chapter 10 fundamental income tax issues. tax basis: its nature and significance newly acquired...
TRANSCRIPT
Chapter 10
Fundamental Income Tax Issues
Tax Basis: Its Nature and Significance
Newly acquired property’s initial tax basis is starting point in determining income tax consequences of operating the property and, ultimately, the tax consequence of disposal
During holding period, tax basis is adjusted to reflect disinvestment or additional capital investment
Tax Basis: Its Nature and Significance
Selling or exchanging a property generates a gain or loss equal to the difference between the sales price and the adjusted basis of the property at the time of disposal
The Initial Tax Basis
Property acquired as gift, initial tax basis the same as donor’s, unless donor incurs gift tax liability
Property acquired by inheritance, initial tax basis is market value as determined for estate tax purposes
Property acquired by purchase, cost forms buyer’s initial tax basis
Allocation of the Initial Tax Basis
Two or more assets acquired together, initial tax basis must be allocated between them using ratio of their relative market value Specify price of each in original
purchase contract Use ratio of land value to
building value estimated by tax assessor
Have independent appraiser estimate relative value of land and buildings
Adjustment of the Basis in Cost Recovery
Depreciation allowance –An allowance of capital invested in improvements of property held for business or investment purposes.
Does not apply to property held for personal use or primarily for resale
Land, considered virtually indestructible, is not included in depreciation allowance computation
Adjustment of the Basis in Cost Recovery
Claiming tax deduction for cost recovery allowances reduces a property’s tax basis
Lower the adjusted tax basis when property is sold, the greater the taxable gain on disposal
Recovery of Building and Other Improvements
27.5 years for buildings intended for residential rental purposes
39 years for buildings intended for other allowable purposes
15 years for land improvements such as walks, roads, sewers, and fences
Recovery of Building and Other Improvements
Allowance for buildings are computed using straight-line method
Allowances for improvements on and to the land may be computed using the 150 percent declining balance method
Other Adjustments to the Tax Basis
Basis is reduced when portion of asset is sold or destroyed by casualties such as fire, flood, or storm
Owner’s tax basis is increased by expenditures that materially increase the property’s value or useful life
Transaction costs are added to the tax basis
Table 10.2
Tax Consequences of Ownership Form
Ownership by individuals Corporate Ownership Subchapter S Corporations Ownership in a general
partnership Limited partnerships Limited liability company
Tax Consequence of Property Sales
Adjusted tax basis at time of sale is the initial tax basis plus all additional capital investments, minus cumulative depreciation allowances, plus-or-minus certain other adjustments that may sometimes apply
Gain or loss on property’s sale is difference between the value of consideration received and the adjusted tax basis at the time of the transaction
Tax Consequences of Financial Leverage
Borrowing or repaying debts are not taxable events
Interest expense is usually tax-deductible in the year the interest is paid
Exception--prepaid interest is not deductible until actually earned by the lender
Tax Consequences of Financial Leverage
Construction period interest is special exception—must be capitalized; reflected in annual depreciation allowances
Deductibility of mortgage interest is limited by passive asset loss limitation rules
Strategy—borrow against equity rather than selling, as selling will trigger a taxable gain
Income Tax Credits for Property Rehabilitation
Tax credits – direct, dollar-for-dollar offsets against one’s income tax obligation
Expenditures to rehabilitate certain buildings qualify for a 10 percent rehabilitation tax credit
Limitations on Deductibility of Losses
Limited partner’s income and expenses from a partnership are always considered passive asset items
Real estate held for rental purposes is passive unless it is incidental to the primary business activity
Special exception for real estate investors who are not actively engaged in a real estate trade or business to deduct up to $25,000 of passive asset losses each year
Figure 10.1
Foreign Investors’ Taxes
Taxpayer who acquires a U.S. real estate interest from a foreign owner must withhold and remit to the IRS 10 percent of the gross sales price, unless Property is worth no more than
$300,000 and is to be used by purchaser as personal residence
Transaction is protected from taxation pursuant to a U.S. tax treaty
Seller or buyer obtains a certificate form the IRS that reduces the amount to be withheld
Foreign Investors’ Taxes
Buyer who fails to withhold the correct amount may be liable for the under-withheld amount, plus interest and penalties
Alternative Minimum Tax (AMT)
After figuring tax liability the regular way, taxpayers must perform an alternative computation, and pay taxes on whichever computation method results in the greater liability
Alternative computation tax credits, and many tax deductions, that are permitted in the regular computation must be excluded