (the amount of time between the day a property is bought and the day it is sold), called the holding period. If the holding period was shorter than 366 days, then the capital gain is short term; if the holding period was greater than or equal to 366 days, the capital gain is considered a long-term gain.

Short-Term Capital Gains
Short-term capital gains are taxed as normal income, according to federal income tax rates. This means that in most cases, short-term gains are taxed at a much higher rate than long-term gains.

Long-Term Capital Gains
Long-term capital gains are currently taxed at 0%, 15%, 20%, 28% or a combination of these rates. The first two rates are used in most cases; income level determines which one applies. For individuals in the top four federal income tax brackets, a tax rate of 15% applies. Most people claiming capital gains fall into this category. However, capital gains are taxed at 0% for those in the 10% and 15% income tax brackets. If the capital gain would push these individuals into one of the top four income tax brackets, then the portion of the capital gain below the minimum for the lowest of these brackets is taxed at 0%, while the rest is taxed at 15%.

Previously, rates were 5% higher for most people: 20% for those in the top four income tax brackets, and 10% for those in lower tax brackets. The American Taxpayer Relief Act of 2012 (signed on January 2, 2013) made qualified dividends a permanent part of the tax code but added a 20% rate on income in the new highest 39.6% tax bracket.

As a result:
Ordinary dividend and short-term capital gain: Tax rate is same as ordinary income tax rate.

Qualified dividend and long-term capital gain: Tax rate is 0% for the 10%-15% brackets; 15% for the 25%-35% brackets; and 20% for the 39.6% bracket.
The recapture tax of 25% applies to depreciated properties, which are discussed later in this lesson. The tax rate is higher because investors received previous tax benefits by depreciating a property over its useful life; this helps the federal government to recapture money.

The 28% capital gains tax rate applies to gains from the sale of small business stock and collectibles. Examples of collectibles are antiques, gems, expensive wine collections, and works of art.

QUESTION
An investor sells a building for $700,000. The building has depreciated $100,000 and was originally purchased for $500,000.
What will the capital gains taxes be for this sale? Assume that the seller is in one of the top four income tax brackets.

ANSWER
Because the building has depreciated $100,000, the gain is $300,000. The $100,000 portion is taxed at 25%, and the remaining $200,000 of the gain is taxed at 15%. Therefore, the total tax paid will be equal to the following:

(25% x $100,000) + (15% x $200,000) = $25,000 + $30,000 = $55,000 (total capital gains tax)
The entire capital gain generated by the sale of real property must be claimed immediately, so taxes must be paid for the entire amount that year. However, many investors take advantage of installment sales and like-kind exchanges to spread out or defer the payment of taxes.

Installment Sales
Installment sales are sales of real estate that take place over a period of several years. Gains are claimed only when payments are received, so sellers are not immediately liable for paying taxes for the total gain that will be generated. Installment sales are less beneficial, however, for capital losses, which may not be spread over a period of years. The entire loss must be registered when the installment sale begins.

Like-Kind Exchanges
A like-kind exchange is an exchange of property that belongs to the same class; for our purposes, this means that real property must be exchanged for real property for the conveyance to qualify as a like-kind exchange. However, the exchange does not have to involve the same kind of investment real estate: a commercial investment property, for example, may be exchanged for a residential investment property.

Tax deferment
Sellers do not have to pay taxes immediately in like-kind exchanges; taxes are paid when the exchanged property is sold. This is beneficial for investors because they may reap the benefits of an investment while waiting to pay a large amount of taxes.

Boot
In many cases, additional unlike property or personal property is exchanged to make up for the difference of values in exchanged property. The term for this personal property is boot. Whoever receives this property in an exchange must pay taxes on it.