RPRACTICES16: Taxes, Tax Year, Prop 13, Capitol Gains, Determining a Profit or Loss, Depreciation

Like homeowners, investors of income-producing property can deduct these three items from their income taxes:

- Mortgage loan interest - There is no maximum loan amount for investors. - Property taxes - Prepayment penalties

Real property is reassessed when? At what rate?

-every time it is transferred - The property tax is usually set at 1% of the selling price

Exchanges are particularly popular among investors who-

-own apartment buildings and commercial real estate. Many of these owners are already in high income tax brackets; so exchanging gives them the opportunity to acquire more valuable property without the high tax consequences. They can keep their money invested in real estate holdings by "rolling over" the properties - which mimics selling and buying at the same time.

Tax-Deferred Exchanges is

-simply the trade of one property for another - Commonly referred to as a 1031 exchange after the IRS Code section that defines the parameters, property owners can exchange one investment property for another as long as the transaction qualifies according to the section 1031 guidelines. If the transaction qualifies, the exchange is tax-deferred(Taxes will be owed at the time the exchanged property is sold).

Determining Profit or Loss on a Personal Residence:

Alan and Amanda purchased a home 20 years ago for $100,000. They have done some recent remodeling that cost another $150,000. They sold their home for $950,000. What is their gain? Cost Basis $100,000 Improvements + 150,000 Adjusted Cost Basis $250,000 Sale Price $950,000 Sales Expenses - 6,500 Adjusted Sales Price $943,500 Adjusted Sales Price $943,500 Adjusted Cost Basis - $250,000 Gain (before exclusion) $693,500 Gain (before exclusion) $693,500 Exclusion - 500,000 Gain (after exclusion) $193,500 Alan and Amanda will have to pay capital gains tax on $193,500.

Under IRS section 1031, a property that is held for productive use in a trade or business can be exchanged for like-kind property. Like-kind property includes:

Apartments and residential rentals Commercial property Industrial property Farms or land The properties must be "like-kind" in nature or character, not in use, quality or grade. For example, a farm could be exchanged for a store building, vacant land for an apartment building, or a rental home for vacant land.

There are also exemptions or other types of relief for:

Homeowners Veterans Seniors

Progressive VS Regressive Tax:

Income taxes are progressive taxes. A progressive tax is one in which the rate increases as the amount to be taxed increases. Some taxes are regressive taxes. A regressive tax is one that uses the same rate regardless of income. A state sales tax is an example of a regressive tax.

Sally purchased a home on January 15 for $450,000. Their new property tax will be $4,500. The previous assessment on the home was $150,000; so the previous tax was $1,500 for the fiscal year from July 1 of last year to June 30 of this year.

Sally will receive the "regular" tax bill of $750 for the second installment of the fiscal year taxes due on February 1, which is based on the old assessment. But she actually owes $2,250 (half of $4,500) in taxes on the property she just purchased. Once the county collector reads the county assessor's supplemental tax roll, she will receive a supplemental tax bill of $1,500, which represents the $2,250 she owes less the $750 she paid.

A real estate salesperson cannot and should not be expected to be an expert on the taxes involved in real estate transactions. Just as a licensee should never give legal advice to a client, he or she should never give tax advice to a client.

That being said, licensees should have a basic understanding of the tax aspects of real estate transactions, since many clients will have questions regarding these issues. You should have some idea of when to recommend that a client seek the advice of a CPA to discuss the tax implications of a potential sale

Who is responsible for collecting ad Valorem taxes?

The county collector is responsible for collecting these taxes, which are paid annually or semi-annually.

A city's or county's operating revenue comes mostly from?

assessing and collecting taxes on real property.

Personal Residence - Capital Gains:

- A seller can exclude up to $250,000(x 2 if married) of any capital gain on the sale - This exclusion can be used once every two years - the seller must have lived in the home for two out of the last five years

As you might guess, the amount due in property taxes can be a confusing issue at the time a property is sold. Depending on the timing, a seller may have paid:

- None of the taxes for the upcoming year (for example, a sale that closed on July 15). -Half the property taxes for the fiscal year (a sale that closed on December 15). -All the property taxes for the fiscal year (a sale that closed on March 15). Escrow will prorate the property taxes using the seller's assessed value as of January 1.

Real Property Taxes are also called and these are based on?

- ad valorem taxes - based on the assessed value of the property

Since the broker could be held liable, it's imperative for the broker (or his or her licensee) to:

- ind out the citizenship or non-foreign status of all sellers of residential property that is priced at $300,000 or more - Be sure to require this information, even if someone does not appear to be foreign. - When taking a listing, require a statement of non-foreign status from the seller.

A special assessment:

- is not technically a property tax. - This tax is actually levied by a city council or a county board of supervisors and requires voter approval - A special assessment tax is usually levied only once and is done so to offset the costs of specific local improvements, such as streets, sewers, irrigation, drainage, or flood control. - According to state law, cities or counties may establish a special assessment district board to levy a special assessment. The district usually issues its own bonds to finance the improvements and then assesses all the properties in the district to repay the funds.

Installment Sales is?

- one in which the buyer makes payments for a property over more than one calendar year. Persons use installment sales to help spread a gain over more than one calendar year to avoid having the entire gain taxed in the first year.

If the properties are not of equal value,

- one party may receive cash or mortgage relief to "equalize" the transaction. - Any cash or relief one party receives in addition to the actual property is called boot. The person who receives the boot has a net gain and must pay taxes on it. In a situation like this, the exchange is not fully tax-free, only partially tax-free.

Any person who acquires property that is subject to taxes must notify who, how and by when?

- the county recorder or assessor - by filing a change in ownership statement - within 45 days of the date of recording or, if not recorded, within 45 days of the ownership change. If this is not done, the owner will pay a penalty of $100 or 10% of the taxes applicable to the new valuation, whichever is greater.

Veteran's Exemption:

-A California war veteran is eligible to receive a $4,000 exemption against the assessed value of one property. - This exemption also applies to the unmarried spouse of a deceased veteran. - Depending on the level of disability, a disabled veteran could be eligible for an exemption of up to $150,000 against the assessed value of the home. Note: A veteran cannot take both a homeowner's exemption and a veteran's exemption. If the veteran is eligible for only the $4,000 exemption, it might be a better option to apply for the homeowner's exemption.

Some properties that are assessed are actually exempt - wholly or in part.

-All government institutions - some not-for-profit educational entities - many churches - many charitable organizations

What could relieve the broker and buyer of liability for any unpaid taxes in a foreign status buyer or seller?

-CAR has a form called the Seller's Affidavit of Nonforeign Status and/or California Withholding Exemption that a seller can sign attesting that he or she is not a nonresident alien - Signing this statement could relieve the broker and buyer of liability for any unpaid taxes. -CAR also has a form called a Buyer's Affidavit. This form states that the sales price is less than $300,000 and the home will be used as the buyer's primary residence and should be signed by the buyer. - Both of these forms together immediately exempt the buyer from the withholding requirement. If neither form can be truthfully signed, the broker should make sure that the 10% is withheld in escrow.

What is FIRPTA?

-In 1985, Congress passed the Foreign Investment in Real Property Tax Act to eliminate the problem of collecting delinquent taxes from foreigners who owned and sold property in the US and left the country without paying the taxes due on the sale.

Prop 13

-In June 1978, California voters approved Proposition 13 - an ammendment so that the max annual tax on real property is limited to one percent (1%) of "full cash value," or market value, plus a maximum two percent (2%) increase in market value per year -a transfer of a property triggers a reassessment. For example, Jim and Martha Jones purchased a home last year for $250,000. Their tax bill for last year was $2,500. Assuming an inflation rate of 1.5% this year, the market value of their home would be $253,750 ($250,000 x 1.015) and their taxes will be $2,537.50. The Jones' future property tax bills can be calculated using the same process for each subsequent year they own the property.

When a person sells personal real estate, he or she can exclude up to $250,000 if single or $500,000 for a couple that files jointly of the capital gains on that sale. But what happens if the property sells for higher than those amounts? Or what happens when an investor sells property that is not subject to the exclusions mentioned?

-In either of those cases, the person will have a capital gain (or loss) that will trigger a tax event. Capital gains are taxed at a lower rate than ordinary income. Capital losses can be deducted from capital gains. -The lower tax rate on capital gains encourages investors to risk making a long-term investment.

Here's how the timetable for taxes works:

-On January 1, the taxes for the upcoming fiscal year become a lien on the property. - Tax year begins on July 1. - On November 1, the first installment for half the taxes becomes due. - On December 10, at 5 p.m., the first installment becomes delinquent if not paid and a 10% penalty charge is added to the bill. - On February 1, the second installment for the balance of the taxes comes due. - On April 10, at 5 p.m. the second installment becomes delinquent if not paid and a 10% penalty charge is added to the bill. Note: If taxes are due on a weekend or holiday, the due date or delinquency date is extended to the close of the next business day.

Senior Citizen's Property Tax Postponement:

-Persons who are 62 years or older and who have a household income of $24,000 or less may be eligible for this postponement program - Qualifying participants have the option of allowing the state of California to pay all or part of their property taxes. - In return, the state will place a lien on the property for the amount of the taxes the state pays. The lien will become payable when the senior sells the residence or dies. -This assistance program is also available to persons of any age who are disabled and meet the income requirement.

Homeowner's exemption:

-Residence that is owner-occupied as of March 1 is eligible for homeowner's exemption of 7K of the assessed value. -To receive the full exemption, should file between Jan 1 and Feb 15 - Once the exemption is filed, it remains on the property until the owner terminates it - The homeowner is responsible for letting the assessor know when the property is no longer eligible for exemption - Failure to notify the assessor could result in an assessment with interest plus a 25% penalty

Can a loss on a personal residence be deducted?

-cannot be deducted from income taxes - if the client turns the property into income-producing property by renting it, then any loss resulting from that sale would be deductible

The California tax laws allow a county or city to adopt a?

-documentary transfer tax to apply to the transfer of properties located in the county - The tax is computed on the total price paid for the property, less any assumed loans. The tax is computed at the rate of 55 cents for each $500 of consideration or fraction thereof. For example, if a home sold for $175,000 the transfer tax would be $192.50. $175,000 ÷ $500 = 350 x $.55 = $192.50 If a home sold for $280,000 and the buyer assumed the seller's $30,000 loan, the transfer tax would be $275. $280,000 - $30,000 = $250,000 $250,000 ÷ $500 = 500 x $.55 = $275 - A city within a county that has adopted a transfer tax can adopt its own transfer tax ordinance. The city's tax amount must be fixed at one-half the rate charged by the county. The county will collect the total tax and then send the city its share.

Depreciating Income-Producing Property:

-the amount of depreciation must be allocated evenly over the useful life of the property - This is called straight-line depreciation - The depreciation schedule for rented homes and apartments is a minimum of 27.5 years - The schedule for commercial buildings is a minimum of 39 years. For example, let's say an investor owns a single-family residence that he rents out. The home cost $150,000 and the land is worth $30,000, leaving an improvement value of $120,000. If the investor divides the $120,000 by 30 years (the minimum is 27.5), he will have a depreciation figure of $4,000 per year. So he can deduct $4,000 per year for depreciation on this property.

Sale of Real Property - Determining Profit or Loss:

1) Calculate what's called the "adjusted cost basis." This is the original purchase price, plus improvements, minus depreciation (not applicable on personal residences). 2) Calculate what's called the "adjusted sale price." This is the sales price minus any sales expenses. 3) Calculate the gain by subtracting the adjusted cost basis from the adjusted sales price.

Personal Residence- Homeowners can typically deduct these three items from their annual income taxes:

1) Mortgage loan interest - This is a major advantage of owning a home. A person can finance up to one million dollars ($1,000,000) and deduct all of the interest paid out for the year on that loan. - A portion of the interest on home equity loans, and loans to purchase a second home may also be deducted. The deduction is limited to interest on the first $100,000 of such loans. 2) Property taxes - These taxes are deductible for both first and second homes. 3) Prepayment penalties - If a client is assessed a prepayment penalty for paying off or drastically reducing a loan amount, he or she can deduct the penalty from income taxes.

Unlike owners of personal residences, investors can also deduct:

1) Operating expenses - These are recurring costs, such as interest, insurance and taxes. 2) Depreciation of improvements - This is a deduction for wear and tear on "improved" investment property. An investor can depreciate apartment buildings, commercial buildings and improvements to other investment property, but land cannot be depreciated.

Under Proposition 13, a transfer of a property triggers a reassessment. However, there are some circumstances that are exempt from the reassessment:

1) Prop 58 allows the transfer of property from one spouse to another or to children, without triggering a reassessment. 2) Based on Prop 60 and 90, homeowners may be permitted to transfer their current Proposition 13 tax base with them if all of the following conditions apply: - At least one homeowner must be 55 years or older - Replacement property must be purchased within two years of the original sale. - The new home must be of equal or lesser value if the recordings are simultaneous. If the new property closes during the first year after the old home, the price may go up by 5%, and if the new property closes during the second year after the old home, the price may go up as much as 10% over the old selling price. The new home must be in the same county (or in another "participating" county).

It's important for buyers to understand that they will receive one tax bill, which may be followed by one or more supplemental tax bills.

The county assessor puts new values on a supplemental tax roll from the date of change of ownership. If the new value is greater than the current assessed value, a supplemental tax bill will be sent to the new owner that reflects the higher valuation for the remainder of the tax year.

Income Taxes Determining Profit or Loss on an Income-Producing Property:

Tom sells an apartment building that he's owned for 10 years. What will his gain be? Cost Basis $600,000 Improvements + 300,000 Depreciation (10 years @ $15,000/yr) - 150,000 Adjusted Cost Basis $750,000 Sale Price $1,250,000 Sales Expenses - 75,000 Adjusted Sales Price $1,175,000 Adjusted Sales Price $1,175,000 Adjusted Cost Basis - $750,000 Gain $425,000 Tom will owe capital gains tax on $425,000.

Questions2:

Under what circumstances can a loss on the sale of a personal residence be deducted from income taxes? Normally, under no circumstances. But if the property is converted to an income-producing rental, then a loss on the subsequent sale could be deducted. What items can an owner of an income-producing property deduct that an owner of a personal residence cannot? Operating expenses and depreciation. What are the capital gains exclusions associated with the sale of a personal residence? A single seller can exclude up to $250,000 of gain and a couple can exclude up to $500,000. What is important for a broker to remember about the Foreign Investment in Real Property Tax Act? The buyer is responsible for withholding 10% of the sales price if the seller is a foreigner and the home is priced over $300,000. If the money is not withheld, the buyer and broker are equally responsible and the broker could end up paying the entire unpaid taxes due

Questions:

When is real property reassessed? Real property is reassessed every time it is transferred. What does Proposition 58 state? Proposition 58 allows the transfer of property from one spouse to another or to children without triggering a reassessment. For whom do property tax exemptions exist and for how much? There is a homeowner's exemption for $7,000 against the assessed value and a veteran's exemption for $4,000 against the assessed value. Explain the documentary transfer tax. The California tax laws allow a county or city to adopt a documentary transfer tax to apply to the transfer of properties located in the county. The tax is computed on the total price paid for the property, less any assumed loans. The tax is computed at the rate of 55 cents for each $500 of consideration or fraction thereof.

California has adopted its own law dealing with sales of real property by foreign persons who are not US citizens or US resident aliens. This law states that:

if the foreign seller's last known address is outside of California, the buyer may be required to set aside 3.3% of the sales price for the Franchise Tax Board. The exemptions to the rule include: The sales price is $100,000 or less. The property is the seller's primary residence. The seller signs a California Residency Declaration. The seller receives a waiver from the Franchise Tax Board. As with the federal FIRPTA rules, the broker and the buyer could be liable for the tax if it is owed and not paid. Note: Brokers and buyers must keep the documentation regarding these foreign sales for five (5) years.

California uses a system based on?

the fiscal year(July 1 - June 30) rather than the calendar year.

In general, FIRPTA requires a buyer to

withhold estimated taxes equal to 10% of the sale price in any sale or exchange of property owned by a foreigner (not a US citizen). The IRS keeps this 10% to ensure that any capital gains on the sale are paid. Note: Residential property that sells for under $300,000 and will be used as the buyer's personal residence is exempt from the FIRPTA requirement.