Real Estate Investing Tax Implications of Ownership 5 — Questions and Answers
Question 1: What is 'phantom income' in real estate investing?
- Rental income received but not reported to the IRS
- Taxable income that arises without a corresponding cash payment to the investor (Correct answer)
- Income attributed to a property's estimated future appreciation
- Undisclosed income from short-term vacation rentals
Correct answer: Taxable income that arises without a corresponding cash payment to the investor
Phantom income occurs when a taxable event (such as debt forgiveness or a partner's share of income) creates a tax liability without the investor actually receiving cash.
Question 2: How does the IRS treat cancellation of debt (COD) income when a lender forgives part of a mortgage on an investment property?
- It is always tax-free for investment properties
- It is generally taxable as ordinary income unless an exclusion applies (Correct answer)
- It reduces the investor's basis in the property with no immediate tax
- It is taxed at long-term capital gains rates
Correct answer: It is generally taxable as ordinary income unless an exclusion applies
Cancellation of debt income is generally taxable as ordinary income, though exclusions may apply if the taxpayer is insolvent or the property is in bankruptcy.
Question 3: An investor owns a rental property in an LLC taxed as a partnership. How does rental income flow to the investor for tax purposes?
- The LLC pays corporate tax; the investor pays tax on dividends received
- Income passes through to the investor's personal return and is taxed at individual rates (Correct answer)
- The income is tax-deferred until the investor withdraws cash from the LLC
- The LLC files no tax return; only the investor's K-1 is filed
Correct answer: Income passes through to the investor's personal return and is taxed at individual rates
In a partnership-taxed LLC, income and losses pass through directly to the members' personal tax returns, reported via Schedule K-1, and taxed at individual rates.
Question 4: Which depreciation method is required for residential rental property under MACRS?
- Declining balance, switching to straight-line
- 150% declining balance
- Straight-line over 27.5 years (Correct answer)
- Sum-of-the-years' digits
Correct answer: Straight-line over 27.5 years
Residential rental property must be depreciated using the straight-line method over 27.5 years under the Modified Accelerated Cost Recovery System (MACRS).
Question 5: What happens to unused passive activity losses from a rental property when the property is sold in a fully taxable transaction?
- They expire and cannot be used
- They carry forward indefinitely to offset future passive income only
- They are released and can offset any type of income in the year of sale (Correct answer)
- They convert to a tax credit equal to 25% of the loss
Correct answer: They are released and can offset any type of income in the year of sale
When a passive activity property is disposed of in a fully taxable transaction, all suspended (unused) passive activity losses are released and can offset any type of income in the year of sale.
Question 6: A real estate investor contributes appreciated property to a partnership. Which of the following generally occurs?
- The investor immediately recognizes gain equal to the appreciation
- No gain is recognized at the time of contribution; the partnership takes the investor's carryover basis (Correct answer)
- The partnership receives a stepped-up basis equal to fair market value
- The investor must pay depreciation recapture tax at the time of contribution
Correct answer: No gain is recognized at the time of contribution; the partnership takes the investor's carryover basis
Under Section 721, contributing property to a partnership in exchange for a partnership interest is generally tax-free, and the partnership takes a carryover basis in the contributed property.
Question 7: Which of the following best describes 'material participation' as it relates to the passive activity loss rules for real estate?
- Owning more than 50% of a property qualifies as material participation
- The investor must participate in rental operations for more than 500 hours in the tax year (Correct answer)
- Material participation requires managing all maintenance personally
- Any level of involvement in a rental property constitutes material participation
Correct answer: The investor must participate in rental operations for more than 500 hours in the tax year
One of the IRS tests for material participation requires that the taxpayer participate in the activity for more than 500 hours during the tax year, allowing losses to be treated as non-passive.
Real Estate Investing Tax Implications of Ownership 5
What is 'phantom income' in real estate investing?