Notes

Capital Gains and Losses
For federal tax purposes, profits and losses on real estate investments are called capital gain and capital loss, respectively. If an investment property is sold for an amount greater than the adjusted basis (the purchase price of the property plus what it costs to acquire and improve it), a capital gain is generated. If the property is sold for an amount less than the adjusted basis, a capital loss has been generated (the basis of investment properties incorporates any depreciation). Capital gains must be reported to the IRS and taxes then paid on them.

Capital Gains and Losses
The exception to this rule is the sale of a primary residence. The Taxpayer Relief Act of 1997 allowed homeowners to exclude from income-reporting certain amounts due to the sale of their primary residence ($250,000 for a single homeowner, $500,000 from married couples filing jointly). The stipulations of this Act are:
Exclusion is only allowed on primary residences that the home owner(s) lived in for at least two of the last five years.

The new provision replaced the prior rollover provision on home sales.



As was touched on in the previous topic, basis is the original value indicator that determines, after factoring in appreciation or depreciation, whether or not an increase or decrease in value has resulted from investment. The adjusted basis then is a homeowner's original cost, plus or minus whatever adjustments must be made because of expenditures or gains. If the basis is adjusted upward—because of appreciation or improvements—sale of the property will result in lessened capital gains once the adjusted basis is subtracted from the selling price. The reverse is true of a lessened adjustment.

Appreciation
It's important to note that a property can increase in price without necessarily appreciating, as happens in times of inflation. Inflation is a rise in general prices; the future value of a property must be adjusted for inflation before its appreciation can be determined. One must remember that in inflation, all surrounding areas increase in value as well as the subject property (the keys around Florida for example).

Equity
The difference between what a property is worth, and what an owner owes on that property, is equity. Simply, this is the amount of a property that the investor has actually paid for. An investor increases his or her equity through amortization (killing off) of the property's mortgage.

Amortization is the decrease in the principal balance on a loan over time, which is what increases equity. Equity builds slowly over the initial term of an amortized loan because the lion's share of its initial payments is applied to the interest on the loan, not its principal. The more equity that is built up increases the return on an investment.

Liquidity
Recouping one's expense of purchase is an important aspect of real estate investment. Liquidity refers to the speed with which this can be accomplished and, by and large, it is rarely the case that real property has this liquidity quality. The reason for this is there is no central marketplace for real estate investments, and selling real estate is a complicated and time-consuming process.

Because real estate does not have high liquidity, often when a quick turnover of real estate is needed a loss to the seller will normally be the result.

One of the advantages of investing in real estate is the protection offered against having to pay taxes. Sheltering oneself from taxes is a major concern in transactions involving large sums of money, and real estate is an extremely popular means of doing this.

The most common tax shelter in real estate investing is depreciation, sometimes called cost recovery. The term deprecation generally refers to the allocation of the cost of an asset over its useful life. Improvements to a parcel of real estate may 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 base of the property.

As discussed in Lesson 1, leverage—also known as positive leverage—is a means by which one borrows money to make money. The less an investor puts down on a property, the more money can be made on that property, resulting in increased leverage. Since most real estate investments are leveraged investments, this is one of the principal means of maximizing one's profit through real estate investing.

However, in using this method of profit enhancement, negative leverage must be avoided. Negative leverage is when borrowed funds are used to invest in a property that, because of lack of occupancy or other return-reducing factor, does not make enough money to cover the payments involved in repaying the debt incurred. Negative leverage could likely result in a default on the loan made to purchase the property, and, thus, a considerable loss to the investor.