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Why Taxes are Important to the Investor

Why Taxes are Important to the Investor. Income taxes (federal, state, and local) are part of the cost of any investment. To get the highest net return on the money invested, taxes must be minimized. The planner must attempt to minimize the tax portion of the investment cost.

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Why Taxes are Important to the Investor

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  1. Why Taxes are Important to the Investor • Income taxes (federal, state, and local) are part of the cost of any investment. • To get the highest net return on the money invested, taxes must be minimized. • The planner must attempt to minimize the tax portion of the investment cost.

  2. The Problem of Understanding Tax Laws • The complexity of the federal income tax law is almost overwhelming. • State & local taxes are almost as complex. • However, to maximize investment return, planners and clients both must understand: • Taxes involved in the acquisition and disposition of an investment; • Taxes relating to income and expenses during the period the investment is held; and • The federal income tax rate structure.

  3. Acquisition and Disposition Tax Issues • Basis (including the “at risk” rules). • Business, energy, and rehabilitation tax credits. • Timing of reporting gain or loss upon disposition. • Character of gain or loss upon disposition.

  4. Income and Expenses Tax Issues • IRS definition of “Income.” • Character of income or loss. • Deductible expenses. • Timing of recognition of income and expenses.

  5. Special Features of the Federal Income Tax Rate Structure • Income tax rates. • The alternative minimum tax (“AMT”). • The revised “kiddie” tax.

  6. Basis • The cost or “Basis” is the starting point for determining the amount of gain or loss. • It is also the measure of the maximum amount of depreciation or amortization allowable for certain types of assets. • Basis is not always what you think it will be – how you treat an investment on your taxes can change its cost basis for tax purposes.

  7. Investor’s Original Basis • An investor’s original basis in a purchased asset is its cost. • The cost of property is the amount the investor paid for it in cash or other property. • For example, if Bob buys a rental property for $100,000 cash, his original basis in the acquired property is $100,000. • Basis applies not just to real property – but to all assets.

  8. Property used to Acquire an Investment • When property other than (or in addition to) cash is used to acquire an investment, and the transaction does not qualify as a tax-free exchange, the cost (basis) of the property acquired is the sum of any cash paid plus the fair market value of any property given. • For instance, if Bob purchased the rental property for $10,000 cash plus stock of IBM worth $90,000, Bob’s original basis in the rental property would be $100,000 (the sum of the $10,000 cash paid plus the $90,000 fair market value of the stock).

  9. Exchanging one Property for Another • When an investor exchanges one property for another, the market value of the two properties will usually be approximately equal. • The fair market value of both properties (for income tax purposes) will usually be ascertained by reference to the property whose value is most easily determined. • Example: An exchange of stock for a real property: The stocks are readily marketable and can be valued easily. Thus, their value will determine the market value of the real property.

  10. Mortgage or Other Debt • When property is acquired subject to a mortgage or other debt, the basis of the property is not merely the amount of the investor’s equity in the property – the basis is the total of the cash and the value of other property paid plus the amount of the debt. • Basis = Cash + Other property + Debt acquired • For example, if Rich buys a $1,000,000 apartment house, paying $250,000 in cash and borrowing the remaining $750,000, his basis in the property is the full $1,000,000.

  11. “At Risk” Rules • An investor’s ability to create basis through the use of debt is limited by the “at risk” rules. • These rules provide that losses are deductible only to the extent the investor is personally “at risk.” • For example, sometimes there are “non-recourse loans” to partners in a project. This means that the partners are not personally responsible to pay the debt. The partners cannot use the debt as part of their basis, because they are not at risk for that debt.

  12. Example of the “At Risk” Rules • The “at risk” rules limit deductions for borrowing when there is no actual economic risk to the investor. • For instance, assume Georgia wants to purchase a $100,000 interest in an oil drilling venture. She intends to invest $20,000 of her own funds while borrowing the $80,000 balance. • The bank providing the loan to Georgia has agreed to make a “nonrecourse” loan to her. • In other words, the bank will rely solely on the value of the property as its collateral for the debt. • In the event Georgia cannot repay the loan, the bank cannot look to Georgia’s other assets to cover the unpaid balance. • Since the most Georgia can lose on her investment is $20,000 in cash, her deductions will be limited to that $20,000 (plus the amount of income generated from the investment).

  13. Qualified Nonrecourse Financing • The “at risk” rules cover essentially all investment activities except for real estate acquired before 1987. • With respect to real estate subject to the “at risk” rules, “qualified nonrecourse financing” is treated as an additional amount at risk. • “Qualified” financing is generally defined as borrowings (except convertible debt) from persons or entities actively engaged in the business of lending money (such as banks), and not the former owner of the property. • Loans from or guaranteed by a federal, state, or local government agency will also qualify.

  14. Applying “At Risk” Rules to Other Production of Income Aside from real estate investments, the “at risk” rules apply to the following examples of activities engaged in by an individual for the production of income: • Holding, producing, or distributing motion picture films or video tapes. • Farming. • Exploring for or exploiting oil and gas reserves or geothermal deposits. • Leasing of depreciable personal property.

  15. Investor is Considered “At Risk” When… An investor is considered at risk to the extent of: • Cash invested, plus • The basis of property invested, plus • Amounts borrowed for use in the investment that are secured by the investor’s assets (other than the property used in the investment activity), plus • Amounts borrowed to the extent the investor is personally liable for its repayment, plus • When the investment is made in partnership form – • The investor-partner’s undistributed share of partnership income, plus • The investor-partner’s proportionate share of partnership debt, to the extent he is personally liable for its repayment

  16. No “At Risk” Nonrecourse Debt • An investor is not considered “at risk” with respect to nonrecourse debt (other than qualified nonrecourse financing) used to finance the activity, or to finance the acquisition of property used in the activity, or with respect to any other arrangement for the compensation or reimbursement of any economic loss. • For example, if Georgia is able to obtain commercial insurance against the risk that the oil drilling fund will not return her original $20,000 cash investment, she would not even be considered “at risk” on that amount.

  17. Limiting Losses with Deductions • Losses limited by the “at risk” provisions are not lost; instead, these amounts may be carried over and deducted in subsequent years (but only if the investor’s “at risk” amount is sufficiently increased).

  18. Investor’s “At Risk” Amount is Reduced Below Zero • The benefit of previously deducted losses must be recaptured when the investor’s “at risk” amount is reduced below zero. • For example, assume Tania’s loss deductions from her interest in an oil drilling venture total $5,000 through the end of last year. • Her basis in the venture at the end of last year (after the deductions) was $1,000. • In the current year Tania received $3,000 in cash distributions. • That distribution reduces Tania’s basis by $3,000 to -$2,000.

  19. Investor’s “At Risk” Amount is Reduced Below Zero (cont’d) • Since an investor cannot have a negative basis in an investment for tax purposes, Tania must recapture the $2,000 of prior year deductible losses in order to bring her basis up to zero. • In addition, Tania will not be able to deduct any losses from the venture in the current year because she has a zero basis.

  20. Basis of Property Acquired from a Decedent • Under current law, when an investor dies (in a year other than 2010) the beneficiary of his property does not “carry over” the decedent’s basis. • Instead, the basis of property acquired from or passing from a decedent is the fair market value of the property as of the date of: • The investor’s death; or • The federal estate tax alternate valuation date if that date (typically six months after the date of death) is elected by the estate’s executor.

  21. Basis of Property Acquired from a Decedent • Therefore, if the value of an investment held until death increases from the date of its acquisition, the potential gain (or loss in the case of a decrease in value) is never recognized for income tax purposes. • An increase in the property’s basis to its federal estate tax value is called a “step-up” in basis.

  22. No Income Tax on the Stepped-Up Basis • This “stepped-up basis” is obtained even though no one pays income tax on the intervening appreciation. • For example, if an individual had purchased stock that cost $10,000 and that had a fair market value of $50,000 at the time of his death, his beneficiary would receive a $50,000 basis for the stock. • The $40,000 appreciation in the value of the stock would never be taxed. • If the beneficiary then sold the property for $65,000, his taxable gain would be only $15,000.

  23. Alternate Valuation Method • The alternate valuation method may be elected by an executor or administrator only if the election will decrease: • The value of the gross estate; and • The amount of the federal estate tax imposed. • Generally, an election to use the alternate valuation date means that property will be included in the gross estate at its fair market value as of six months after the decedent’s death. • However, if any property is distributed, sold, exchanged, or otherwise disposed of within six months after the decedent’s death, the value of the property at that disposition date becomes the “alternate value.”

  24. Economic Growth and Tax Relief Reconciliation Act of 2001 • As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the “stepped-up basis at death” rules were repealed for property acquired from a decedent after December 31, 2009.  • Due to a “sunset” provision of the 2001 Act, this repeal is in effect for only one year. After 2010, the entire act is revoked and the law reverts to the old tax law. • For property inherited during 2010, special, modified carryover basis rules apply. 

  25. Economic Growth and Tax Relief Reconciliation Act of 2001 • The recipient of the property will receive a basis equal to the lesser of the adjusted basis in the hands of the decedent or the fair market value of the property as of the date of death.  • Under these rules, a partial basis step-up is allowed, which is limited to $1,300,000 or $3,000,000 in the case of a surviving spouse.  • The determination of which assets will receive the step-up is discretionary, to be made by the executor or administrator of the estate.

  26. Property Acquired by Gift – Transferred Basis • When property is acquired by lifetime gift and there is a gain on the sale by the donee, the general rule is that the property in the hands of the donee has the same basis (subject to an adjustment) it had in the hands of the donor. • This is called a “substituted” or “transferred” or “carryover” basis. • The donee of the gift – the new owner – computes his basis by referring to the basis in the hands of the donor. • In other words, the donor’s basis is “transferred” and “carried over” to the donee so that gain will not escape tax but merely be deferred. • The gain remains deferred only until the donee disposes of the property in a taxable transaction.

  27. Example of Transferred Basis • Assume that Alex purchases stock for $3,000. • After it appreciates in value to $9,000, he gives it to Sara. • The basis of the stock in Sara’s hands for determining gain on a later sale by Sara is still $3,000. • Therefore, if she sells it for $10,000, she has a $7,000 gain. • Alex gave his tax liability to Sara along with the gift! • Note that if Sara is in a lower tax bracket, this transfer gets taxed at a lower rate. This means that Sara will have more money in her hands than she would have had if Alex had sold the stock, paid the taxes and given the rest to her.

  28. Adjustments • When the donor’s basis is used, it is subject to an adjustment for any gift taxes paid on the net appreciation in the value of the gift (but not above the amount of the gift tax paid). • For instance, in the previous example, if the gift tax were $1,500, the donee’s basis would be the $3,000 carryover basis plus $1,000 adjustment, a total of $4,000.

  29. Computing the Adjustment to the Transferred Basis • The addition to basis is computed according to the following formula: • In our example, the computation would be:

  30. Different Rules for Gains and Losses • The basis rule for determining loss on the sale of property acquired by gift is different from the rule for determining the amount of the gain on the sale. • For purposes of determining the amount of a loss, the basis of the property in the hands of the donee is the lesser of: • The donor’s basis; or • The fair market value of the property at the time of the gift. • The purpose of this special provision is to prevent investors from gaining a tax benefit by transferring property with a built-in loss to persons who could take advantage of tax losses.

  31. The Deck is Stacked in Favor of the IRS • Rarely does it pay to give a gift that has lower value than its original basis. • Assume, for instance, that in the example above the value of the stock at the time of the gift was only $1,000. • If Alex sold the stock, he would have a capital loss of $2,000 ($3,000 basis – $1,000 amount realized). • If Alex had other capital losses of at least $3,000, but no capital gains, the $2,000 loss would be of no immediate tax benefit to him. • Were it not for the special provision, Alex might give the stock to his father who had capital gains. • If his father were allowed to use Alex’s $3,000 basis, his father could sell the stock, take a $2,000 loss, and obtain the tax benefit from the loss that Alex himself could not have used.

  32. Can’t Give Away Losses • For this reason, the father, in determining his loss on the sale, must use as his basis the $1,000 fair market value of the property at the time of the gift since that is lower than Alex’s $3,000 basis. • If Alex’s father sold the property for $900, he would only recognize a $100 loss on the sale ($900 proceeds less $1,000 basis). • If Alex’s father sold the property at a time when it was worth only $1,200 (or any other amount between the $1,000 fair market value at the date of the gift or the $3,000 carryover basis), no gain or loss would be recognized.

  33. General Business Tax Credits • A credit is a dollar-for-dollar reduction in the investor’s tax. • The business tax credits include energy, rehabilitation, and low-income housing tax credits, designed to encourage investment in certain types of property used in a trade or business, including rental property (and, thus, stimulate economic growth).

  34. Tax Credits • The energy credit is a percentage of the taxpayer’s qualified investment in energy property and is generally limited to 10%. • This category includes solar energy and geothermal property. • The rehabilitation credit is available for expenditures incurred to rehabilitate buildings that are certified historic structures or were initially placed in service before 1936. • The credit is limited to 10% of qualified rehabilitation expenditures for buildings that are not certified historic structures. • Rehabilitation expenditures for buildings that qualify as certified historic structures are eligible for a credit of 20%. • Both of the rehabilitation credits apply to residential as well as nonresidential properties. • A credit is also available for investment in certain low-income housing.

  35. Tax Credits Forming the General Business Credit • The energy, rehabilitation, and low-income housing credits are aggregated with certain other credits to form the general business credit. • The amount of the general business credit that may offset income taxes in any one year is limited.

  36. Reduction of Basis • The energy and rehabilitation tax credits are not without cost. • The investor must reduce his basis for both purposes of computing future depreciation deductions and computing gain or loss upon the sale or other taxable disposition of the asset. • The property’s basis must be reduced by: • 50% of the business energy tax credit, and • 100% of the rehabilitation credits.

  37. “Recaptured” • Disposing of property for which an energy or rehabilitation credit was claimed before five years and that reduced the investor’s tax liability requires that some or all of the investment credit must be “recaptured,” (i.e., reported as an additional tax). • Property that is held at least five full years from the date it was placed in service is not subject to recapture. • Likewise, early dispositions triggered by the investor’s death or by a tax free transfer to a corporation in exchange for its stock will not result in recapture. Recapture is sometimes called “tax on phantom income.”

  38. Recaptured Chart • If recapture is required, the investor must add to his tax a portion of the credit as indicated in the following table:

  39. Increasing the Investor’s Basis • This recapture has the effect of increasing the investor’s basis in the property (which was previously reduced when the credit was claimed). • This adjustment to basis is treated as if it were made immediately before the disposition. • However, the low-income housing credit is subject to a 15-year recapture period rather than the 5-year schedule.

  40. Reporting a Gain or Loss upon Disposition • The timing of when a gain or loss is reported for tax purposes is critical to the success of the investment. • Deferring income until a later year, particularly a year in which the investor is in a lower tax bracket, or accelerating a deduction into a year in which the taxpayer has a great deal of income, can significantly enhance the after-tax return from an investment. “On your tax return, put off income as long as you can, and take deductions as soon as you can.”

  41. Annual Accounting Periods • The problems of determining the correct year to report income or take deductions flow from the requirement that income is to be reported on the basis of annual periods. • Although there are a few exceptions, as a general rule investors must report income and claim deductions according to annual accounting periods.

  42. Disposition and “Closed” Transactions • Most individuals are “cash basis” taxpayers. • A “cash basis” investor generally will recognize a gain or loss from the disposition of an asset at the time the transaction is “closed.” • The mere signing of an agreement to sell does not trigger the recognition of gain or loss. • A transaction is not closed until the seller transfers title to the property in exchange for cash or other proceeds.

  43. Installment Sales • The installment sale provisions are particularly important to an investor who has sold an asset for a substantial profit and has received a cash down payment and note from the purchaser for the balance due. • Usually these notes are not readily transferable. • Without the installment sale rules, the investor would incur a large tax in one year even if he does not have sufficient cash to pay the tax. • Installment sales are also indicated when an investor wants to sell property to another party who does not have enough liquid assets to pay for the property in a lump sum at closing.

  44. Four Basic Rules for Reporting an Installment Sale The basic rules for installment sale reporting include the following: • A seller of property can defer as much or as little as desired and payments can be set to fit the seller’s financial needs. • Even if payments are received in the year of sale, the installment method may still be used for the unpaid balance. • For instance, a sale for $1,000,000 will qualify even if $300,000 is received in the year of sale and the remaining $700,000 (plus interest on the unpaid balance) is paid over the next five years.

  45. Four Basic Rules for Reporting an Installment Sale (cont’d) • No payment has to be made in the year of sale. • For example, the parties could agree that the entire purchase price for payment of a $1,000,000 parcel of land will be paid five years after the sale (with interest being earned on the $1,000,000 during the 5-year period). • The only requirement is that at least one payment must be made in a taxable year after the year of sale. • This means that an investor should contract to have payments made to him at the time when it is most advantageous (or the least disadvantageous).

  46. Four Basic Rules for Reporting an Installment Sale (cont’d) • Installment sale treatment is automatic unless the investor affirmatively elects not to have installment treatment apply. • The installment note receivable may be independently secured (such as with a letter of credit obtained from a bank) without triggering the recognition of income when the note is secured.

  47. Computation of Gain Recognized From an Installment Sale • The computation of the gain recognized with each receipt of each cash payment from an installment sale can be illustrated as follows: • Example: Assume an investor purchased land that cost $10,000. Five years later she sells the land for $50,000. Upon closing, she receives $20,000 cash plus a note for the remaining $30,000. The note provides for three annual payments of $10,000 plus interest of 10% on the unpaid balance.

  48. Installment Sale Chart • The investor’s cash received each year is as follows:

  49. Computation of Gain • Computation of gain – Income is realized in the same proportion that the gross profit (selling price less seller’s adjusted basis) bears to the total contract price (amount to be received by the seller). • The installment method of reporting is not available for losses. • Losses are recognized in full in the year of sale and may be deductible, subject to certain limitations. • In addition, upon the sale of certain depreciable property, gain must be recognized in the year of sale to the extent of the “depreciation recapture” amount, even if no cash is received in that year.

  50. Computation of Gain (cont’d) • This rule results in the following treatment of the components of the proceeds: • The amount of each component in any given payment is computed as follows:

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