Real Estate Investing Legal and Tax Implications 2 β Questions and Answers
Question 1: What is the primary tax advantage of a 1031 exchange in real estate?
- Eliminates capital gains tax permanently
- Defers capital gains tax when reinvesting in like-kind property (Correct answer)
- Reduces property tax assessed value
- Converts ordinary income to capital gains
Correct answer: Defers capital gains tax when reinvesting in like-kind property
A 1031 exchange allows investors to defer capital gains taxes by reinvesting proceeds into a like-kind property.
Question 2: Under a tenancy in common (TIC) arrangement, what happens to a co-owner's share upon their death?
- It automatically passes to the surviving co-owners
- It passes to the deceased owner's heirs or estate (Correct answer)
- It reverts to the government
- It must be sold immediately
Correct answer: It passes to the deceased owner's heirs or estate
In a TIC, each owner's share passes to their heirs through their estate, unlike joint tenancy where the right of survivorship applies.
Question 3: Which IRS tax form is used to report rental income and expenses for a residential rental property?
- Schedule C
- Schedule D
- Schedule E (Correct answer)
- Form 4797
Correct answer: Schedule E
Schedule E (Supplemental Income and Loss) is used to report rental income, expenses, and depreciation for residential rental properties.
Question 4: What is the maximum annual passive activity loss a real estate professional can deduct against ordinary income?
- $25,000
- $50,000
- Unlimited, with no income ceiling (Correct answer)
- $100,000
Correct answer: Unlimited, with no income ceiling
Qualifying real estate professionals can deduct unlimited rental losses against ordinary income, provided they meet IRS material participation tests.
Question 5: A 'due-on-sale' clause in a mortgage requires that:
- The buyer pays all closing costs
- The seller must pay off the loan before listing
- The full loan balance becomes due if the property is transferred (Correct answer)
- The lender must approve any property improvements
Correct answer: The full loan balance becomes due if the property is transferred
A due-on-sale clause accelerates the mortgage, making the full balance payable when the property is sold or transferred to a new owner.
Question 6: Which legal entity structure provides 'pass-through' taxation and limits personal liability for real estate investors?
- C Corporation
- Sole Proprietorship
- Limited Liability Company (LLC) (Correct answer)
- S Corporation only
Correct answer: Limited Liability Company (LLC)
An LLC provides pass-through taxation (avoiding double taxation) and shields members from personal liability for business debts.
Question 7: What is 'depreciation recapture' in real estate taxation?
- A method to increase a property's depreciation basis
- Taxing previously claimed depreciation deductions when a property is sold (Correct answer)
- A penalty for selling before the depreciation period ends
- Reclaiming depreciation from a tenant
Correct answer: Taxing previously claimed depreciation deductions when a property is sold
When a depreciated property is sold, the IRS taxes the previously deducted depreciation at a maximum rate of 25% under Section 1250 recapture rules.
Real Estate Investing Legal and Tax Implications 2
What is the primary tax advantage of a 1031 exchange in real estate?