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CHAPTER 21 INCOME TAXATION AND VALUE Test Problems 1. Taxable income from the rental of actively managed depreciable real estate is classified as: b. Passive income. 2. Under current federal income tax law, what is the shortest cost recovery period available to investors purchasing residential rental property? e. None of the above. 3. If an investor is a “dealer” with respect to certain real estate, then that real estate is classified (by the IRS) as being held: b. For sale to others 4. When a property is sold for less than its remaining book value, its depreciation (wear and tear) was: b. Underestimated. 5. For tax purposes, a substantial real property improvement made after the initial purchase is: a. Treated like a separate building. 6. What percent of the rental income from residential property must be derived from the leasing of units occupied by tenants as housing? c. 80 percent 7. In 2007, you purchase a small office building for $450,000, which you financed with a $337,500, 25-year, fixed-rate mortgage. Up-front financing costs total $6,750. How much of this expense could be written off against ordinary income in 2007? c. $270 8. If the investor is in the 33% income tax bracket, how much will a tax credit of $2,000 save the investor in taxes? a. $2,000.00 9. Which of the following best describes the taxation of gain and losses from the sale of Section 1231 assets? d. Net gains are taxed as capital gains; net losses are taxed as ordinary income. 21-1
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10. Which of the following statements is false? d. Net passive losses can be used to offset dividend income from a REIT stock. Study Questions 1. Why do investors generally care whether the IRS classifies cash expenditures as operating expenses rather than capital expenditures? Solution : Operating expenses are generally deductible for income tax purposes in the year they are paid. Capital expenditures are added to the tax basis of a property, treated like a separate building, and expensed through annual depreciation deductions. Tax benefits, like other cash flow benefits, have higher present values when they are received sooner rather than later. 2. How are the discount points associated with financing an income property handled for tax purposes? Solution : All up-front financing costs are amortized over the life of the loan used to finance the purchase. If the loan is prepaid before the end the loan term, the remaining up-front financing costs are fully deductible in the year in which the loan obligation is extinguished. 3. What will be the taxes due on sale? Assume 6% selling costs, 33% percent ordinary income tax rate, a 15 percent capital gains tax rate, and a 25 percent recapture rate. Solution : Annual depreciation deduction = $750,000 x (1/27.5) = $27,272.73 Total depreciation over 5 years = 5 x $27,272.73 = 136,364 Sale Price $1,270,000 Less: Selling Expenses @ 6% (76,200) Net Sale Proceeds 1,193,800 Less: Adjusted Basis (1,000,000 - 136,364, or five years of 27,272.73 in annual depreciation)
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