INCOME TAXATION

INCOME TAXATION

Federal Income Tax

While the Tax Reform Act of 1986 reduced most tax rates and simplified the rate structure, certain real property
tax benefits were changed or repealed. The 60% deduction for long-term capital gain was repealed and capital
gain was treated as ordinary income and taxed at a rate no higher than 28%. Mortgage interest also became
subject to different rules that could limit its deductibility, especially if the home was refinanced, or a second
mortgage, home equity loan, or line of credit was obtained. The rules regarding depreciation also changed, so
that all tangible property placed in service after December 31, 1986 was subject to the modified acceleration
cost recovery system (MACRS).

The Taxpayer Relief Act of 1997 changed the overall capital gains tax rate. The top rate for high income
earners was lowered from 28 percent to 20 percent. The lowest bracket was reduced from 15 percent to 10
percent. The new rates apply to assets sold after May 6, 1997. Investment property owners will experience
slightly different treatment regarding depreciation recapture under the new tax bill than in previous years. The
difference between the purchase price and selling price (profit) of a property will enjoy the lower overall capital
gains tax rate, but any gains due to depreciation recapture will be taxed at 25 percent. Individual taxpayers will
need to consult their tax specialist to determine the application of the new law to their investments.

Starting with 2008, there's a new zero percent tax rate on long-term capital gains. The zero percent rate applies
to individuals who are in the 10% and 15% marginal tax brackets. The zero percent rate is scheduled to expire
at the end of 2010, when capital gains rates will increase to at least 15%.

Capital Gains Tax Rates

Type of Capital Asset Holding Period

Tax Rate

Short-term capital gains (STCG)

Long-term capital gains (LTCG)

One year or less

More than one year

Ordinary income tax rates up to 35%

5% for taxpayers in the 10% and 15% tax brackets
(zero percent starting in 2008)

15% for taxpayers in the 25%, 28%, 33%, and 35%
tax brackets

Passive activity losses and credits. Before the Tax Reform Act of 1986, taxpayers, with some limitation, could
use deductions from one activity to offset income from any other activity. Similarly, most tax credits generated
in one activity could be used to offset tax on income from any of the taxpayer’s other activities.

In response to concerns that extensive tax shelter activity was unfair, Congress enacted the passive activity loss
(PAL) rules.

After 1986, income was separated into three categories: non-passive income, portfolio income, and passive
income. As a result of these PAL rules, taxpayers generally cannot offset non-passive or portfolio income with
losses from passive activities. Nor can they offset taxes on such income with credits from passive activities.
The new law does contain exceptions for certain activities, including rental real estate, and also has phase-in
rules for some losses.

A passive activity generally is any activity involving the conduct of any trade or business in which you do not
materially participate. In addition, any rental activity is a passive activity regardless of whether you materially
participate. For this purpose, a rental activity generally is an activity the income from which consists of
payments principally for the use of tangible property, unless substantial services are performed in connection
therewith. A taxpayer materially participates in an activity if the taxpayer is involved on a regular, continuous,
and substantial basis in the operation of the activity.

At-risk rules extended to real property. The at-risk rules have been extended to apply to the holding of real
property. The at-risk rules place a limit on the amount of deductible losses from certain activities often
described as tax shelters. Until 1987, activities associated with holding of real property (other than mineral
property) were not subject to the at-risk rules.

The at-risk rules apply to losses incurred through real property placed in service after 1986. In the case of an
interest in an S corporation, a partnership, or any other pass-through entity acquired after 1986, the at-risk rules
apply to real estate activities regardless of when the entity placed the property in service.

In general, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount
the taxpayer has at-risk in the activity at the end of the tax year. A taxpayer is considered at risk in an activity to
the extent of cash and the adjusted basis of other property the taxpayer contributed to the activity and certain
amounts borrowed for use in the activity.

A taxpayer is not considered at risk for amounts protected against loss through nonrecourse financing.
Nonrecourse financing is financing for which the taxpayer is not personally liable. However, an exception
applies to qualified nonrecourse financing secured by real property used in an activity of holding real property.
Qualified nonrecourse debt is debt for which no one is personally liable and that is:

1. borrowed by the taxpayer with respect to the activity of holding real property;

2. secured by real property used in the activity;

3. not convertible from a debt obligation to an ownership interest; and

4. a loan from, and guaranteed by, any federal, state, or local government, or borrowed by the taxpayer from a
qualified person.

A qualified person is a person who actively and regularly engages in the business of lending money. The most
common example is a bank. A qualified person is not:

1. a person related to the taxpayer (except as described later);

2. the seller of the property, or a person related to the seller;

3. a person who receives a fee due to the taxpayer’s investment in the real property, or a person related to that
person.

A person related to the taxpayer may be a qualified person if the nonrecourse financing is commercially
reasonable and on substantially the same terms as loans involving unrelated persons.

Depreciation

Depreciation is a deductible periodic accounting charge that represents the recovery of capital investment over
the useful life of property used in a trade or business or other income producing activity. Land is not included,
as it does not depreciate.

For depreciable properties acquired prior to January 1, 1981, the principal methods for computing depreciation
are straight-line, declining balance and sum-of-the-years’ digits.

For depreciable properties acquired on and after January 1, 1981 and before August 1, 1986, depreciation is
computed under a method called accelerated cost recovery system (ACRS), permitting cost recovery over much
shorter periods.

The Modified Accelerated Cost Recovery System (MACRS) must be used to depreciate property placed into
service after 1986. Taxpayers need to consult their tax advisors for more information on any changes in the
depreciation schedules that have been effected since 1986.

Appraisal and income tax concepts. Depreciation for tax purposes is to be distinguished from depreciation for
appraisal purposes. In appraisal practice, depreciation is loss in value due to any cause, including functional
obsolescence or physical deterioration. For income tax purposes, depreciation is a possible annual deduction
from taxable income in recognition of the fact an asset may become economically obsolete or wear out
physically and the owner has the right to recover his investment.

Improvements to real property are depreciable for income tax purposes if they are used in business or held for
the production of income and have a determinable life longer than one year.

Even if a taxpayer does not take a deduction for depreciation, the basis of the property is reduced by the amount
of the depreciation. Upon sale, the IRS charges the taxpayer with the full amount of depreciation the taxpayer
could have taken.

Home Mortgage Interest Deduction

For years beginning after 1987, the rules for deducting mortgage interest have been modified. The amount of
interest a taxpayer may deduct depends on the date, amount, and use of the loan.

In general, the interest on any loan obtained before October 14, 1987 and secured by a main or second home is
fully deductible.

If a taxpayer obtained a first loan after October 13, 1987 to buy, build, or substantially improve a main or
second home, interest is deductible on the first $1 million of principle ($500,000 if married filing separately).
Interest may be deductible on up to $100,000 of junior loan(s) secured by a taxpayer’s main or second home.

For more information, see IRS Publication 936, Limits on Home Mortgage Interest Deduction.

Mortgage Credit Certificates

State and local governments sometimes issue mortgage credit certificates (MCCs). Under any such program,
MCCs may be issued until a total dollar amount set by the state or local government is reached. An MCC
allows a borrower to use mortgage interest as a credit against income tax, making it easier for a low or
moderate income person to qualify for a loan for acquisition, qualified rehabilitation, or qualified home
improvement of a residence.

Disposition of Real Property - Tax Effects

The characterization and tax treatment of a sale of real property depend upon the use to which the transferor put
the property.

Sales or exchanges must be reported to the Internal Revenue Service on Form l099-S, Statement for Recipients
of Proceeds from Real Estate Transactions.

Capital gain is the taxable profit derived from the sale of a capital asset (generally, that property of a taxpayer
other than inventory). The gain is calculated as the sales price reduced by the adjusted basis, expenses of sale,
and closing costs. Adjusted basis is the original tax basis of the property adjusted for capital improvements,
depreciation and fixing-up expenses.

The capital gains deduction was repealed for tax years beginning after 1986. Although set to increase in 2011
tax year, currently long term net capital gains generally will be taxed at a rate no higher than 15%.

Special rules - sale of personal residence. Until the passage of the Taxpayer Relief Act of 1997, a taxpayer
was only permitted to postpone the gain on sale of principal residence by way of a one time only $125,000
exemption on the sale of his/her principal residence if the taxpayer was age 55 or older and had resided in the
home for at least three of the last five years. The principal residence replacement rule required the taxpayer to
purchase another principal residence of equal or greater value and use it within two years before or after sale of
the previous principal residence. The original gain was not recognized at the time of sale but was used to reduce
the cost basis of the new house

The Taxpayer Relief Act of 1997 granted a $500,000 capital gains tax exclusion to couples and a $250,000
exclusion to single filers, who sell their principal residence. The bill specified that:

The “rollover” and “over 55” requirements were repealed.

Individuals must have lived in the house for two of the last five years. For purposes of the exclusion, on
sales after September 30, 1988, taxpayers who are mentally or physically incapacitated are treated as
occupying the principal residence while they are in nursing homes or similar care facilities, as long as the
principal residence is actually occupied for periods aggregating at least one year of the applicable five-year
period. The facility must be licensed by a state or political subdivision to care for individuals in such
condition. [Internal Revenue Code §121(d)(7]

The sales transaction must have taken place after May 6, 1997.

Sellers and buyers who signed a binding contract between May 7, 1997 and August 5, 1997 could apply
either the old or new law into their transaction.

The new law gives buyers more options because they are no longer forced to purchase new homes of equal or
greater value. Individuals who meet the requirements can sell their homes every two years and still qualify. In
addition, individuals who marry someone who has already taken the “over 55” exclusion, or individuals forced
to sell because of an emergency, like a job transfer or large medical bills, will be able to use the new exclusion.
The new plan does not allow taxpayers to deduct losses on the sale of their property from their income tax.
Individuals will need to consult their own tax advisor to determine how to apply the new law to their particular
tax situation.

1031 exchanges. Property may be disposed of by exchange rather than sale. Some exchanges qualify as tax
deferred. If the exchange does not qualify as tax-free, it is treated in all respects as a sale.

To qualify as a tax-free exchange, the properties must be “like kind” in nature or character, not in use, quality
or grade. The “like-kind” rules give parties a relatively high degree of flexibility: a farm may be exchanged for
a store building; vacant land for an apartment building; a rental house for a vacant parcel. Personal use real
property does not qualify. A vacation property or a primary residence may qualify as “like-kind” property, and
qualify for tax free exchange treatment, provided certain guidelines are followed. If a tax-free exchange has
been made, neither gain nor loss is recognized at the time of the exchange, but is deferred by attributing to the
property received the same cost basis as that of the property transferred. The holding period of the new property
includes that of the old parcel.

Complications arise when like-kind property received is accompanied by cash or other assets (“boot”). When
boot is received, gain is recognized but losses are still excluded from recognition. The taxable gain is the lesser
of the value of “boot” received or the gain realized on the exchange. The result may be a fully taxable or a
partially tax-free exchange.

For example: A taxpayer exchanges a fourplex with a depreciated cost basis of $190,000 for a duplex worth
$194,000 plus $2,000 cash. The taxpayer’s gain is $6,000, but only a portion of this gain, the $2,000 boot, is
recognized and taxable at the time of the exchange. The remaining $4,000 of gain is not recognized at this time
but is postponed by leaving the cost basis of the new property at $190,000. Upon sale of the duplex, the
taxpayer must recognize the $4,000 of former gain.

If one of the properties exchanged is encumbered by mortgage debt, the debt relief is treated as boot received.
If both properties are encumbered, the debts are netted for purpose of determining the amount and assignment
of boot.

Of course, the principal difficulty in effecting a tax-free exchange is finding suitable properties and investors.
Usually, two real estate investors are not interested in each other’s property and a multi-party exchange must be
arranged.

The tax rule which requires an owner to carry over the basis of the old property as the basis for the new
property is a problem when exchanging pre-1981 properties for post-1981 properties. Special rules apply to
exchanges of pre-accelerated cost recovery system (ACRS) and post-ACRS properties. To avoid this problem,
a taxpayer may consider selling the pre-1981 property and purchase the post-1981 property with the proceeds.

Installment sales. Taxpayers selling real property and receiving one or more payments in a later year or years
must report the sale as an installment sale unless the taxpayer specifically elects otherwise.

By selling on multi-year terms, a taxpayer avoids bunching gain/income in the year of sale. Rather, recognition
of gain is deferred by spreading it over a number of tax years.

The installment sale method may be used for any kind of real estate, including vacant land. The taxable part of
installment payments is calculated by applying to each payment the profit percentage realized on the full
transaction. This percentage is found by dividing the realized profit on the sale by the full contract price. IRS
instructions should be followed for determining this percentage based on the contract price, selling price, gross
profit and payments received.

Example: Real property is sold for $200,000; unadjusted basis is $132,000; selling costs are $8,000.
Installment payments of $50,000 are to be made in the year of sale and in each of the next three years.

Contract price (selling price............ $200,000

Less: Selling costs and unadjusted basis. -140,000

Gross Profit............................. $60,000

Gross Profit Percentage = $60,000 ÷ $200,000 = 30%

For the year of sale and each of the following three years, a profit of $15,000 (30% of $50,000) is reported.

Leases. Rent is taxable to the lessor as ordinary income and, for non-residential property, deductible as a
business expense to the lessee. Payments by a lessee on execution of a lease may be either advance rent or a
security deposit. If the former, a (non-residential) lessee has a deduction and the lessor must report the payment
as income in the year paid. A security deposit remains the property of the lessee until default/forfeiture. If
forfeited, the deposit is deductible by the lessee and is income to the lessor. If the lessor pays the lessee interest
on the deposit, the lessee has reportable income.

If the lessee receives lease cancellation payments from the lessor, they are treated as being in exchange for the
sale of the lease to the lessor. If the lease is not a capital asset, the income is ordinary income to the lessee. The
lessor is treated as making an expenditure for the acquisition of a property right. The lessor’s payment must be
capitalized and added to the basis of the property. If the lessor receives lease cancellation payments from the
lessee, the lessor has ordinary income and the lessee treats the expenditure as a current business expense.

A lessor or lessee’s costs of procuring a lease (i.e., commissions, legal fees, and title expenses) must be
prorated over the life of the lease. It should always be remembered that losses and expenses of lessees of
residential property are considered personal and not deductible.

State Income Tax

As of January 2005, California generally conforms to the Internal Revenue Code (IRC). However, there are
continuing differences between California and federal tax law. When California conforms to federal; tax law
changes, not all of the tax changes made at the federal level are always adopted by California. For more
information refer to www.ftb.ca.gov and search for “conformity.”