What tax class is your real estate?
Thus, understanding the tax classification of real estate holdings is extremely important.
For federal income tax purposes, real estate use falls into four separate classifications:
* Held for personal use
* Held for sale to customers
* Held for trade or business
* Held for investment
Personal-Use Real Estate
Generally, a taxpayer's "principal residence" is the only asset in this classification. In addition to a single-family house, property that may qualify as a principal residence includes a mobile home, trailer, houseboat, cooperative apartment (tied to stock ownership), or a condominium.
Real estate held for personal use has a number of important tax characteristics that distinguish it from the three other classifications of property. For discussion purposes, these characteristics are categorized by the time period to which they apply.
Ownership Period. The taxpayer may not deduct expenses incurred for maintenance, upkeep, or other "operating expenses" for real estate held for personal use. Moreover, the taxpayer is not permitted to deduct an allowance for depreciation. However, qualified mortgage loan interest and real estate property taxes for a residence are deductible, provided that the taxpayer forgoes the standard deduction and itemizes on state and federal tax forms.
The amount of the mortgage debt and how the loan proceeds will be used dictates whether or not full mortgage interest can be deducted on loans obtained after October 13, 1987. Loans used to purchase, construct, or improve a principal residence (including a second home) are referred to as home acquisition loans, and up to $1 million of such debt qualifies for mortgage interest deductions. Loans used for any other purpose are referred to as home equity loans and may qualify for deductions to a loan amount of $100,000.
If a taxpayer's principal residence is damaged or destroyed by a "casualty" (e.g. fire, hurricane, vandalism, etc.), the taxpayer may have a deductible loss. The measurement of the loss depends on whether there was a partial or a total loss. Any reimbursement through insurance will reduce the amount of the deductible loss. Moreover, if the reimbursement exceeds the adjusted basis of the property, the taxpayer may report a gain. The first $100 of any casualty loss is not deductible, and a separate $100 limitation applies to each casualty. After the $100 limitation is applied, total casualty losses are deductible only to the extent that they exceed 10 percent of the taxpayer's adjusted gross income.
Disposition. In the case of a sale or exchange, any gain is taxed as a short- or long-term capital gain (depending on the holding period). Selling expenses, such as advertising, commissions, title services, costs to make the new home suitable for sale, etc., may be subtracted from the selling price to arrive at the "amount realized" on the sale. Any loss is not deductible.
A "rollover" benefit applies to any gain on the sale of a principal residence. The owner is allowed (actually required) to defer all or part of the gain realized on a sale or exchange, provided that another residence is purchased within a specified time. The gain that is deferred is "rolled over" into the new residence by reducing the adjusted basis of the new residence. If the taxpayer buys or builds a new home, he or she must actually begin to use the new home within two years before or after the old residence is sold.
In order to defer tax on the full amount of the gain, the purchase price of the new residence must equal or exceed the "adjusted sales price" of the old residence. If the purchase price of the new residence is less than the adjusted sales price of the old residence, gain will be taxed to the extent of the difference in prices.
If a taxpayer is 55 years of age or older, he or she may elect to exclude up to $125,000 of any gain realized on the sale of a principal residence. In order to claim this once-in-a-lifetime exclusion, the taxpayer must specifically elect the exclusion on his or her tax return, be 55 or older on the date of sale, and have owned and occupied the residence as a principal residence for three of the last five years ending on the date of sale. This excluded gain is not just deferred; it is excluded from all tax.
When an owner sells his or her principal residence at a gain and receives one or more principal payments from the buyer in a year (or years) subsequent to the year of sale, he or she must use the installment method of reporting to defer the tax on any gain. The gain is taxed only as installment payments are received by the buyer. Interest payments on the installment obligation are reported separately as interest income. While the owner of a principal residence may use the installment method to defer gain on a sale, he or she may not take advantage of the tax-deferred exchange provisions of the Internal Revenue Code. However, given that the more liberal rollover and exclusion provisions apply, this is not a significant drawback to using this payment method.
Real Estate Held for Sale
Real estate that is held primarily for sale to customers in the ordinary course of business is considered inventory and referred to as "dealer property." An example would be a condominium project held for sale by a builder or lots held for sale by a subdivider. The primary purpose of holding the real estate in both of these examples is to sell it for a profit, instead of holding the property for rental income or long-term capital appreciation.
Ownership Period. The taxpayer who holds property for sale to customers may deduct expenses incurred on the property, including maintenance, repairs, property taxes, and mortgage interest. However, no depreciation deduction is permitted on property held for sale.
Casualty losses (e.g., fire, hurricane, floods, vandalism, earthquakes, or similar events) generally are deductible for federal income tax purposes. In general, the rules that apply to casualties for real estate held for personal use apply to real estate held for sale. However, the loss deduction is not subject to the $100 or adjusted gross income limitations. Finally, no depreciation deduction is permitted on property held for sale.
Disposition. All gains on disposition of property held for sale are treated as ordinary income, and any losses incurred are deductible as ordinary losses. And because real estate held for sale is not a capital asset, no capital gain (or loss) treatment is available. Selling expenses are deductible as ordinary business expenses rather than being deducted from the selling price of the property, as is the case with the sale of properties in the other three classifications. Neither the rollover of gain nor the $125,000 senior-citizen exclusion is available for the owner who holds property for sale. However, the owner of appreciated property with a low basis may still find it more advantageous to pay the capital-gains tax than to convert the building to another use (apartment to condominium, for example). Such a conversion might convert capital gains into ordinary income, which might be taxable at a higher rate.
In general, gain on the disposition of real estate held for sale to customers may not be reported using the installment method. There are, however, exceptions where the installment method is permitted for sales to individuals of:
* time-share rights to use or time-share ownership interests in, residential real property for not more than six weeks annually;
* rights to use campgrounds for recreational purposes; and
* residential lots, but only if the taxpayer (or any related person) is not making any improvements to the lots.
In addition, the installment method is available for sales of property used in farming. An owner/dealer may not utilize the tax-deferred exchange provisions to postpone any gain or loss on disposition.
Real Estate Held for Use in a Trade or Business
Real estate held for use in a trade or business receives, perhaps, the most advantageous tax treatment among the four classifications. Examples of trade or business property would include an industrial plant owned by a manufacturer or a retail store owned by a retailer. The tax treatment of property in this classification is based on Section 1231 of the Internal Revenue Code, thus it is often referred to as "Section 1231 property." Real estate held for rental purposes (e.g., apartment buildings, office buildings, shopping centers, etc.) qualifies as Section 1231 property. The owner of such property is considered to be in the rental business, that is, he or she is in the business of owning space and renting it to tenants.
The courts have analyzed the property owner's activities with respect to renting property in an effort to determine whether or not rental activities are sufficient to constitute a trade or business or whether or not such activities are merely incidental activities associated with the owner's investment activities. Both the courts and the Internal Revenue Service are in agreement that an owner who devotes a substantial portion of his or her activities to managing a number of rental units is engaged in a trade or business within the meaning of the Internal Revenue Code.
Ownership Period. The owner of trade or business property is entitled to deduct all of the expenses related to operating and maintaining the property, including property taxes and mortgage interest. An allowance for depreciation is permitted, and the owner may take a casualty loss deduction without the limits applicable to personal use property.
Disposition. On the sale of trade or business property held for more than one year, the owner [TABULAR DATA OMITTED] treats any gain or loss as a Section 1231 transaction. Thus, if gains on all such transactions for the year exceed the losses, the net gain is taxed as long-term capital gain. On the other hand, if losses exceed gains, the owner can deduct the net loss as an ordinary loss. Selling expenses are offset against the selling price and are not taken as separate deductions, as is the case with dealer property. The rollover and exclusion provisions are not applicable to trade or business property. However, the owner of such property can take advantage of the installment sale and the tax-deferred exchange provisions of the Internal Revenue Code.
As noted above, an owner holding real estate for use in a trade or business may benefit from the tax-deferred exchange provisions. In order to qualify under the applicable Code section, three basic requirements must be satisfied. First, both the property received and the property transferred in the exchange must be property held for use in a trade or business or for investment. (The investment classification is discussed in the next section.) Trade or business property may be exchanged for investment property or investment property may be exchanged for trade or business property.
However, if either property held for personal use or property held for sale is either transferred or received, the tax-deferral provisions do not apply.
Second, there must be an exchange rather than a sale followed by a purchase. An exchange is a reciprocal transfer of property, as distinguished from a transfer of property for money consideration only. However, the transfer of money along with qualifying property will not disqualify the exchange. Money received in the transaction simply results in the recognition of gain to the extent of the money received.
Third, the properties exchanged must be of "like kind." The term "like kind" refers to the distinction between real and personal property. Real property may be exchanged for real property, and personal exchanged for personal - provided that trade or investment property is involved.
The definition of real property is very broad, in that all real estate qualifies, regardless of its grade or quality.
One kind or class of property may not be exchanged for property of another kind or class. Thus, an exchange of an apartment building for business machinery will not qualify as a like-kind exchange. However, the exchange of an apartment building for unimproved land would be considered a like-kind exchange. Note also that leasehold interests of 30 years or more may be exchanged for fee interests in property under these provisions.
Investment Real Estate
Property held for investment includes property held for capital appreciation rather than the receipt of rental income. Unimproved parcels of land or lots are examples of real estate assets that fit into this classification. It should be noted that if the owner receives nominal income from sources such as billboard rentals or grazing fees, this will generally not result in a reclassification of the property from the investment classification to the trade or business classification.
Ownership Period. The owner of property held for investment may deduct expenses for managing and conserving the property. Moreover, if the property is unimproved and is not producing any current income, the owner may elect to either deduct or to capitalize (i.e., add to basis) mortgage interest, property taxes, and other carrying charges on the property. Also, this election may change from year to year.
For the individual taxpayer, mortgage interest on investment property is subject to the investment interest limitation. The interest expense on debt incurred to purchase or carry investment property can be deducted only to the extent of "net investment income" for that year. Net investment income is the aggregate net income from all of the taxpayer's investment activities determined without regard to interest expense (e.g., dividends from a stock portfolio). Any current-year interest expense that is not deducted may be carried forward (but not back) indefinitely for deductions in future years.
Casualty losses on investment property may be deducted in full, less reimbursements received from insurers. However, the owner may generally not deduct an allowance for depreciation as the property is not considered income producing.
Disposition. Gains realized on the disposition of investment property are taxed as either short- or long-term capital gains, depending on the holding period. Losses on the disposition of investment property are generally deductible as short- or long-term capital losses. Both short- and long-term capital losses may be used to offset ordinary income on a dollar-for-dollar basis up to $3,000. Any excess losses may be carried over, indefinitely, to subsequent years and applied as short- or long-term losses in those years.
Selling expenses for investment property are treated as a deduction from the selling price rather than as an ordinary expense deduction. In addition, the owner of investment property may take advantage of both the installment method of reporting gain and the tax-deferred exchange.
Donald J. Valachi, CPA, CAM, is Clinical Professor of Real Estate at California State University, Fullerton. He holds a doctorate in business administration, with emphasis in real estate, from the University of Southern California. In addition to his work as a CPA, Mr. Valachi is active as a broker and investor, specializing in apartments.
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|Author:||Valachi, Donald J.|
|Publication:||Journal of Property Management|
|Date:||Mar 1, 1996|
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