Investments in Real Estate
Real Estate has proven to be an excellent investment over time. The following represent the benefits of investing.
Personal Residence as an Investment - With most Americans, their home is their only personal investment. They might have a few thousand in savings, but that is about it. Buying a home is one of the best investments that a person can make.
Why Buy - Purchasing a home creates the following:
Capital Gains Tax
Capital Gains Tax - When selling assets for a profit, the taxpayer has to pay a capital gains tax. This tax applies when a person sells their assets for a profit. Example: Selling owned securities, an owned business, collections, etc. as well as investment real estate that is not a personal residence.
Long Term and Short Term Capital Gains Tax
The length of ownership is the key to Long Term versus Short Term capital gains and the appropriate I.R.S. tax rate.
Short Term Gain or Loss - Ownership of the sold asset being 1 day shor of 1 year. (364 days)
Long Term Gain or Loss - Ownership of the sold asset being 1 year and 1 day or longer (367 days)
Short Term Gain - When selling owned assets within less than a year and 1 day, the gain or loss is reported for that year. In a reporting year the taxpayer can subtract losses from one asset from any gains on other assets. The positive gain is reported at the ORDINARY INCOME Tax Rate which tops out at 39.8%.
Long Term Gain - When selling owned assets after a year and 1 day, the gain or loss is reported for that year as a long term gain. In a reporting year the taxpayer can subtract losses from one long term asset from any gains on other long term assets. The positive gain is reported at the appropriate long term tax rate which is usually lower than the ordinary income rate.
Additional 3.8% Tax
Additional 3.8% Tax - The health care reform law also tacks a 3.8 percent tax on wealthier taxpayers' investment income. This net investment income tax, or NIIT, applies to taxable capital gains, dividends, interest, rental income and annuities, among other types of income.
The income thresholds are more than $200,000 for single or head of household filers; and $250,000 for married couples filing jointly and qualifying widows or widowers with a dependent child. Again, these income limits are not indexed for inflation.
Tax Exemption - A tax exemption is the amount of money exempt from paying tax. The personal residence of taxpayers can be sold with a profit exempt from tax. This is under The American Taxpayer Relief Act of 2012, or ATRA - Personal residences can be sold without paying a capital gains tax up to specific limits, but there are specific requirements.
Tax Exemption - An owner pays no tax on the profit from sale of their primary residence if the profit did not exceed $250,000 for a single person or $500,000 for a married couple filing jointly. Any amounts over these exemptions are subject to capital gains tax. These $250,000 and the $500,000 exemptions can be utilized by taxpayers living in a house 2 years out of the past 5 year period.
Example: Harriet bought her home for $122,000, added a patio and swimming pool for $34,000, paid a commission to the broker for $7,000, and repaired the carpet as requested by the buyer for $2,200. Her basis for the total of these is $165,200.
A sale price of $440,000 minus her basis of $165,200 equals a profit of $274,800. If she was single the $274,800 minus her $250,000 exemption means that $24,800 would be subject to tax.
Income property would be any property that the buyer does not intend to make their residence. This would include rental housing, apartments, commercial rentals, and commercial buildings. These purchases are also known as commercial property; not a residence. Major Considerations:
Down Payment - As an investor, you have to think about the amount and safety of a down payment. You probably don't want to expend a large amount of cash for a down payment. You want your cash down payment to be as safe as possible.
Leverage - Buying and trading of real estate with the equity of the owned properties. Basically, leverage is using another person's money instead of your own. We mainly use the money of financial institutions to finance the purchase of property. Let's look at some of the advantages and disadvantages of leverage.
Risk/Reward - What is best? Buying 10 houses with $1,000 down or buying 1 house with $10,000 down. Obviously the buying of 10 homes with $1,000 down is of much higher risk. There are 10 times the chances of vacancy in a down economy. If there are vacancies and income can't support the 10 properties, it could cause foreclosure.
Advantage - There are 10 times the chances of profitable income. There are 10 times the amounts of appreciation. There are 10 times the chances of profit when sold.
Personality - A investor's personal make up is very important. Can the investor sleep at night with 10 possible losses instead of 1? Can the investor be patient with 1 investment instead of 10? The personality of the investor is important.
Real Estate Exchanges
Exchanging property among parties rather than buying and selling property. In the past, people would exchange property instead of buying property because it was not looked upon as a taxable event. Now the Internal Revenue Service has caught on and exchanges are a taxable event.
Exchange/Trading - Trading property with another instead of selling and then purchasing.
Normally Creates Some Gain. The IRS treats it as if you sold your property and then purchased a new property. Any gain under this arrangement will be taxed normally as if it was a sale and purchase arrangement.
Taxable - The IRS handles the transaction as if you sold then bought ... any gain on the sale portion is taxed as a gain in the year of exchange.
Like-for-Like - The like-for-like portion is tax deferred.
Advantages of Exchanges:
Tax Deferred Exchanges
The so called Tax Free Exchange. No transaction is tax free. All we are doing is delaying taxation on profit. This is why we use the words Tax Deferred Exchange.
Difficult to Prove - This is very specialized and difficult to accomplish. If you work with exchanges on a regular basis, you eventually will be able to accomplish this maneuver.
I.R.S. Requirements - The specific requirements are as follows:
"Like-for-Like" - If traded properties are the same form of investment (like-for-like), they do not have to report the trade. The traders must claim that the traded properties are the same type of properties. It would be the same type of property, the same price, but it can be in different States.
Greater Value - If one of the properties is of greater value than another it is taxable in the year of the exchange. This difference in values of the property is called "Boot." This boot or difference in values paid to the other party can be paid in any form.
Form of Boot - "net mortgage relief." This is when property is exchanged and one of the traders ends up owing less on a mortgage after the exchange. This is a form of "boot" and has tax ramifications.
Forms of Ownership
Forms of Ownership - When selling real property, the sale of the ownership interests would include all of the following:
Example: Paula was granted 5 life estates by 5 different relatives. She could sell 3 of these life estates, but she has to report the sale to the IRS.
Exceptions to Reporting
Exceptions to Reporting- There are transfers of real property that are not reportable to the State and the IRS. Exceptions that are not reportable transactions would include:
IRS Exemption - Currently, the IRS allows an exemption of $250,000 of profit on the sale of a residence. This is per taxpayer. This means a married couple would enjoy a $500,000 profit exemption from the sale of a residence.
Definition of a Residence - A residence is a dwelling that the taxpayer lived in at least two years of the previous 5 years.
Less Than 2 Out of 5 Years - The IRS regulations allow an exemption, BUT it is figured on a prorated basis.
Reporting the Sale - As of the year 2002, the government requires an escrow officer to have the seller fill out a residency form. The seller/taxpayer has to declare the amount of time the real property was used as a residence. If the form shows residency in excess of 2 years within the past 5 years, the escrow officer does not have to send in the Form 1099 to the IRS. The seller/taxpayer has to declare the sale on their Individual 1040 form by April 15 th of the following year.
State Exam Purposes - This procedure is probably NOT on the State Exam. You will still have to think in terms of the Escrow Officer sending in the Form 1099 for all real property sales transactions.
An investor would use which of the following as a hedge against inflation?
C) a savings account
D) a fixed rate bond
The value of property above the total liens or mortgages is:
The most significant requirement of the so called tax free exchange is that the properties:
A) are residential
B) are of equal value
C) are of equal equities
D) are of like kind
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