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Tax consequences of real estate investment.

Tax consequences of real estate investment

In today's economic climate, the question of whether real estate presents an investment opportunity is commonly asked. With prices seemingly depressed and interest rates low, many taxpayers are considering real estate as an investment opportunity.

We are constantly being queried as to the tax ramifications of a real estate investment.

The most common type of real estate investment for the individual is in the form of rental property. The usual scenario is for the taxpayer to purchase either a single unit (a none-family house, an apartment, or a commercial building) or a multiple unit rental property (an apartment building or several apartments) and rent them. The property will generally be mortgaged. The taxpayer will operate the property as a landlord and sometime in the future sell the property.

Tax consequences occur during the period of operation and upon the sale of the property in the future.

Our first concern is the accountability of the profit or loss from the rental property during the operation. If the property is operated at a profit, then the profits are taxed as ordinary income at the taxpayer's normal income tax rate (15 percent, 28 percent or 31 percent). If the property is operated at a loss, then a rather complex set of rules covering the tax treatment applies. Since most rental properties operate at a loss after depreciation, in the first years of ownership, the loss provisions of the tax law are important.

The first consideration in the deductibility of the loss is the AT-RISK rules of the Internal Revenue Code. You are only allowed to deduct an amount which you have invested or are obligated to contribute in the future. The At-Risk rules limit the loss deduction to the amount of the taxpayer's cash contribution and the adjusted basis of other property contributed to the activity, plus amounts borrowed for use in the activity if the taxpayer is personally liable for the amount borrowed or has pledged assets not used in the activity as security for the borrowing. Special consideration is given on non-recourse debt of individuals in RIE Investment.

If the taxpayer has losses which qualify under the At-Risk provisions, he must then look to the Passive Activity loss limitation rules which became

effective for tax years beginning after Dec. 31, 1986. There is a special five-year phase-in period for taxpayers who acquired an interest in a Passive Activity before Oct. 23, 1986.

The general rule for Passive Activity losses is that losses from Passive Activities may not be deducted from other types of income.

What is a Passive Activity? A Passive Activity is an activity that involves the conduct of a trade or business in which the taxpayer does not materially participate. By the Internal Revenue Services definition, a rental activity is considered a Passive Activity regardless of the taxpayer's participation. However, special rules apply to real estate rental activities which may allow an individual the deduction of the loss from rental activities.

There are elective rules for aggregating rental real estate activities which allow the taxpayer to combine rental real estate undertakings as a single activity.

If the taxpayer actively participates in a rental real estate activity, there is a limited exception to the Passive loss rules. This exception is only available to individual taxpayers (and to their estates). The active participation requirement will be met by individuals if they are involved in making management decisions or arranging for others to provide services in a significant and bona fide sense. This requirement of active participation applies in the year in which the loss arose as well as in the year in which the loss was allowed to be deducted.

The maximum Passive Activity loss from rental real estate allowed is $25,000 and this may be used as an offset against income from non passive sources (e.g. wages, interest, dividends) each year. The individual must own a 10 percent interest or more of the rental real estate activity in order to qualify. The $25,000 maximum will be reduced, but not below 0, by 50 percent of the amount by which the individual's adjusted gross income exceeds $100,000 disregarding adjustments for social security, U.S. savings bonds, retirement contributions and Passive Activity losses.

Prior to the year of disposition, losses which are unallowed in any given year are carried forward to the next to be recalculated to see whether they will be deductible or whether they will have to be carried forward again.

In the year of disposition taxpayers may apply all carried forward losses against their ordinary income. The losses must first be applied against the taxpayer's net income or gain from passive activities. The transaction must be a fully taxable disposition in order to take advantage of the carry forward losses.

There are several other tax considerations which a real estate investor should consider.

Depreciation for rental properties are not as favorable as they were before the tax reform act of 1986. Residential real property must be depreciated over 27.5 years and non-residential real property over a life of 31.5 under methods prescribed under the Modified Accelerated Cost Recovery System (MACRS).

The maximum tax rate on capital gains for individuals is 28 percent whereas the maximum tax rate on individuals is 31 percent. If a taxpayer's taxable income falls within the 31 percent bracket then a special calculation must be performed to insure that no net Capital Gains are taxed at the 31 percent tax rate.

The installment method is available for reporting the gains from the sale of property. Under this method a gain is pro-rated and recognized over the years when the payments are received. The sale of Real Estate will qualify under this method unless the taxpayer elects not to use the installment method on a timely filed tax return for the year of the sale.

Real Estate investing offers the opportunity for large profits in today's market. The tax law, though complicated, if understood, can be used to maximize profits. The At-Risk rules and Passive Activity loss rules while cumbersome and complicated must be adhered to.

The rules and tax rates on Capital Gains may be changing in the near future. Depreciation rates and the installment sales rules may likewise be modified.

The bottom line is buy right, sell right, maintain records, and consult your tax advisor on the tax consequences.
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Title Annotation:Review & Forecast Section IV
Author:Lewin, Gilbert
Publication:Real Estate Weekly
Date:Jan 29, 1992
Previous Article:1992: year for commitment/year for action.
Next Article:How to survive the recession.

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