(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
Proposition
13
Starting
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
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
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.
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 1½
% 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
Tax
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
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
Veterans' Exemption
Under the California Constitution, a
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
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.
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
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
The Board of Equalization has offices throughout the
state. Any questions should be referred to the nearest office.
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.
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.
Since
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 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.
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
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
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
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
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.
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
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
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
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.