© 2010 Rockwell Publishing Lesson 13: Income Taxation and Real Estate Principles of California Real...

© 2010 Rockwell Publishing

Lesson 13:Income Taxation andReal Estate

Principles of California Real Estate


Basic Taxation ConceptsProgressive tax

Federal income tax is progressive tax.Progressive tax: Person with higher

income is taxed at higher rate—he pays more money in taxes, and also higher percentage of his income in taxes.

Marginal tax rate: Rate that will apply to the last dollar taxpayer earns (higher bracket).


Basic Taxation ConceptsIncome

For taxation purposes, income includes more than just salary or wages.

Income is any economic benefit realized by taxpayer, unless excluded by tax code.


Basic Taxation ConceptsDeductions and tax credits

Deductions: Certain expenses may be subtracted from income before taxes.

By reducing amount of income taxed, amount of tax is also reduced.

Tax credits: Credits are subtracted directly from the amount of tax owed.

Tax credit usually represents greater savings than tax deduction.


Basic Taxation ConceptsTax shelters

Investor may seek investments called tax shelters to reduce overall tax liability through deductions or credits associated with those investments.


Basic Taxation ConceptsGains and losses

Gain results when someone sells an asset for more than she invested in it.

Gain is taxable income, unless tax code provides specific exception.


Basic Taxation ConceptsGains and losses

If property is sold for loss, loss is usually not deductible unless it is connected with:

taxpayer’s trade or businesstransaction entered into for profittheft or casualty loss of taxpayer’s

property


Basic Taxation ConceptsCapital gains and losses

Capital gain or loss: Gain or loss that results from the sale of capital asset.

Capital asset: Property held for personal use or investment purposes.

Capital gains are taxed at lower rate than ordinary income.

Capital losses also receive special tax treatment.


Even though a loss on home or other property held for personal use is capital loss, it isn’t deductible.

Capital losses on property held for investment purposes are deductible.



Deductible capital losses are netted against capital gains, resulting in net gain or loss.

Net loss may be deducted.But no more than $3,000 in net capital

losses may be deducted in single year.Net losses in excess of limit may be

carried forward and deducted in future years.



Different rules apply to sales of business and rental properties.

If property owned for a year or more and then sold, gain is capital gain, but loss is ordinary loss, so $3,000 cap on deductions doesn’t apply.



Basic Taxation ConceptsBasis

Basis: Property owner’s investment in property.

If taxpayer sells property for more than basis, any amount received that exceeds basis is taxable profit.


BasisInitial basis

Initial basis: Original cost of acquisition, including purchase price and closing costs.

Also called cost basis or unadjusted basis.

Taxpayer who paid $300,000 for property plus $10,000 in closing costs has initial basis of $310,000.


BasisAdjusted basis

IRS uses adjusted basis to calculate capital gain or loss when property is sold.

To calculate adjusted basis:start with initial basisadd capital expendituressubtract allowable depreciation

deductions


Capital expenditures: Expenditures that add to property’s value or extend its life.

Examples: remodeling or new roof.

Maintenance expenses are not capital expenditures.

Examples: painting or fixing leaky plumbing.

Adjusted BasisCapital expenditures


When depreciation deductions are allowed, deductions are subtracted from initial basis to determine adjusted basis.

Adjusted BasisDepreciation deductions


Basic Taxation ConceptsRealization

Income isn’t taxed until it is realized.Gain is realized when owner sells or

exchanges property.


Basic Taxation ConceptsRealization

Amount realized: All benefits received by seller, including money, property, and debt relief, less any selling expenses (such as broker’s commission).

Also known as net sales price.


Basic Taxation ConceptsRecognition

Taxes must be paid on gain in year in which it is recognized.

Usually, gain is recognized in same year it is realized.

However, for certain transactions, taxpayer may defer recognition until a later year.Example: installment sales.


SummaryBasic Taxation Concepts

• Income

• Deductions

• Tax credits

• Gains and losses

• Capital asset

• Initial basis• Adjusted basis• Capital expenditure• Realization• Recognition


Classifications of Real Property

The way property is taxed will depend on its property classification. Tax code has 6 classifications for real property:

principal residence propertypersonal use propertyunimproved investment propertyproperty held for the production of incomeproperty used in trade or businessdealer property


Principal residence property: Home owned by taxpayer that he lives in most of the time (also called main home).

Person can have only one principal residence at a time.

Classifications of Real PropertyPrincipal residence


Personal use property: Real estate owned for personal use that is not principal residence.

Example: vacation home.

Classifications of Real PropertyPersonal use property


Unimproved investment property: Vacant land that is held for appreciation and produces no income.

Classifications of Real PropertyUnimproved investment property


Property held for production of income: Any type of property (residential, commercial, or industrial) from which owner collects rent.

Classifications of Real PropertyProperty held for production of income


Property used in trade or business: Commercial or industrial land or buildings associated with business owned by taxpayer.

Classifications of Real PropertyProperty used in trade or business


Dealer property: Property taxpayer is holding for later sale to customers.

Example: subdivided land available for sale.

Classifications of Real PropertyDealer property


SummaryClassifications of Real Property

• Income property

• Trade or business property

• Dealer property

• Principal residence

• Personal use property

• Unimproved investment property


Nonrecognition Transactions

Although taxpayer is generally required to pay tax on gain in year it is realized, if nonrecognition provision applies, that tax can be deferred.

Real estate transactions covered by nonrecognition provisions include:

installment salesinvoluntary conversions“tax-free” exchanges


Nonrecognition TransactionsInstallment sales

Installment sale: Sale where seller receives less than 100% of price in year sale was made.

Most seller-financed transactions are installment sales.

Only gain that seller receives in particular tax year is taxed that year.

Gain is prorated over contract term.


Nonrecognition TransactionsInvoluntary conversion

Involuntary conversion: When property is converted into cash without owner’s voluntary action.

May occur through:condemnationdestructiontheftother loss of property


Involuntary conversion usually involves gain for owner.

Government or insurer usually compensates owner based on property’s market or replacement value.

Involuntary ConversionMay result in gain


IRS allows deferral of gain if taxpayer replaces property within allowed replacement period.

Replacement period generally lasts for 2 years after year gain realized.

Any gain not applied toward replacement property will be taxed as income.

Involuntary ConversionDeferral of gain


Nonrecognition Transactions“Tax-free” exchanges

“Tax-free” exchange: When certain real property is exchanged for other real property, owner is allowed to defer recognition of gain. Also known as 1031 exchange.

Exchange isn’t truly tax-free: recognition of gain is only deferred, not avoided altogether.


“Tax-free” ExchangesEligible properties

Properties eligible for tax-free exchange include:

investment propertyincome producing propertyproperty used in trade or business

Properties not eligible:principal residencepersonal use propertydealer property


To qualify, properties exchanged must be like-kind.

Real property must be exchanged for other real property located in U.S.

Like-kind property isn’t necessarily same type of real property.Example: apartment building can be

exchanged for unimproved land.

“Tax-free” ExchangesLike-kind property


“Tax-free” ExchangesBoot

Boot: Anything received in property exchange other than like-kind property.

cashstockpersonal propertydebt relief (difference in mortgage

balances)

Boot is recognized in year of exchange.


If boot received exceeds realized gain, only amount of gain is taxed, not full amount of boot.

“Tax-free” ExchangesBoot taxable only to extent of gain


General rule: taxpayer’s basis in property he exchanged is transferred to property he receives.

But if exchange involved boot, then adjustments to basis will be necessary.

“Tax-free” ExchangesTransferred basis


Exchange of real property may be “tax-free” for one party but not the other.

Example: Taxpayer A trades personal residence for Taxpayer B’s rental home.A and B will each use their new

property as rental.Exchange tax-deferred for B but not for

A, because personal residence is not eligible.

“Tax-free” ExchangesNot always tax-free for both parties


Real estate agent who arranges tax-free exchange may be paid commission by both parties to transaction.

“Tax-free” ExchangesAgent’s commission


SummaryNonrecognition Transactions

• Installment sale

• Involuntary conversion

• Tax-free exchange

• Like-kind property

• Boot


Sale of Principal Residence

Capital gain on sale of principal residence:may be permanently excluded

from taxationnot just deferred (as in exchange

or installment sale)


Sale of Principal ResidenceLimits on exclusion of gain

Individual home seller may exclude up to $250,000.

Married couple filing joint return may exclude up to $500,000.

Any amount in excess of $250,000 or $500,000 will be taxed as capital gain in year of sale.


Sale of Principal ResidenceQualifying for the exclusion

Within last 5 years, property seller must have:owned home for at least 2 years, andlived in home as principal residence for

at least 2 years.

Because of this rule, taxpayer may not use this exclusion more than once every two years.


Deductions for Property Owners

Tax deductions for property owners include:depreciation deductions (cost recovery)uninsured casualty and theft lossesrepairsproperty taxes and special assessmentsmortgage interestpoints and other loan costsoperational losses from rental property


Depreciation Deductions

Taxpayer can recover cost of asset used: for production of income, orin a trade or business.

Depreciation deductions are also called cost recovery deductions.


Assets are depreciable only if they will eventually wear out and need to be replaced.

Includes rental property, business or factory equipment, commercial fruit orchards, etc.

Does not include principal residences, personal use property, or land.

Depreciation Deductions


Allowable depreciation deductions are subtracted from initial basis to arrive at adjusted basis.

Initial basis + Capital expenditures – Allowable depreciation Adjusted basis

Cost recovery deductions are subtracted even if taxpayer did not take them.

Depreciation DeductionsSubtracted from basis


Loss Deductions

Property owner may deduct uninsured loss from taxable income.

Property damaged, destroyed, or stolen.

Loss was not fully covered by insurance.


Repair Deductions

Repair deductions: Property owner may deduct expenditures necessary to keep property in ordinary operating condition.

Unavailable for principal residence or personal use property.

Capital expenditures not deductible.Cost of these improvements added to

basis and eventually reduce capital gain.


Property Tax Deductions

General real estate taxes may be deducted from property owner’s taxable income.

Special assessments are:deductible if for maintenance or repairsnot deductible if for improvements


Mortgage Interest Deductions

Mortgage interest is usually deductible, subject to these limits for personal residences (main home or second home):

Taxpayer can deduct interest paid on:loan up to $1,000,000 used to buy, build, or

improve principal/second residence.home equity loan of up to $100,000, no

matter what used for.

Interest paid on amount over limit not deductible.


Mortgage Interest Deductions

If condo project borrows money by mortgaging common areas, and unit owners are required to pay share of mortgage payment, unit owner may deduct interest portion of her share from taxable income.


DeductionsPoints and other loan costs

Points paid in connection with new loan:are considered prepaid interestcan be deducted from taxable income

Includes:discount pointsorigination fee


Fees charged by lender for specific services are not deductible.

Examples: appraisal fee, mortgage insurance premiums, document preparation fees.

Prepayment penalty is considered to be interest, and therefore may be deducted.



Points paid by seller on borrower’s behalf are deductible.

But borrower’s basis must be reduced by amount of seller-paid points.



DeductionsOperational losses from rental property

Taxpayer who owns and actively manages rental property may deduct up to $25,000 of operational losses from ordinary income.

If taxpayer (owning and managing rental property) is real estate professional, $25,000 limit on deductions does not apply.

Losses due to vacancies are not operational losses.


Rental payment deductions are available to tenants only if rented property is used in trade or business.

So in sale-leaseback, seller who continues to lease property may deduct the rental payments.

But rent paid for residential property is never deductible.

DeductionsRental payments


California Income Tax

California’s state income tax laws mirror federal government’s.

Key terminology is same.Tax rates and standard deductions are

different.To factor in inflation, Franchise Tax

Board makes annual adjustments to tax brackets and standard deductions.


SummaryExclusions and Deductions

• Principal residence exclusions• Depreciation deductions• Depreciable property• Uninsured loss deductions• Repair deductions• Property tax deductions• Deductions for mortgage interest, points

© 2010 Rockwell Publishing Lesson 13: Income Taxation and Real Estate Principles of California Real...

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