Real Estate Taxation 101

By Attorney William Bronchick

This article will discuss the basic tax issues involved in real estate transactions, plus some creative ways to take advantage of tax laws.

The current tax code still provides many loopholes and breaks for real estate investors.  The foolish entrepreneur is the one that waits until April 14th to file his taxes, then hands a shoebox full of receipts to his accountant.  The wise entrepreneur must plan for your taxes at the beginning of the tax year, and consult with tax advisors throughout the year.  People who say the tax system isn’t fair are just ignorant of the rules.  Taxes will eat up a large percentage of your money over your lifetime, so learn how to make the rules work for you!

DEPRECIATION

The first tax break is depreciation for rental properties.  While property values generally increase, the structure on the land wears out.  Thus, the Code allows you to take a deduction for the depreciation of the structure.  Even if you have positive cash flow on your rental properties, you still may show a loss on your tax return.

CAPITAL GAINS

Normally, a seller of investment property pays tax on the profit he makes.  The profit is the difference between his basis (in simple terms, what he paid, plus what he paid to improve it) and his sales price.  If the property is held for productive use for 12 months or longer, capital gains rates apply, which max out at 20%.  By contrast, if the gain were a result of a property that was held for less than twelve months, the gain would be “ordinary” and subject to personal income tax rates as high as 39.6%.

SALE OF PRINCIPAL RESIDENCE

An owner selling his principal residence to you is not subject to gains tax if the gain is less than $250,000 ($500,000 for married couples).   See Internal Revenue Code §§1034, 121.   The residence must be owned and used two of the last five years prior to closing to qualify.  Thus, a seller who moved out and left the property vacant for a year or two (good candidate for a “subject-to” sale) could sell it to you and still qualify for exemption from capital gains.  Keep in mind that if the seller’s loan balance is more than he paid for the property, the debt you have agreed to assume is considered income to the seller.

INSTALLMENT SALE METHOD

A seller may elect to report the gain from a wrap on the installment method.  This is desirable because much of the profit made on a wrap is on paper, not in cash.  By using the installment method, the seller can spread out the tax on his profits over several years.  In this fashion, the gain is taxed pro-rata as it is received.

An installment sale is defined under the Code as a disposition of property wherein the seller receives one or more payments after the close the tax year in which the sale occurred. I.R.C. §453.  Installment sales are reported on IRS form 6252.

REAL ESTATE SEMINARS, ETC.

Under the Tax Code, you can only deduct educational expenses that are necessary for your current employment (e.g., continuing education requirement) or to maintain or improve the skills in your current employment.  You cannot deduct educational expenses that train you for a new profession (e.g., “real estate entrepreneur”).

Try this: Form a corporation that is in the business of buying real estate, then have the employer (the corporation) pay for you (the employee) to attend the seminar.  If you already have a corporation that is in another business, have your board of directors execute a resolution that directs the corporation to expand its business into real estate investment.  In other words, the education is for the benefit of the employer, which may be deductible.

About William Bronchick

William Bronchick
Attorney & Best-Selling Author William Bronchick - Host of Legalwiz.com

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