Real Estate - Level 5, Chapter 3 - Taxes and Real Estate

Married couple Carmen and Laura bought a primary residence for $500,000. Ten years later, they sold it for $700,000. How much of the profit do they owe capital gains taxes on?

$0 - because as a couple, they would have to profit $500k to owe money

Single homeowners are exempt from paying taxes on up to ____ of the capital gains from the sale of their home every ___ years.

$250,000; two

Now let's solve for Laura's depreciation recapture tax. She sells the lake house after seven years. Recall that her annual depreciation allowance was $9,374.55. What is her depreciation recapture tax liability?

$9,374.55 x 7 = $65,621.85 $65,621.85 x 0.25 = $16,405.46

How to Find the Annual Depreciation Allowance:

*So now we know that a property depreciates over either 27.5 or 39 years, but how do you know how much you can claim each year? Essentially, you divide what's known as your "depreciable basis" by either 27.5 or 39 to get your annual "depreciation allowance" Purchase Price + Acquisition Costs + Renovations - Land Value = Depreciable Basis

depreciation

*is a tax deduction people who own investment property can take advantage of. *is another tax shelter

What is the depreciable basis?

*is essentially the total value of the property that is eligible to be depreciated. Remember how we said land can't depreciate? So the value of a property's land is REMOVED when finding the depreciable basis. *Also, any acquisition costs or renovations a person makes before putting the property "into service" (an IRS way of saying "start using it to make money") can be included in the depreciable basis. *is the purchase price of the property, plus the cost of acquiring it (expenses like broker fees, appraisal fees, title insurance, and other closing costs), plus any improvements you made to it before putting it in service, minus the value of the land.

The Qualifications of the Intermediary:

1. Accountant 2. Lawyer 3. Investment broker 4. Employee 5. Family member *So, who is this mysterious intermediary? It's up to you, the agent, to help your client find someone trustworthy. They aren't required to be bonded, certified, audited, licensed, or insured, and you're essentially handing them a bag of cash, so choose carefully!

1031 Exchanges: What You Can Exchange:

1. Commercial property 2. Industrial property 3. Income-producing residential property 4. Vacant property held for investment purposes (dealers excluded) 5. Hotels 6. Motels 7. Holiday Inns 8. Leaseholds that bear lease terms greater than 30 years

1031 Exchanges: The No-No List:

1. Personal residences 2. Properties owned by dealers 3. Properties owned by related parties 4. Properties located outside of the U.S. 5. Properties owned by someone who has done a 1031 exchange in the last two years

What a Qualified Intermediary in a 1031 Does:

1. Prepares all the necessary paperwork and documentation 2. Gets, holds, and distributes the money for the exchange 3. Resolves any title issues for the investor 4. Makes sure all parties are in compliance with treasury regulations *If anybody but the qualified intermediary handles the money or stuff involved, BAM, capital gains tax kicks in.

Rules for a 1031 Exchange:

1. The new property (or properties) must be identified in less than 45 days from closing on the sale of the old property. 2. The new closing must happen less than 180 days from the sale of the original property or the tax return due date, whichever is sooner. 3. The properties must be of "like kind." 4. Any cash has to go through a qualified intermediary. 5. Personal property, inventory, partnership interests, and securities are not eligible.

1031 Exchanges: Identifying a Property:

1. You can't exchange real property for personal property without a boot. A boot is non-like-kind property that evens out the exchange, and is not tax-deferred. 2. You can't exchange a primary residence or vacation home (so, a non-income-producing property). 3. You can't exchange a flipped property unless you've used it as an income-producing property (rented it) before selling. 4. You can't exchange livestock of different sexes (I know, there goes that plan). 5. You can't exchange U.S. property for non-U.S. property.

3 common kinds of boots:

1. cash 2. mortgage 3. personal property

TRA97 and Capital Gains Exemptions

1. gave people a capital gains tax exemption on their primary residence. 2. Married homeowners may exclude up to the first $500,000 on the sale of a primary residence and single homeowners may exclude up to the first $250,000. This exclusion is reusable every two years. *Anything above $250,000/$500,000 is known as taxable income and is subject to capital gains taxes. *Again, the exemption is only for a primary residence, not an investment property or vacation home.

1031 exchange

1. is a tax shelter 2. also known as: tax-deferred exchange or like-kind exchange 3. is the tax-deferred sale or exchange of one investment property for another similar one. 4. lets an investor sell a property, reinvest the proceeds in a brand new property, and defer all capital gain taxes. 5. It's called a "like-kind exchange", because you're exchanging a property for a property (or properties) like it. 6. The difficulty with a 1031 is that you have a limited period of time in which to identify the new property (45 days) and close on it (180 days).

the boot

1. is non-like-kind property that evens out the exchange, and is not tax-deferred. 2. refers to non-like-kind property received in an exchange. Usually boot is in the form of cash, an installment note, debt relief or personal property and is valued to be the "fair market value" of the non-like-kind property received.

assessment

1. is the determination of the value of a property for tax purposes. 2. A tax assessor will determine this value based on the value of other properties in the area, plus any improvements you've made to the home since purchasing it. 3. home are typically reassessed each year

ad valorem explained:

1. property taxes fund fire control, police, schools, road, health initiatives 2. assessment - a tax assessor will determine the value of your house based on other properties in the area and if you've made improvements. 3. these taxes are taxes a property owner owes based on the area's tax rate and the property's assessed value

capital gain

1. the increase in the value of an asset 2. if you bought your home for $300k and sold it for $400k, your capital gain would be $100k 3. they are taxed separately from regular income

After owning his cobblery for seven years, Peter decides it's time to move on. Given that his annual depreciation allowance was $10,256.41, what amount of depreciation recapture tax will he owe?

10,256.41 x 7 = 71,794.87 71,794.87 x 0.25 = $17,948.72

With a depreciable basis of $257,800, what is Laura's annual depreciation allowance?

257,800 / 27.5 = $9,374.55

The recovery period for residential income-producing property is -

27.5 years; Residential investment property includes apartment buildings, vacation rentals rented out more than 14 days a year, rental homes, and any other property people rent to live in.

The recovery period for commercial investment property is -

39 years; Commercial investment property includes things like office buildings, shopping centers, industrial parks, and professional buildings.

Let me introduce you to my friend Peter. He has a spot in Decatur where they make the best peach cobbler. They make 'em every kind of way: vegan, gluten-free, paleo, regular, all that good stuff. You should try them some time. The depreciable basis of his shop is $400,000. Can you find his annual depreciation allowance?

400,000 / 39 = $10,256.41

physical deterioration

A reduction in a property's value resulting from a decline in physical condition; can be caused by action of the elements or by ordinary wear and tear; stuff is getting old and breaking. *physical deterioration becomes "incurable" when the cost of fixing it is higher than the value of having it fixed.

tax district

An authority, such as a city, county, school board, or special levy area (e.g., water district), with the power to assess property owners annually in order to meet its expenditures for the public good.

cash boot

If a seller gives the buyer money to cover repairs (often called a concession in non-investment property), that is a cash boot, and the buyer will need to pay capital gains tax on it.

mortgage boot

If an investor takes over a mortgage worth less than the mortgage on the property they're exchanging, that's a mortgage boot and they pay taxes on the difference.

What Is a 1031 Exchange?

If you own investment property and are thinking about selling it and buying another property, you should know about the 1031 tax-deferred exchange. 1. This is a procedure that allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax. 2. allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value. 3. any proceeds received from the sale of a property remain taxable. For that reason, proceeds from the sale must be transferred to a qualified intermediary, rather than the seller of the property, and the qualified intermediary transfers them to the seller of the replacement property or properties. A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property. 4. The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property.

what can NOT depreciate?

Land; because land doesn't have a determinable useful life, and it doesn't lose value over time. 1. Equipment used to build capital improvements (What's a capital improvement? Any upgrade or improvement to a property that falls outside the scope of normal repair and maintenance, usually with the intention of increasing value.) 2. Personal property, including clothes 3. Property placed into service and disposed of in the same year 4. Stocks and bonds 5. Intangible property 6. American Girl dolls *Personal Property, like Primary Residences, can NOT depreciate.

External obsolescence

Losses of property value caused by forces or conditions beyond the borders of the property. The losses are deducted from a building's reproduction cost in the cost approach to estimating market value; like a change in zoning or a highway being built through a neighborhood = loss of property value.

Depreciation math EXAMPLE:

Meet Maya. She's an investor who owns a multi-family building. The depreciable basis of her building is $550,000. How would we solve for her annual depreciation allowance? First, we need to identify what Maya's building's recovery period is. Since it's a residential building, we can recall from earlier screens that her recovery period is 27.5 years. To find her annual depreciation allowance, we divide her depreciable basis by the recovery period, like this: $550,000 ÷ 27.5 = $20,000 Maya's annual depreciation deduction allowance is $20,000. so let's calculate that depreciation recapture tax. Let's imagine Maya held the building for five years. When she sells, how much will she owe Big Tax Collection? Remember, Maya's annual depreciation allowance was $20,000. She held the building for five years. So the total depreciation for the time she owned the building is: $20,000 x 5 = $100,000 Remember, the depreciation recapture tax rate is 25%, regardless of income bracket or sale price. To find Maya's tax bill, we multiply her total depreciation amount by 0.25: $100,000 x 0.25 = $25,000 So when she sells her building, Maya is in the hole for twenty-five big ones, whether she actually deducted that $100,000 from her taxes or not.

MACRS

Modified Accelerated Cost Recovery System - is how the IRS requires people with investment property to calculate their depreciation.

What can depreciate?

Only investment properties depreciate — you can't claim depreciation on a primary residence. 1. It must be property you own. 2. It must be used in your business or income-producing activity. 3. It must have a determinable useful life. 4. It must be expected to last more than one year.

partial tax assessment math (example):

Partial assessment is kind of a weird concept. Let's look at an example to see how it works. Imagine that Martha owns a home with a market value of $300,000. The tax rate for her area is 5%. If her municipality used a full assessment, her annual tax bill would be 5% of $300,000, or $15,000. Wowza! In Georgia, however, she would get a bill explaining that her home's market value is $300,000, while its assessed value is $120,000, or 40% of $300,000. Her annual tax bill would then be 5% of the assessed value, or $6,000: 120,000 x 0.05 = 6,000

capital gains tax exemption (example):

Priscilla bought a lovely little ranch-style home in 2012. She paid $400,000. Five years later, she sold the place for $600,000. Not bad, Priscilla, not bad! Does she owe capital gains tax? Let's figure it out! To do that, we subtract the purchase price from the sale price to get the profit: $600,000 - $400,000 = $200,000 As a single lady, she gets a $250,000 exemption every two years. $200,000 < $250,000, so no tax owed!

partial assessment

Properties in Georgia are assessed at 40%, unless a municipality has passed a law that says otherwise. What that means is that property owners pay taxes on 40% of their home's market value. A property owner's tax bill will have both the market value and the assessed value listed on it. If you disagree with your assessment, you can file an appeal (it doesn't mean it'll work).

Depreciable Basis (EQUATION): *won't need to memorize this equation*

Purchase Price + Acquisition Costs + Renovations - Land Value = Depreciable Basis

Recovery Periods for Depreciable Assets:

The IRS has determined "recovery periods" for depreciable assets. Your asset will fully depreciate (meaning your depreciable basis will be $0) by the end of the recovery period. 1. The recovery period for residential income-producing property is 27.5 years. Residential investment property includes apartment buildings, vacation rentals rented out more than 14 days a year, rental homes, and any other property people rent to live in. 2. The recovery period for commercial investment property is 39 years. Commercial investment property includes things like office buildings, shopping centers, industrial parks, and professional buildings.

What is TRUE about 1031 exchange?

The properties must be exchanged within a limited time frame.

personal property boot

This could be appliances or fixtures in a hotel or motel included in the exchange. That's right, the investor pays taxes on that too.

What is NOT an example of a boot?

an undeveloped property that is exchanged for a developed property

capital gains taxes

are federal taxes property owners owe when they sell a property that has appreciated in value. We'll talk about some ways homeowners can avoid paying them.

tax shelters

are strategies they can employ to limit their tax exposure; they shelter your money from the roaring winds of the tax code.

tax shelters

are ways that real estate investors avoid paying federal taxes on their investment income

Why must you subtract the value of the land from your depreciable basis?

because LAND can't be depreciated

qualified intermediary

carries out the exchange for the investor, since they can't just buy and sell the properties for cash, they have to exchange them. *If anyone but the qualified intermediary touches the cash, the 1031 exchange is disqualified.

What does the qualified intermediary do in a 1031 exchange?

handle the funds and make the exchange

capital gain taxes

is a type of tax applied to the profits earned on the sale of an asset; if you bought your home for $300k and sold it for $400k, you would pay taxes on the gains - $100k

Straight-line depreciation

is an accounting method used to figure depreciation that allows the taxpayer to deduct the same amount every year of the asset's useful life.

depreciation recapture tax

is taxed at 25% of the total allowable depreciation deductions. It is not 25% of the deductions you actually take. It is 25% of the deductions you could have taken. Whether or not you actually deduct the annual depreciation allowance from your taxes, you will owe this tax when you sell.

tax rate

is the percentage of the value that is taxed.

special assessment

is when additional taxes are levied on the homeowners in a neighborhood or area to pay for improvements that benefit the people living there.

Functional obsolescence

is when something loses value because it becomes outdated. *It can be curable or incurable, depending on the cost of fixing it.

ad valorem taxes

or property taxes, are taxes property owners pay — they're based on the value of the property in question. These are paid to local tax authorities.

tax base

the total taxable assets available in a specific area.

incurable

when the cost of fixing it is higher than the value of having it fixed.