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

© 2010 Rockwell Publishing Basic Taxation Concepts Progressive tax Federal income tax is progressive tax. Progressive tax: Person with higher income is taxed at higher rate—he pays more money in taxes, and also higher percentage of his income in taxes. Marginal tax rate: Rate that will apply to the last dollar taxpayer earns (higher bracket).

© 2010 Rockwell Publishing Basic Taxation Concepts Income For taxation purposes, income includes more than just salary or wages. Income is any economic benefit realized by taxpayer, unless excluded by tax code.

© 2010 Rockwell Publishing Basic Taxation Concepts Deductions and tax credits Deductions: Certain expenses may be subtracted from income before taxes. By reducing amount of income taxed, amount of tax is also reduced. Tax credits: Credits are subtracted directly from the amount of tax owed. Tax credit usually represents greater savings than tax deduction.

© 2010 Rockwell Publishing Basic Taxation Concepts Tax shelters Investor may seek investments called tax shelters to reduce overall tax liability through deductions or credits associated with those investments.

© 2010 Rockwell Publishing Basic Taxation Concepts Gains and losses Gain results when someone sells an asset for more than she invested in it. Gain is taxable income, unless tax code provides specific exception.

© 2010 Rockwell Publishing Basic Taxation Concepts Gains and losses If property is sold for loss, loss is usually not deductible unless it is connected with: taxpayer’s trade or business transaction entered into for profit theft or casualty loss of taxpayer’s property

© 2010 Rockwell Publishing Basic Taxation Concepts Capital gains and losses Capital gain or loss: Gain or loss that results from the sale of capital asset. Capital asset: Property held for personal use or investment purposes. Capital gains are taxed at lower rate than ordinary income. Capital losses also receive special tax treatment.

© 2010 Rockwell Publishing Even though a loss on home or other property held for personal use is capital loss, it isn’t deductible. Capital losses on property held for investment purposes are deductible. Basic Taxation Concepts Capital gains and losses

© 2010 Rockwell Publishing Deductible capital losses are netted against capital gains, resulting in net gain or loss. Net loss may be deducted. But no more than $3,000 in net capital losses may be deducted in single year. Net losses in excess of limit may be carried forward and deducted in future years. Basic Taxation Concepts Capital gains and losses

© 2010 Rockwell Publishing Different rules apply to sales of business and rental properties. If property owned for a year or more and then sold, gain is capital gain, but loss is ordinary loss, so $3,000 cap on deductions doesn’t apply. Basic Taxation Concepts Capital gains and losses

© 2010 Rockwell Publishing Basic Taxation Concepts Basis Basis: Property owner’s investment in property. If taxpayer sells property for more than basis, any amount received that exceeds basis is taxable profit.

© 2010 Rockwell Publishing Basis Initial basis Initial basis: Original cost of acquisition, including purchase price and closing costs. Also called cost basis or unadjusted basis. Taxpayer who paid $300,000 for property plus $10,000 in closing costs has initial basis of $310,000.

© 2010 Rockwell Publishing Basis Adjusted basis IRS uses adjusted basis to calculate capital gain or loss when property is sold. To calculate adjusted basis: start with initial basis add capital expenditures subtract allowable depreciation deductions

© 2010 Rockwell Publishing Capital expenditures: Expenditures that add to property’s value or extend its life. Examples: remodeling or new roof. Maintenance expenses are not capital expenditures. Examples: painting or fixing leaky plumbing. Adjusted Basis Capital expenditures

© 2010 Rockwell Publishing When depreciation deductions are allowed, deductions are subtracted from initial basis to determine adjusted basis. Adjusted Basis Depreciation deductions

© 2010 Rockwell Publishing Basic Taxation Concepts Realization Income isn’t taxed until it is realized. Gain is realized when owner sells or exchanges property.

© 2010 Rockwell Publishing Basic Taxation Concepts Realization Amount realized: All benefits received by seller, including money, property, and debt relief, less any selling expenses (such as broker’s commission). Also known as net sales price.

© 2010 Rockwell Publishing Basic Taxation Concepts Recognition Taxes must be paid on gain in year in which it is recognized. Usually, gain is recognized in same year it is realized. However, for certain transactions, taxpayer may defer recognition until a later year. Example: installment sales.

© 2010 Rockwell Publishing Summary Basic Taxation Concepts Income Deductions Tax credits Gains and losses Capital asset Initial basis Adjusted basis Capital expenditure Realization Recognition

© 2010 Rockwell Publishing Classifications of Real Property The way property is taxed will depend on its property classification. Tax code has 6 classifications for real property: principal residence property personal use property unimproved investment property property held for the production of income property used in trade or business dealer property

© 2010 Rockwell Publishing Principal residence property: Home owned by taxpayer that he lives in most of the time (also called main home). Person can have only one principal residence at a time. Classifications of Real Property Principal residence

© 2010 Rockwell Publishing Personal use property: Real estate owned for personal use that is not principal residence. Example: vacation home. Classifications of Real Property Personal use property

© 2010 Rockwell Publishing Unimproved investment property: Vacant land that is held for appreciation and produces no income. Classifications of Real Property Unimproved investment property

© 2010 Rockwell Publishing Property held for production of income: Any type of property (residential, commercial, or industrial) from which owner collects rent. Classifications of Real Property Property held for production of income

© 2010 Rockwell Publishing Property used in trade or business: Commercial or industrial land or buildings associated with business owned by taxpayer. Classifications of Real Property Property used in trade or business

© 2010 Rockwell Publishing Dealer property: Property taxpayer is holding for later sale to customers. Example: subdivided land available for sale. Classifications of Real Property Dealer property

© 2010 Rockwell Publishing Summary Classifications of Real Property Income property Trade or business property Dealer property Principal residence Personal use property Unimproved investment property

© 2010 Rockwell Publishing Nonrecognition Transactions Although taxpayer is generally required to pay tax on gain in year it is realized, if nonrecognition provision applies, that tax can be deferred. Real estate transactions covered by nonrecognition provisions include: installment sales involuntary conversions “tax-free” exchanges

© 2010 Rockwell Publishing Nonrecognition Transactions Installment sales Installment sale: Sale where seller receives less than 100% of price in year sale was made. Most seller-financed transactions are installment sales. Only gain that seller receives in particular tax year is taxed that year. Gain is prorated over contract term.

© 2010 Rockwell Publishing Nonrecognition Transactions Involuntary conversion Involuntary conversion: When property is converted into cash without owner’s voluntary action. May occur through: condemnation destruction theft other loss of property

© 2010 Rockwell Publishing Involuntary conversion usually involves gain for owner. Government or insurer usually compensates owner based on property’s market or replacement value. Involuntary Conversion May result in gain

© 2010 Rockwell Publishing IRS allows deferral of gain if taxpayer replaces property within allowed replacement period. Replacement period generally lasts for 2 years after year gain realized. Any gain not applied toward replacement property will be taxed as income. Involuntary Conversion Deferral of gain

© 2010 Rockwell Publishing Nonrecognition Transactions “Tax-free” exchanges “Tax-free” exchange: When certain real property is exchanged for other real property, owner is allowed to defer recognition of gain. Also known as 1031 exchange. Exchange isn’t truly tax-free: recognition of gain is only deferred, not avoided altogether.

© 2010 Rockwell Publishing “Tax-free” Exchanges Eligible properties Properties eligible for tax-free exchange include: investment property income producing property property used in trade or business Properties not eligible: principal residence personal use property dealer property

© 2010 Rockwell Publishing To qualify, properties exchanged must be like-kind. Real property must be exchanged for other real property located in U.S. Like-kind property isn’t necessarily same type of real property. Example: apartment building can be exchanged for unimproved land. “Tax-free” Exchanges Like-kind property

© 2010 Rockwell Publishing “Tax-free” Exchanges Boot Boot: Anything received in property exchange other than like-kind property. cash stock personal property debt relief (difference in mortgage balances) Boot is recognized in year of exchange.

© 2010 Rockwell Publishing If boot received exceeds realized gain, only amount of gain is taxed, not full amount of boot. “Tax-free” Exchanges Boot taxable only to extent of gain

© 2010 Rockwell Publishing General rule: taxpayer’s basis in property he exchanged is transferred to property he receives. But if exchange involved boot, then adjustments to basis will be necessary. “Tax-free” Exchanges Transferred basis

© 2010 Rockwell Publishing Exchange of real property may be “tax-free” for one party but not the other. Example: Taxpayer A trades personal residence for Taxpayer B’s rental home. A and B will each use their new property as rental. Exchange tax-deferred for B but not for A, because personal residence is not eligible. “Tax-free” Exchanges Not always tax-free for both parties

© 2010 Rockwell Publishing Real estate agent who arranges tax-free exchange may be paid commission by both parties to transaction. “Tax-free” Exchanges Agent’s commission

© 2010 Rockwell Publishing Summary Nonrecognition Transactions Installment sale Involuntary conversion Tax-free exchange Like-kind property Boot

© 2010 Rockwell Publishing Sale of Principal Residence Capital gain on sale of principal residence: may be permanently excluded from taxation not just deferred (as in exchange or installment sale)

© 2010 Rockwell Publishing Sale of Principal Residence Limits on exclusion of gain Individual home seller may exclude up to $250,000. Married couple filing joint return may exclude up to $500,000. Any amount in excess of $250,000 or $500,000 will be taxed as capital gain in year of sale.

© 2010 Rockwell Publishing Sale of Principal Residence Qualifying for the exclusion Within last 5 years, property seller must have: owned home for at least 2 years, and lived in home as principal residence for at least 2 years. Because of this rule, taxpayer may not use this exclusion more than once every two years.

© 2010 Rockwell Publishing Deductions for Property Owners Tax deductions for property owners include: depreciation deductions (cost recovery) uninsured casualty and theft losses repairs property taxes and special assessments mortgage interest points and other loan costs operational losses from rental property

© 2010 Rockwell Publishing Depreciation Deductions Taxpayer can recover cost of asset used: for production of income, or in a trade or business. Depreciation deductions are also called cost recovery deductions.

© 2010 Rockwell Publishing Assets are depreciable only if they will eventually wear out and need to be replaced. Includes rental property, business or factory equipment, commercial fruit orchards, etc. Does not include principal residences, personal use property, or land. Depreciation Deductions

© 2010 Rockwell Publishing Allowable depreciation deductions are subtracted from initial basis to arrive at adjusted basis. Initial basis + Capital expenditures – Allowable depreciation Adjusted basis Cost recovery deductions are subtracted even if taxpayer did not take them. Depreciation Deductions Subtracted from basis

© 2010 Rockwell Publishing Loss Deductions Property owner may deduct uninsured loss from taxable income. Property damaged, destroyed, or stolen. Loss was not fully covered by insurance.

© 2010 Rockwell Publishing Repair Deductions Repair deductions: Property owner may deduct expenditures necessary to keep property in ordinary operating condition. Unavailable for principal residence or personal use property. Capital expenditures not deductible. Cost of these improvements added to basis and eventually reduce capital gain.

© 2010 Rockwell Publishing Property Tax Deductions General real estate taxes may be deducted from property owner’s taxable income. Special assessments are: deductible if for maintenance or repairs not deductible if for improvements

© 2010 Rockwell Publishing Mortgage Interest Deductions Mortgage interest is usually deductible, subject to these limits for personal residences (main home or second home): Taxpayer can deduct interest paid on: loan up to $1,000,000 used to buy, build, or improve principal/second residence. home equity loan of up to $100,000, no matter what used for. Interest paid on amount over limit not deductible.

© 2010 Rockwell Publishing Mortgage Interest Deductions If condo project borrows money by mortgaging common areas, and unit owners are required to pay share of mortgage payment, unit owner may deduct interest portion of her share from taxable income.

© 2010 Rockwell Publishing Deductions Points and other loan costs Points paid in connection with new loan: are considered prepaid interest can be deducted from taxable income Includes: discount points origination fee

© 2010 Rockwell Publishing Fees charged by lender for specific services are not deductible. Examples: appraisal fee, mortgage insurance premiums, document preparation fees. Prepayment penalty is considered to be interest, and therefore may be deducted. Deductions Points and other loan costs

© 2010 Rockwell Publishing Points paid by seller on borrower’s behalf are deductible. But borrower’s basis must be reduced by amount of seller-paid points. Deductions Points and other loan costs

© 2010 Rockwell Publishing Deductions Operational losses from rental property Taxpayer who owns and actively manages rental property may deduct up to $25,000 of operational losses from ordinary income. If taxpayer (owning and managing rental property) is real estate professional, $25,000 limit on deductions does not apply. Losses due to vacancies are not operational losses.

© 2010 Rockwell Publishing Rental payment deductions are available to tenants only if rented property is used in trade or business. So in sale-leaseback, seller who continues to lease property may deduct the rental payments. But rent paid for residential property is never deductible. Deductions Rental payments

© 2010 Rockwell Publishing California Income Tax California’s state income tax laws mirror federal government’s. Key terminology is same. Tax rates and standard deductions are different. To factor in inflation, Franchise Tax Board makes annual adjustments to tax brackets and standard deductions.

© 2010 Rockwell Publishing Summary Exclusions and Deductions Principal residence exclusions Depreciation deductions Depreciable property Uninsured loss deductions Repair deductions Property tax deductions Deductions for mortgage interest, points