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Click on link to go to:
Table of Contents; Chapter I: Real Property; Chapter II: Legal Ownership; Chapter III: Agency & Ethics; Chapter IV: Contracts; Chapter V: Real Estate Mathematics; Chapter VI: Financing; Chapter VII: Mortgage Insurance; Chapter VIII: Appraisal; Chapter IX: Transfers of Real Estate; Chapter X: Property Management; Chapter XI: Land Control; Chapter XII: Taxation; Chapter XIII: Fair Housing Laws; Chapter XIV: Macroeconomics; Chapter XV: Legal Professional Requirements; Chapter XVI: Notarial Law; Chapter XVII: Selling Real Estate; Chapter XVIII: Trust Funds Handling; Glossary; Index.

Chapter XII: Taxation and Assessments

(The following is reprinted by permission from the CalBRE Reference Book, p.493-522)

 

Property taxes are levied according to the value (ad valorem) of the property as of the date acquired, or the date of completion of newly constructed improvements. Generally the more valuable the property, or the more current its acquisition or construction date, the higher the tax. Property taxes represent the largest single source of income for local governments. A growing form of local revenue is received from special assessments on properties which are related to benefits received rather than to ad valorem taxes. All property within the jurisdiction of the taxing authority (federal, state, county, city) is taxable unless specifically exempt.

 

REAL AND PERSONAL PROPERTY TAXES 

 

Procedure in Assessing

 

Property assessment rolls reflect California's policy of showing real property assessed values at 100% of values rather than the 25% level used statewide until fiscal year 1981-82.As the assessed value quadrupled, the tax rate was dropped to no more than one percent of the assessed value. The lien date in California is March 1, at 12:01 a.m. of each year.

 

 

Proposition 13

 

 

Starting July 1,1983, county assessors must also issue Supplemental Real Property Tax Assessments based on reappraisal after any change in ownership or new construction completed after the lien date.

 

In June 1978 California voters approved the Proposition 13 amendment to the California State Constitution whereby the maximum annual tax on real property is limited to one percent of "full cash value" (market value) plus a maximum of up to two percent annual inflationary factor and plus an additional sum to pay for indebtedness on affected property approved by voters prior to the passage of the amendment. Recently adopted legislation would allow selected new indebtedness following a vote of the voters affected. The last amount, when applicable, will vary from county to county and within each county. As a rule of thumb, estimates of the average charge have been less than 1/10 of one percent.

 

Property owners may contact the appropriate county assessor or appeals board office for detailed information concerning property appraisals and classifications and for appeals for protesting any Supplemental Tax Assessments (as discussed below).There are rules of both procedure and time limitations to be followed in regard to assessment appeals. An applicant for an assessment appeal should be prepared to justify applicant's opinion of the "full cash value" of the property in question as of the date of change of ownership or date of new construction which has occurred on the property since the former base value was issued. Comparable sales data, income data or cost data may be used to support the opinion of value.

 

A county equalization agency may reduce an assessed value which has been appealed by the owner, increase an assessment value or enroll a property that has escaped assessment, provided such agency gives the assessee notice and a hearing.

 

In brief, the above changes in the Revenue and Taxation Code mean that all property within the taxing jurisdictions has been appraised at the 1975 value level and, thereafter, it will be reappraised when the property is purchased, newly constructed, or whenever a change in ownership occurs after the 1975 lien date.The base year valuations may be increased thereafter up to the maximum rate of two percent per year.

 

In general, except for that owned by a government, all real property and all tangible personal property except inventory used in business is subject to assessment in California. Publicly owned property generally is exempt from taxation except that property located outside the jurisdiction of the public entity holding title is assessable by the taxing authority within whose jurisdiction it is located if the property was taxable at the time it was acquired or is new construction that replaces property that was taxable when acquired. A private possessory interest right to exclusive beneficial use of public-owned real property is taxable. Intangible property, such as shares of stock and promissory notes, as well as household furnishings and personal effects of individuals are not assessed or taxed.

 

Supplemental Real Property Tax Assessments

 

New procedures for enrolling adjustments to assessed valuations of real property have been used by assessors for each assessment year since 1983.

 

Under legislation which added Chapter 3.5 to Part 0.5 of Division 1 of the Revenue and Taxation Code, titled "Change in Ownership and New Construction After the Lien Date", assessors appraise real property which has changed ownership or is newly constructed at its full cash value.

 

Added taxes become due on the date the change in ownership occurs or the new construction is completed. This is done by issuing supplemental assessments (SAs) to be added to a supplemental tax roll whenever either of the above events occur. The value determined becomes the new base year value of the transferred or newly-constructed property. There are appeal procedures for protesting supplemental assessments just as there are for assessments made on the regular local roll.

 

If the reassessment (change of ownership or construction completion) takes place between March 1st and May 31st, inclusive, two supplemental assessments are made. Those events occurring between June 1st and the last day in February inclusive generate only one SA. Further, whenever a property changes ownership more than once during an assessment year, or whenever there are multiple completion dates for new construction during an assessment year or any combination of transfers and construction, a new SA is made for each of these multiple occurrences, in addition to the regular SA.

 

A supplemental assessment, as determined by the county assessor, is the difference between the new base year value and the former base year value. If a supplemental assessment is based on an increase in a property's value, taxes are calculated by the county auditor using the tax rate in effect for the year in which the change occurred. Such SAs are in addition to the normal secured taxes. Supplemental assessment of property that has decreased in value results in the auditor issuing a partial refund of taxes paid in advance. Such a refund is made to the new owner, not the original taxpayer.

 

There are exclusions from SAs for certain new construction; e.g., where the owner will not occupy but intends to market the improvement, and has so notified the assessor in writing prior to commencement of construction. But should the newly-constructed improvements be transferred leased or rented, a SA shall be made as of that date.

 

SAs will not affect an exemption for which the property or assessee is otherwise eligible, for example, a homeowners' exemption.

 

Taxation and Assessments

 

County assessors are generally alerted to changes in ownership through documents filed with the county recorder and made aware of construction starts by the issuance of building permits. When the assessor determines that an ownership change or new construction completion has occurred the assessor: (1) places a notice of the pending supplemental billing on the roll prepared, (2) notifies the auditor who places an appropriate notation on the current roll or on a separate document kept with the roll that a supplemental billing may be forthcoming and (3) sends a prescribed notice to the assessee. The notice includes, among other things, the new base year property value, the taxable value appearing on the current roll and/ or roll being prepared, information concerning the assessee's right to appeal the SA, and procedure for filing a claim of exemption. The notice advises the assessee that a refund will be made by the auditor should the SA be a negative amount (decrease).

 

The tax collector then mails supplemental tax bills showing the amount of supplemental taxes due and other specifically designated information.

 

SA taxes become a lien on the real property on the date of the change in ownership or completion of new construction. Supplemental taxes are due on the date the tax bills are mailed. The first installment becomes delinquent on the last day of the month following the month in which the bill is mailed.

 

The second installment becomes delinquent on the last day of the fourth calendar month following the date the first installment becomes delinquent. When they are billed between July 1 and October 31, the SA taxes become delinquent December 10 (first installment) and April 10 (second installment) .

 

If the taxes due become delinquent a penalty of 10 percent attaches to them. If all delinquent amounts are not paid in full by June 30th, next following the date of delinquency, the property is declared to be in a tax-defaulted status.

 

Exemptions

 

There are numerous properties that are assessed, but are partially or totally tax-exempt, as well as some kinds of real and tangible business and personal property that are neither assessed nor taxed. Each residential property that is owner-occupied on the lien date (12:01 a.m., March 1) and meets other qualifying tests, including an owner-occupied unit in a multiple unit residential structure and each owner-occupied condominium, cooperative apartment, or unit in a duplex, receives an exemption of the first $7,000 of full value (homeowner's exemption).Once granted, the exemption remains in effect until terminated. Each homeowner is responsible for notifying the assessor of any termination. An escape assessment plus a 25 percent penalty and interest may be added for failure to notify the assessor.

 

There is an exemption of $4,000 of full value of the properties of certain war veterans (veterans exemption).This exemption cannot apply to a property on which the homeowner's exemption has been successfully claimed. But a veteran owning property of all kinds, whether taxable or exempt, worth $5,000 or more ($10,000 if owned by husband and wife) is ineligible. In computing the $5,000 property limitation, one-fourth of the assessed value of the taxable property and the full value of nontaxable property is used in order to maintain the same proportionate values of such property and such limitations that previously existed. A totally disabled veteran may receive an exemption of the first $100,000 of the value of his residence. There is no income or asset limitation, however, the veteran must have been a resident of California upon entering the military or on January 1, 1975.A disabled veteran who met a residency requirement in effect before January 1,1975 likewise can qualify, even if not a resident of California on January 1,1975.An unmarried, surviving spouse of a qualified disabled veteran may also qualify for an exemption. The county assessor can provide application forms and other information on filing for the disabled veteran's exemption.

 

All growing crops, fruit, and nut bearing trees less than four years old and grapevines less than three years old, property held or exclusively used for human burial or owned by nonprofit entities, including certain nursery and kindergarten-to-12th grade schools, used exclusively for religious charitable, or hospital purposes, churches, nonprofit private schools and colleges, business inventories, household furnishings, personal effects and pets, and many boats and seagoing vessels are exempt. Timber is no longer subject to property tax, but owners now pay a yield tax on downed or felled timber. However, timberland remains taxable.

 

Change in Ownership Statement

 

Section 480 of the California Revenue and Taxation Code requires any person acquiring an interest in real property or a mobilehome subject to local property taxation to file a change in ownership statement with the County Recorder or Assessor. The change in ownership statement must be filed within 45 days of the date of recording, or if the transfer is not recorded, within 45 days of the date of the change in ownership. Failure to file a change in ownership statement within 45 days from the date of a written request by the Assessor will result in a penalty of one hundred dollars ($100) or 10 percent of the taxes applicable to the new base year value reflecting the change in ownership of the real property on the real property or mobilehome, whichever is greater. This penalty will be added to the roll and is treated and collected like, and will be subject to the same penalties for delinquency as, all other taxes on the roll on which it is entered. This penalty may also be applied if, after a request, the person who is a transferee of any interest files an incomplete statement and does not supply the missing information upon a second request. There are various provisions governing the penalty being added to either the unsecured roll or on the current or subsequent year's secured roll as a lien against the property transferred.

 

Sections 480.3 and 480.4 of the Revenue and Taxation Code were added by Assembly Bill 3132 (Chapter 1237, Statutes of 1984) requiring county assessors and recorders to make available to property buyers a "Preliminary Change of Ownership Report" form. This form is to be completed by the buyer prior to transfer of the property. If a document evidencing a change of ownership is presented to the recorder for recordation without the concurrent filing of this preliminary change of ownership report, the recorder may charge an additional recording fee of twenty dollars ($20).The additional fee will not be charged if the document is accompanied by an affidavit that the transferee is not a resident of California.

 

Property Tax Liens

 

Taxes due upon real property are liens against the real property. Taxes on personal property are also liens against real property if assessed on the secured assessment roll; the real property securing them is that with which they are listed on the roll or to which they are cross-referenced on the roll.

 

Whether locally assessed personal property is assessed on the secured roll or on the unsecured roll depends upon certain facts and judgments.

 

If the personal property is owned by the owner of the land on which it is located on the lien date and the assessor believes that the real property at this location is sufficient security for the tax, the personal property is assessed on the secured roll.

 

The personal property tax will also be secured by a lien on real property of the same owner located elsewhere in the county when the taxpayer so requests and the assessor issues a certificate that is recorded with the county recorder on or before the lien date.The personal property and the securing real property are cross-referenced in such cases.

 

Secured property taxes become liens against real property on March 1.The tax rates are determined on or before September 1.One half the taxes on real property are due on November 1 and payable without penalty until 5 pompon December 10.The second half is due on February 1 and is delinquent if not paid by 5 pompon April 10.If either December 10 or April 10 falls on a Saturday, Sunday, or legal holiday, the time of delinquency is extended until 5 p.m. on the next business day. A 10 percent penalty applies to an installment that becomes delinquent. After the second installment is delinquent, the tax collector must collect a charge of $10 on each parcel of real property for preparing a delinquent roll.

 

In the case of a supplemental assessment (when a change of ownership occurs or new construction is completed other than on March 1) the date of such event is used to determine a new base year value and as a basis for a one time tax lien.

 

Unsecured property taxes are due on March 1, the date as of which they are valued. Last year’s secured property tax rate is applied to the assessed value. The tax may be paid without penalty until the close of business on August 31.A 10 percent penalty applies to delinquent unsecured taxes, and a further penalty begins to accrue at the rate of 1 % per month on November 1.

 

Postponement of Property Tax.

 

The law permits "senior citizens" (persons 62 years of age or older) and persons who are blind or disabled to defer payment of taxes on their residences. To qualify, an individual must own and occupy the home, have at least a 20% equity in the property (using the assessor's full value as the standard), and have a yearly total household income of $24,000 or less ($34,000 for those who filed in 1983).If married, only one spouse need qualify.

 

In applying the law, a lien in favor of the State of California is placed against the property and an interest rate determined by the rate earned by the Pooled Money Investment Fund is charged. The postponed taxes and interest run for an indefinite period; they are not recovered until the property is sold, the claimant no longer occupies the property or does not meet the terms of the program.

 

Tax Sale and Redemption of Real Property

 

Real property tax-defaulted or tax-defaulted with the power to sell may be redeemed upon payment of taxes, interest, costs and redemption penalties. Redemption payment is made to the county tax collector, who then issues a certificate of redemption as evidence of payment.

 

Delinquent taxes, costs, interest and penalties may be paid in five annual installments if the current taxes are kept current. When the final installment is made, redemption is complete.

 

If the property has not been redeemed within five years after the initial declaration of default made by the tax collector, the property will (by operation of law and upon notice given by the tax collector) become subject to the tax collector's power to sell. The right of redemption terminates at the close of business on the last business day prior to the date a tax collector's auction begins. If the property is not sold, the right of redemption revives. When the property which is subject to the tax collector's power to sell is redeemed, the tax collector will execute and record a "Recission of Notice of Power to Sell Tax- Defaulted Property".

 

Tax Sale. The tax collector may sell the properties to taxing agencies, revenue districts, and to certain non-profit organizations. In the case of residential property the sale to a non-profit organization is conditional upon the rehabilitation and subsequent sale of the property to low-income persons. In the case of vacant property, the non-profit organization must either construct a residential building on the property and sell the property to low-income persons or dedicate the vacant property to public use.

 

The tax collector may sell tax-defaulted real properties which are subject to the power to sell to any person at a public auction or to adjoining property owners at a sealed bid sale. The tax collector is required by law to attempt to sell all properties which have become subject to the power to sell, within two years. The minimum price at which property may be sold at public auction must be an amount not less than 25 percent of the fair market value as established by the county assessor within one year of the date of the sale. When properties are rendered unusable by their size location, or other conditions, they may be sold by the tax collector at a sealed bid sale to contiguous property owners at a price established by the tax collector.

 

The minimum bid has to be approved by the County Board of Supervisors. After the authorization by the State Controller, the tax collector publishes or posts the required notices, setting the date of sale. At the time of the sale all property will be sold to the highest bidder. The amount of the highest bid shall be paid in cash (lawful money of the United States) or negotiable paper, or any combination thereof which the tax collector specifies. Upon completion of the Tax Sale, the purchaser receives a tax deed, which conveys title free of all encumbrances of any kind existing before the sale, except those shown in Section 3712 of the Revenue and Taxation Code.

 

Veterans' Exemption

 

Under the California Constitution, a California resident who has given military service in time of war is entitled to an exemption of $4,000 on the full value of property, with certain exceptions. This same advantage is given to the unmarried surviving spouse or a pensioned father or mother of a deceased veteran.

 

Disabled Veterans' Exemption

 

The principal residence of a veteran who is blind, has lost the use of two or more limbs, or is totally disabled because of injury or disease incurred in military or naval service may be exempt to the amount of $40,000 market value ($60,000 if the household income does not exceed an amount determined yearly--the county assessor should be called to find out the amount).The principal residence of a disabled veteran, including those who are blind or have lost the use of two or more limbs, who are classified as totally disabled may be exempt to the amount of $100,000 assessed value. No income limit is applicable. The veteran must have been a resident of California upon entering the service or a resident of the state on certain specified dates, if qualifying as either blind or having lost the use of two or more limbs. Concerned persons should contact the assessor's office.

 

No limitation on assets is imposed for eligibility. The exempted property may be in mixed ownership, including property of a corporation. The unmarried surviving spouse of a qualified veteran may also receive the exemption.

 

Federal Taxes

 

Under the Internal Revenue Code (Title 26 of the U.S.Code), any Internal Revenue tax unpaid after assessment and demand becomes a lien on all property and rights to property belonging to the taxpayer at any time during the period of the lien, including any property or rights to property acquired after the lien arises. However the Federal Tax Lien is not valid against purchasers, holders of security interests including mortgages, mechanics lienors, and judgment lien creditors until a notice of lien has been filed in the proper place. Even though a notice of lien has been filed, it is not valid against certain classes of creditors (known as "Superpriorities") defined in Section 6323(b) of the Internal Revenue Code (Title 26 U.S.Code.) With respect to real property, the notice must be filed with the office of the recorder of the county in which the real property subject to the Federal Tax Lien is situated.

 

In addition to the general tax lien the Internal Revenue Code provides for special liens for Estate and Gift Taxes. The special Estate Tax Lien attaches at the date of the decedent's death to every part of the gross Estate, whether or not the property comes into the possession of the Executor or Administrator, and continues for a period of ten years. The Estate Tax Lien is not recorded. Unlike the general tax lien, the Estate Tax Lien is valid as against most purchasers and transferees even though unrecorded.

 

The special Gift Tax Lien attaches to all gifts made during the calendar year for the amount of the Gift Tax imposed upon the gifts made during such year. If the Gift Tax is not paid by the donor when due, the donee of any gift becomes personally liable for the tax to the extent of the value of the gift. The Gift Tax Lien extends for a period for ten years from the time the gifts were made. Like the Estate Tax Lien, the Gift Tax Lien is not recorded.

 

There are also two specific Estate Tax Liens imposed by the Internal Revenue Code. Unlike the special Estate Tax Lien, these specific liens are recorded. One of these liens is for estates electing to pay estate tax in installments for up to fifteen years. The other lien is for estates that elect to file an estate tax return using a special valuation for certain farms and real property used in closely held family businesses. This special valuation will result in a lower estate tax. In the event that the special use does not continue during the required period, then the tax attributable to the special valuation is recaptured. The lien attaches to the specific property valued this way. These specific liens must be filed in the office of the county recorder for the county in which the real property is located.

 

Federal Gift Tax--Unified Credit

 

This tax applies to completed voluntary transfers by an individual of any type of property for less than an adequate and full consideration in money or money's worth.

 

If the transfer is of a present interest, a yearly exclusion of $10,000 per donee is allowed. If the gift qualifies for this exclusion, no return is due.

 

If a gift to any donee exceeds $10,000 in a year a return is due. A return is due regardless of value if the gift is of a future interest.

 

Beginning in 1982, two types of transfers are no longer considered gifts, thus negating the necessity of a return. These include any amount paid on behalf of an individual:

 

a) as tuition to an educational organization, or

 

b) to any person who provides medical care.

 

The due date of the Federal Gift Tax Return, Form 709, is April 15 of the year following the gift. Any extension of time granted for filing the form 1040 shall also operate as an extension for filing Form 709.The filing requirement can be complex in some situations. Any questions should be referred to your local I.R.S. office.

 

Even though a return may be due does not mean it will be taxable. For example, transfers between spouses are not taxable.

 

Also, donors may make large transfers and use their Unified Credit rather than pay tax. The Unified Credit is a dollar for dollar offset against the tax.

 

State Taxes

 

Documentary Transfer Tax

 

This state enabling act allows a county or city to adopt a documentary transfer tax to apply on all transfers of real property located in the county. Notice of payment is entered on the face of the deed or on a separate paper filed with the deed.

 

The tax applies when the consideration (exclusive of the value of any lien or encumbrance attaching to property at time of sale and not removed or replaced upon consummation of the sale) exceeds $100.Tax is computed at the rate of 55 cents for each $500 of consideration or fraction thereof. If a portion of the total price paid for the property is exempt because a lien or encumbrance remains on the property, this fact must be stated on the deed or on a separate paper filed with the deed.

 

The law requires that "The declaration (of the amount of tax due) shall include a statement that the consideration or value on which the tax due was computed was, or that it was not, exclusive of the value of a lien or encumbrance remaining on the interest or property conveyed at the time of sale."

 

A city within a county which has adopted the transfer tax may also adopt its own transfer tax ordinance with the tax amount fixed at one-half the rate chargeable by the county. In effect this merely means that the county collects the total tax in the amount recited above but does not keep it all for county use; half the amount collected is turned over to the city.

 

MISCELLANEOUS TAXES

 

Sales and Use Tax.

 

The real estate broker may be concerned with the tax on sales of real property. Tax applies to the transfers of buildings which are not considered occasional sales under the law, if pursuant to the contract of sale the buildings are to be severed by the seller. If the contract of sale requires they be severed by the purchaser, the transaction is not taxable as a sale of tangible personal property. The tax may also apply to the value of machinery, equipment and fixtures that do not constitute occasional sales when included with the sale of a buildings.

 

Where a business which required a seller's permit is being sold, the purchaser may be held liable as a successor for tax owing by the seller. If there is any question, sufficient money should be held in escrow to cover possible sales tax liability until a tax clearance is received from the State Board of Equalization.

 

Real Estate Broker and Mobilehome Sales

 

A real estate broker who sells mobilehomes as a retailer is required to hold a seller's permit and report to the Board of Equalization the sales or use tax applicable to these transactions. If a new mobilehome is sold for occupancy as a residence on or after July 1, 1980, the real estate broker classified as a retailer-consumer is required to declare and pay tax on 75% of the real estate broker's purchase price of the mobilehome.

 

The Board of Equalization has offices throughout the state. Any questions should be referred to the nearest office.

 

Unemployment Insurance Tax

 

Real Estate Salesperson and Broker Exclusion. Services performed as real estate salespersons and brokers are excluded from covered employment for purposes of Unemployment Insurance (UI), Employment Training Tax (ETT), Disability Insurance (DI) and Personal Income Tax (PIT) withholding, if all of the following conditions are met:

 

When dealing with Title I loans (HUD) the agent is considered as a statutory employee with FICA, UI, ETT and DT being deducted. Deduction of federal and state income taxes is optional in this case. A W2 Form will be issued at the end of the year.

 

1) The individual must be a licensed real estate broker or salesperson;

 

2) Substantially all of the remuneration paid to the individual is paid based on sales or other output rather than by the number of hours worked by the individual; and

 

3) There is a written contract between the individual performing the services and the person for whom the services are performed and, the contract provides that, for purposes of state taxes, the individual performing the services will not be treated as an employee.

 

If all of these conditions are met, the services of the individual are excluded from employment. If any of these conditions are not met, the status of the services of the individual will be determined under the usual common law rules for determining employer-employee relationships.

 

State Tax Lien Law

 

Under applicable State law, any tax liabilities which become due and payable, including penalties and interest, together with any costs, constitute an enforceable State Tax Lien on all real property located in this State. However, the lien is not valid against (1) a successor in interest of the taxpayer without knowledge of the lien; (2) a holder of a security interest; (3) a mechanic's lienor; or (4) a judgment lien creditor where the right, title, or interest was acquired prior to the recording of the State Tax Lien.

 

California Worker's Compensation Law. An employer's statutory liability toward an employee injured on the job is covered by worker's compensation insurance. While not technically a tax, it is included in this section because it does involve payments by the employer. This insurance provides for weekly benefit payments to employees unable to work as the result of an industrial injury or illness, as well as payment of all medical and hospital costs in connection therewith.

 

Since California law is very specific about which employees must be covered, it would be wise if doubt arises, to refer to Sections 3351-3700 of the California Labor Code. Problems are most likely to arise in the areas of independent contractors and part-time employees. Additional information about the law and coverage can be obtained from State Compensation Insurance Fund or other California insurance carriers.

 

ACQUISITION OF REAL PROPERTY

 

Cost Basis

 

One of the most important factors in determining the amount of ultimate gain or loss on a transaction is the "cost basis" attributable to the property and based upon its original acquisition. Property purchased has a basis equal to the purchase price paid. Property received as a gift takes the donor's cost (or market value at date of gift if this is lower and taxpayer desires to claim a loss).The basis of property acquired from a decedent is generally the fair market value at the date of death.

 

Tax Planning

 

Tax planning for future returns plays a significant role in real estate transactions because the government is virtually a partner (and a substantial one) in the sharing of a taxpayer's profit and loss. The price of a property may be less important than the financial position of the buyer and seller after taxes in controlling acquisition and/or disposition strategy. Tax planning should start in the pre-acquisition stage in order to control the history that ultimately will be reported in the tax return. Real estate historically has enjoyed a favorable position in both federal and state income tax laws, but to receive the available benefits, tax consciousness should start prior to the acquisition and continue through the entire life cycle of ownership.

 

Broker's Role. There are many subtleties in the real estate income tax laws and unless a real estate broker is an income tax investment counselor in his or her own right, the agent should never offer tax advice to others. The licensee should urge clients to consult a real estate tax attorney, certified public accountant or other qualified consultant to ascertain the current status of income and property tax laws.

 

INCOME TAXATION

 

Federal Income Tax

 

The Tax Reform Act of 1986 and subsequent tax laws modifications made important changes to significant provisions of the Federal Internal Revenue Code governing the taxation of personal and real property income. While the Act reduced most tax rates and simplified the rate structure, certain real property tax benefits were changed or repealed that may be of significant consequence to real property owners. For example, the 60% deduction for long term capital gain was repealed, and capital gain is now treated as ordinary income (taxed at a rate of no higher than 20% while long term capital gain refers for property held over one year.)Mortgage interest also became subject to different rules that could limit its deductibility, especially if the home is refinanced, or a second mortgage, home equity loan, or line of credit is obtained. The rules regarding depreciation also changed, so that all tangible property placed in service after December 31,1986 is subject to the modified acceleration cost recovery system (MACRS).

 

Corporations are subject to the payment of federal income taxes and they make their reports on a more comprehensive form than the individual taxpayer. Full discussion of income tax implications for real property is beyond the scope of this book. Taxpayers should seek the competent and unbiased advice of his or her real estate tax attorney, accountant or other qualified professional before investing in investment property. Information concerning tax forms and procedures can be obtained from the local office of the Internal Revenue Service.

 

Filing Returns. A taxpayer's marital status, filing status, age and gross income determines whether an individual must file a tax return. Gross income usually means money, goods and property received and tax must be paid on these items.

 

A tax return must be filed on a Form 1040, 1040EZ or 1040A completed and postmarked by April 15, the preceding tax year if you meet the filing requirements. There are many factors that affect whether or not a taxpayer must file a tax return. To make this determination the taxpayer should consult IRS 1040 Instructions.

 

Passive Activity Losses and Credits.

 

After 1986, individuals and certain other taxpayers generally cannot offset income, other than passive income, with losses from passive activities. Nor can they offset taxes on such income with credits from passive activities. The new law does contain exceptions for certain activities, such as rental real estate activities, and it also has phase-in rules for some losses.

 

A passive activity generally is any activity involving the conduct of any trade or business in which you do not materially participate. In addition, any rental activity is a passive activity regardless of whether you materially participate. For this purpose, a rental activity generally is an activity the income from which consists of payments principally for the use of tangible property, rather than for the performance of substantial services. A taxpayer materially participates in an activity if the taxpayer is involved on a regular, continuous, and substantial basis in the operations of the activity.

 

At-Risk Rules Extended to Real Property. The at-risk rules have been extended to apply to the holding of real property. The at- risk rules place a limit on the amount of deductible losses from certain activities that are often described as tax shelters. Although often referred to as a tax shelter activity, the holding of real property (other than mineral property) was not previously subject to the at-risk rules.

 

The at-risk rules apply to losses incurred on real property the taxpayer placed in service after 1986.However, in the case of an interest in an S corporation, a partnership or any other pass- through entity acquired after 1986, the extended rules apply regardless of when the entity placed the property in service.

 

Depreciation and Ownership -Income / Investment Properties.

 

Depreciation is an expense deduction or cost recovery which may be charged off on capital investments in buildings used in business, rental or other income-producing activities. It is deducted annually. Ownership of investment real property normally produces both income and expense. All payments received for the use of investment property must be included in gross income. These payments may include a bonus upon execution of a lease, taxes paid by a tenant for the landlord and receipts for miscellaneous services, for example, use of landlord's equipment. All ordinary and necessary expenses of operation of the property are deductible. These include wages paid for maintenance and operation, repairs, interest on deeds of trust, property taxes and depreciation allowance.

 

For income tax purposes, an annual accounting charge for capital recovery taken for an investment in depreciable real property by systematically apportioning the amount of the investment in the improvements (land does not depreciate) over a predetermined recovery period selected by the taxpayer and allowed for the asset by IRS regulations.

 

It should be noted that whether depreciation is taken advantage of by the taxpayer on the tax return or not, the government charges the taxpayer upon sale with the full amount the taxpayer might have taken, since the taxpayer may not choose to forego the deduction or accumulate deductions.

 

Appraisal and Income Tax Concepts. Depreciation for tax purposes is to be distinguished from depreciation for appraisal purposes. In appraisal practice, depreciation is loss in value due to any cause, whether by external or functional obsolescence or by physical deterioration. For income tax purposes, depreciation is an annual expense deduction (cost recovery allowance) taken from taxable income and charged off on capital investments in depreciable real property. This is in recognition of the fact an asset may become economically obsolete before it wears out physically and the owner has the right to recover his capital investment before the using up of the asset because of physical wear and tear.

 

Improved real property is depreciable for income tax purposes if: it is used in business or held for the production of income; has a determinable life longer than one year; wears out, decays, becomes obsolete, or gets used up or loses its value

 

from natural causes. Land itself does not depreciate and is not depreciable. Nonbusiness property is not depreciable.

 

Home Mortgage Interest Deduction. Beginning in 1988, there are new rules for deducting mortgage interest. Most people can deduct all of their home mortgage interest. However, how much interest you may deduct depends on when you got the loan, the amount of the loan, and use of its proceeds.

 

In general, if you got any loan that was secured by your main or second home before October 14,1987, all of the interest is deductible. If you got a loan that was secured by your main or second home after October 13, 1987, and you used the funds to buy, build, or substantially improve that home, in general, you can deduct all of the interest if the loan is for $1 million or less ($500,000 or less if married filing separately).In addition to this, in general, you may deduct all of the interest paid on any other loans secured by your main or second home as long as the total of these loans is $100,000 or less ($50,000 or less if married filing separately).For more information, see IRS Publication 936, Limits on Home Mortgage Interest Deduction.

 

Mortgage credit certificates. State and local governments' authority to create new programs under which mortgage credit certificates (MCCs) may be issued, has been extended to December 31,1989.Under any such program created, MCCs may be issued until a total dollar amount set by the state or local government for MCCs is reached. MCCs are used to give a credit against the income tax of certain low and moderate income home-owners in connection with their getting a loan for the acquisition, qualified rehabilitation, or qualified home improvement of their main home.

 

Disposition of Real Estate: Tax Effect. Real estate may be disposed of by a "sale." A sale occurs only when either a deed or possession (as under a contract of sale) is delivered to the buyer. As long as the seller withholds both a deed and possession, the taxable event known as a sale is postponed. Assuming a sale has occurred, its tax treatment will be based upon the particular classification the property has acquired during ownership.

 

Sales or exchanges must be reported to the Internal Revenue Service on Form 1099-S, Statement for Recipients of Proceeds from Real Estate Transactions. The Act provides that beginning November 10, 1988, real estate reporting persons cannot charge any customer separately for complying with the requirements relating to Form 1099-S.  The filing of the 1099-S is not required if the value is less than $120,000.

 

Capital Gain. Capital Gain is the taxable profit derived from the sale of a capital asset (all property of a taxpayer except property held primarily for sale in the ordinary course of trade or business).Capital Gain is the difference between the sales price of property and its basis, after making allowable adjustments for closing costs, capital improvements, depreciation and fixing-up expenses.

 

The capital gains deduction is repealed for tax years beginning after 1986.However, net capital gains generally will be taxed at a rate no higher than 20%.

 

Special Rules Sale of Personal Residence. You may exclude from income up to $250,000 of gain realized on a sale or exchange of a residence, if you owned and occupied it as a principal residence for an aggregate of at least two years out of five years before the sale or exchange. If you are married filing jointly, you may be able to exclude up to $500,000 of gain.

 

Frequency of exclusion. The exclusion is not a once-in-a-lifetime benefit. If you meet the ownership and use tests for a principal residence, you may claim the exclusion when you sell it although you previously claimed the exclusion for another residence, provided that the sales are more than two years apart.

 

Principal residence. A principal includes a mobile home, trailer, houseboat, and condominium apartment used as a principal residence. An investment in a retirement community does not qualify as a principal residence unless you receive equity in the property. If you sold stock in a cooperative housing corporation during the five-year period ending on the date of sale, you must have:

 

1. Owned stock for at least two years, and

 

2. Used the house or apartment that the stock entitles you to occupy as your principal residence for at least two years.

 

In figuring whether you have owned and occupied a home as your principal residence for at least two years during the five-year period ending on the date of sale, the periods of ownership and use do not have to be continuous. The ownership and use tests may be met in different two-year periods, provided both tests are met during the five-year period ending on the date of sale.

 

 

 

Tax-Free Exchanges.

 

Property may be disposed of by exchange rather than sale. In this case, if the exchange does not qualify as a "tax-free" exchange, it is treated in all respects as a sale. But if the exchange is a "tax-free" exchange, it is treated differently.

 

To qualify as a tax-free exchange, all properties involved must be "like kind" in nature or character, not in use, quality or grade. A farm may be exchanged for a store building; vacant land for an apartment building; a rental house for a vacant parcel. A tax-free exchange cannot be made by a real estate dealer exchanging property he holds for sale to customers, or if property received is held for immediate resale, nor can a private residence be exchanged "tax free" for a rental house. If a tax-free exchange has been made, neither gain nor loss is recognized at the time of the exchange, but is deferred by the device of attributing to the property received the same cost basis as that of the property transferred. The holding period of the new property includes that of the old parcel.

 

Complications arise when the "tax-free" exchange is accompanied by the transfer of cash or other assets, i.e., "boot." Here a loss is not recognized and gain becomes taxable at the time of the exchange to the extent of the value of "boot" received. Hence, a "partially tax-free" exchange has occurred.

 

For example: A taxpayer exchanges a fourplex with a depreciated cost basis of $190,000 for a duplex worth $194,000 plus $2,000 cash. The taxpayer's gain is $6,000, but only a portion of this gain, i.e., $2,000 "boot," is recognized and taxable at the time of the exchange. The remaining $4,000 of gain is not recognized at this time but is postponed by the device of leaving the cost basis of the new property at $190,000, hence, upon resale of the duplex the remaining $4,000 of former gain is then "picked up" by the government.

 

Even more complex is the situation where the transfer of property subject to mortgage indebtedness is involved. If one property is mortgaged, gain becomes taxable at the time of the exchange to the extent of relief of the taxpayer from such indebtedness regardless of personal liability therefore. And if both properties are mortgaged the difference between the mortgages is considered subject to immediate tax to the extent of the actual gain.

 

Of course, the principal difficulty in effecting a tax-free exchange is finding suitable properties and investors to qualify in the trade. Usually, two real estate investors are not interested in each others property and an exchange must be worked out among several owners and multiparty exchanges among several parties is often the answer. The maximum time-period to buy the new exchange property is 180 days.

 

Installment Sales. Taxpayers selling real property and receiving one or more payments in a later year or years, must report the sale as an installment sale, unless the taxpayer specifically elects otherwise.

 

By selling on terms, rather than for all cash, a taxpayer often avoids being pushed into a higher tax bracket. Since income taxes must be paid on all gain in the year of sale, by using the installment method, a portion of each payment received represents a part of the gain, thus gain is postponed. Gain is taxed at the capital gains rate in effect at the time the installment payment is received.

 

The installment sale method may be used for any kind of real estate including vacant land. The taxable part of installment payments is calculated by applying the profit percentage to each payment. This percentage is found by dividing the gross profit by contract pricelist instructions should be followed for determining this percentage based on the contract price, selling price, gross profit and payments received.

 

Example: Real property is sold for $200,000; unadjusted basis is $132,000; selling costs are $8,000. Installment payments of $50,000 are to be made in the year of sale and in each of the next three years.

 

Contract price (selling price)$200,000

 

Less: Selling costs and adjusted basis -$140,000

 

Gross Profit$60,000

 

Gross Profit/Contract Price= $60,000 / $200,000 = gross profit ratio of .30 or 30%

 

For the year of sale and each of the following three years, a profit of $15,000 is reported (30% of $50,000).

 

Leases. Not only may property be sold, or disposed of in a tax- free exchange, but it may be disposed of by lease. Generally, rent received by the lessor is taxable in full as ordinary income and rent paid by the lessee is deductible in full as business expense (though not deductible for residential use). Payments by a lessee on execution of a lease may be either advance rentals or security deposits. If the former, the lessee must deduct these in the year paid and the lessor must report the payment as income in the year of receipt. Security deposits, however, remain the property of the lessee until default, therefore, they are not deductible by the lessee until forfeited and lessor reports no income until such forfeiture.

 

The effect of assignments and subleases on income taxes will depend upon whether or not the basic rental is more or less than the value of the leasehold. If more, an assignment of the lease results in a capital loss, whereas subleasing results in ordinary loss. If the basic rental is less than the value of the leasehold, an assignment results in capital gain, whereas a sublease results in ordinary income.

 

Costs of procuring a lease, i.e., commissions, legal fees, and title expenses, must be prorated over the life of the lease. It should always be remembered, however, with respect to the tenants of residential property, that their losses and expenses are considered personal, and therefore in no event deductible.

 

Tax Credits Related to Real Estate

 

Low-Income Housing Credit.

 

California follows federal law in allowing a credit for a percentage of costs incurred in constructing or rehabilitating low-income housing located in California. A low-income housing credit is allowed under both state and federal law for qualified residential rental projects providing low-income housing placed in service after 1986 and before 1990.Generally, either:

 

20% or more of the combined residential units in the project must be occupied by those with incomes of 50% or less than area median income, or

 

40% or more of the combined residential units are occupied by those with incomes of 60% or less than area median income. Restrictions apply on the amount of rent that may be charged to families occupying the low-income units.

 

The credit for buildings placed in service in 1987 is 9 percent of qualifying costs for the first three years, and 3 percent for the fourth year (regardless of any federal subsidization).California follows the federal definition of "qualified low income housing project," except that in California: (1) a taxpayer is entitled to receive a cumulative cash distribution in an amount not to exceed 8 percent per year of the taxpayer's cash investment in the project. If the taxpayer is a partnership or S corporation, the limitation applies to each of the partners or shareholders; and (2) the taxpayer must apply any cash available for distribution in excess of 8 percent to reduce the rent on rent-restricted units or to increase the number of such units as provided under federal law.

 

For low-income housing buildings placed in service in taxable years beginning in 1988 or 1989, the applicable percentage for the first three years is the highest percentage allowed for federal purposes in the month the building is placed in service. For the fourth year, the credit percentage is the difference between 30 percent and the sum of the credit percentages for the first three years.

 

(End of the CalBRE Reference Book excerpts)

 

Update 1993

 

Nonresidential buildings

 

For nonresidential buildings placed in service after May 12, 1993, the depreciation recovery period has been increased to 39 years. The prior 31.5-year recovery period may be used for buildings placed in service during 1993, provided that there either was a binding written contract in effect before May 13, 1993, or construction had begun before May 13.For years other than the first and last years of the recovery period, the deductible rate for 39-year realty is 2.5641%.

 

Investment interest deduction limited

 

Under prior law, capital gains realized on the disposition of investment property were treated as investment income for purposes of figuring the "net investment income" ceiling for the investment interest deduction. However, for 1993 and later years, taxpayers who claim the benefit of the 20% maximum rate for net capital gains cannot treat those gains as investment income for purposes of the interest deduction.

 

Low-income housing credit.

 

The credit, which expired on June 30, 1992, has been extended retroactively and permanently. Qualifying investors may claim their allocable credit over a ten-year period. The new law makes technical changes concerning qualifying tenants, developmental and operational costs and income recertification tests.

 

Relief for discharge of business real estate debt.

 

Solvent taxpayers may elect to avoid tax on a discharge of qualifying real property business debt. Such a discharge may occur where the fair market value of the property securing the debt has fallen in value. This relief applies to debt discharges after 1992.The debt must have been incurred or assumed in connection with business real property. A debt incurred or assumed after 1992 must be incurred or assumed to buy, construct, or substantially improve real property used in a business, or to refinance such acquisition debt (up to refinanced amount).The debt must be secured by the property. The new law does not apply to discharges of farm indebtedness, which may be tax free under a separate law. The tax-free amount may not exceed the excess of the outstanding loan principal (immediately before the discharge) over the fair market value of the real property securing the debt, less any other outstanding debts secured by the property. The excludable amount also may not exceed the taxpayer's adjusted basis for all depreciable real property held before the discharge. The excluded amount reduces basis in all depreciable real property.

 

Real estate persons may avoid passive loss treatment

 

Under current law, active real estate persons must treat rental losses as passive activity losses. This disadvantage will no longer apply in taxable years starting after 1993, provided a person can show material participation in a real estate activity. The tax definition for real estate activity is very broad, covering development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing or brokerage businesses. The material participation tests require real estate activity of more than 50% and more than 750 hours during a taxable year.

 

IRS PARTICIPATION TEST RULES

 

Test 1. You participate in the activity for more than 500 hours during the tax year.

 

Test 2. Your participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals including non-owners for the year.

 

Test 3. You participate in the activity for more than 100 hours during the tax year, and your participation is at least as great as that of any other person including non-owners for that year.

 

Test 4. You are active in several enterprises but each activity does not in itself qualify as material participation. However, if you spend more than 100 hours in each activity and the total hours of these more-than-100-hours activities exceeds 500, you are treated as a material participant in each of these activities. This test is described as the significant participation test.

 

Test 5. You materially participated in the activity for any five tax years during the 10 tax years preceding the tax year in question. The five tax years do not have to be consecutive. Use only Test 1 for determining material participation in years before 1987. Thus, if you are retired but meet the five-out-of-10-year participation test, you are currently considered a material participant, with the result that net income is treated as no passive, rather than passive. If you retired from a personal service profession, an even stricter rule applies; see Test 6.

 

Test 6. In a personal service activity, you materially participated for any three tax years preceding the tax year in question. The three years do not have to be consecutive. Use only Test 1 for determining material participation in years before 1987. Examples of personal services within this test are the professions of health, law, engineering, architecture, accounting, actuarial science, the performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.

 

Test 7. Under the facts and circumstances test, you participate in the activity on a regular, continuous, and substantial basis. According to the IRS, you do not come within this test if you participate less than 100 hours in the activity.