Chapter 25 - Income Tax Issues in Real Estate Transactions

I. Taxpayer Relief Act of 1997

This landmark legislation fundamentally changed how Americans are taxed on their homes. Most importantly, it replaced the old "rollover" rules and the "one-time age 55 exclusion" with a much more generous and recurring tax benefit.

• Principal Residence Exclusion: Allows homeowners to exclude a massive amount of gain from their income when they sell their primary home.

• IRA Withdrawal: Established the rule allowing first-time homebuyers to tap into retirement funds penalty-free.

II. Primary Residence Benefits

Your Principal Residence is the home you live in most of the time. The tax code offers three major "subsidies" for these owners:

1. Mortgage Interest Deduction: You can deduct the interest paid on up to $750,000 of mortgage debt used to buy, build, or improve your home.

2. Property Tax Deduction: You can deduct your local real estate taxes. Note: Under current law (SALT cap), the total deduction for state and local taxes (including property tax) is capped at $10,000.

3. IRA Down-Payment: A "First-Time Homebuyer" (defined as anyone who hasn't owned a home in the last 2 years) can withdraw up to $10,000 from a Traditional IRA penalty-free.

• Rule: You must use the funds within 120 days.

• Note: You still pay ordinary income tax on the withdrawal, but the 10% early-withdrawal penalty is waived.

III. The $250,000 / $500,000 Rule (Section 121)

This is the single most important tax rule for residential agents.

• The Benefit: You can exclude up to $250,000 (Single) or $500,000 (Married Filing Jointly) of profit from the sale of your home.

• The Ownership & Use Test: To qualify, you must have owned and lived in the home as your primary residence for at least 2 of the last 5 years prior to the sale.

• Frequency: You can use this exclusion once every 2 years.

IV. Investment Property: Classifications of Income

The IRS categorizes income into three "buckets." You generally cannot use losses from one bucket to offset gains in another (with some exceptions).

• Active Income: Money earned from "getting out of bed" (salary, commissions, bonuses).

• Passive Income: Money earned from rental properties or limited partnerships where you do not materially participate.

• Portfolio Income: Money earned from paper assets (stocks, bonds, dividends, interest).

V. Depreciation: The Tax "Shield"

Depreciation is a non-cash expense that allows investors to recover the cost of an asset over its "useful life."

• Straight-Line Method: You take the same deduction every year.

• Residential Investment: Depreciated over 27.5 years.

• Non-Residential (Commercial): Depreciated over 39 years.

• The Land Rule: Land never depreciates. You must always subtract the value of the land from the acquisition cost before calculating depreciation.

VI. Like-Kind Exchanges (1031 Exchange)

A 1031 Exchange allows an investor to sell an investment property and buy another without paying capital gains tax at that time.

• Qualified Intermediary (QI): You cannot touch the money from the sale. A QI must hold the funds in escrow.

• Timelines (Strict):

• 45 Days: You must identify the replacement property in writing to the QI.

• 180 Days: You must close (title transfer) on the new property.

• Boot: Any "unlike" property received in the deal (like cash left over or a reduction in debt) is called Boot and is taxable immediately.

⚠️ EXAM ALERT: QUICK FACTS

• Short-term vs. Long-term: Gains on assets held for 1 year or less are "Short-term" and taxed at high ordinary income rates. More than a year is "Long-term" and gets a lower rate (usually 15% or 20%).

• Points: Points paid to a lender to "buy down" an interest rate on a purchase of a primary residence are generally deductible in full the year they are paid. On a refinance, they must be deducted over the life of the loan.

• Depreciation Recapture: When you sell an investment property, the IRS "takes back" the tax benefit you got from depreciation. This portion of the gain is taxed at a maximum rate of 25%.

• Second Homes: You can deduct interest on a second home, but you cannot use the $250k/$500k capital gains exclusion unless it becomes your primary residence for 2 years.

Key Terms

Active Income: Income earned through "hands-on" participation, such as wages, salaries, commissions, and bonuses from a job or a business in which the taxpayer materially participates.

Adjusted Basis: The original cost of a property (its basis) plus any allowable capital improvements, minus any sales of portions of the property and allowable tax depreciation deductions taken during ownership. 

Appreciation: An increase in the worth or value of a property over time, often due to economic inflation or changes in market conditions. 

Basis/Adjusted Basis: Basis is the initial cost of a property for tax purposes (the purchase price plus certain closing costs). 

Adjusted Basis is that initial cost modified by capital improvements (increases) and depreciation (decreases). 

Boot: Cash or other non-like-kind property received by a taxpayer in a tax-deferred exchange; because boot is not "like-kind" real estate, it is generally taxable in the year it is received. 

Capital Gain: The profit realized from the sale of a property or investment when the sale price exceeds the property's adjusted basis. 

Capital Loss: The loss realized when a property is sold for less than its adjusted basis. 

Cash Flow: The net amount of cash remaining from an investment property after all operating expenses and debt service have been paid. Debt Service: The total amount of money required to make periodic payments of principal and interest on a mortgage loan over a specific period. 

Passive Activity Income: Income derived from a business or trade in which the taxpayer does not materially participate, such as rental income from most real estate investments. 

Tax Depreciation: A tax deduction that allows real estate investors to recover the cost of an income-producing building over its useful life; it is based on the idea that structures wear out over time, though the land itself never depreciates. 

Tax Depreciation/Recaptured Depreciation/Straight-Line Depreciation: Tax Depreciation is the annual deduction for physical wear and tear. 

Recaptured Depreciation is the tax (up to 25% for real estate) applied at the time of sale to "claw back" the tax benefits previously gained from depreciation. 

Straight-Line Depreciation is the standard method required by the IRS where the same amount is deducted each year over a set period (27.5 years for residential and 39 years for commercial properties). 

Tax Shelter: An investment, such as real estate, that provides a legal way to minimize or defer income taxes through various deductions like interest and depreciation. 

Tax-Deferred Exchange: Also known as a Section 1031 Exchange, this is a transaction that allows an investor to sell a property and reinvest the proceeds into a "like-kind" property while deferring the payment of capital gains taxes until a later date.