Progressive Tax
A Federal Tax
This means that the tax rate a taxpayer is charged depends on how much income she has, with more income resulting in a higher tax rate.
If Taxpayer Z has more income than Taxpayer X, Z generally not only pays more taxes than X, Z pays a grea
Tax brackets
Tax rates increase in uneven steps
An additional dollar earned by a taxpayer may end up being taxed at a higher rate than the dollar earned just before it.
This is because the taxpayer's earnings crossed the line into a higher bracket.
But that additional
Marginal tax rate
The rate that will apply to the last dollar that a taxpayer earns
Income
As a general rule, any economic benefit realized by a taxpayer is regarded as income.
Any economic benefit realized by a taxpayer that isn't excluded from income by the tax code.
When asked about their income, many people tend to think only in terms of th
Deductions
A deduction is an expense that can be used to reduce taxable income.
Under IRS rules, taxpayers can subtract certain expenses from their income before it is taxed.
These are called deductions.
In connection with real estate, the most familiar example is t
Gains and Losses
A gain is taxable unless it falls into a specific exception in the tax code.
A loss is only deductible if the tax code specifically allows it to be deducted.
The sale or exchange of an asset (such as real estate) nearly always results in either a gain or
Gain
Gains are treated as income, so any gain is taxable unless the tax code specifically says otherwise
When someone sells real estate (or another asset) for more than he invested in it, a gain results.
The IRS considers any gain to be taxable income unless i
Loss
A loss may be deducted from income only if the deduction is specifically authorized by the tax code
Since gains are generally treated as income, are losses then generally assumed to be deductible?
Not by the IRS.
The tax code allows deductions for losses
Capital Gains and Losses
A gain or loss on the sale of an asset held for personal use or as an investment is considered a capital gain or a capital loss.
Capital gains and capital losses are netted against each other
Certain gains and losses are classified as capital gains and ca
Capital gain
The difference between a higher selling price and a lower purchase price, resulting in a financial gain for the seller
If there's a net gain, it's taxed as a capital gain.
Capital gains receive favorable tax treatment: the maximum tax rate applied to most
Capital loss
There is an annual limit on the deductibility of capital losses.
No more than $3,000 in net capital losses can be deducted in a single tax year.
Capital losses in excess of the limit may be carried forward and deducted in future years.
Remember that losse
Business and Rental Property
Gains and losses on the sale of real property used in a business or held for the production of income (rental property) are treated somewhat differently from gains and losses on the sale of personal use and investment property.
If business property or ren
Basis
A taxpayer's investment in his property.
For income tax purposes, a property owner's basis in the property is his investment in it.
If a taxpayer sells an asset, the basis is the maximum amount that he can receive in payment for the asset without realizin
Initial Basis
(Cost basis)
(Book value)
(Unadjusted basis)
The amount he paid to acquire the property
The initial basis is the amount of the taxpayer's original investment in the property.
In other words, it's how much it cost to acquire the property.
The amount of a t
Adjusted Basis
A taxpayer's adjusted basis in a property equals the initial basis plus capital expenditures, less allowable depreciation deductions.
The initial basis plus capital expenditures and minus allowable depreciation deductions.
A property's initial basis may b
Capital expenditures
A capital expenditure is money spent on property improvements, which add to the property's value or prolong its economic life.
Capital expenditures are any expenses the owner incurs to improve the property�expenses that add to the property's value or exte
Realization
A gain is not taxed until it is realized.
A gain is not realized until the asset is sold or exchanged.
A gain or a loss is realized when it is separated from the asset; this separation generally occurs when the asset is sold.
Not every gain is immediately
Recognition and Deferral
A gain is taxed in the year it is realized, unless a provision in the tax code allows recognition of the gain to be deferred.
The year in which a gain is taxed is referred to as the year in which it is recognized.
The general rule is that a gain is recogn
Nonrecognition provisions
Any specific tax code provision that defers income taxation on any gain to some future transaction or event when, depending on the property involved and the circumstances, there may not be a tax due.
Classifications of Real Property
Whether a particular type of real estate transaction qualifies for special tax treatment depends on the type of property involved.
The tax code divides real property into the following classes:
1. principal residence property,
2. personal use property,
3.
Classifications of Real Property 1.
Principal Residence Property
(Main home)
A principal residence is the home the taxpayer owns and occupies as her primary dwelling.
It might be a single-family home, a duplex, a condominium unit, a cooperative apartment, or a mobile home.
If the taxpayer o
Classifications of Real Property 2.
Personal Use Property
Personal use property is real estate that the taxpayer owns for personal use.
Ex. A vacation home or cabin qualifies as personal use property.
Obviously, principal residence property is owned for the taxpayer's personal use.
But it's
Classifications of Real Property 3.
Unimproved Investment Property
Vacant land that produces no income is called unimproved investment property in the tax code.
An owner holds investment property with the hope that it will increase in value in the future.
Unimproved investment property is v
Classifications of Real Property 4.
Property Held for Production of Income
Property held for the production of income includes residential, commercial, and industrial property that's used to generate rental income for the owner.
So if a taxpayer owns an office building and rents it out to t
Classifications of Real Property 5.
Property Used in a Trade or Business
This category includes land and buildings that the taxpayer owns and uses in his trade or business, such as a factory owned by the manufacturer, or a small building the owner uses for his own retail business.
If a taxp
Classifications of Real Property 6.
Dealer Property
Dealer property is property held primarily for sale to customers rather than for long-term investment.
Dealer property is property the taxpayer is holding for sale to customers; in effect, it's the taxpayer's inventory.
If a taxpayer subdi
Principal Residence Property
**See Classifications of Real Property 1.
Personal Use Property
**See Classifications of Real Property 2.
Unimproved Investment Property
**See Classifications of Real Property 3.
Property Held for Production of Income
**See Classifications of Real Property 4.
Property Used in a Trade or Business
**See Classifications of Real Property 5.
Dealer Property
**See Classifications of Real Property 6.
Nonrecognition Transactions
When a nonrecognition provision in the tax code applies to a particular transaction, the taxpayer isn't required to pay taxes on a gain in the year it is realized.
Recognition of the gain is deferred to a later time.
The following types of real estate tra
Installment Sales
Under the tax code, an installment sale is any sale in which the seller receives less than 100% of the total sales price in the year the sale was made.
Installment sale reporting can be used for all types of real estate except dealer property.
Just about
Gross profit
The difference between the sales price and the adjusted basis
The amount of gain a seller reports in any year for an installment sale is determined by the gross profit ratio (also called the gross profit percentage).
The gross profit ratio is the relation
Gross profit ratio
(Gross profit percentage)
The next step is to compare the gross profit to the contract price to arrive at the gross profit ratio.
The contract price is the total amount of all principal payments the buyer will pay the seller.
In most cases, unless the buy
Involuntary Conversions
Occurs when an asset is turned into cash without voluntary action on the part of the owner: the asset is condemned, destroyed, stolen, or lost, and the owner receives a condemnation award or insurance proceeds.
When property is destroyed, stolen, or conde
Tax-Free Exchanges
("Tax-free" exchanges)
A tax-free exchange is a transaction in which one piece of investment, income-producing, or business property is traded for a piece of like-kind property.
When like-kind property is exchanged, the taxation of the gain is deferred.
S
Like-kind property
To qualify for a tax-free exchange, the property must be exchanged for like-kind property.
The like-kind requirement means that both properties must be of the same general kind.
That is, real property must be exchanged for real property rather than for pe
Boot
Boot is anything received in an exchange, other than like-kind property. For example, cash is boot.
If the properties to be exchanged aren't of equal value, the parties may agree to include other items in the transaction.
Anything other than like-kind pro
1031 facilitator
An agent who arranges a tax-free exchange
Sale of a Principal Residence
A property seller may exclude up to $250,000 of the gain from the sale of her home if she is filing a single return, or up to $500,000 if she is married and filing a joint tax return.
To qualify for this exclusion, the seller must have both owned and used
Amount of Gain Excluded
Under current law, a taxpayer may exclude the entire gain on the sale of her principal residence, up to $250,000 if the taxpayer is filing a single return, or $500,000 if the taxpayer is married and filing a joint return.
Ex.
$380,000 Amount realized (aft
Eligibility
To qualify for this exclusion, the seller must have both owned and used the property as a principal residence for at least two years during the five-year period ending on the date of sale.
Because of this rule, this exclusion is available only once every
Depreciation Deductions Available to Property Owners
Depreciation deductions are also called cost recovery deductions.
The taxpayer is permitted to deduct the cost of acquiring an asset over a period of years.
These deductions are allowed for property used in a trade or business and for income property.
A d
Deductions 1.
Depreciation deductions
(Cost recovery deductions)
Depreciation refers to a decline in the value of property as it is used up.
The tax code allows the property owner to claim deductions for this depreciation.
Permit a taxpayer to recover the cost of an as
Deductions 2.
Uninsured Casualty or Theft Loss Deductions
A taxpayer whose property was damaged or stolen may deduct the uninsured portion of the casualty loss.
When property is damaged or stolen and the loss isn't covered or is only partially covered by insurance, the
Deductions 3.
Repair Deductions
Repair expenses are funds spent on repairs to keep property in ordinary, efficient operating condition.
Repair expense deductions are allowed for all types of property except principal residences and personal use property.
A repair expen
Deductions 4.
Property Tax Deductions
General real estate taxes are deductible for any type of property, and so are special assessments for maintenance and repairs..
Special assessments for repairs or maintenance are deductible, but those for improvements (such as new
Deductions 5.
Mortgage Interest Deductions
For most property, mortgage interest paid on a mortgage or deed of trust is usually completely deductible, although there are limits on the interest deduction for mortgages on personal residences.
However, there are some limit
Deductions 6.
Deductibility of Points and Other Loan Costs
Deductible
-Discount points
-Origination fee
Not Deductible
-Appraisal fee
-Document preparation fee
-Mortgage insurance premiums
-Other fees for service
Points paid to the lender during the home buying process
Deductions 7.
Deducting Operational Losses from Rental Property
Under some circumstances, a taxpayer who owns a rental property may deduct operational losses on the property.
However, the IRS considers gains or losses from rental property to be a passive activity, and
Depreciation
**See Deductions 1.
Cost recovery
**See Deductions 1.
Uninsured casualty and theft losses
**See Deductions 2.
Repairs
**See Deductions 3.
Real property taxes
**See Deductions 4.
Mortgage interest
**See Deductions 5.
Points paid to a mortgage lender
**See Deductions 6.
Operational losses from rental property
**See Deductions 7.
Depreciable Property
Only property that wears out and will eventually have to be replaced is depreciable�that is, eligible for depreciation deductions.
Ex. Apartment buildings, business or factory equipment, and the trees in commercial fruit orchards all have to be replaced,
Time Frame
The entire expense of acquiring an asset can't be deducted in the year it's incurred (although that's permitted with many other business expenses, such as wages, supplies, and utilities).
However, the expense can be deducted over a number of years; for mo
Effect on Basis
Any allowable depreciation deductions reduce the taxpayer's adjusted basis in the property.
Note that this reduction occurs whether or not the taxpayer actually takes the deduction.
If the deduction was allowable�that is, the taxpayer was entitled to take
Eligibility for tax-free exchanges
1. Only property held for production of income, property used in a trade or business, or unimproved investment property is eligibile
2. Must be exchanged for like-kind property
3. Any boot is taxed in the year it is received
Passive income
Income a taxpayer earns from an enterprise (such as a limited partnership) that he doesn't materially participate in.
However, the IRS always considers rental income to be passive income, even if the taxpayer participates in the management of the rental p
Rental Payment Deductions
One deduction connected with real estate that concerns not property owners but tenants.
Rent paid for property used in a trade or business is deductible as a business expense.
However, rent paid for property not used in a trade or business (such as rent f
California Income Tax
In addition to the federal income tax, there's a California state income tax.
The provisions of California's income tax laws are substantially the same as the Internal Revenue Code.
Ex. With limited exceptions, the California statutes simply refer to the
Deduction
An expense that can be used to reduce taxable income.
Recognition
A gain is said to be recognized when it is taxable; it is recognized in the year it is realized, unless recognition is deferred by the tax code.
Installment sale
A sale in which less than 100% of the sales price is received in the year of sale.
Involuntary conversion
When property is converted to cash without the voluntary action of the owner, as when property is destroyed, stolen, lost, or condemned, and the owner receives insurance proceeds or a condemnation award.
Depreciation deductions
Deductions from the taxpayer's income to allow the cost of an asset to be recovered over a period of years. These are allowed only for depreciable property that's held for the production of income or used in a trade or business. Also called cost recovery
Repair expenses
Money spent on repairs to keep property in ordinary, efficient operating condition.
Tax-free exchange
When like-kind property is exchanged, allowing taxation of the gain to be deferred. Also called a Section 1031 exchange.
1. A homeowner's basis in her principal residence would be adjusted to reflect:
A.depreciation deductions
B. expenses incurred to keep the property in good repair
C. mortgage interest paid
D. the cost of installing a deck
D. the cost of installing a deck
2. A married couple bought a home for $250,000. After living in the home for three years, they sold it for only $246,000. How much of this loss can they deduct on their federal income tax return?
A. The full $4,000 loss
B. Only $3,000
C. Only $2,000
D. No
D. None of it
3. Which of the following could the owner of unimproved investment property deduct on her federal income tax return?
A. A loss on the sale of the property
B. The depreciation of the land
C. Depreciation deductions
D. Any of the above
A. A loss on the sale of the property
4. Which of the following exchanges could not qualify as a "tax-free" exchange?
A. An office building for a hotel
B. An apartment house for a warehouse
C. Timber land for farm equipment
D. A city lot for a ranch
C. Timber land for farm equipment
5. Under the federal income tax code, income is always taxed in the year it is:
A. realized
B. recognized
C. recovered
D. deferred
B. recognized
6. Ortega just sold his principal residence. After subtracting his selling costs, the amount of gain realized was $163,000. Ortega will be allowed to exclude the entire amount of the gain from taxation only if:
A. he is married and is filing a joint retur
D. he owned and occupied the property as his principal residence for two of the previous five years
7. Torrence owns a triplex as an investment property. She paid $550,000 for it, including her closing costs. The allowable depreciation deductions for the property have amounted to $20,000, Torrence has spent $50,000 on capital improvements, and the marke
C. $580,000
The initial basis, plus the capital expenditures, less the allowable depreciation deductions, equals an adjusted basis of $580,000.
$550,000
+ $50,000
- $20,000
= $580,000
(Ignore the increase in market value; it doesn't affect the taxpayer's
8. Gillespie is buying a home that will be his principal residence. He is financing the purchase with a $300,000 mortgage loan. How much of the interest that he pays on the loan can he deduct from his income?
A. All of it
B. Up to $100,000 in interest
C.
A. All of it
9. The Wongs are selling some property on a five-year contract. Their gross profit ratio on the sale is 15%. This year, they will receive $6,178 in interest and $4,453 in principal. With installment sale reporting, approximately how much of that will be r
C. $6,846
Multiply the principal payments by the gross profit ratio to determine the amount of principal that will be recognized this year. Then add that to the entire amount of interest received (all of the interest is taxable).
$4,453
� 15%
= $667.95
+
10. Sherrick is selling a lot for $172,000. Her adjusted basis in the property is $136,000. In addition to the 6% commission she'll be paying her real estate broker, she will also have to pay $3,500 in closing costs. For federal income tax purposes, what
B. $22,180
Sherrick will realize a $22,180 gain in the transaction. First subtract her selling expenses (the commission and closing costs) from the sales price to determine the amount realized; then subtract her adjusted basis from the amount realized to
Tax Credits
A taxpayer may be entitled to a tax credit, which is subtracted from the amount of tax owed.
In contrast to deductions, tax credits are subtracted directly from the amount of tax owed.
The taxpayer's income is added up, the tax rate is applied, and then a
Tax shelter
A tax shelter is a financial arrangement used to reduce a taxpayer's income tax liability.
Loss - Deductible
The only losses that an individual taxpayer (in contrast to a business entity) can deduct are those connected with:
1. the taxpayer's trade or business,
2. a transaction entered into for profit, or
3. theft or casualty loss of the taxpayer's property.
Operating loss
(Ordinary loss)
Note that losses resulting from the operation of an income-producing or investment property are deductible as ordinary losses, not capital losses.
That's because they represent lost income rather than a loss on the sale of the property.
Fo
Realization - Calculating the amount realized
To determine the amount realized on a sale, you add up all benefits received by the seller.
In addition to cash, this would include any other property the seller received in exchange for the property sold, and also any debt that the buyer is taking over f
Capital asset
Property held for personal use or for investment purposes is considered a capital asset. A capital gain or loss is a gain or loss on the sale of a capital asset.
Taxed gain - Installment Sales
At the end of each tax year, the seller multiplies the sum of all the principal payments received that year by the gross profit ratio.
The resulting figure is the amount of gain that will be taxed that year.
Total Principal Payments
x Gross Profit Ratio
=
Dealer property ineligible - Installment Sales
Installment sale reporting is permitted for all classes of property except dealer property.
A transaction involving dealer property can be reported as an installment sale only under special conditions.
Basis - "Tax-Free" Exchanges
After a straight exchange of one like-kind property for another, the taxpayer's basis in the property received is whatever his or her basis in the property traded away was.
The old basis is transferred to the new property. (If the exchange involved boot,
Agent's compensation - "Tax-Free" Exchanges
A real estate agent who arranges a tax-free exchange may be paid a commission by both parties to the exchange.
Exchanges are the type of real estate transaction in which an agent is most likely to be compensated by more than one party.
Property classifications
Real property is classified in the tax code as either principal residence property, personal use property, unimproved investment property, property held for the production of income, property used in a trade or business, or dealer property.
Sale of Principal Residence
Another type of tax benefit a property owner can get is the exclusion of gain from the sale of a principal residence.
The gain from the sale is not just deferred as with an installment sale or tax-free exchange. Instead, it is permanently excluded from ta
Amount of exclusion - Sale of Principal Residence
The individual seller of a home may exclude up to $250,000 of the entire gain from the sale of the home.
Up to $500,000 may be excluded if the seller is married and filing a joint tax return.
If the amount of the gain on the sale of the home is more than
Qualification for exclusion - Sale of Principal Residence
To qualify for the exclusion, ownership and use tests must be met. Within the five years prior to the sale, the property owner must have:
-owned the home for at least two years, and
-lived in the home as a principal residence for at least two years.
Becau
Depreciable - Depreciation Deductions
Eligible for depreciation deductions
Generally, an asset is only depreciable if it will eventually wear out and need to be replaced.
Ex. Equipment used in farming or some other trade or business needs to be replaced periodically, and therefore is deprecia
Recovery period - Depreciation Deductions
The cost of acquiring depreciable property is deducted over a period of years.
The tax code sets forth different recovery periods for different types of property.
For most real estate, the recovery period is between 27.5 and 39 years.
Depreciation deducti
Condominiums - Mortgage Interest Deductions
If a condominium association takes out a mortgage on its common areas in order to raise funds, and the unit owners are required to pay portions of the mortgage payment, then the unit owners may deduct the interest part of their payments from their taxable
Rental Payment Deductions
The tax deductions we've discussed so far apply to property owners, but this one applies to tenants.
Tenants are allowed to deduct their rental payments from their income, but only if the leased property is used in a trade or business.
Rent paid for other
California Income Tax
California also has a state income tax. California income tax laws largely mirror those of the federal government.
The tax rates and standard deductions are different, but for the most part, California statutes simply refer to federal law for definitions