Chapter 14 - Real Estate Taxes and Other Tax Aspects of Real Estate

1. Chapter 14

Real Estate Taxes and Other Tax Aspects of Real Estate

2. Property Tax Computation

Property taxes are computed each year by multiplying the assessed value of the property times the tax rate


Assessed value = $500,000

Tax rate = $12 per $1,000 of assessed value (1.2%)

Annual property taxes: $500,000 x 1.2% =$6,000

3. Property Taxes before 1978

Real property was taxed according to value

Ad valorum

Properties of equal value paid the same amount of tax

From 1970 until 1978, the median home price in California nearly tripled

Taxpayers in California approved Proposition 13 in 1978 to control the rise of property taxes

4. After 1978: Proposition 13

Proposition 13 placed constitutional limits on:

The initial assessed value of property

the rate of tax

the rate of increase in assessed value

5. Prop. 13: Initial Assessed Value

Proposition 13 rolled back the full cash value (assessed value) to the 1975 value

The roll back reduced property taxes by an average of 57%

6. Prop. 13: Rate of Tax

Proposition 13 set the base property tax rate at 1% of "full cash value"

Voters can agree to raise the rate of tax

rates for voter-approved bonds are added to the 1% base tax rate

2/3rds majority required to approve new bonds

Subsequently reduced to 55% majority for some types of bonds

7. Prop. 13: Increase in assessed value

Assessor can reassess property to new full cash value if there is a change in ownership

New full cash value is usually the sales price

Assessor can add the value of new improvements to the assessed value when an owner makes improvements

If no change in ownership or new improvements, assessor can increase full cash value (assessed value) by maximum of 2% per year

8. Proposition 13 Tax Computation

9. New Construction

If a property owner improves the property, the assessed value will increase by the value of the new construction

The entire property is not reassessed - the value of the new construction is added to the base assessed value

The new assessed valuation (including value of new construction) can increase by 2% per year

10. Change in Ownership

Property is reassessed to the current full cash value if the property changes owners

New full cash value generally = sales price

Change of ownership excludes:

Transfers between spouses

Transfers to living trust

Transfers between parents and children

Personal residence of any value and other property up to maximum of $1 million [Proposition 58]

11. Slide 11

Slide 11 - Tax Bill Example

12. Transfer of Assessed Value

Proposition 60: Persons over 55 can transfer the assessed value of their personal residence to a new personal residence

Properties must be in the same county

New property must have a purchase price approximately equal to the sales price of the old residence


Homeowner acquired property in 1988 for $168,000

Assessed value increased at 2% per year from 1988 to 2006, with a 2006 assessed value of $239,945

Homeowner sold property in 2006 for $575,000, purchases new residence for $575,000

$239,945 assessed value transferred from old residence to new residence saves homeowner $3,350 per year in property taxes

13. Property Tax Exemptions

Totally exempt:

Property owned by governments, schools, churches, and hospitals

Partial exemptions:

Homeowners: assessed value reduced by $7,000

Saves homeowner $70 per year in taxes at 1% tax rate

Veterans: assessed value reduced by $4,000

Cannot combine with homeowners exemption

Income limitations may apply

14. Property Taxes: Tax Year

Property taxes are due based upon a fiscal year from July 1 through June 30

Property taxes for the next fiscal year become a lien against the property on January 1 prior to that fiscal year

Property taxes are due in two installments of 6 months each

First half payment covers period from July 1 through December 31

Second half payment covers period from January 1 through June 30

15. Property Taxes: Important Dates

First half-year taxes:

Due on November 1

Delinquent if not paid by December 10

Second half-year taxes

Due on February 1

Delinquent if not paid by April 10

Memory tool: No Darn Fooling Around

16. Tax Year: Recap

17. Supplemental Taxes

Change in ownership: taxes increase on first day of the month following the date of transfer

New construction: taxes increase when construction is complete

Tax collector will send supplemental tax bills for the difference between the old tax assessment and the new tax assessment

18. Special Assessments

Special assessments are levied to pay for specific local improvements

Special assessments are imposed under several acts, including:

Mello-Roos Community Facilities Districts Act

Street Improvement Act of 1911

Special assessments have the same priority as general taxes and are levied at the same time

19. Income Taxes and Real Estate

Tax planning is a key consideration in purchase, investment, and sale of real estate

Property owners may be able to:

shelter other income from income taxes

get favorable income tax treatment on the sale of real property

Changes in income tax law affect value of and investment in real estate

20. Tax Rules Vary

Some tax rules apply only to property held for investment

Examples: depreciation deduction, tax-deferred exchanges

Other tax rules apply only to personal residences

Example: excluding portion of capital gains

21. Home Owners: Income Tax Benefits

Homeowners can reduce income taxes by deducting the costs of:

Interest paid on home loans

All interest on loans made prior to 10/13/87

Interest on up to $1 million of loans after 10/13/87 (first and second home combined)

Interest on up to $100,000 on junior loans

Real property taxes

22. Homeowners: Not Deductible

Homeowners cannot deduct other costs of owning their homes, such as:



Other property expenses

23. Income Tax Benefits of Investment Property

Owners of property used for investment or business purposes can deduct the cost of:


Property taxes


Repairs and maintenance

Management fees


Other property expenses

24. Depreciation for Income Tax

Depreciation for income tax purposes is an annual deduction from income based on theory that property wears out over time

25. Depreciable Property

Only property held for investment or business can be depreciated for tax purposes

Buildings and improvements can be depreciated

Land cannot be depreciated

investor must allocate purchase price between land and improvements

26. Depreciation Methods

Current depreciation methods for real property:

residential property: 27.5 years straight-line

non-residential property: 39 years straight-line

investor can elect to use 40 years straight-line for either type of property

Depreciation methods can change

27. Depreciation Example

Apartment Building: Purchase Price = $2,000,000

Value of Land: $800,000

Value of improvements: $1,200,000

Life of building for depreciation purposes = 27.5 years

Depreciation each year = $1,200,000 ? 27.5 = $43,636

28. Rental Property Income and Deductions

Gross Rents, Deductible Expenses, Deduction for Depreciation, Net Income or Loss (reported on 1040)

29. Income Tax: Types of Income

Three types of income for income tax purposes:

Active (Example: Wages), Portfolio (Example: Interest), Passive (Example: Real Estate Rental Income)

30. Limits on Tax Deductions

If real property generates a tax loss, IRS rules might limit the amount of loss that the taxpayer can deduct from income

Losses can be deducted from income earned from other passive sources

for example, income from other real estate

Passive losses cannot be deducted against active income or portfolio income

Exception: owners active in management of property may be able to deduct up to $25,000 in passive losses against active and portfolio income

31. Capital Gains Tax

When a property owner sells real property, the gain on the sale is income to the owner, and is subject to income tax

Tax rate on capital gains may be less than property owner's overall tax rate

Example: taxpayer in 28% tax bracket may pay 15% tax on capital gain

32. Capital Gains: Basis

When a property is purchased, the purchase price plus costs of acquisition is the owners original basis

During ownership of the property, the original basis is adjusted by adding the cost of improvements and subtracting depreciation

Original basis + cost of improvements - depreciation = adjusted basis

33. Capital Gains: Calculating Gain

When a property is sold, the capital gain (or capital loss) is calculated by subtracting the costs of sale and adjusted basis from the sales price

Sales price - costs of sale - adjusted basis = capital gain

34. Capital Gain Example

Rental House: Purchase Price = $200,000

Original Basis = $200,000

Cost of improvements = $25,000

Allowable depreciation = $8,727

Adjusted basis = $200,000 +25,000 - $8,727 = $216,273

Sales price = $400,000; costs of sale = $28,000

Gain = $400,000 - $28,000 - $216,273 = $159,727

Tax on Gain = $159,727 x 15% = $23,959

35. Excluding Tax on Capital Gains

Homeowners can exclude income tax on capital gains on the sale of their principal residence:

Married taxpayers filing jointly can exclude $500,000 in gains from tax

Unmarried taxpayers can exclude $250,000 in gains from tax

Property must have been taxpayer's principal residence for at least 2 years of the previous 5 years before the sale

36. Deferring Taxes on Capital Gains

Section 1031 tax-deferred exchanges

Only for investment property

Not available for personal residence

Installment sales tax treatment

For any property when the seller carries back financing

37. Section 1031 Exchanges

Tax on capital gain is deferred, not "tax free"

Basis in old property transferred to new property

Two main requirements:

Property must be investment property

Used in trade or business or held for investment

Properties must be "like-kind"

Example: real property for real property

Tax charged if taxpayer:

receives property that is not like-kind ("boot")

has a net reduction in debt ("debt relief")

38. Types of Exchanges

Two party exchange

Owner A exchanges property with Owner B

39. Types of Exchanges

Three party exchange

Buyer purchases property owned by Owner C, and exchanges properties with Owner A

40. Delayed ("Starker") Exchange

Owner transfers title in exchange before identifying the exchange property

Exchanging owner must

identify the exchange property within 45 days after transfer of original property

close on purchase of exchange property within 180 days after transfer of original property

41. Deferring Capital Gains: Installment Sales

If owner sells property and receives payment of the purchase price over more than one tax year, capital gain is taxed each year based on proportion of purchase price paid in that tax year

42. Installment Sales Example

Sale transaction:

owner sells property for $200,000, with borrower paying $50,000 each year for 4 years

seller's adjusted basis = $132,000

costs of sale = $8,000

Gain analysis:

gain = $200,000 - $132,000 - $8,000 = $60,000

Allocating gain to each installment payment:

ratio of gain to sales price = $60,000 ? $200,000 = 30%

Capital gain on each $50,000 installment = $15,000

$15,000 gain recognized in each of 4 tax years

43. Tax Withholding on Sale

Federal withholding: "FIRPTA":

Foreign Investment in Real Property Tax Act

Property sold by foreigner subject to tax withholding of 10% of the sales price

Buyer has the obligation to withhold taxes

No withholding if property will be buyer's personal residence and price ? $300,000

No withholding if seller signs an affidavit of non-foreign status

44. State Tax Withholding on Sale

State withholding "Cal-FIRPTA"

Property sold in California subject to withholding of 3 1/3% of sales price

Effective 1/1/2003, applies to all sales by individuals, with certain exceptions:

sales price ? $100,000

seller signs affidavit that property is seller's principal residence

seller signs affidavit that there is a tax loss on the sale