GLOSSARY

1031 exchange A like-kind exchange allowing the deferral of capital gains; named for the Internal Revenue Code (IRC) Section 1031 that provides this benefit for real estate investors.

accelerated depreciation A form of depreciation that allows higher deductions in the earlier years, compared to straight-line depreciation rates.

active participant An investor who spends time managing real estate investments in order to qualify for deducting losses for tax purposes. Active participation involves making management decisions concerning the property, even if a separate manager is hired.

adjusted basis The value of property, for tax purposes, consisting of the purchase price plus improvements and closing costs, adjusted downward for depreciation and further adjusted downward when profits from another investment are deferred through a like-kind exchange. The adjusted basis is subtracted from the adjusted sales price to arrive at taxable capital gain.

adjusted gross income (AGI) The dollar amount on an individual tax return consisting of total taxable income minus adjustments (e.g., student loan interest, contributions to an IRA, and alimony) and before deducting itemized deductions or the standard deduction, or personal exemptions.

adjusted sales price The sales price of investment real estate, consisting of the price minus real estate commission and other costs of sale. The adjusted basis is subtracted from the adjusted sales price to arrive at taxable capital gain.

after-tax cash flow The calculated amount of cash received (positive cash flow) or paid out (negative cash flow) when rental income, expenses, and other payments are adjusted to determine tax benefits of real estate investments.

allocation The process of assigning expenses among properties, used for those expenses not directly tied to any one property. The usual method is to base the allocation on the percentage breakdown of rental income.

amortization An expense calculated to be spread over a number of years, rather than written off in a single year. For example, loan points may be amortized over the term of a loan but cannot be deducted in the year paid.

asset allocation Spreading of investment capital over many dissimilar investments, for the purpose of achieving different financial goals, exposing capital to different forms of market risk and opportunity, and achieving broad diversification.

basis (1) The value of a real estate investment, calculated by adjusting the cost for closing costs, depreciation, and deferred profit from other investments; (2) the dollar value of property that is subject to depreciation, consisting of the cost of all improvements but without including the value of land.

buyer’s market The condition of the real estate market in which buyers have the advantage, usually when an excess inventory of homes is available and prices can be negotiated downward.

capital asset Spending that cannot usually be deducted in the year money is spent but that has to be depreciated over a recovery period.

capital gain (loss) The gain or loss from real estate investments or business property, subject to rates different from those on ordinary income.

cash flow The amount of cash received and paid each month; rents minus expenses paid and nonexpense payments (e.g., principal on mortgage loans), adjusted further to calculate tax benefits and savings from depreciation expenses.

depreciation An expense calculated to allow deductions of real estate improvements over a period of years. Residential real estate is depreciated over 27.5 years, and assets used to manage investment real estate are depreciated over shortened recovery periods. Depreciation is a noncash expense and is deductible on the investor’s federal tax return.

disbursements journal A specialized record used to record payments, as part of the bookkeeping system.

first mortgage A mortgage on real estate with first priority in the event of default. The first mortgage holder is paid first from proceeds of a foreclosure sale, for example.

fixer-upper A property requiring cosmetic improvements, such as painting, landscaping, and other minor repairs.

half-year convention A calculation of depreciation in the first year as though all assets in a particular class were acquired exactly halfway through the year. The half-year convention is used for shorter recovery periods.

impounds Amounts added to monthly mortgage payments, held by the lender, and then paid to third parties. Commonly, impounds include monthly payments toward property taxes and homeowner’s insurance.

leverage The use of investment capital to control more equity than would be possible through direct ownership. Buying investment real estate is an example. By putting down 20 percent, the investor leverages the remaining 80 percent of the investment through borrowed money.

like-kind exchange The sale of one property and replacement with another, in which the gain is deferred. As a result, that gain is not taxed until the placement property is sold. Also called a 1031 exchange.

limited partnership A form of real estate investment in which the limited partner has no voice in management decisions and in which passive losses cannot be deducted but must be applied against other passive activity gains.

liquidity (1) The availability of cash in a particular investment, or the investor’s ability to convert an investment to cash; (2) descriptive of a particular market, with the stock market being an example of a highly liquid market and real estate an example of a market with low liquidity.

midmonth convention A method of calculating first-year depreciation for real estate, in which depreciation is based on the assumption that the asset was acquired halfway through the month that the asset was placed in service.

modified adjusted gross income For the purpose of calculating allowable deduction of losses from real estate, modified AGI is the value of adjusted gross income without certain deductions. If modified AGI is above $100,000, deduction limits on real estate losses are reduced.

negative cash flow An undesirable situation in which more money is paid out each month than is being received. Negative cash flow may occur if the property is vacant, or if tenants do not pay rent, or if mortgage and other payments exceed the level of income that can be reasonably expected from an investment.

occupancy or vacancy rate The calculation of average periods of time a property is either occupied or vacant, usually expressed in the form of a percentage. If a property is occupied eleven out of twelve months, it has a 91.7 percent occupancy rate (or an 8.3 percent vacancy rate).

passive activity An investment activity in which the investor is not involved directly. As such, losses from passive activity cannot be deducted but must be applied against other passive activity gains. An exception to this rule is real estate, where up to $25,000 per year can be deducted as long as the investor is an active participant and has at least 10 percent ownership of the property.

payments journal Another name for the bookkeeping record or the disbursements journal.

positive cash flow A situation in which total income received exceeds cash expenses and other payments from month to month, on an after-tax basis (after counting tax savings from the activity).

primary residence The residence in which you live. You may have only one primary residence, and, for the purpose of exemption from income taxes on the gain from sale of your residence, you must live in the property for no less than two years of the five-year period immediately preceding the sale.

receipts journal A record used to record rent income and other receipts in the bookkeeping system.

recovery period In calculation of depreciation, the period of time that assets are to be depreciated. Most residential real estate is depreciated over 27.5 years, for example. Other assets used as part of the investment activity (e.g., automobiles or computers) belong in the five-year recovery period.

second mortgage A mortgage in second place of priority in the event of default. A first lien holder is paid before the second lien holder in the event of foreclosure.

seller financing Condition in which a seller offers to carry all or part of a loan upon sale of the property.

seller’s market A market condition in which there are more buyers than sellers, which drives up prices for a limited number of properties on the market.

straight-line depreciation A form of depreciation in which the amount deducted is the same each year (with the exception of first and last years). This is the prescribed method that is used for real estate or that can be elected for use in other recovery periods.

tax deferral The delay of tax liability on capital gains until a replacement property has been sold. The gain on one property is deferred by replacing it with another property within the like-kind exchange guidelines.