Income taxes
Capital
gains.
The 2003 tax relief act has cut long-term
capital gains to a maximum of 15% to for gains from the sale of
assets held for more than 12 months. Gains from the sale of
assets held for one
year or less are taxed as regular income.
For taxpayers in the 10% and 15% tax brackets, the long-term gain
was cut to 5%. In the 2008, the long-term capital gains
tax for the these lower income brackets will be zero.
Business and investment property.
Property held for business and investment.
Has some distinct differences in the federal income
tax treatment from property used as a personal residence.
Depreciation.
Depreciation is a method of accounting for the wear results from
the use of capital good. A capital good, such as piece of
equipment or a building, does not lost last forever. As it is
used, it wears out or becomes obsolete, the owner must replace it or
repair it. Depreciation is used to reflect this replacement cost.
The main reason depreciation is allowed are to encourage investment
is real estate and to reflect, in accounting terms, the real cost of
property ownership. Only investment or income property may benefit
from depreciation.
For depreciation purposes real estate can be divided into two
categories:
1) Residential property
2) Non-residential
property
Residential property is where people live, single family
residence,duplexes and so on. Non-residential property is property
that is not residential in nature, for example: industrial,
commercial, office buildings and other similar properties. Since
Janury1,1987 all real property must use the straight line method of
depreciation where the value of the property is depreciated in equal
annual amounts over the depreciable life of the property.
Residential rental property must use a useful life of 27.5 years
and nonresidential property must use a useful life of 39 years.
Basis.
The original Basis (OB) is used to determine the depreciable
basis and adjusted basis. The depreciable basis (DB) is used to
determine the amount of allowable depreciation. The adjusted
basis (AB), which changes as time pregresses, is required to
calculate the gain on the disposition of a property.
ORIGINAL BASIS: The original basis of property is the sum of its
purchase price and buying expenses on acquisition. When a client
purchases a property, the escrow statement includes the sale price
and a listing of other costs and expenses. These amounts can be
classifieds into four basis groups:
1) Purchase price
2) Operating
Expenses
3) Buying Expense (non-recurring closing
cost)
4) Non-deductible items (such as impound accounts)
1) Purchase price: The purchase
price is the amount the buyer is willing to pay and the seller
willing to accept in payment for the property. On the escrow
statement , the purchase price usually is on the top line and is
called total consideration. Purchase price is often financed in some
manner. These loans do not affect the basis. Furthermore, if the
buyer takes out a new loan, refinances, or takes out a second
mortgage, these loans also do not increase the basis.
2) Operating Expenses. Operating
Expanses, usually recurring cost such as interest, insurance and
taxes) are written off against the income produced by the property.
Points (loan origination fees) are nonrecurring interest costs that
are amortized over the life of the loan; they are not operating
expenses.
3) Buying Expenses. Buying
Expenses are defined as nonrecurring escrow costs. The buying
expenses are added to the purchase price, making up the original
basis. Points are never added to the basis.
Original Basis - Purchase Price + Buying expenses
4) Depreciable Basis. The
depreciable basis is defined as the original basis multiplied by the
percentage of improvements to the land.
Depreciable basis = Original basis x Percentage of improvements
to land.
A alternative formula is:
Depreciable basis - Original basis -
Land value
Investment real estate is composed if two items, the land and the
structure; only the structure can be depreciated. Because land is
not depreciable, its value must be subtracted from the total
original basis to arrive at the depreciable basis, the improvement.
Three methods for determining the percentage of improvements are the
assessed value method and the contracts method.
Asses value method.
The county assessor's property tax statement now lists the full
cash value of the land and the improvements. The value of the
improvements for depreciation purposes is thus the assessor's
determination of the part of the purchase price that represents the
value of the improvements.
For example: John purchased a property for $100,000 and received
the following tax bill from the county assessor's office:
Assessed value:
Land: $30,000
Improvements:
$70,000
Total: $100,000
The improvements give John a depreciable basis of 70% of his
purchase price plus buying expenses.
Appraisal method.
The appraisal method may give homeowner more or less favorable
ratio than the assessed value method.
Contract method.
With this method the buyer and the seller determine the relative
values of the improvements and land and designate these values in
the contract, deposit receipt or escrow instructions.
Adjusted Basis.
The adjusted basis of a property is the amount that the client
has invested in the property for tax purposes. The adjusted basis is
equal to original basis, plus improvements made, less all
depreciation taken:
Adjusted basis = Original basis + Improvements-Depreciation
Calculation of the basis is affected by how the property
originally was purchased.
a) Basis by purchase: is the price
paid for the property
b) Basis by gift: is the donor's (gift
giver) adjusted basis plus the gift tax paid, not to exceed the fair
market value at the time of the gift.
c) Basis by
inheritance: is the fair market value at the time of the owner's
death.
Computing Gain.
The basis is the beginning point for computing the gain or loss
on the sale, but numerous adjustments to the basis always are made
during the ownership period. Some of the costs that increase the
basis are title insurance, appraisal fees, cost of capital
improvements, and sales costs on disposition. Accrued (past)
depreciation is deducted from the basis. The result is the adjusted
basis.
For example:
Purchase price: $80,000
Buying
expenses: $800
Capital
Improvements: $3,000
Total: $83,000
Accumulated depreciation: $-12,500
Adjusted cost basis: $71,300
Sales price: $100,000
Sale
cost: $-4,000
Adjusted cost
basis: $71,300
Total gain $24,700
Calculating Depreciation.
To compute the depreciation, follow these six steps:
1) Compute the original basis.
2) Determine
allocation between land and building
3) Compute the
depreciable basis.
4) Determine whether the property is
residential or nonresidential. If residential you must use the 27.5
year table for residential property. If nonresidential use 39 yea
table.
5) Find the month the property was placed into
service, go to the year you want to depreciate, and find the
appropriate percentage.
6) Compute the depreciation by
multiplying the depreciable basis by the appropriate percentage.
Example: Joe purchased 10 unit apartment on July 8. He paid
$800,000 plus nonrecurring closing cost of $10,000. The land value
is $300,000.
1)Original basis = $800,000 = $10,000 =
$810,000
2) Land value is $300,000
3) Depreciable basis -
$810,000 - $300,000 = $510,000
4) Apartments are residential,
therefore use 27.5 table to determine the appropriate
percentage.
5) The property was put into service in July. You
will need a "Depreciation of Real Property" Table. Your account
should have one.
6)Depreciation = $510,000 x (depreciation of
real property table), in this case 0.0167 = $8,517
Capital Gains Due to Depreciation.
The capital gains tax rate for gains attributable to depreciation
is 25%.
Example:
Property cost: $300,000
Depreciation
take: $100,000
Adjusted cost basis: $200,000
If the property sold for $500,000 there would be $300,000 gain.
$200,000 of the gain would be taxed at 15% rate, but the $100,000
would be taxed at 25%
rate.
Principles of Income
Tax
Income tax is a charge levied or tax on earnings,
which is money that individuals, corporations, trusts or other legal
entities receive in different ways and from different sources.
The 'tax net' refers to the different types of money
payments on which taxes are charged. Generally, taxes are charged on
personal earnings or wages, welfare donations received, capital
gains, as well as business income. While the rates for different
types of income vary, some types of income may not be taxed at
all.
For instance, capital gains may be taxed when realized
(for e.g. when shares are sold) or when incurred (for e.g. when
shares appreciate in value). Business income may only be taxed if it
is of a certain value or above it or else based on the manner in
which it is paid. Some kinds of income, such as interest on bank
savings, may be considered to be personal earnings (similar to
wages) or as a realized property gain (similar to selling shares).
In some tax systems the exact criteria based on which income is
classified as personal earnings may be strictly defined such as a
requirement that labor, skill, or investment was required (e.g.
wages); while in others they may be defined broadly to include
windfalls (e.g. gambling wins).
Tax rates may be also be classified as either
progressive or flat. A progressive tax taxes a differential amount
based on the income that has been earned. For instance, the first
$10,000 in earnings may be taxed at 5%, the next $10,000 at 10%, and
any more income at 20%. On the contrary, a flat tax taxes all
earnings at the same rate. A tax system may use both progressive and
flat taxes for different types of income.
Usually, income tax systems also have deductions
available. These deductions help lessen the total tax liability by
reducing total taxable income. Income tax systems may also allow
losses from one type of income to be counted against another. For
instance, a loss on the stock market may be deducted against tax
paid on wages. Other tax systems incorporate a system of isolating
the loss, such that business losses can only be deducted against
business tax, by carrying forward the loss to tax years to
come.
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