Income Taxation and Real Estate PDF

Income Taxation and 13 Real Estate Learning Objectives After completing this lesson, students should be able to… Distinguish between tax deductions and tax credits Differentiate between initial basis and adjusted basis Explain ho...

Income Taxation and 13 Real Estate Learning Objectives After completing this lesson, students should be able to… Distinguish between tax deductions and tax credits Differentiate between initial basis and adjusted basis Explain how to calculate gains, losses, and amounts realized on transactions List the real property classifications contained in the tax code Name the types of transactions that qualify as nonrecognition transactions Describe the types of property that are eligible for tax-free exchanges Define the terms “boot” and “debt relief” Describe the circumstances under which a taxpayer may exclude the gain on the sale of personal residence Name at least five types of income tax deductions available to property owners Suggested Lesson Plan 1. Give students Exercise 13.1 to review the previous chapter, “Closing Real Estate Trans- actions.” 2. Provide a brief overview of Chapter 13, “Income Taxation and Real Estate,” and review the learning objectives for the chapter. © 2021 Rockwell Publishing  Principles of California Real Estate Instructor Materials 3. Present lesson content: Basic Taxation Concepts – Progressive tax – Income – Deductions and tax credits – Classifications of real property – Gains and losses – Basis – Realization – Recognition and deferral EXERCISE 13.2 Basic tax concepts Nonrecognition Transactions – Installment sales – Involuntary conversions – “Tax-free” exchanges EXERCISE 13.3 Nonrecognition transactions Exclusion of Gain from the Sale of a Principal Residence Deductions Available to Property Owners – Property tax deductions – Mortgage interest deductions – Deductibility of points and other loan costs – Uninsured casualty or theft loss deductions – Depreciation deductions – Repair deductions – Deducting operational losses from rental property – Rental payment deductions EXERCISE 13.4 Home mortgage interest deduction California Income Tax 4. End lesson with Chapter 13 Quiz. 2  Chapter 13: Income Taxation and Real Estate Chapter 13 Outline: Income Taxation and Real Estate I. Basic Taxation Concepts A. Federal income tax is a progressive tax, meaning that the more a taxpayer earns in a year, the higher his tax rate may be B. Income is any economic benefit realized by a taxpayer (unless specifically excluded) C. A deduction is subtracted from a taxpayer’s income before tax owed is calculated; a credit is subtracted directly from the amount of tax owed D. The tax code classifies real property in six classes: principal residence, personal use, unimproved investment property, property held for production of income, property used in a trade or business, and dealer property E. Gains from the sale or exchange of an asset are treated as income, but in some cases losses may be deducted from income; losses on the sale of a principal residence may not be deducted F. A taxpayer’s basis in a property is her investment in it; adjusted basis is the ac- quisition cost plus capital expenditures (minus, for some properties, depreciation deductions) G. A gain is not taxable income until it is realized, when a sale or exchange occurs; the gain or loss is the amount realized minus the adjusted basis H. A gain is recognized in the year it is taxed (usually the year it is realized, unless it is a tax-deferred transaction or taxes are excluded) EXERCISE 13.2 Basic tax concepts II. Nonrecognition Transactions A. Installment sales 1. An installment sale occurs when less than 100% of the sales price is received in the year of sale 2. Taxes are only paid on the portion of the profit received each year 3. Installment sale reporting is allowed for all types of property except dealer property 4. The gain recognized in a given year is calculated based on the ratio of the gross profit (the difference between the sales price and adjusted basis) to the contract price 5. The gross profit ratio is applied to principal payments received each year; all of the interest payments received are taxable B. Involuntary conversions 1. Involuntary conversion occurs when an asset is turned into cash without vol- untary action (such as when it is destroyed and the owner receives insurance proceeds) 3  Principles of California Real Estate Instructor Materials 2. The owner may realize a gain on the conversion, but recognition of the gain may be deferred if the money is used to replace the property within the replacement period C. “Tax-free” exchanges 1. Section 1031 of the tax code allows tax-deferred exchanges of unimproved in- vestment property, income property, or property used in a trade or business for like-kind property 2. If nothing other than like-kind property is received in the exchange, no gain or loss is recognized in the year of the exchange 3. If anything other than like-kind property is exchanged, it is known as boot and is recognized in the year of the exchange 4. Boot may be cash, stock, personal property, or debt relief (the difference between mortgage balances) EXERCISE 13.3 Nonrecognition transactions III. Exclusion of Gain from the Sale of a Principal Residence A. A taxpayer may exclude the entire gain on the sale of his principal residence, up to $250,000 if filing singly or $500,000 if filing jointly 1. To qualify, the taxpayer must have owned and used the property as a principal residence for at least two years in the previous five years IV. Deductions Available to Property Owners A. Property tax deductions (and deductions for special assessments for repairs or main- tenance) are allowed for any type of property B. Mortgage and home equity loan interest deductions are allowed on debt of up to $750,000 used to buy, build, or improve a first or second residence (limit is higher for loans originated before 2018) C. Discount points and origination fees are considered prepaid interest and may be de- ducted; other loan costs may not be deducted D. Uninsured casualty or theft loss deductions 1. If property is damaged or stolen, the property owner may deduct any uninsured loss from taxable income 2. For most types of property, the deductible loss is the reduction in value of the property minus the amount of the insurance reimbursement E. Depreciation deductions 1. Depreciation deductions cannot be taken for a principal residence, personal use property, unimproved investment property, or dealer property 2. For most real estate, the depreciation period is from 27½ to 39 years 3. Depreciation deductions reduce the taxpayer’s adjusted basis in the property F. Repair deductions are allowed for some properties, but not principal residences or personal use property 4  Chapter 13: Income Taxation and Real Estate G. Operational losses from rental property may sometimes be deducted from ordinary income H. Rental payment deductions are allowed for business tenants (not owners) EXERCISE 13.4 Home mortgage interest deduction V. State Income Tax A. California’s state income tax code is similar to the federal law, in terms of deductions and definitions of income Exercises EXERCISE 13.1 Review exercise To review Chapter 12, “Closing Real Estate Transactions,” read the following True/False questions aloud to students and have them jot their answers down on a piece of paper; discuss the answers together. 1. If there is no provision in the escrow instructions specifying a termination date, the escrow will terminate after 60 days. 2. An escrow is terminated by the death or incapacity of either party. 3. A real estate broker can provide escrow services for a fee, without being a licensed escrow agent, as long as the services are related to a transaction in which the broker is also providing the brokerage services. 4. Once a deed or other closing-related documents or funds are deposited into es- crow, they can’t be released to any party without the consent of all parties to the transaction. 5. A real estate broker is representing a buyer in the purchase of a home. He will also provide escrow services for the transaction. In his role as escrow agent, the broker is considered a dual agent, representing both the buyer and the seller. 6. At the beginning of the escrow process, the buyer and the seller sign written escrow instructions which set the conditions that must be met before the transaction can close. Answers: 1. FALSE. An escrow will terminate after a reasonable time if no closing date is specified. 5  Principles of California Real Estate Instructor Materials 2. FALSE. The death or incapacity of one of the parties does not terminate an es- crow. Escrow terminates when the transaction closes, when the termination date is reached (or after a reasonable period of time, if no termination date is specified), or by mutual agreement of the parties. 3. TRUE. In California, a real estate broker may charge a separate fee for escrow services when handling escrow for a transaction for which he is also providing brokerage services. 4. TRUE. Once a party to a transaction has deposited something into escrow, she can’t retrieve it without the consent of the other party or parties. 5. TRUE. An escrow agent is a dual agent. When a real estate broker provides escrow services, he is representing both the buyer and the seller. 6. TRUE. The instructions direct the escrow agent to take all of the necessary steps to close the transaction in accordance with the purchase agreement. Until the condi- tions set forth in the instructions have been met, the transaction cannot close. EXERCISE 13.2 Basic tax concepts Fill in the blanks in the sentences below with the appropriate term. (Terms may be used more than once.) Deduction Adjusted basis Initial basis Capital gain Capital expenditure Realized Marginal tax rate Tax credit 1. In most cases, a taxpayer’s ______________ is equal to the actual amount of his investment—that is, how much it cost to acquire the property. 2. A taxpayer who is entitled to a/an ______________ can subtract a specified amount from her income before it’s taxed. 3. A gain on the sale of an asset held for personal use or as an investment is con- sidered a/an ______________. 4. A/an ______________ increases the value of the property or significantly extends its useful life. 5. Capital expenditures are added to the initial cost of acquiring the property in calculating the ______________. 6  Chapter 13: Income Taxation and Real Estate 6. A taxpayer’s income is added up, the tax rate is applied, and then any applicable ______________ is subtracted to determine how much the taxpayer will actually have to pay. 7. A gain is not considered taxable income until it is ______________. 8. A maintenance expense, such as repainting or replacing a broken window, is not a/an ______________. 9. The ______________ is the tax rate that will be applied to the last taxable dollar that a person earns. Answers: 1. Initial basis 2. Deduction 3. Capital gain 4. Capital expenditure 5. Adjusted basis 6. Tax credit 7. Realized 8. Capital expenditure 9. Marginal tax rate EXERCISE 13.3 Nonrecognition transactions Read the following True/False questions aloud to students and have them jot their an- swers down on a piece of paper; discuss the answers together. 1. If a developer exchanges one of the new homes in his subdivision for a similar home in another part of town, he is eligible for the tax advantages of a tax-free (tax-deferred) exchange. 2. In installment sales, the gross profit is used in calculating the gain to be recognized in any given year. 3. Installment sale reporting is permitted for all classes of property, except for dealer property. 4. Jones sold his property for $150,000, and his gross profit was $24,000. His gross profit percentage is 12%. 7  Principles of California Real Estate Instructor Materials 5. In a tax-free exchange, anything other than like-kind property that the taxpayer receives is called boot, and it is recognized in the year of the exchange. 6. In a tax-free exchange of two rental properties, one taxpayer traded away a prop- erty with a higher mortgage balance than the one he received. This advantage is called mortgage relief, which is boot and taxable in the year of the exchange. 7. In an installment sale, the gross profit percentage applies to all principal and interest payments received in a given calendar year. 8. To qualify for a tax-free exchange, the property must be unimproved investment property, income property, personal use property, or property used in a trade or business. 9. An investor owns a property free and clear. It’s valued at $420,000 with a book value (or basis) of $320,000. He exchanges the property for another property, owned free and clear, valued at $435,000. He receives no boot. The book value of his new property would be $335,000. 10. If an owner receives money because a property has been destroyed or condemned, it’s called an involuntary conversion. Answers: 1. FALSE. A developer is a dealer, and the homes in his subdivision are considered inventory. Dealer-held property is not eligible for a tax-free exchange. 2. TRUE. To determine the gross profit, take the seller’s basis at the time of sale, add the commission and other selling expenses, and subtract this sum (the adjusted basis) from the sales price. 3. TRUE. Dealer property is inventory, and the full profit is recognized in the year of the sale. All other types of property are eligible for installment sale reporting. 4. FALSE. You determine the gross profit percentage by dividing the gross profit by the sales price. $24,000 ÷ $150,000 = 0.16. The gross profit percentage is 16%. 5. TRUE. For instance, if Adams exchanges her $400,000 duplex for a $370,000 single-family rental and $30,000, the $30,000 cash received by Adams is boot and is taxable in the year of the exchange. 6. TRUE. Since properties involved in an exchange are not likely to have identical mortgage balances, mortgage relief is a standard part of tax-free exchanges. It is considered boot and taxable in the year of the exchange. 7. FALSE. The gross profit percentage applies only to principal payments received. Interest payments are taxable as ordinary income in the year they are received. 8  Chapter 13: Income Taxation and Real Estate 8. FALSE. Personal use property, such as a second home, is not eligible for a tax-free exchange. (Neither is a principal residence or dealer property.) 9. FALSE. If no boot is exchanged, the old property’s basis (sometimes called “book value”) is transferred to the new property. So in this case, the basis or book value of the new property would be $320,000. 10. TRUE. Involuntary conversion occurs when an owner receives reimbursement or compensation for destroyed, stolen, or condemned property, usually from an insurer or from the government. In effect, the property is “converted” to cash. EXERCISE 13.4 Home mortgage interest deduction Discussion Prompt: Federal tax law allows a homeowner to deduct interest on a loan to buy, build, or improve a first or second residence. Why does the government allow this deduction? The U.S. Constitution promises citizens equal protection of the laws. Is it fair to give a tax benefit to one group (homeowners), but not to another group (renters)? Analysis: Subsidizing home ownership through tax policy helps strengthen a significant portion of the economy. Also, neighborhoods with high percentages of owner- occupied dwellings tend to be better maintained and to have lower crime rates than those with lower rates of ownership. On the other hand, homeowners may tend to demand more in the way of government services than renters. As for fairness, tax policy discriminates in all sorts of ways to achieve social goals. For example, tax breaks are provided to: 1) taxpayers with minor children; 2) developers of alternative energy sources; and 3) growers of certain crops. 9  Principles of California Real Estate Instructor Materials Chapter 13 Quiz 1. Judy owns an apartment building that’s worth 6. James decides to sell his home. This sale may $800,000. The building’s adjusted cost basis is result in: $770,000 and it has an outstanding $720,000 A. either a capital gain or a capital loss mortgage. She enters into an exchange with B. neither a capital gain nor a capital loss Bruce, who owns a shopping center worth C. a capital gain, but not a capital loss $785,000. The shopping center is mortgaged for D. a capital loss, but not a capital gain $700,000. Bruce also pays Judy $10,000 cash boot. What is Judy’s actual gain, and what’s her deferred gain? 7. The capital gain exclusion is available for married couples or individuals who lived in a A. $45,000 and $15,000 principal residence for at least: B. $70,000 and $15,000 C. $30,000 and $10,000 A. 12 months D. $30,000 and $20,000 B. 2 years C. 5 years D. 6 years 2. Which of the following could result in a tax advantage? 8. Regarding tax-free exchanges, which of the A. A tax-free exchange following is true? B. An installment sale C. A depreciation deduction A. An office building cannot be exchanged for D. All of the above an apartment complex B. A personal residence may be exchanged for a house of similar worth 3. Adam is holding a piece of unimproved prop- C. Property exchanged must be used in a trade or erty as an investment. Which of the following business or held for income or investment is he entitled to deduct for income tax pur- D. Both properties must carry mortgages poses? A. Annual appreciation in the land’s value 9. To be depreciable under income tax law, a B. A loss on the sale of the property property must be: C. A gain on the sale of the property D. None of the above A. a personal residence B. unencumbered C. improved 4. Which of the following properties could be D. vacant depreciated for income tax purposes? A. An owner-occupied farmhouse 10. For tax purposes, which of the following per- B. A commercial apple orchard sonal residence expenses may be deducted from C. Vacant land ordinary income? D. Any of the above A. Cleaning and general maintenance costs B. Repair costs 5. Depreciation on real property means that the: C. Property taxes and mortgage interest A. property becomes virtually worthless D. Loss when property is sold B. property’s value increases C. basis decreases D. basis increases 10  Chapter 13: Income Taxation and Real Estate 11. For income tax purposes, a property owner 15. An owner of an apartment complex reports living in her own home may not deduct which income on a cash basis. Which of the following of the following expenses? is not tax-deductible? A. The cost of painting a bathroom A. Mortgage interest B. An uninsured loss from damages resulting B. Lost income from vacancies from a kitchen fire C. Cleaning and maintenance costs C. Property taxes D. Improvement and redecorating costs D. Mortgage interest 12. In 2008, Seymour bought a home for $515,000. In 2014, he sold it for $640,000 and bought another home for $657,000. Based on this information, what is his cost basis on his new house and the recognized gain reported on his income tax return? A. $515,000 and $125,000 B. $657,000 and $125,000 C. $515,000 and none D. $657,000 and none 13. Kathy and John, a married couple, purchase a home for $250,000. After living in it for six years, they sell it for $282,000. On what amount will they have to pay capital gains taxes? A. $32,000 B. $250,000 C. $282,000 D. Nothing 14. A condominium owner living in his condo- minium is permitted to deduct which of the following expenses on his federal income tax return? A. Repair and upkeep of his individual unit B. Interest paid on a loan secured by the com- mon areas C. Monthly payment toward upkeep of the common areas D. None of the above 11  Principles of California Real Estate Instructor Materials Answer Key 1. A. Judy’s actual capital gain is the gain on the sale of her building. She 8. C. To be eligible for a tax-free exchange, received a shopping center worth a property must be used in a trade $785,000, plus $10,000 cash and or business or held for income or in- $20,000 in mortgage relief, totaling vestment. It must be exchanged for $815,000. Since her cost basis in the like-kind property. apartment building is $770,000, her realized (actual) gain is $45,000. Of 9. C. Vacant land does not depreciate. that, $30,000 is not like-kind property Therefore, depreciable real estate must and is therefore boot (and thus subject have some sort of improvement or de- to tax). The remaining $15,000 is de- velopment. ferred gain. 10. C. Property taxes and mortgage interest 2. D. Any of the above options could pro- are tax-deductible. vide a federal income tax advantage. 11. A. Uninsured theft or casualty losses, 3. B. If he loses money when he sells the property taxes, and mortgage interest property, he has suffered a capital loss. are all deductible expenses for an own- A capital loss on property held for in- er-occupied single-family residence. vestment purposes is tax-deductible. General upkeep and repair costs are not deductible. 4. B. As property used in a trade or busi- ness, a commercial apple orchard 12. D. The cost basis on the new house is the could be depreciated for income tax purchase price, $657,000. Under cur- purposes. rent income tax law, up to $250,000 in gain may be excluded from tax for an 5. C. Depreciation has the effect of lowering individual selling a personal residence. the property’s cost basis. 13. D. Since they lived in the house for 6. C. A gain from the sale of a personal resi- over two years, they qualify for the dence may be treated as a capital gain. $500,000 capital gain exclusion for A loss from the same sale, however, is married couples. not deductible. 7. B. A capital gain exclusion is available on the sale of a principal residence if the owner(s) lived in it for at least two years. 12  Chapter 13: Income Taxation and Real Estate 14. B. He may deduct his share of the inter- est paid on a mortgage of the common areas. Individual unit maintenance and repair costs are not deductible and neither are assessments for upkeep of common areas. 15. B. Lost income from vacancies is simply not reported as income. The other ex- penses are tax-deductible. 13  Principles of California Real Estate Instructor Materials PowerPoint Thumbnails Use the following thumbnails of our PowerPoint presentation to make your lecture notes. Principles of California Real Estate Lesson 13: Income Taxation and Real Estate © 2021 Rockwell Publishing 1 Basic Taxation Concepts Progressive tax Federal income tax is progressive tax. ⚫ Progressive tax: Person with higher income is generally taxed at higher rate—pays higher percentage of income in taxes and also more total money in taxes. ⚫ Marginal tax rate: Rate that will apply to the last dollar taxpayer earns (higher bracket). © 2021 Rockwell Publishing 2 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. © 2021 Rockwell Publishing 3 14  Chapter 13: Income Taxation and Real Estate 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. © 2021 Rockwell Publishing 4 Classifications of Real Property The way property is taxed depends on its property classification. Here are 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 © 2021 Rockwell Publishing 5 Classifications of Real Property Principal residence 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. © 2021 Rockwell Publishing 6 15  Principles of California Real Estate Instructor Materials Classifications of Real Property Personal use property Personal use property: Real estate owned for personal use that is not principal residence. ⚫ Example: vacation home. © 2021 Rockwell Publishing 7 Classifications of Real Property Unimproved investment property Unimproved investment property: Vacant land that is held for appreciation and produces no income. © 2021 Rockwell Publishing 8 Classifications of Real Property Property held for production of income Property held for production of income: Any type of property (residential, commercial, or industrial) from which owner collects rent. © 2021 Rockwell Publishing 9 16  Chapter 13: Income Taxation and Real Estate Classifications of Real Property Property used in trade or business Property used in trade or business: Commercial or industrial land or buildings needed to operate business owned by taxpayer. © 2021 Rockwell Publishing 10 Classifications of Real Property Dealer property Dealer property: Property taxpayer is holding for later sale to customers. ⚫ Example: subdivided land available for sale. © 2021 Rockwell Publishing 11 Summary Classifications of Real Property Principal residence Income property Personal use Trade or business property property Unimproved Dealer property investment property © 2021 Rockwell Publishing 12 17  Principles of California Real Estate Instructor Materials 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 says it’s exempt. © 2021 Rockwell Publishing 13 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 © 2021 Rockwell Publishing 14 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. © 2021 Rockwell Publishing 15 18  Chapter 13: Income Taxation and Real Estate Basic Taxation Concepts Capital gains and losses Capital losses are netted against capital gains, resulting in net gain or loss. Generally, no more than $3,000 in net capital losses may be deducted in single year. ⚫ Net losses over $3,000 may be carried forward and deducted in future years. © 2021 Rockwell Publishing 16 Basic Taxation Concepts Capital gains and losses Different loss rule applies 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. © 2021 Rockwell Publishing 17 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. © 2021 Rockwell Publishing 18 19  Principles of California Real Estate Instructor Materials 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. © 2021 Rockwell Publishing 19 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. © 2021 Rockwell Publishing 20 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 depreciation deductions (if applicable) © 2021 Rockwell Publishing 21 20  Chapter 13: Income Taxation and Real Estate Adjusted Basis Capital expenditures 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. © 2021 Rockwell Publishing 22 Adjusted Basis Depreciation deductions When depreciation deductions are allowed, deductions are subtracted from initial basis to determine adjusted basis. © 2021 Rockwell Publishing 23 Basic Taxation Concepts Realization Gain isn’t taxed until it is realized: when owner sells or exchanges property. Gain (or loss) on transaction is calculated by taking amount realized from sale and subtracting property’s adjusted basis. © 2021 Rockwell Publishing 24 21  Principles of California Real Estate Instructor Materials 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. © 2021 Rockwell Publishing 25 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 (discussed next). © 2021 Rockwell Publishing 26 Summary Basic Taxation Concepts Income Initial basis Deductions Adjusted basis Tax credits Capital expenditure Gains and losses Realization Capital asset Recognition © 2021 Rockwell Publishing 27 22  Chapter 13: Income Taxation and Real Estate Nonrecognition Transactions Tax on gain usually must be paid in year it is realized. But if nonrecognition provision applies, tax can be deferred (postponed). Real estate transactions covered by nonrecognition provisions include: ⚫ installment sales ⚫ involuntary conversions ⚫ “tax-free” exchanges © 2021 Rockwell Publishing 28 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. © 2021 Rockwell Publishing 29 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 © 2021 Rockwell Publishing 30 23  Principles of California Real Estate Instructor Materials Involuntary Conversion May result in gain Involuntary conversion usually involves gain for owner. ⚫ Government or insurer usually compensates owner based on property’s market or replacement value. © 2021 Rockwell Publishing 31 Involuntary Conversion Deferral of gain IRS allows deferral of gain if taxpayer replaces property within allowed replacement period. ⚫ Replacement period generally lasts for 2 years after year property was lost, destroyed, etc. ⚫ Any gain not applied toward replacement property is taxed as income. © 2021 Rockwell Publishing 32 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. © 2021 Rockwell Publishing 33 24  Chapter 13: Income Taxation and Real Estate “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 © 2021 Rockwell Publishing 34 “Tax-free” Exchanges Like-kind property To qualify, properties exchanged must be like-kind. ⚫ Real property must be exchanged for other real property. ⚫ Like-kind property isn’t necessarily same type of real property. ⚫ Example: apartment building can be exchanged for unimproved land. © 2021 Rockwell Publishing 35 “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. © 2021 Rockwell Publishing 36 25  Principles of California Real Estate Instructor Materials “Tax-free” Exchanges Boot taxable only to extent of gain If boot received exceeds realized gain, only amount of gain is taxed, not full amount of boot. © 2021 Rockwell Publishing 37 “Tax-free” Exchanges Transferred basis 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. © 2021 Rockwell Publishing 38 “Tax-free” Exchanges Not always tax-free for both parties 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. © 2021 Rockwell Publishing 39 26  Chapter 13: Income Taxation and Real Estate “Tax-free” Exchanges Agent’s commission Real estate agent who arranges tax-free exchange may be paid commission by both parties to transaction. © 2021 Rockwell Publishing 40 Summary Nonrecognition Transactions Installment sale Involuntary conversion Tax-free exchange Like-kind property Boot © 2021 Rockwell Publishing 41 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) © 2021 Rockwell Publishing 42 27  Principles of California Real Estate Instructor Materials 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. © 2021 Rockwell Publishing 43 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. © 2021 Rockwell Publishing 44 Deductions for Property Owners Tax deductions for property owners include: ⚫ property taxes and special assessments ⚫ mortgage interest ⚫ points and other loan costs ⚫ uninsured casualty and theft losses ⚫ depreciation deductions ⚫ repairs ⚫ operational losses from rental property © 2021 Rockwell Publishing 45 28  Chapter 13: Income Taxation and Real Estate Property Tax Deductions General real estate taxes may be deducted up to a certain limit. Special assessments are: ⚫ deductible if for maintenance or repairs ⚫ not deductible if for improvements © 2021 Rockwell Publishing 46 Mortgage Interest Deductions Mortgage interest is usually deductible, subject to limits for personal residences (main home or second home): Taxpayer can deduct interest paid on: ⚫ mortgage or home equity loan up to $750,000 used to buy, build, or improve principal/second residence (limit is $1,000,000 for loans before 2018). Interest paid on amount over limit not deductible. © 2021 Rockwell Publishing 47 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. © 2021 Rockwell Publishing 48 29  Principles of California Real Estate Instructor Materials Deductibility of Points Points paid in connection with new loan: ⚫ are considered prepaid interest ⚫ can be deducted from taxable income Includes: ⚫ discount points ⚫ origination fee © 2021 Rockwell Publishing 49 Deductibility of Points Points paid by seller on borrower’s behalf are deductible. ⚫ But borrower’s basis must be reduced by amount of seller-paid points. © 2021 Rockwell Publishing 50 Deductibility of Points Fees charged by lender for specific services are not deductible. ⚫ Examples: appraisal fee, mortgage insurance premiums, document preparation fees. Prepayment penalty is considered interest, and may be deducted. © 2021 Rockwell Publishing 51 30  Chapter 13: Income Taxation and Real Estate Uninsured Casualty/Theft If property is destroyed, damaged, or stolen, any loss not covered by insurance is generally deductible. ⚫ But uninsured losses involving principal residence or personal property is only deductible if caused by federally declared disaster. © 2021 Rockwell Publishing 52 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. © 2021 Rockwell Publishing 53 Depreciation Deductions 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. © 2021 Rockwell Publishing 54 31  Principles of California Real Estate Instructor Materials Depreciation Deductions Subtracted from basis Depreciation deductions are subtracted from initial basis to arrive at adjusted basis. Initial basis + Capital expenditures – Depreciation Adjusted basis Note: depreciation deductions are subtracted even if taxpayer did not take them. © 2021 Rockwell Publishing 55 Loss Deductions Property owner may deduct uninsured loss from taxable income. ⚫ Property damaged, destroyed, or stolen. ⚫ Loss was not fully covered by insurance. © 2021 Rockwell Publishing 56 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 capital improvements added to basis and eventually reduce capital gain. © 2021 Rockwell Publishing 57 32  Chapter 13: Income Taxation and Real Estate Deductions Operational losses from rental property Taxpayer who owns and actively manages rental property generally may deduct up to $25,000 of operational losses. ⚫ Rental income considered passive income. ⚫ If taxpayer is real estate professional, rental income is not passive income and $25,000 limit does not apply. ⚫ Lost income due to vacancies is not itself an operational loss. © 2021 Rockwell Publishing 58 Deductions Rental payments 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. © 2021 Rockwell Publishing 59 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. © 2021 Rockwell Publishing 60 33  Principles of California Real Estate Instructor Materials Summary Exclusions and Deductions Principal residence exclusions Property tax deductions Deductions for mortgage interest, points Uninsured loss deductions Depreciation deductions Depreciable property Repair deductions © 2021 Rockwell Publishing 61 34