Real Estate

<div class="Section1">Real estate investments can provide &ldquo;shelter&rdquo; from taxes through (1) deferral of payment of tax from one year to another and (2) absolute tax savings (<em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7790">7790</a>).<div class="Section1"><br /> <br /> When depreciation deductions and any other noncash deductions are large enough, the taxable income from the property can be substantially less than its positive &ldquo;cash flow&rdquo; (the amount of cash receipts remaining after subtracting from gross cash receipts all cash expenses and payments on mortgage principal). Often, the noncash deductions produce a loss that partly or totally &ldquo;shelters&rdquo; the net cash flow. In many instances, deductions for depreciation and other expenses can produce a tax loss that offsets other taxable income. Because investment in real estate will generally be a passive activity, such losses may normally offset only other passive income of the taxpayer, although passive losses and the deduction-equivalent of credits with respect to certain rental real estate activities may offset up to $25,000 of nonpassive income of an individual. (The passive loss rules are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7793">7793</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>.)<br /> <br /> However, when mortgage amortization payments exceed the depreciation on the property, taxable income and even the tax itself can exceed the investor&rsquo;s share of cash flow or tax savings.&nbsp;This taxable but noncash income is often referred to as &ldquo;phantom income&rdquo; and, assuming constant rental income and constant mortgage amortization, phantom income can increase each year.&nbsp;The carryover of disallowed passive losses from earlier years may reduce or even eliminate the phantom income in later years. If the individual has not prepared for phantom income, he or she may want to dispose of the investment.&nbsp;The tax consequences of disposition of property, including a partnership interest, are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7753">7753</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7766">7766</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7833">7833</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7836">7836</a>.<br /> <br /> </div></div><br />

<div class="Section1">Generally, the &ldquo;at risk&rdquo; rules apply to losses incurred after 1986 with respect to real estate placed in service after 1986.<a href="#_ftn1" name="_ftnref1">¹</a> However, in the case of an interest in an S corporation, a partnership, or other pass-through entity acquired after 1986, the &ldquo;at risk&rdquo; rules will apply to losses incurred after 1986 no matter when the real estate was placed in service.<a href="#_ftn2" name="_ftnref2">²</a><div class="Section1"><br /> <br /> In general, the &ldquo;at risk&rdquo; rules limit the deduction an investor may claim for the investor&rsquo;s share of net losses generated by the real estate activity to the amount he or she has at risk in that activity.&nbsp;The rules do not prohibit an investor from offsetting the investor&rsquo;s share of the deductions generated by the activity against the income received from the activity. For a detailed explanation of the operation of the &ldquo;at risk&rdquo; limitation, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8006">8006</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8009">8009</a>.<br /> <br /> Put as simply as possible, an investor is initially &ldquo;at risk&rdquo; to the extent that he or she is not protected against the loss of money or other property contributed to the program. One special exception applies in the real estate context, however. An investor is considered at risk with respect to certain qualified nonrecourse financing incurred in the holding of real property. For the specifics as to how an investor&rsquo;s &ldquo;amount at risk&rdquo; is calculated, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8005">8005</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;465(c);&nbsp;TRA &rsquo;86 &sect;&nbsp;503(c)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; TRA &rsquo;86 &sect;&nbsp;503(c)(2).<br /> <br /> </div></div><br />

<div class="Section1">The regulations permit the gain from sales or exchanges of vacant land to be excluded under IRC Section 121 if the following requirements are satisfied: (1) the vacant land must be adjacent to the land containing the taxpayer’s principal residence; (2) the taxpayer must have owned and used the vacant land as part of the taxpayer’s principal residence; (3) the land sale must occur within two years before or after the date of the sale of the residence; and (4) the statutory requirements must have otherwise been met with respect to the vacant land.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> The sales or exchanges of the residence and the vacant land are treated as one sale or exchange. Therefore, only one maximum limitation amount of $250,000 ($500,000 in the case of certain married taxpayers filing jointly) applies to the combined sales or exchanges of vacant land and the residence.<a href="#_ftn2" name="_ftnref2">²</a> For more information on the rules governing sales or exchanges of vacant land, <em><em>see</em></em> Treasury Regulations Sections 121-1(b)(3)(ii)(A) (how to apply the maximum limitation amount to sales or exchanges occurring in different taxable years); 1.121-1(b)(3)(ii)(B) (sale or exchange of more than one principal residence in a two-year period); 1.121-1(b)(3)(ii)(C) (sale or exchange of vacant land before residence).<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 1.121-1(b)(3)(i).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. § 1.121-1(b)(3)(ii)(A).<br /> <br /> </div>

<div class="Section1">IRC Section 121 does not apply to the gain allocable to any portion of property that is separate from the “dwelling unit” to which a taxpayer does not satisfy the use requirement. A taxpayer is <em>not</em> required to allocate gain if both the residential and business portions of the property are within the <em>same</em> dwelling unit. Although the taxpayer must pay tax on the gain equal to the total depreciation taken after May 6, 1997, he or she may exclude any additional gain on the residence up to the maximum amount. However, if the business portion of the property is <em>separate</em> from the dwelling unit, the taxpayer is required to allocate the gain, and is able to exclude only the portion of the gain attributable to the residential unit.<a href="#_ftn1" name="_ftnref1">¹</a> The term “dwelling unit” has the same meaning as in IRC Section 280A(f)(1), but does not include appurtenant structures or other property.<a href="#_ftn2" name="_ftnref2">²</a> The method for determining the amount of gain allocable to the residential and nonresidential portions of the property is explained in Treasury Regulation Section 1.121-1(e)(3).</div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.121-1(e)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.121-1(e)(2).<br /> <br /> </div>

<div class="Section1">A taxpayer may make an election <em>not</em> to have the exclusion of gain on the sale or exchange of a principal residence apply. If this election is made, the gain from the sale or exchange of a principal residence would not be excluded.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 121(f); Treas. Reg. § 1.121-4(g).<br /> <br /> </div>

<div class="Section1"><em>Editor’s Note:</em> The 2017 tax reform legislation provides a 20 percent credit for qualified rehabilitation expenses made with respect to a historic structure. This credit is to be claimed ratably over a five-year period beginning with the tax year in which the structure is first placed in service (i.e., 4 percent each year).<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> Designed as a tax incentive to encourage the preservation of historic buildings and as a means of spurring commercial growth in older cities and neighborhoods, a special investment tax credit is available for certain expenditures incurred in the rehabilitation of qualified buildings. The credit has been available for qualifying expenditures incurred after 1981 but underwent substantial revision in TRA ’86.<br /> <br /> A 20 percent credit is available for expenditures incurred in rehabilitations of certified historic structures (residential or nonresidential) and a 10 percent credit was available for expenditures incurred in the rehabilitation of other buildings (nonresidential) that were first placed in service before 1936. These percentages apply to property placed in service (as a result of the rehabilitation) after 1986.<a href="#_ftn2" name="_ftnref2">²</a> Under the 2017 tax reform legislation, the 20 percent credit is to be claimed ratably over a five-year period beginning with the tax year in which the structure is first placed in service (i.e., 4 percent each year).<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> This credit is effective for tax years beginning after December 31, 2017. However, a transition rule provides that: (1) if the building is owned or leased by the taxpayer during the entire period beginning after December 31, 2017 and (2) the 24-month period for substantial rehabilitation work (60 months in the case of phased projects) begins within 180 days of the legislation’s enactment, the amendments will not apply until after the 24-month (or 60-month) period ends.<br /> <br /> The final bill eliminated the previously existing credit for pre-1936 non-historic<br /> buildings.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 47(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC §§ 47(a), 50(b)(2), 47(c); Treas. Reg. § 1.46-1(q).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 47(a).<br /> <br /> </div>

<div class="Section1">Yes. Gain from sale of property is defined as the excess of the amount realized over the seller’s tax basis (as adjusted for items such as depreciation). Loss is the excess of the tax basis (as adjusted) over the amount realized.<a href="#_ftn1" name="_ftnref1">¹</a> The tax basis of property includes any unpaid nonrecourse mortgage liability, and on sale of the property subject to the mortgage the amount realized by the owner includes the unpaid balance of any nonrecourse mortgage on the property.<a href="#_ftn2" name="_ftnref2">²</a> It does not make any difference that the unpaid balance of the mortgage exceeds the fair market value of the property at the time of sale.<a href="#_ftn3" name="_ftnref3">³</a></div><br /> <div class="Section1"><br /> <br /> Abandonment of property subject to a nonrecourse debt is treated as a sale or exchange and the amount of outstanding debt is an “amount realized” on sale or exchange for purposes of determining and characterizing gain or loss.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 1001.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  <em>Crane v. Comm.</em>, 331 U.S. 1 (1947).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 7701(g); <em>Comm. v. Tufts</em>, 103 S. Ct. 1826, 83-1 USTC ¶ 9328 (1983).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  <em>Yarbro v. Comm.</em>, 737 F.2d 479, 84-2 USTC ¶ 9691 (5th Cir. 1984); <em>Middleton v. Comm.</em>, 77 TC 310 (1981), <em>aff’d</em>, 693 F.2d 124, 82-2 USTC ¶ 9713 (11th Cir. 1982).<br /> <br /> </div>

<div class="Section1">Gain on the sale of property depreciable by the purchaser is ordinary gain if the sale is between certain related parties. For this purpose, related parties are: (1) a person and a corporation or partnership of which the person owns (directly or indirectly) a 50&nbsp;percent or more interest; (2) an individual and a trust in which the individual (or the individual&rsquo;s spouse) is a beneficiary having more than a remote interest; (3) generally, an executor and a beneficiary of an estate; and (4) an employer and a welfare benefit fund.<a href="#_ftn1" name="_ftnref1">¹</a> In determining 50&nbsp;percent ownership, the general rules of constructive ownership under IRC Section&nbsp;267(c) apply (except paragraph (3) thereof).<a href="#_ftn2" name="_ftnref2">²</a><div class="Section1"><br /> <br /> If the sale is an installment sale, the installment method of reporting is denied and the proceeds are deemed to be received in the year of sale, unless the Service is satisfied that avoidance of federal income taxes was not one of the principal purposes of the disposition<a href="#_ftn3" name="_ftnref3">³</a> (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="667">667</a>).<br /> <br /> Gain or loss on transfers between spouses or former spouses incident to a divorce is not recognized, and the basis of the property generally remains the same in the hands of the transferee as in the hands of the transferor<a href="#_ftn4" name="_ftnref4">⁴</a> (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="789">789</a>).<br /> <br /> Loss on the sale of property to certain related persons is not recognized (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="701">701</a>).<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect;&nbsp;1239(a), 1239(d).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;1239(c)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;453(g).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;1041.<br /> <br /> </div></div><br />

<div class="Section1">Some types of real estate investment (e.g., low-income housing and rehabilitation of old or historic structures) provide tax credits that directly reduce the tax on an individual&rsquo;s income. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7801">7801</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7808">7808</a>. Because investment in real estate will generally be a passive activity, such credits may normally offset only taxes from passive activities of the taxpayer, although passive losses and the deduction-equivalent of credits with respect to certain rental real estate activities may offset up to $25,000 of nonpassive income of an individual. (The passive loss rules are explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>.) Investment tax credits can offer absolute shelter of income that would otherwise be spent for taxes, provided the property is held long enough. If not, there is some recapture. Even if this is the case, however, there has been the benefit of deferral.</div><br />

<div class="Section1">The reduced maximum exclusion is computed by multiplying the maximum dollar limitation of $250,000 ($500,000 for certain joint filers) by a fraction.</div><br /> <div class="Section1"><br /> <br /> The numerator of the fraction is the shortest of: (1) the period that the taxpayer owned the property during the five-year period ending on the date of the sale or exchange; (2) the period that the taxpayer used the property as a principal residence during the five-year period ending on the date of the sale or exchange; or (3) the period between the date of a prior sale of property for which the taxpayer excluded gain under IRC Section 121 and the date of the current sale or exchange. The numerator of the fraction may be expressed in days or months.<br /> <br /> The denominator of the fraction is 730 days or 24 months (depending on the measure of time used in the numerator).<a href="#_ftn1" name="_ftnref1">¹</a> Thus, for example, a single taxpayer who would otherwise be permitted to exclude $250,000 of gain, but who has owned and used the principal residence for only one year and is selling it due to a job transfer, the fraction would be ½ and the maximum excludable amount would be $125,000 [½ × $250,000].<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 1.121-3(g)(1); see also IRC § 121(c)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  See, e.g., Treas. Reg. § 1.121-3(c), Ex. 1; General Explanation of Tax Legislation Enacted in 1998 (the 1998 Blue Book), p. 166.<br /> <br /> </div>