Chapter 18 (Taxes Affecting Real Estate) Flashcards

Question

Nonpayment of Real Property Taxes

Answer 1

Property taxes constitute a lien superior to all other liens on real property. Special assessments are next in priority. When a property owner fails to pay property taxes, the taxing authority must take steps to obtain the tax money needed to help pay for the cost of government. In Florida, unpaid property taxes are considered a debt, just as though the property owner had signed a promissory note for the amount of the taxes. Further, the property is security for the debt and can eventually be sold to satisfy the obligation. The city or county government is responsible for the cost of its day-to-day operation and must collect delinquent taxes in some manner. To do this, a property tax certificate in the amount of taxes owed is issued for each delinquent property. A list of all delinquent properties is published in a newspaper having general circulation throughout the county. This publication gives all delinquent owners notice that tax certificates on their properties will be sold if the taxes are not paid before the date of sale. The published list of properties, including the amount of taxes in arrears, specifies a date, time, and place for public auction of tax certificates on each property listed. The county tax collector may conduct electronic online sales of tax certificates. At the auction, any qualified person is entitled to bid for the tax certificate on any property. Instead of bidding in dollars, investors bid interest rates at the auction, starting at 18% and going down. The bidder who is willing to accept the lowest interest rate is issued the tax certificate. Once the certificate is sold, the bidder must pay the face amount of the certificate to the county (taxes, interest, and advertising cost). For a certificate to be redeemed by the owner of the property, the tax collector must collect the face amount of the certificate plus all accrued interest. The certificate holder is then paid the face amount of the certificate plus accrued interest. * The holder of the tax certificate can force a public auction of the property by requesting a tax deed after two years but no later than seven years. * A tax certificate expires seven years from the date of issue. Anyone can bid at the foreclosure sale, and the property will be sold to the highest bidder. If not the successful bidder on the property, the holder of the tax certificate then will be paid the amount invested plus interest. If there are no bidders, the holder of the certificate is issued a tax deed. Once the property is transferred by tax deed, all other liens against the property—including mortgages—are wiped out, with the exception of any government liens.

Answer 2

Current federal tax laws greatly affect the benefits that may be obtained from the purchase, ownership, and disposition of real property. The tax considerations of owning personal or investment property are important, but they are also complex.

Answer 3

Tax laws are designed to encourage homeownership and give preferred treatment to taxpayers who own their residences. The owner-occupied residence may be a house, condominium, mobile home, or houseboat. Regardless, the homeowner has certain tax advantages. If homeowners-taxpayers itemize deductions rather than claim the standard deduction on their annual federal income tax returns, they may deduct the following: 1. Mortgage interest. Interest paid on a mortgage loan on a principal and second home is deductible (certain limitations apply). 2. Property taxes. The annual property taxes paid on principal and second homes are deductible. 3. Interest on a home equity loan. The interest paid is deductible if the loan does not exceed $100,000. 4. Mortgage origination fees (points). Points are deductible in the year they are paid, unless they are paid when refinancing a loan—in such cases, the points must be deducted over the life of the loan. Additional tax advantages of homeownership include the following: 5. First-time homebuyers. First-time homebuyers may make penalty-free (but not tax-free) withdrawals up to $10,000 from their tax-deferred individual retirement funds (IRAs) for a down payment. Different IRS rules apply to withdrawals from Roth IRAs. Exclusion of gain from the sale of a principal residence. An exclusion of up to $250,000 of gain ($500,000 for married couples filing a joint return) realized on the sale or exchange of a principal residence.

Answer 4

Federal tax laws classify real property as a capital asset. Capital gain income is profit from the sale of a principal residence, an investment property, a property used in a trade or business, or an income-producing property, and it must be reported for tax purposes. The taxable gain on real estate is determined by two factors: the amount realized from the sale and the adjusted basis. The gain is the amount realized from the sale less the adjusted basis. *The formula to compute the amount realized from a sale is: sale price - expense of the sale = amount realized For example, assume a homeowner sells her home for $165,000 and pays the broker $8,250 and state transfer taxes of $1,155. What is the amount realized? $165,000 sale price - $9,405 = $155,595 amount realized from sale The adjusted basis is the owner's original cost plus buying expenses plus capital improvements (less certain deductions, if applicable). The formula to compute adjusted basis is: original purchase price + purchase expenses and capital improvements = adjusted basis For example, if the homeowner's original cost was $80,000 and there were purchase costs of $800 and capital improvements totaling $5,200, how much is the adjusted basis? $80,000 price + $800 costs + $5,200 improvements = $86,000 adjusted basis A taxpayer-seller's capital gain (loss) is the amount realized from the sale less the adjusted basis. The formula to compute capital gain (or loss) is: amount realized - adjusted basis = capital gain (or loss) For example, using the information in the previous example, how much capital gain must be reported? $155,595 amount realized - $86,000 adjusted basis = $69,595 capital gain While profit from the sale of a principal residence (if not excluded) is included as a capital gain, a loss from such a sale is not allowed as a capital loss and thus may not be deducted. The IRS allows homeowners to exclude up to $250,000 of gain ($500,000 for married couples filing a joint return) realized on the sale or exchange of a principal residence. *Any gain above the exclusion is taxed at the applicable capital gains rate. The exclusion is allowed each time taxpayers sell or exchange a principal residence, as long as the homeowners have occupied the property as their residence for at least two years during the five-year period ending on the date of the sale. The taxpayer is not required to reinvest the sale proceeds in a new residence to claim the exclusion. *The exclusion of gain is generally allowed only once every two years. However, homeowners who do not meet the two-year requirement because of a change in health, job transfer, or other allowable reasons may be eligible for a prorated exclusion of gain.

Answer 5

Another federal government regulation that licensees need to be aware of concerns the purchase of real property in the U.S. from foreign sellers. To prevent foreign sellers from avoiding the payment of taxes due on the sale of real property, the IRS requires that buyers withhold 10% of the gross sale price (including cash paid and any debt assumed by the buyer). The buyer must report the purchase and pay the IRS the amount withheld. There are a few exceptions to this rule. All licensees should encourage their buyers and sellers to consult the IRS or a tax specialist regarding the application of this rule. Tax laws are constantly changing, and they are also very complex. For example, the home equity loan as a source of funds on which the interest is tax deductible may either benefit careful homeowners or result in disaster for homeowners who mishandle their finances. For these and other reasons, it is always wise to retain professional counsel regarding tax situations.

Answer 6

Federal income tax laws encourage real estate investment. Tax benefits include the following: allowable deductions from income, tax deferral and exemptions on resale, installment sale treatment, and like-kind exchanges. Buyers and sellers should always seek competent tax advice to ensure the most favorable tax treatment in a real estate transaction. Advance planning is necessary if an investor's after-tax return on investment is to be maximized.

Answer 7

For tax purposes, ordinary income consists of three types: 1. Active income includes wages, tips, commission, and so forth. 2. Portfolio income includes income from interest, stock dividends, capital gains, royalties, and annuity income. 3. Passive income includes income from activities in which the taxpayer does not participate. *Most income from rental or leased real property is classified as passive income. The significance of these income classifications is that income losses from passive activities cannot be used, with few exceptions, to reduce active and portfolio taxable income. Investors in rental properties should be advised to consult their tax specialist.

Answer 8

Real estate, stocks, bonds, and so forth that are owned for investment purposes are capital assets. When you sell a capital asset, the difference between the amount that you sell it for and your basis, which is usually what you paid for it, is a capital gain or a capital loss. * You have a capital gain if you sell the asset for more than your basis (for profit). * You have a capital loss if you sell the asset for less than your basis. Capital gains are taxed at the applicable capital gains rate. A capital gain from the sale of real estate investment property can be used to offset a capital loss from the sale of other investment property. Furthermore, if an investor's capital loss exceeds capital gains, the investor may deduct up to $3,000 in losses in a given year. Assume, for example, an investor has two investment properties. One earns a capital gain of $10,000, and the other has a capital loss of $15,000. The investor can offset the $10,000 gain with $10,000 of the loss. This leaves a net $5,000 loss of which the investor can deduct $3,000. The investor must carry forward the remaining $2,000 loss to the next year. As previously discussed, a loss from the sale of your personal residence is not deductible.

Answer 9

Three types of deductions from gross income are allowed when calculating the taxable income from investment real property: 1. Operating expenses. Operating expenses are those cash outlays necessary for running and maintaining the property, and they are deductible in the year paid. Property taxes are considered operating expenses and are deductible. While reserve for replacements is deducted when determining NOI, it is not a cash expense and is not deductible when computing taxable income. Replacement expenses (not capital improvements), however, are deductible in the year paid. 2. Financing expenses. Financing expenses include the interest paid, as well as the costs of obtaining borrowed money. While mortgage interest is deductible, principal payments are not. Costs associated with obtaining borrowed funds, such as loan origination fees and points, must be amortized over the life of the loan. 3. Depreciation. Depreciation is a means of deducting the costs of improvements to land over a specified period of time. The land itself is not depreciable. Depreciation (or cost recovery) allows taxpayers to recover the cost of depreciable property by paying less tax than they would otherwise have to pay. Under present tax law, the depreciation deduction usually bears little relationship to actual changes in property value. Depreciation is used to stimulate economic expansion by making certain types of real property more attractive to investors. Depreciation is allowed only for business property and income-producing property (which includes investment property). It is not allowed for inventory property or for a personal residence. As it relates to annual income from a property, depreciation provides favorable tax relief as an allowable deduction that requires no current outlay of cash, as is necessary to deduct other expenses (such as property taxes and mortgage interest). In addition, depreciation is based on the total cost of improvements, including that portion paid for with borrowed funds (the leveraged portion).

Answer 10

The depreciable basis of the property is the amount that may be depreciated. For real property, it is generally the initial cost of the asset plus acquisition costs minus the value of the land. Acquisition costs generally include such items as the buyer's attorney's fees, appraisal fees, survey fees, and title insurance costs. Because land is not depreciable, this basis (total cost) must be allocated between the improvements (buildings, etc.) and the land, based on the respective values of each.

Answer 11

Depreciation is calculated using the straight-line method. An equal amount of depreciation is taken annually over the useful life of the asset. The Internal Revenue Service (IRS) has currently established useful asset life as 27.5 years for residential rental property and 39 years for nonresidential income-producing property. The formula to compute straight-line method depreciation is: depreciable basis ÷ 27.5 years (or 39 years) = annual depreciation For example, assume that in 2010, a residential real estate investment property is purchased for $250,000, with a land value of $50,000. The depreciable basis is $200,000 ($250,000 sale price less the land value). What is the amount of the yearly depreciation deduction? $200,000 depreciable basis ÷ 27.5 years = $7,273 annual depreciation deduction

Answer 12

In general, when income property is sold for cash, all gain or loss must be recognized (reported) immediately for income tax purposes. The total realized gain is the difference between the net sale price (selling price less selling expenses) and the depreciated basis of the property. The seller pays tax on the gain from the sale of real estate in the year the gain is collected. Because of the tax consequences of the immediate recognition of gain, the installment sale method or a like-kind exchange may provide beneficial tax results.

Answer 13

Under the installment sale method, the gain is received over a number of years, and the seller recognizes the gain for tax purposes over the same period. The installment sale method relieves the seller of paying tax on gain not yet collected. Generally, it calls for the gain to be reported only as payments are actually received, with each payment treated as part profit and part recovery of investment in the property sold. If an installment sale results in a loss, however, the seller may not use the installment sale method to report the loss over a period of years for tax purposes. A qualified loss must be recognized (reported) in the year of sale. Because the IRS requirements regarding the installment sale method are complex, early tax counsel is mandatory.

Answer 14

Real estate investors can defer paying taxes by exchanging real property. The income tax is deferred, not eliminated. A like-kind exchange enables a taxpayer-investor to realize the benefits of investment and property appreciation immediately while paying taxes later. When the investor sells the property, the capital gain will be taxed. To qualify as a tax-deferred exchange under Section 1031 of the Internal Revenue Code, real property must be exchanged for other real property (hence the term "like-kind"). However, it may be a different type of real property. For example, a multifamily complex can be exchanged for an office complex. *Any additional capital or personal property included with the transaction to even out the value of the exchange is called boot. The IRS requires tax on the boot to be paid at the time of the exchange by the party who receives it. Because exchanges are subject to a number of IRS rules that must be strictly adhered to, the transactions must be carefully structured, with early tax counsel mandatory. Personal residences and foreign property do not qualify.

Answer 15

Tax shelter is a term that describes some of the advantages of owning real estate (or other investments). An investment is a tax shelter when it shields income or gain from payment of income taxes. One of the features of a tax-sheltered real estate investment is depreciation. Depreciation is a key deduction because it reduces taxable income without involving a cash outlay. Depreciation protects at least a portion of income from tax and also may produce a tax loss, thus possibly creating additional tax sheltering of other income. Under the tax code, sheltering of income is restricted due to income classifications (active, portfolio, or passive). Sound real estate investments depend primarily on the inherent productivity of a property, not on its tax aspects. A good real estate investment always combines positive cash flow (if income-producing property) with appreciation of property value. If a property declines in value in an amount equal to or greater than the depreciation deduction allowable for tax purposes, that property is not a tax shelter.

Answer 16

The shielding of income or gain from payment of income taxes.

Answer 17

A key deduction when calculating taxable income from investment property because it reduces taxable income without requiring a cash outlay.

Answer 18

Property taxes are payable for the current year on or after November 1. Unpaid property taxes become delinquent on April 1 of the following year. Assessed value is the value of a property established for property tax purposes. Property owners use a three-step procedure to protest the assigned assessed value: (1) contact the county property appraiser, (2) appeal to the Value Adjustment Board, and (3) file a suit in court (certiorari proceeding). The Value Adjustment Board is made up of five members: two county commissioners, one school board member, and two citizen members. Immune properties consist of city, county, state, and federal government properties. Immune properties are not assessed and are not subject to taxation. Exempt properties include property belonging to churches and nonprofit organizations. Exempt properties are subject to taxation, but the owner is released from the obligation. Partially exempt property is subject to taxation, but the owner is partially relieved of the burden. Taxable value is determined by beginning with assessed value and subtracting appropriate exemptions. Florida residents who hold title to a home in Florida and use the home as their permanent residence may homestead the property. Homeowners are entitled to a $25,000 homestead exemption from the assessed value of the home for city, county, and school board taxes. Homesteaded properties with an assessed value of $75,000 or more are entitled to an additional $25,000 homestead exemption from city and county taxes (but not school board taxes). An additional $500 exemption from the assessed value of homesteaded property is available to widows and widowers, legally blind persons, and nonveterans who are totally and permanently disabled. An additional $5,000 exemption is available to veterans who are at least 10% disabled by military service–connected misfortune. Florida’s Green Belt Law shields agricultural property from higher tax assessments. The Save Our Home amendment caps how much the assessed value of homesteaded property may increase each year to 3% annually or the CPI, whichever is less. A mill is one one-thousandth of a dollar or one-tenth of a cent. Cities, counties, and school boards are capped at a basic real property tax rate of no more than 10 mills each. Special assessments are one-time taxes levied on properties to help pay for a public improvement that benefits the property. A special assessment becomes a lien on the property. Property taxes constitute a lien superior to all other liens on real property. Property taxes become a lien on January 1 of each year. Property owners who itemize deductions may deduct interest, property taxes, and mortgage origination fees on a principal residence and second home, and interest on a home equity loan. Deductions from taxable income on investment property include operating expenses (but not reserve for replacements), financing expense, and depreciation. Depreciation is a means of deducting the cost of improvements to land over a specified time. The land itself is not depreciable. Depreciation is calculated using the straight-line method; an equal amount is taken annually over the useful life of the asset. The IRS has established the useful life of 27.5 years for residential rental property and 39 years for nonresidential income-producing property.

Chapter 18 (Taxes Affecting Real Estate) Flashcards

(42 cards)