Real Estate Investments Taxation
Investments in real estate offer several tax advantages:
- long-term holdings are usually taxed at the long-term capital gains rate;
- depreciation can offer a temporary tax-free cash flow;
- it can be used offset passive losses, since rental income is considered a form of passive income;
- capital gains taxes can be deferred through tax-free exchanges.
Since real estate losses are generally considered passive losses, they can only be used to offset passive income unless the taxpayer is a real estate professional or the $25,000 rental income rule applies, in which case, up to $25,000 of rental income can be used offset active income, such as earnings from a business or wages.
A taxable real estate transaction is considered to occur in the year which title or possession to the property passes to the buyer.
Real Estate Ventures
Real estate investments generally provide current income and can also provide appreciation in value of the property. Moreover, a real estate investment may yield considerable tax-free income in the early years of the investment if a large depreciation can be claimed on the property. Since the depreciation is not an actual outlay of cash, the amount can be distributed to investors. However, if the real estate has a mortgage, then the amount that is necessary to amortize the mortgage principal reduces the income that can be distributed. Of course, this assumes that the building does not actually depreciate as fast as the allowable deduction. If the property is deteriorating rapidly, then the depreciation will be offset by maintenance costs. The payment of interest can be deducted from taxes, but not the payment of principal.
The income earned from an investment in real estate investment trusts (REITs) is either reported as dividend income on Form 1099-DIV, Dividends and Distributions or as long-term capital gains, which are considered long-term regardless of how long shares in the REIT have been held by the investor. However, the dividend income earned from the real estate does not qualify for the reduced tax rates on qualified dividends.
A real estate mortgage investment conduit (REMIC) is a partnership, or other pass-through entity that holds a fixed pool of mortgages and that issues securities to investors based on those mortgages, but with different returns and risk profiles. The REMIC itself is a pass-through entity — its gains and losses are passed through to the investors. However, unlike a regular pass-through entity, the gains or losses are not passed through to the investors pro rata, but are distributed according to the type of security held by the investors. The investors are considered either to be holding a regular or a residual interest in the partnership. The income earned from a regular REMIC interest is considered interest and is reported on Form 1099-INT, Interest Income or, if it is original issue discount interest, then it is reported on Form 1099-OID, Original Issue Discount. After all the payments have been made to the regular interest holders, the net income of the REMIC is passed through to the holders of the residual interests, which is reported quarterly on Schedule Q of Form 1066, Quarterly Notice to Residual Interest Holder of REMIC Taxable Income or Net Loss Allocation. The residual interest investor then reports the total annual share in Part 4 of Schedule E, Supplemental Income and Loss.
Sales of Subdivided Land
The tax treatment of subdivided land sales depends on whether the taxpayer is considered a dealer or investor. Investors can benefit from the favorable tax treatment accorded to capital gains, and capital losses can be used to offset other capital gains of the investor. Real estate is considered inventory — not a capital asset — in the hands of the real estate dealer, so the sale of real estate is an ordinary income or loss to the dealer. However, the interest paid by the dealer for the real estate is a fully deductible business expense, while the deduction of interest for investors is limited by the investment interest deduction limits. Investors can also elect to sell land using the installment sale method, which is not available to dealers.
Whether the seller of real estate is a dealer or investor, income earned from the sale of lots is not considered passive activity income. Thus, losses can be used to offset active income, such as from employment or from other businesses.
The sale of many real estate property lots may be considered as evidence that the property owner is a dealer in real estate rather than an investor, and thus, the selling of lots is considered a sale of inventory, which is ordinary income. However, IRC §1237 allows capital gain treatment for real estate investors if their engagement is limited and the taxpayer held the lots for at least 5 years, unless they were inherited, in which case, there is no minimum holding period. Section 1237 treatment requires:
- that the taxpayer is not a C corporation or a real estate dealer;
- no substantial improvements were made to the lots sold, which the IRS defines as a 10% increase in the value of the lot, such as by adding buildings, roads, or utilities, such as sewers, water, gas, or electric lines. However, filling, leveling, and clearing operations are not considered substantial improvements.
There is an exception to the no substantial improvement rule if the following requirements are met:
- the property was held at least 10 years;
- the improvements were necessary to be able to sell lots at market prices for similar properties;
- the taxpayer elects not to adjust the basis of the property by the cost of the improvements nor can their cost be deducted as expenses.
If the above requirements are met, then all gain is considered capital gain until the tax year in which the 6th lot is sold. Thereafter, 5% of the revenue from all the lot sales is considered ordinary income. However, since the income can be offset by selling expenses, the practical effect of this rule is nil since sales commissions are usually at least 5%. The sales of contiguous lots to a single buyer is considered the sale of 1 lot, even if the lots are separated by a road or other land that is not a lot. This tax treatment of lots can be repeated if at least another 5 years elapses since the sale of the last lot.
| Case #1 | Number of Lots Sold ≤ 5 | |
|---|---|---|
| Adjusted Basis for Each Lot | $20,000 | |
| Number of Lots Sold | 3 | |
| Sale Price of Each Lot | $60,000 | |
| Long-Term Capital Gain for Each Lot | $40,000 | = Lot Sale Price − Lot Adjusted Basis |
| Total Capital Gain | $120,000 | = Number of Lots × Gain for each Lot |
| Case #2 | Number of Lots Sold > 5 | |
| Adjusted Basis for Each Lot | $20,000 | |
| Number of Lots Sold | 8 | |
| Sale Price of Each Lot | $60,000 | |
| Total Gain for Each Lot | $40,000 | = Lot Sale Price − Lot Adjusted Basis |
| Ordinary Gain for Each Lot | $3,000.00 | = (Lot Sale Price − Lot Adjusted Basis) × 5% |
| Capital Gain for Each Lot | $37,000.00 | = Total Gain for Each Lot − Ordinary Gain for Each Lot |
| Total Ordinary Gain | $24,000.00 | = Ordinary Gain for Each Lot × Number of Lots |
| Total Capital Gain | $296,000.00 | = Capital Gain for Each Lot × Number of Lots |
If real estate is bought to subdivide the land for sale, then the allocated tax basis of each lot must be equitable, meaning that the value of each lot must be assessed independently — the purchase price cannot simply be divided ratably among the lots.
Any losses from the sale of subdivided real property is considered ordinary loss unless the property qualifies as a capital asset under §1221.
Tax-Free Real Estate Exchanges
Generally, real estate can be exchanged for other real estate without recognition of gain or loss if the property was used in business or held for investment. Therefore, a personal residence does not qualify as a tax-free exchange, unless it was a vacation home that meets the IRS safe harbor rules for tax-free exchanges. The exchange does not have to happen simultaneously but it must be completed within a 180 day period and the property that will be exchanged must be identified within 45 days of the 1st transfer of property.
Land can be exchanged for buildings tax-free, but if the building is subject to recapture provisions, then the recaptured amount will be recognized as ordinary income.
An exchange will not be considered tax-free if the received property is immediately resold or offered on the market. If the exchange occurs between related parties, then the exchange will not be tax-free if either party disposes of the exchanged property within 2 years.
To be tax-free, the real estate exchange must consist only of like-kind property. If money or other types of property are also exchanged, then this, collectively called boot, will be taxable. If a taxpayer is released of a mortgage by transferring property with a mortgage, then the amount of the mortgage will be considered boot. If the received property also had a mortgage, then the mortgages are netted out, and the taxpayer who receives the largest reduction in mortgage debt is considered to have received boot in the amount of the differences in the mortgages.
| Present Value of Received Property | $200,000 | |
| Cash | $35,000 | |
| Mortgage Released on Transferred Property | $150,000 | |
| Total Received | = | $385,000 |
| − Adjusted Basis of Transferred Property | $300,000 | |
| − Mortgage on Received Property | $40,000 | |
| Total Gain on Exchange | = | $45,000 |
| Figuring Boot | ||
|---|---|---|
| Cash Received | + | $35,000 |
| Released Mortgage | + | $150,000 |
| Assumed Mortgage | - | $40,000 |
| Taxable Gain | = | $145,000 |
The disadvantage of tax-free exchanges is that losses will not be recognized, so if a taxpayer has a loss on his property, it may be better to sell the property and buy a new one with the proceeds.
Transferring Mortgaged Realty
Generally, taking out a mortgage on property is not a taxable event unless the mortgage exceeds the adjusted basis of property and the property is either given away or transferred to a controlled corporation, in which case the excess is taxable gain.
If mortgaged property is donated to a charity, then the portion of the property that is allocable to the mortgage is considered a sale and if the mortgage liability exceeds the basis allocated to the sale, then the donor has taxable gain equal to the difference.
Taxable Gain = Release of Mortgage Liability − Allocated Basis