Chapter 3 - Tax Benefits

To be fully clear, IRC Section 1031 (a)(1) says:

"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."

Tax Exemptions

An exemption removes a percentage or an absolute dollar amount from the assessed taxable value of the property. Many properties are exempt from ad valorem taxes by state governments because the properties are used for tax-exempt purposes.

Capital Gains

Before we dive into tax deductions, let's talk about a different tax benefit for homeowners. Capital gains exemptions are a benefit enjoyed by homeowners who sell their principal residence. Capital gains taxes are taxes on the profit a person makes. We'll talk more about capital gains in the following pages.

Homestead and Disability

Most homeowners will file for a homestead exemption as soon as possible. A buyer who closes during any given year will not be allowed to file for this tax saving until they have been in the home on January 1st. Then the exemption will kick in for that year. Texas also provides tax exemptions for qualifying homeowners who are seniors and those who have a disability. Exemptions help these people save money on their taxes by lowering the amount of their home's value that can be taxed.

Ad valorem tax are calculated by...

They are calculated according to the assessed value of real estate. They are collected from each property owner to create revenue to run the local governmental agencies and provide benefits to residents of the community.

IRA Withdrawals

A first-time homebuyer may be able to withdraw up to $10,000, penalty free, from their tax-deferred individual retirement account (IRA) to go towards their down payment. It's like withdrawing money from your bank account to help pay for the home, except its your retirement account. And first-time homebuyers in Texas have other assistance options besides their IRAs. The state, county, and, in some cases, the city have programs for first-time homebuyers and low income families. The Aceable Agent will want to learn what is available to help people who fall into those two categories.

Written Assurance Ever since May 6, 1997, sellers of principal residences have been required to provide the government with a written assurance containing the following two items:

A statement that the entire gain made from the sale can be excluded A statement that the property is the owner's principal residence The 1997 law allows most people to avoid any taxes from gains on the sale of their primary residences because the exclusion can be used frequently. However, these benefits do not apply to investment properties.

Homeowner Ana 👩 has just sold her primary residence. Property values have gone up considerably over the years. Anna originally bought the property for $180,000, but she was able to sell it for $400,000. She has lived in the home for the past 10 years. Assume that the capital gains tax rate is 15% and that Anna is in the 28% federal income tax bracket. What is the total amount of tax that Homeowner Ana must pay for the sale of her home?

Anna does not have to pay any tax on the gain. According to the 1997 tax law, sales of principal residences are exempt from capital gains taxes for gains up to $250,000, or $500,000 for those filing jointly ($250,000 for each spouse). To be exempt from capital gains taxes, homeowners must have lived in their primary residence for two of the previous five years before the sale, so the sale of Homeowner Ana's home is exempt from capital gains taxes. Anna's capital gains are $400,000 - $180,000 = $220,000.

What About Investment Property? I know what you're wondering, Elizabeth. But Ace! What kind of tax applies to the gain on the sale of an investment property that was bought nine months prior?

Answer: Federal income tax! Because the investor owned the property for less than one year, the gain is taxed as normal income. The investor would most likely save money if she had waited to sell the property and generated a long-term gain instead of a short-term gain.

Tax Deduction Example (cont.) 2

Assume Homeowner Gale owns a $100,000 home, and her monthly payment is $1,000. Also assume that the amortization period is 20 years, and the principal portion of the payment is $417, so the interest portion is $583 a month. She pays a total of $6,996 in interest each year. Let's say that both Stedman and Gale are in the 28% income tax bracket. After Homeowner Gale applies her deductions, she pays less tax than Renter Stedman. He pays $900 a month, which comes to $10,800 per year to live in a rented house. He pays the following federal income tax: 28% x $50,000 = $14,000 (federal income tax)

Prorated Taxes

At closing, the taxes for the property will be prorated, or divided, between the seller and buyer. The seller will pay for the taxes up to or through the day of closing with a portion of the proceeds they receive from the sale. A portion of the buyer's closing costs will be put toward the taxes for the rest of the year.

Taxes on Capital Gains

Capital gain refers to the profit received from selling a capital asset. Conversely, capital loss refers to the loss incurred from selling a capital asset. Capital assets include all of the taxpayer's tangible property, such as real estate, investment properties, and equipment, but do not include property that is held for regular sale to consumers.

Exemption Districts - Counties

Counties are required to offer a $3,000 exemption if the county collects farm-to-market road taxes or flood control taxes.

Tax Deduction Example - 1

Deductions can greatly benefit an individual by lowering that person's tax liability. However, many of these deductions apply only to individuals who own and pay property taxes on a home. Consider the following example, which illustrates how a tax deduction can make owning a home more lucrative than renting: Example: There's a homeowner 👩 (We'll call her Gale!) and a renter 👨 (Let's call him Stedman!). Assume that each of them make $50,000 a year. Renter Stedman pays $900 per month to rent a house, but he cannot deduct any portion of rent payments for tax purposes. Homeowner Gale, on the other hand, can deduct both the interest on her mortgage payment and property taxes.

Prorated Taxes (cont.)

Depending on what time of year the closing takes place, the seller may pay and the buyer may receive significant funds for the taxes up to the closing day. The buyer may be able to use that money to help with closing costs but would then be responsible for the full amount of the taxes at the end of the year. Buyers also have the option to pay their property taxes (and homeowners insurance) up-front in a lump sum, or in installments through an escrow account.

Tax Deductions

Federal income tax is assessed according to an individual's net income. Deductions are ordinary expenses that a person pays in a taxable year that may be subtracted from their taxable income, thus reducing the tax liability on that income.

Some time and use requirements, however, may be modified or waived for certain individuals who cannot meet these requirements due to incapacitation, divorce, or death of a spouse.

For example, if homeowners are forced to sell their homes as a result of a change in employment or health, they can exclude a fraction of $250,000, or $500,000 for joint filers, proportionate to the fraction of two years they spent at the residence.

Benefits of Ownership

For example, the interest on mortgage payments on a primary residence and a second home can be deducted from the annual income tax bill. Other deductions that can be used are real estate taxes and payments for private mortgage insurance, or PMI. When a home is purchased, the loan origination fees and the loan discount points, if any, may also be deducted from the annual income tax bill.

Tax Exemptions- 65 older

For homeowners aged 65 or older, the appraised value of the property established by the county is frozen, meaning the value will not go up any more on the home. (However, the tax rate might.)

Tax Deduction Example (cont.) 3

Homeowner Gale pays $12,000 a year in mortgage payments, plus $1,000 in real estate tax, for a total of $13,000 per year to live in her home. She can deduct the interest portion of her mortgage payment, which equals $6,996, as well as the real estate tax, so she pays the following federal income tax: ($50,000 - ($6,996 + $1,000)) x 28% = $42,004 x 0.28 = $11,761 (federal income tax)

Not Deductible

Homeowners may NOT deduct the following expenses from their primary residence from taxable income: The principal portion of a mortgage payment Depreciation expenses Insurance premiums Escrow payments Utility expenses

Examples of properties commonly exempted include the following:

Hospitals School property Property owned by religious organizations Property owned by non-profit organizations Property owned by municipalities, cities, and counties

Conclusion: You Did It!

In Chapter 2, you learned: First-time homebuyers can withdraw up to $10,000 from their IRA to assist with a down payment ✔️ License holders should have a sales pitch ready to espouse the virtues of homeownership ✔️ Different counties have different tax exemption. Make sure you know your county's regulations! ✔️

Homestead Rights

In Texas, a homeowner has state constitutional homestead rights on their owner occupied primary residence. This right is automatic and protects homeowners from claims by creditors being made against their homes, preventing any eviction by these creditors. This protection does not encompass all creditors. There are exemptions to homestead rights for creditors such as mortgage lenders. This is because the homestead itself is used as collateral. Also, homestead rights don't offer protection from tax liens. There are some limits to the amount of real estate that can be homesteaded. In an urban environment, the maximum amount of land cannot exceed 10 acres. The homestead can be made up of multiple lots, but they must be contiguous or adjoining. If it is a rural property, the maximum homestead is 200 acres for a family and 100 acres for a single person.

Deferring Capital Gains Tax (cont.) The investor could keep doing this and not have to pay the capital gains tax until everything is sold off or the estate is probated when the investor is deceased.

In the residential sector, you will not run into a 1031 very often unless you work with investors. As an agent, working with investors can be challenging, as they behave differently than other homebuyers. But building strong relationships with investors can pay off.

Investing in Real Estate

Investing is popular for many reasons, but probably the most important one is that a real estate investment is long-term and considered very stable. Most investments in real estate are held for 20 to 30 years. The hope is that the property increases in value and provides a small monthly income after expenses have been paid. There are also tax deductions that will assist the owner when it comes to those dreaded income taxes. The interest on the mortgage is deductible as well, as are many of the improvements made to the property.

Assessed value

Is the value placed on a property by a governmental unit for use in levying annual real estate taxes.

Taxes on Capital Gains (cont.) The purchase price in the equation may be replaced by the price of the lot plus construction costs.

It is important to note: when calculating capital gains, residential properties do not depreciate. This part of the equation must be omitted when calculating gain on the sale of a primary residence. Don't sweat it — we will cover why and discuss depreciation in detail later in this level.

"elevator pitch"

It's a concise presentation that you can give in the time it takes to ride an elevator. Practice your pitch, and you can give it to anyone who does not own a home but mentions the idea. You may even find opportunities where you can give a longer version of this pitch to larger audiences.

Long-Term Capital Gains

Long-term capital gains are currently taxed at 5%, 15%, 25%, 28%, or a combination of these rates. Of course, the income level of the individual taxpayer determines the tax bracket they are a part of, and thus, the rate at which the gain will be taxed. For individuals in the top four federal income tax brackets, a tax rate of 15% applies. Most people claiming capital gains fall into this category. Capital gains are taxed at 5% for those in the 10% and 15% income tax brackets. If the capital gain would push these individuals into one of the top four income tax brackets, then the portion of the capital gain below the minimum for the lowest of these brackets is taxed at 5%, while the rest is taxed at 15%.

Ad Valorem Taxes

Many state statutes provide for the governmental agencies at the county, city, town, or district level to levy property taxes on each property owner. These taxes are known as ad valorem (Latin for "according to value") taxes.

A homeowner sells her primary residential home and realizes a gain (profit) of $185,000 from the sale. How much tax will this homeowner pay on the capital gains?

No taxes are owed on her capital gains. A single homeowner is exempt from paying capital gains taxes on up to $250,000 of realized profit from the sale of a primary residence. This exemption can be used every two years.

Tax Exemptions - acreage

Owns acreage in a rural area, it is possible that the taxes could be lowered with an agricultural exemption, due to any farming or ranching that takes place on the property. There is also a program for an agricultural tax exemption for wildlife conservation.

Exceptions to the two-year use requirement also include the following:

Property acquired in rollover transactions, which are transfers of funds to investments of the same type, used to defer the payment of taxes (i.e., 1031 exchanges) Property transferred by a spouse Property owned by a spouse, former spouse, or deceased spouse Owners who have received care from a nursing home

Common deductions for homeowners include:

Real estate taxes levied on primary residences Interest on mortgage payments for primary residences Other costs associated with a mortgage, such as prepayment penalties, fees, and discount points

The IRS imposes a tax on all forms of capital gains. In real estate, capital gain can be calculated using the following equation:

Sales price - (Purchase price + Cost of improvements) + Total depreciation - Expenses = Gain If someone sells their house for $200,000, that doesn't mean that they've made a profit of $200,000. The formula above helps us account for all of the seller's expenses (including what they originally paid for the house, any improvements they added, and any depreciation that may have occurred).

Short-Term Capital Gains

Short-term capital gains are taxed as normal income, according to federal income tax rates. This means that in most cases, short-term gains are taxed at a much higher rate than long-term gains.

Tax Reductions

State and local governments also may reduce general real estate taxes for: Senior citizens Land used for agricultural purposes Certain industries Other possible reductions include those for homesteads and for persons with disabilities.

Tax Deduction Example (cont.)

Tax Deduction Example (cont.) Renter Stedman pays a total of $24,800 in rent and federal income tax; the homeowner pays a total of $24,761 in mortgage payments and federal income tax. Even though Homeowner Gale's monthly mortgage payment is $100 more than the renter's monthly rent payment, they spend almost the same amount of money to live and pay taxes in this example. If their monthly payments had been the same, Gale would effectively have had much lower monthly payments, after deductions were taken into account. Her benefits are greater still when we consider that in this case she also generated the following equity: $417 (principal portion of mortgage payment) x 12 months =$5,004 (amount of the principal paid off)

Capital Gains Exclusion Eligibility

Taxpayers must meet ownership and use requirements to be eligible for the exclusion. The taxpayer must have owned and occupied the home as a principal residence for at least two of the five years preceding the sale. The two years may be an aggregate amount of time, and need not be continuous. For married couples, both spouses must have occupied the residence for at least two years out of the prior five years. Only one spouse needs to have owned the property for at least two out of five years.

Senior Tax Exemptions

Texas law requires school districts to offer a $10,000 exemption for people who are over the age of 65 or those who have a disability. The exemption can be filed at the time a person turns 65 or gets a disability during the year. Another great advantage for Texas seniors is that when they file their senior exemptions, their school taxes are frozen. No matter how high the tax rate goes, their tax rate will stay the same for life. The only way their school taxes could increase is if they improved the value of the property. The rate would be the same, but the same percentage of a higher number would be a higher amount.

Test Question - Exemptions

Texas law requires school districts to offer a $25,000 tax exemption on residence homesteads.

Exemption Districts- School Districts

Texas law requires school districts to offer a $25,000 tax exemption on residence homesteads. Some of the other tax districts have the option to offer homestead exemptions too.

Long-Term Capital Gains (cont.)

The 25% rate applies to depreciated properties, which are discussed later in this lesson. The tax rate is higher here because investors received previous tax benefits by depreciating a property over its useful life. In turn, this helps the federal government to recapture money. The 15% and 28% capital gains tax rate applies to gains from the sale of small business stock and collectibles. Examples of said collectibles are antiques, gems, expensive wine collections, and works of art. 🖌

Exclusions from Capital Gains *

The Taxpayer Relief Act of 1997 created certain exclusions from capital gains taxes for homeowners. This Act was one of the largest tax-reduction acts in U.S. history, and reduced tax rates while offering new tax credits for taxpayers across the board. This act also introduced the Child Tax Credit, raised the unified credit limit and the tax exclusion from the sale of a personal residence, and provided tax relief for education savings and retirement accounts. Under the universal exclusion, 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 after the sale.

A 1031 exchange lets an investor sell a property, reinvest the proceeds in a brand new property, and defer all capital gain taxes.

The difficulty with a 1031 is that you have a limited period of time (45 days) in which to identify the new property and close (within 180 days). The tough part is identifying the property. Six months is plenty of time to close an investment transaction no matter the size.

An owner can only claim one homestead.

The homestead exemption cannot be filed until the buyer has been in the home past January 1st. This means that buyers who purchase early in the year may have to wait a long time before they can receive this exemption that will save them money on their annual taxes.

Test Q- Homestead RIGHT

The primary benefit of the Texas homestead rights is to protect the home from creditors that do not have specific or tax liens. Homestead protection does not apply to IRS liens, ad valorem (property) tax liens, mortgage liens, etc.

One of the advantages of homeownership is that...

The real estate taxes the owner pays and the dollar amount of the interest paid on the mortgage is tax deductible. That's handy when it comes time to file income tax forms with the IRS. There could be a substantial tax benefit awaiting someone who buys instead of rents (depending on a number of variables).

Homestead Tax Exemption

There is a homestead tax exemption (not to be confused with the homestead right mentioned previously) that can be filed at the appraisal district in the county in which the property is located. This homestead tax exemption will reduce the amount of ad valorem taxes paid on the homestead.

The rule is that if someone is deep into debt and the creditors want to force that person to sell their home to pay off the debt,

They are NOT permitted to do so. The person might be forced by the court to sell other assets and property, but not the home they live in. But as I said, the homestead protection does not apply to unpaid taxes or to specific liens, like mortgage debt where the property is the collateral.

Veterans with Disabilities Exemptions

Veterans with disabilities may also be eligible for a tax exemption based on the severity of their disability as classified by the VA. Some veterans are totally exempt from ad valorem (property) taxes in Texas. Additionally, the spouses of veterans who were killed in action are totally exempt from property taxes in Texas.

Exceptions to the 2-Year Requirement (cont.) Exceptions may only be made once every two years, again unless the sale is the result of a change in health or employment.

When homes are sold for less than $250,000 (or $500,000 for joint filers) above the original purchase price, the owners do not have to file an information return reporting the sale of their principal residence.

When Quoting Taxes

When quoting the amount of estimated taxes that the buyers can expect to pay on a certain property, agents must be careful to quote the dollar amount that does not include any exemptions, not the amount the current occupants of the home are paying. The reason for this is because the current owners may have an exemption that the buyers may not receive for a while. Also, because this is an estimate, the amount is subject to change before everything is said and done.

Capital Gains Holding Period

Whether a capital gain is taxed as a short-term or long-term gain is determined by the length of time the property is held (the amount of time between the day a property is bought and the day it is sold). This is called the holding period. If the holding period was shorter than one year, the capital gain is short-term. If the holding period was greater than or equal to one year, the capital gain is considered a long-term gain.

You've heard of the 1031 exchange,

a program in which the investor can place the proceeds from the sale in the hands of an intermediary (not to be confused with an intermediary broker in a real estate transaction). 💡 A 1031 is a swap of one business or investment asset for another. Although most swaps are taxable as sales, if you utilize a 1031, you'll either have no tax or limited tax due at the time of the exchange. The intermediary will hold the money until the investor can find another property of equal or higher value to use the money from the previous sale to buy. As long as the investor does not touch the money or have it in their possession, then the capital gains tax will be deferred until the second property is sold.

Chapter 2 Key Terms Hey you! Keep your eagle eye out for these terms in this chapter!

✏️️ Ad Valorem Tax: A tax calculated according to the assessed value of real estate ✏️️ Homestead Tax Exemption: Reduces the amount of ad valorem taxes assessed on a homestead ✏️️ Prorate: The dividing of expenses for items like taxes, interest, and rent at the closing between the seller and the buyer