by Attorney William Bronchick

By default, a limited liability company is treated under the federal tax rules as a partnership if it has two or more owners (”members”). If it has one member, it is “disregarded” for Federal income tax purposes, (Treas. Reg. Sec 301.7701-3(b)(1)). As a disregarded entity, the LLC income would be reported on the sole member’s tax return. Thus, if it were active income, it would be reported on schedule C, as rental income on schedule E, etc.

A limited liability company can elect to be treated as a corporation rather than a partnership or disregarded. If you want your LLC or partnership to be treated as such, you can file IRS form 8832, Entity Classification Election. In theory, this could be a “lazy man’s” corporation; it will be treated as a corporation for Federal income tax purposes, without the paperwork formalities of a corporation as required by state law. It could even file an S election using form 2553.

One of the advantages of using an LLC instead of a corporation is the built-in asset protection feature afforded by LLCs. A judgment creditor of a member may not, under state, attach assets owned by the LLC, but rather is limited to a “charging order” (assignment of the member’s income only). Due to a recent Federal Bankruptcy Court decision (In Re Ashley Allbright), it’s not clear whether a single member LLC will still have such protection, so clearly the multiple-member LLC would give better asset protection than a single-member LLC. This is discussed in more detail in my LLC home study course.

The only drawback is that the IRS may still require extensive documentation and corporate formalities for aggressive tax deductions. A Corporation would normally have these formalities, such as annual minutes of meetings, special meetings and resolutions. LLCs are not generally required to have these formalities under State law. However, the IRS is not bound by state law, so theoretically your LLC-taxed-as-corporation could be in trouble if you got audited and had no resolutions!

Thus, if you want the tax benefits of a corporation, you should probably form a regular corporation. If you form an LLC and elect to be taxed as a corporation, be sure to complete the regular formalities that a corporation would normally do, such as resolutions, minutes of meetings, etc.

by Attorney William Bronchick

A question often asked when incorporating is, “where do I incorporate?”  There are many promoters of various jurisdictions, such as Delaware and Nevada and even offshore.

Nevada and Delaware have favorable corporate laws which limited the liability of Directors.  As you may know, corporate directors are often sued for breach of fiduciary duty.  Since the law applied in the case of a lawsuit involving the internal workings of a corporation is the state of formation, DE and NV offer maximum protection from director liability. Nevada is a particularly favorable jurisdiction because it has no personal or corporate state income tax.  Shareholder privacy is protected in NV because there are no state corporate income tax returns filed and no information sharing with the IRS.

In most cases, the benefits described above will not apply to your decision to incorporate, since you will be doing in business in your own state.  If your corporation does business in your own state, it must register as a “foreign” corporation with your Secretary of State.  This involves paying an annual fee in both the state of incorporation and your home state.  In some states, such as Texas, the filing fee for a foreign entity is substantially higher than a domestic corporation.

In addition, income earned in your home state is taxable and the corporation must file a tax return. You cannot earn income in a foreign state with a Nevada corporation and expect to avoid paying income tax there.  And, once you file a tax return there, this will require revealing the identity of the shareholders.  

The only remaining benefit will be limited director liability, which is little consequence if your corporation is made up of you, yourself and you. Thus, in most cases, your best choice for incorporating your small business is your home state.

by Terry Light and RealEstate ABC

Realtors are quick to point out that home ownership allows a lot of tax advantages not available to someone who merely pays rent. A homeowner can deduct points used to obtain a mortgage when buying a home, mortgage interest paid during the year, and property taxes.

To find out what is deductible when buying a home, click here. This article is about deductions during home ownership.

Your Biggest Deduction ?Interest

If you have a mortgage on your home, the loan is probably “fully amortized.” This means a portion of your monthly payment actually repays the debt and another portion pays the interest. After a scheduled period of time your mortgage is paid off.

If you itemize deductions using a Schedule A, the interest portion of your mortgage payment is usually tax deductible.

There are conditions.

The first condition is that your primary residence or a second home must be collateral for the loan.

Defining “Home”

Your home can be a house, co-op, condominium, mobile home, trailer, or even a houseboat. For trailers and houseboats, one requirement is that the home must have sleeping, cooking, and toilet facilities.

Even a rental can be considered a second home, provided you live in it either fourteen days out of the year or at least ten percent of the number of days you rent it for, whichever is greater.

Interest as a Tax Deduction

At the end of each year, your lender should send you a form 1098. This form tells you how much you paid in interest and points during the year. This is your deductible interest, provided you meet certain conditions.

If you obtained the loan prior to October 13, 1987, the loan is considered “grandfathered.” All interest paid on grandfathered loans in a given year is fully tax deductible. After that, there are conditions, but most conditions won抰 apply to most homeowners.

Home Acquisition Debt (an IRS Term)

An important IRS term is “home acquisition debt.” Any first or second mortgage used to buy, build, or improve your home is considered to be home acquisition debt.

Acquisition debt can be a first or second mortgage used to buy your home. If you get a second mortgage and use it all for home improvement, that is also considered acquisition debt. If you do a “rate and term” refinance and don抰 get any “cash out” ?since you are just refinancing your acquisition debt ?that also can be considered acquisition debt.

For any of the above types of loans that aren抰 “grandfathered” — you can still deduct all the interest — but only if your total mortgage debt does not exceed one million dollars. For married couples filing separately, the limit is $500,000 each.

It gets more complicated with refinances and second mortgages.

Home Equity Debt (another IRS Term)

The IRS has another term called “home equity debt.” Basically, this is any loan amount in excess of what was spent to purchase, build, or improve your home.

If you get “cash out” when refinancing your home, the amount in excess of your original loan amount is considered “home equity debt” ?unless some of it was used for home improvement. Anything in excess of the home improvement cost is considered “home equity debt.”

For second mortgages, it works the same way ?anything not used to improve the home is considered “home equity debt.”

For the interest to be fully deductible, home equity debt cannot exceed $100,000 and the total mortgage debt on the home must not exceed its value. This can create a problem for those using 125% loan-to-value second mortgages to consolidate debt. That portion of the loan amount that exceeds the value of your home is not tax deductible (unless you used it for home improvement).

Deducting Points When Refinancing

Points paid during refinancing must be deducted over the life of the loan. For a thirty-year loan, you divide the points by thirty and get to deduct that amount each year.

However, there is an exception.

If you did a “cash out” refinance and used some of the funds to improve your primary residence, a portion of the points are deductible in the year you paid them. That portion is related to how much of the loan was used for home improvement. If you obtained a $200,000 loan and $50,000 was used for home improvement, then one-fourth of the points are deductible in the year you obtained the loan.

Save your receipts.

Deducting Property Taxes

Most homeowners pay property taxes to a local, state or foreign government. In most cases, property taxes are deductible. They must be charged uniformly against all property in the jurisdiction and must be based on the assessed value.

Many states and counties also impose property taxes for local improvements to property, such as assessments for streets, sidewalks, and sewer lines. These taxes cannot be deducted. Local property taxes are deductible only if they are for maintenance or repair, or interest charges related to those benefits.

Impound Accounts

Many mortgages have impound or escrow accounts. The borrower抯 payment exceeds the amount necessary to pay the principal and interest. The excess goes into an account used to pay property taxes, homeowner抯 insurance and mortgage insurance.

When calculating your property tax deduction, don抰 deduct what you pay into that account. Only deduct what is paid from the account to the taxing authority.

Limits on Deductions

You may be subject to a limit on some of your itemized deductions. For 2000, this limit applies if your adjusted gross income is more than $128,950, or $64,475 if you are married filing separately.

Certified Public Accountants

Whenever you reach a point where you begin itemizing deductions, it is best to have your tax returns prepared by a Certified Public Accountant. Internal Revenue Service rules and regulations can quickly become卌onfusing.

by Terry Light and RealEstate ABC

Realtors are quick to point out that home ownership allows a lot of tax advantages not available to someone who merely pays rent. A homeowner can deduct points used to obtain a mortgage when buying a home, mortgage interest paid during the year, and property taxes.

Those are the basics.

There are rules and guidelines to these deductions, however. Even though Realtors and lenders have the best intentions, sometimes they are a little “fuzzy” about exactly what is deductible.

What are Points?

When most people buy a home, they generally obtain a mortgage. Mortgages have costs and one of those costs is the “loan origination fee.” The loan origination fee is usually a percentage of the loan amount, generally expressed as “points.”

For example, one “point” on a $150,000 loan would be $1500. One and a half points on the same loan amount would be $2250.

On VA and FHA loans, points are often broken down into two categories: loan origination fee (which is usually one point) and discount points (which are also a percentage of the loan balance). Both are deductible.

The loan origination fee must be expressed as points in order for it to be tax deductible.

Deducting Points when Buying a Home

When buying a home, points are deductible in the year they are paid, providing they meet certain conditions. The main conditions are that the mortgage is secured by the home you live in most of the time and that you used this mortgage to either purchase or build your home.

However, there are other conditions.

Your lender cannot inflate the points to include other items you would normally be charged. When buying a home, there are normally other charges such as appraisal fee, title insurance fee, property taxes, settlement fees, and so on. If by some miracle you are not charged these fees but your “points” are higher than normal?/p>

In that case you can抰 deduct the points. Sorry.

The cash you put into the deal must also exceed the amount charged in points. In other words, if your points were $3000, but you only had to put in $2000 to close, the IRS knows something is up. Your lender is inflating your loan amount to cover your points. Although a lender can technically do this, you wouldn抰 be allowed to deduct the points.

The only other major condition is that the points must be clearly stated on the HUD1 Settlement Statement. This is a document you receive after closing that clearly lays out all the costs involved in buying the home. The seller also receives a HUD1.

Deducting Seller Paid Points

When purchasing a home, sometimes the buyer negotiates for the seller to pay some closing costs, including the points. Since the seller pays them and not the buyer, one would assume they could not be deductible, right?

Wrong.

If the seller pays the buyer抯 points, the Internal Revenue Service allows the buyer to deduct this as an expense on their federal tax returns. However, the seller cannot deduct them, too. Paying the buyer抯 closing costs, including points, merely reduces the net gain on the home for purposes in calculating capital gains taxes (which are usually deferred).

Deducting Points on Second Homes

Points paid to finance the purchase of a second home must be deducted over the life of the loan, not in the year in which they are paid.

Other Deductible Closing Costs

With two exceptions, other closing costs are not deductible. Those exceptions are pre-paid interest and pro-rated property taxes.

When you buy a home, you may close on any day of the month. However, most lenders want their mortgage payment due on the first of each month. So if you close on the 20^th, for example, you “pre-pay” ten days of interest as part of your closing costs. The ten days of interest pays you up to the end of the month. Your first mortgage payment will not be on the first of the following month, but the month after that. Unlike renting, where you pay in advance, mortgages are paid in arrears.

Since interest is a deductible expense, prepaid interest is also deductible.

A similar thing happens with property taxes. The seller抯 last property tax payment may have covered part of the time where you will actually be the owner of the home. The settlement agent will calculate how much of that last bill you should pay and charge it to you as a closing cost called “pro-rated property taxes.” This is also deductible.

Certified Public Accountants

Whenever you reach a point where you begin itemizing deductions, it is best to have your tax returns prepared by a Certified Public Accountant. Internal Revenue Service rules and regulations can quickly become卌onfusing.

Capitalization rate (or cap rate) is a rate of return used in real estate investing to determine the present value of a real estate investment based upon its future benefits. Cap rate alone does not provide a complete picture of a property’s profitability, but because it provides a quick first-glance look at a property’s ability to pay its own way, it is one of the most popular returns used for real estate investing analysis. Real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property typically all use cap rate in one form or the other.

How cap rate is used for real estate investing

In practice, you’ll use capitalization rate to express the relationship between a property’s value and its net operating income for the current or coming year.

As a result, you can use the cap rate formula to achieve three useful purposes:

1. You can compute a property’s cap rate. When you want to know the cap rate for—as an example—a recently sold property, you would use that property’s net operating income and sale price to determine the cap rate it sold for.
2. You can transpose the formula and compute a property’s estimated value. In preparation for a listing presentation, for instance, you can use the net operating income you estimate for that property and the cap rate for a similar, recently sold property to suggest a price.
3. You can transpose the formula again and compute a property’s net operating income. In cases where you are given a specified price and cap rate, you can determine what the net operating income should be.

 Here are the formulas:

1. Cap Rate = Net Operating Income (NOI) / Property Value
2. Property Value = Net Operating Income / Cap Rate
3. Net Operating Income = Property Value x Cap Rate

Understanding the role of net operating income (NOI)

Net operating income is one of the most important calculations one can make concerning any real estate investment. It is also the key to the cap rate formulations, and it is therefore crucial that you understand net operating income and the role it plays in making capitalization rate such a popular real estate investing return.

Mathematically, net operating income is a property’s gross operating income less the sum of all operating expenses. Why is it important? Net operating income represents the amount of money available to make the mortgage payment. Cap rate then measures the ratio between the money available for loan payment and sale price—essentially revealing whether a real estate investment will pay its own way—and this is why real estate investors and banks typically compute it.

To calculate net operating income correctly, though, one must be clear about the operating expenses. Be sure to include everything considered an operating expense, such as property taxes and repairs and maintenance, but avoid adding what are not true operating expenses like loan payments and depreciation.

If you are not sure about correctly calculating net operating income, befriend a real estate specialist or purchase a quality real estate investment software or real estate investor software solution that will help you do it correctly.

Conclusion

Here are a few parting words about capitalization rate you might find useful:

There is no such thing as a universal capitalization rate—it entirely depends on individual market areas. What might make a rental income property a steal in one city or state at a 5 percent cap rate, might not get a second look in another.

Cap rate can provide an assessment and comparison of investment properties, but you should never rely on cap rate alone when assessing a property’s profitability. You should always compute all relevant numbers, rates of return and cash flow scenarios.

Remember that numbers can be manipulated. When you are being told how great a buy an income property is based upon its cap rate, be sure to reconstruct your own raw data to insure that all is revealed and nothing is concealed before you actively pursue the real estate investment further.

Expect to find capitalization rate in an APOD. Quality real estate investing software solutions will calculate it here, and now that you understand what it means for real estate investing purposes, you should begin to look for it.

James R Kobzeff is the developer of ProAPOD Real Estate Investment Software. Create rental property cash flow, rates of return, and profitability analysis presentations in minutes. See how at http://www.proapod.com

When a business owner considers the sale of a business interest or assets held or used in a company, careful income tax planning should be a priority to deal with the capital gain taxes that will be generated by the sale. Capital gain strategies for tax deferral or tax exclusion can be complicated and confusing to many, so it is critical that business owners review their capital gains and depreciation recapture taxes with their income tax advisors—especially the tax-deferred and tax-exclusion options available to them.

The Section 1031 Exchange may not be suitable or appropriate

When real or personal property that has been held for rental, investment or used in a business is sold or disposed of, owners often turn immediately to the tax-deferred exchange pursuant to Section 1031 of the Internal Revenue Code (”1031 exchange”) in order to defer the payment of their capital gains and depreciation recapture taxes. Though the Section 1031 Exchange is an incredible strategy to defer taxes resulting from the sale of investment real property, it may not be feasible, suitable or appropriate when selling acompany or an asset or property used in a business operation. 

The Section 1031 Exchange requires the businss owner or real estate investor to trade equally or up in value by acquiring a like-kind replacement property. Locating suitable like-kind replacement property for the sale of a business can be nearly impossible, and real estate investors may be at a point in their life where they wish to cash out and not reinvest in more real property. Some may opt to sell and pay the capital gain taxes and depreciation recapture taxes in the current year, but many would prefer to implement some kind of income tax planning strategy that would allow them to defer the payment of their capital gain taxes over a period of time. 

Deferring Capital Gains Taxes without reinvesting in replacement property

There are a number of strategies that a business owner can use to defer the payment of his or her capital gains taxes and depreciation recapture taxes—if any need be paid—so it is important that the business owner meet with his or her tax advisor to review all of the options. The following are the two most common tax-deferral strategies available:

• Installment Sale through a Seller Carryback Note
• Structured Sale through a Deferred Sales Trust, or DST

Installment Sales

The business owner could structure the sale of his or her business by carrying back the financing, which is often referred to as seller financing or a seller carryback note. Seller financing is merely an installment note or promissory note where the buyer of the business entity or assets/property makes periodic payments to the seller. Depreciation recapture taxes are due and paid in the year of sale. The capital gain taxes are partially of fully deferred over the term of the note and are taxed as principal payments are made pursuant to Section 453 of the Internal Revenue Code. 

The installment sale strategy has positive and negative features like any income tax deferral strategy does. The obvious positive is that you can sell your business or property and defer the payment of your capital gain taxes by structuring a seller carryback note. However, the risk of buyer default on the installment sale is a considerable negative. The process to foreclose or otherwise take back the business or asset/property can consume significant amounts of time and money and the business, asset or property may have been irreparably damaged during the buyer’s ownership. 

Deferred Sales Trusts

Deferred Sales Trusts are also referred to as DSTs, and are not to be confused with the Delaware Statutory Trust. DSTs are highly effective capital gain tax-deferred strategies, similar to the installment sale or seller carry back note, but without the risk of buyer default because the Trust receives 100 percent cash proceeds from the buyer at the closing of the transaction, thus removing the buyer from the equation. Default Sales Trusts and provide other great tax and estate planning advantages and sellers do not have to purchase replacement properties as with the 1031 exchange strategy.

Deferred Sales Trusts are drafted pursuant to Section 453 of the Internal Revenue Code, just like the installment sale note or promissory note in seller financing. The capital gains tax is realized or triggered, but not recognized or paid. The capital gains tax liability is partially or fully tax deferred over the term of the installment sale note created within the Deferred Sales Trust account, which you will negotiate in advance directly with the Trustee of the Deferred Sales Trust.

Learn more about Bill Exeter here: www.exeter1031.com/about_william_exeter.aspx

A 1031 exchange, otherwise known as a tax deferred exchange is a simple strategy and method for selling one property, that’s qualified, and then proceeding with an acquisition of another property (also qualified) within a specific time frame. The logistics and process of selling a property and then buying another property are practically identical to any standardized sale and buying situation, a “1031 exchange” is unique because the entire transaction is treated as an exchange and not just as a simple sale. It is this difference between “exchanging” and not simply buying and selling which, in the end, allows the taxpayer(s) to qualify for a deferred gain treatment. So to say it in simple terms, sales are taxable with the IRS and 1031 exchanges are not. US CODE: Title 26, ?031. Exchange of Property Held for Productive Use or Investment

Due to the fact that exchanging, a property, represents an IRS-recognized approach to the deferral of capital gain taxes, it is very important for you to understand the components involved and the actual intent underlying such a tax deferred transaction. It is within the Section 1031 of the Internal Revenue Code that we can find the appropriate tax code necessary for a successful exchange. We would like to point out that it is within the Like-Kind Exchange Regulations, issued by the US Department of the Treasury, that we find the specific interpretation of the IRS and the generally accepted standards of practice, rules and compliance for completing a successful qualifying transaction. Within this web site we will be identifying these IRS rules, guidelines and requirements of a 1031. It is very important to note that the Regulations are not just simply the law, but a reflection of the interpretation of the (Section 1031) by the IRS.

Why 1031 Exchange?

Any Real Estate property owner or investor of Real Estate, should consider an exchange when he/she expects to acquire a replacement “like kind” property subsequent to the sale of his existing investment property. Anything otherwise would necessitate the payment of a capital gain tax, which can exceed 20-30%, depending on the federal and state tax rates of your given state. To make it easy to understand, when purchasing a replacement property (without the benefit of a 1031 exchange) your buying power is reduced to the point, that it only represents 70-80% of what it did previously (before the exchange and payment of taxes). Below is a look at the basic concept, which can apply to all 1031 exchanges. From the sale of a relinquished real estate property, we should understand this concept so that we can completely defer the realized capital gain taxes. The two major rules to follow are:

• 1. The total purchase price of the replacement “like kind” property must be equal to, or greater than the total net sales price of the relinquished, real estate, property.
• 2. All the equity received from the sale, of the relinquished real estate property, must be used to acquire the replacement, “like kind” property.

The extent that either of these rules (above) are violated will determine the tax liability accrued to the person executing the Exchange. In any case which the replacement property purchase price is less, there will be a tax responsibility incurred. To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax. This is not to say that the (1031) exchange will not qualify for these reasons. Keep in mind, partial exchanges do in fact, qualify for a partial tax-deferral treatment. This simply means that the amount, of the difference (if any), will be taxed as a boot or “non-like-kind” real estate property.

THE 1031 Exchange Rule

A property transaction can only qualify for a deferred tax exchange if it follows the 1031 exchange rule laid down in the US tax code and the treasury regulations.

The foundation of 1031 exchange rule by the IRS is that the properties involved in the transaction must be “Like Kind” and Both properties must be held for a productive purpose in business or trade, as an investment.

The 1031 exchange rule also lays down a guideline for the proceeds of the sale. The proceeds from the sale must go through the hands of a “qualified intermediary” (QI) and not through your hands or the hands of one of your agents or else all the proceeds will become taxable. The entire cash or monetary proceeds from the original sale has to be reinvested towards acquiring the new real estate property. Any cash proceeds retained from the sale are taxable.

The second fundamental rule is that the 1031 exchange requires that the replacement property must be subject to an equal or greater level of debt than the property sold or as a result the buyer will be forced to pay the tax on the amount of decrease. If not he/she will have to put in additional cash to offset the low debt amount on the newly acquired property.

1031 Exchange Rules and Timelines:

There are 2 timelines that anybody going for a 1031 property exchange or (NNN) should abide by and know.

The Identification Period: This is the crucial period during which the party selling a property must identify other replacement properties that he proposes or wishes to buy. It is not uncommon to select more than one property. This period is scheduled as exactly 45 days from the day of selling the relinquished property. This 45 days timeline must be followed under any and all circumstances and is not extendable in any way, even if the 45th day falls on a Saturday, Sunday or legal US holiday.

The Exchange Period: This is the period within which a person who has sold the relinquished property must receive the replacement property. It is referred to as the Exchange Period under 1031 exchange (IRS) rule. This period ends at exactly 180 days after the date on which the person transfers the property relinquished or the due date for the person’s tax return for that taxable year in which the transfer of the relinquished property has occurred, whichever situation is earlier. Now according to the 1031 exchange (IRS) rule, the 180 day timeline has to be adhered to under all circumstances and is not extendable in any situation, even if the 180th day falls on a Saturday, Sunday or legal (US) holiday.

One of the tax benefit of  owning a rental property is that you can deduct your income tax by claiming your property losing value, or “depreciating”.  Even over time, yout property are most likely to increase in value, or “appreciating”.  So you pay less tax on your rental income as a result of depreciation.

How to Determine Rental Property Depreciation

Three basic factors determine how much deprecation you may
deduct for your rental property:

You can deduct depreciation only on the part of your property used for rental purposes.  If you rent a room in your house you can only deduct a percentage of the depreciation available.  If you rent a rental property, you may deduct the entire amount of depreciation available to you.  Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

Depreciation Requirements

You can depreciate your rental property if it meets all the following requirements:

Land Cannot be Depreciated

You can never depreciate the cost of land on your rental property
because land does not wear out, become obsolete, or get used up. 

The cost of clearing, grading, planting, and landscaping are usually all part of the cost of land and cannot be depreciated.

Depreciation Recovery Period

For rental property, the depreciation cost is recovered over 27.5
years.  Only the cost of the structure is allowed as a depreciation
deduction; the value of land cannot be depreciated.  If the property is used for commercial purposes, it must be depreciated over 39 years.

Example: if you purchase a piece of rental property for $130,000.
The tax assessor for the county assessed the value of the land to
be $30,000 and the house to be $100,000.  The recovery period for rental property is 27.5 years so you would divide the $100,000 by 27.5 resulting in $3636.36. 

Beginning of Depreciation Period

You begin to depreciate rental property when it is available for rent to tenants.

Example 1:  You purchase a house in March 2008 and spent April and May making repairs.  The house is ready to rent in June and you begin advertising to find a tenant.  You may begin depreciation as of June.  Even if a tenant doesn’t move in for another two months your start date is still June.

Example 2:  You bought a home and used it as your personal
home several years before you converted it to rental property.
Although its specific use was personal and no depreciation was
allowable, you placed the home in service when you began using
it as your home.  You can claim a depreciation deduction in the
year that you converted it to rental property because it’s use
changed to an income-producing use at that time.

Adjusted Basis for Depreciation

Before you can figure the allowable depreciation, you may have to
make certain adjustments (increases and decreases) to the tax
basis of the property.  The result of these adjustments to the basis is the adjusted basis.

Depreciation of Idle Property

You may claim a deprecation deduction on property used in your rental activity even if it is temporary idle (not in use).  For example, if the house is empty while you are making repairs after a tenant moves out, you can still depreciate the rental property during the time it is not available for rent. 

Depreciation Recapture for Rental Property

Depreciation on a rental property reduces your basis for figuring a gain or loss on a later sale or exchange.  If you have a gain on the
sale of your rental property, part or all of the gain may be required to be “recaptured” as ordinary income that is completely taxable in
the year of the sale.  Depreciation recapture is taxed at a rate of 25%.

Example:  You buys a rental property for $130,000.  Over time
he takes $30,000 in depreciation deductions.  These deductions reduce your basis to $100,000 ($130,000 – $30,000).  You sells his rental property for $140,000. Your gain is $40,000 ($140,000 – $100,000).  The gain is comprised of two parts, $30,000 in depreciation deductions and $10,000 in excess of the purchase price.  The $30,000 is counted as part of the taxable gain and taxed at a rate of 25%.

Note that the 25% tax rate is the maximum rate that can be taxed.  So, if your personal income tax rate is 33%, for example, you are ahead 8%.

 
Claiming the Correct Amount of Depreciation

Ilyce R. Glink

In the past few years, hundreds of thousands of consumers bought condos, townhomes and single family houses as second homes or investments.

And with prices appreciating at double-digit rates in some areas, real estate investors are now wondering how they can pocket their profits without paying much – or anything – in the way of tax.

It’s easy for homeowners to shelter a significant amount of profits from the sale of a personal residence. The Internal Revenue Service allows homeowners who have lived in their home as a primary residence for two of the past five years to take up to $250,000 in profits (up to $500,000 if you’re married) tax free when they sell.

But when it comes to investment property, the rules are different. If you sell your investment property within a year of purchase, the profits will be treated as ordinary income and taxed at your marginal rate, capping out at 35 percent in 2006 plus any state tax owed.

If your own your investment property for at least a year, any profits you earn will be taxed at a maximum rate of 15 percent. But if you depreciated your property, you will have to capture that depreciation at a rate of 25 percent, according to Mark Luscomb, principal analyst with CCH (CCH.com), a tax publisher based in Riverwoods, Illinois.

But what if you don’t want to pay anything? Although you can’t keep your profits tax-free, there is a neat way to defer any tax you may owe on the property by using a 1031 tax-free exchange, also known as a Starker Trust.

A 1031 tax free exchange allows you to swap one investment property for another “like-kind” investment that costs at least as much as the property you are selling, according to Scott Nathanson, a senior vice president and Midwest manager for Nationwide Exchange Services (Nationwide1031.com), a leading provider of 1031 tax free exchange products and services.

In addition to purchasing another investment property, all the equity received from the sale of the relinquished property must be used to acquire the replacement property.

When you use a 1031 tax free exchange, you can defer any taxes owed on the profits you’ve earned in the sale of your current investment property. You can continue to do 1031 exchanges through the rest of your life, as long as the tax laws haven’t changed. When you die, the property will be valued at its current market value, and your heirs will inherit your property at its stepped-up basis. 

Completing a 1031 exchange isn’t difficult, but there are specific rules that must be followed in order to avoid running afoul of IRS rules.

First, you must identify the property you are going to purchase in the exchange within 45 days of selling your current property. You have to close on the purchase of the replacement property within 180 days, or a shorter time period in certain circumstances. There is no flexibility written into the rules and no extensions are available. So if you blow the deadline, you blow your 1031.

In the past few years, the IRS noticed that many real estate investors had been buying homes as an investment and then converting them into personal residences.

That’s a smart move, says Nathanson, because after a period of time, the homeowner can sell the property and pocket up to $500,000 in capital gains tax free, although any depreciation that had been taken when the property was still being used as an investment would have to be recaptured.

But the IRS hadn’t determined how long you had to hold onto the investment property before you converted it to personal use.

As part of the Gulf Coast Opportunity Zone Act of 2005, the IRS decided that real estate investors who bought an investment house and later converted it to personal use had to wait a full five years before being able to take up to $500,000 in profits tax-free.

“The IRS was becoming concerned that people were taking investment property in which they had substantial appreciation and were doing a like-kind exchange into a personal residence. Then, they were using that property as a personal residence for 2 years and selling it and obtaining the exclusion on capital gains tax that’s available on the sale of a personal residence,” Luscbombe explained.

Now, real estate investors who convert their investment property to their personal residence will have to wait five years from the date the property was purchased as part of the 1031 exchange. However, the investor only has to live in the property for two of the five years, and can rent out the house during the other three years.

“Now you have to own your property for five years, no matter what,” said Nathanson. “If you sell a two-flat and buy a house in Florida as part of a 1031 exchange, you have to rent it out for two years to be safe, and then you can either live there from years 2 to 5 or rent it out for part of that time. But you’re stuck with the house if you want to be able to sell it and keep your profits tax free.”

The two-year period is considered to be “safe harbor” by many real estate attorneys and tax professionals. If you sell the investment property or trade it for another investment property within two years, you may have to prove that you had the “intent” to use it as an investment when you completed the original 1031 exchange.

Just don’t think you’re going to fool the IRS.

“Intent is a very important part of a 1031 exchange,” explained Nathanson, who is also a real estate attorney. “If you’re exchanging one real estate investment for another, you have to have the intent of keeping it as an investment when you close on the property.”

“There was a case where a real estate agent bought an apartment building and then carved them up into condos and sold them within the first year after buying the building. The IRS said the agent was acting more like a dealer rather than an investor. The agent defended himself by saying he had the intent of renting out the units, but the condo market was too good,” Nathanson recalled.

“But the IRS investigator went into the MLS records and found that the agent was marketing the condos for sale even before purchasing the building,” he added. That sort of squashed the “intention to rent” theory.