3 Real Estate Taxation The tax laws affecting real estate are very complex. This chapter will provide the foundation for further research. Tax advice is not within the scope of most licensees’ employment. Advice from a competent tax lawyer or CPA is indispensable. The only areas of taxation considered here are ad valorem and certain provisions of income taxation that have application to real estate.
4 Ad Valorem Taxes In these times the most fundamental concepts of ad valorem taxation are often questioned. It is a system that will not easily be changed since there are numerous statutes and constitutional provisions dealing with ad valorem taxation.
5 Constitutional Provisions Ad valorem is a Latin phrase that translates to “according to value.” The tax is based on the property’s fair market value. The Texas Constitution states: “all property in this state,... shall be taxed in proportion to its value,”. It also provides that the taxes shall be “equal and uniform”. Each county elects an assessor-collector (or sheriff in small counties). The tax is a prior lien which arises automatically the ﬁrst of each year. The constitution provides for seizure of property for delinquent taxes. The constitution also provides for certain exemptions. Texas has abolished ad valorem taxes for state purposes.
6 Statutory Provisions The constitutional provisions have several enabling statutes authorizing the legislature to pass further tax laws. Speciﬁcally, procedures for assessment, foreclosure, determination of market value, tax equalization, and collecting delinquent accounts. In 1979 the legislature adopted the Tax Code.
7 The Math of Property Taxation! Assessed Value x Tax Rate = Tax Payment The assessed value may not exceed the market value and tax rates are set by the taxing authorities in determining their budgets each year. Rates are expressed as an amount per $100 of value. So it would really be more accurate to say that the formula is: Assessed Value ÷ $100 x Tax Rate = Tax Payment
8 The Math of Property Taxation – Example A property is taxed by these taxing authorities at the following rates (remember that rates are expressed at an amount per $100 of value): City – 65¢ County – 79¢ School District – $1.43 Total Tax Rate = $2.87 Assume the property has a market value of $385,000. $385,000 ÷ $100 x $2.87 = $11,049.50 annual property tax due.
9 Assessed Value Appraised values are now standardized through the establishment of a State Property Tax Board and county appraisal districts (CAD). The appraisal district is responsible for appraising property in the district for ad valorem tax purposes. This requires all school districts, levee districts, water districts, and other taxing authorities to use the same appraised value. The chief appraiser shall deliver a written notice to the property owner indicating the appraised value of his property if the value is increased. A taxpayer may protest and have his value reviewed by an Appraisal Review Board. Beyond this appeal, his case can be reviewed by the local district court.
10 Tax Rate The tax rate is set by the taxing authority in accordance with a formula set out in the Texas Property Tax Code. The tax rate only operates as a function of what the taxing authority needs for operations in the current year. Total $ needed for budget ÷ Number of $100s in total taxable value = Tax Rate If a taxing body needs $10,000,000 for its budget and the total value of the taxable property in that district is $400,000,000 then the tax rate is $2.50. $10,000,000 ÷ 4,000,000 = $2.50 Tax Rate (Total value of taxable property is $400,000,000. Divided by $100 is 4,000,000.) The governing body may not adopt a tax rate that, if applied to the total taxable value, would impose an amount of taxes that exceeds last year’s levy until it has had a public hearing.
11 Tax Payment Once due and appeals exhausted, there is no provision for reduction. The taxing authority may allow a speciﬁed discount for early payment. Taxes are due upon receipt of bill and delinquent Jan 31 of each year. Delinquent tax incurs a penalty of 6% for the ﬁrst month plus 1% for each additional month prior to July 1. A tax delinquent on July 1 incurs a total penalty of 12%. This means a total penalty of 18%, plus interest, for only ﬁve months! Taxes may be paid in semiannual installments. Can pay half by Dec 1 and half by June 30 without penalty or interest. A taxpayer at least 65 may pay in quarterly installments.
12 Transfer of the Tax Lien Foreclosure of the tax lien must be by judicial foreclosure. The tax lien may be transferred to anyone that pays the tax at the request of the owner. The holder of the transferred lien may foreclose non-judicially. Owner may redeem within one year after this foreclosure by paying attorney’s fees, judgment, costs, plus interest not greater than 18%. Otherwise the owner of a homestead may redeem within two years by paying the purchaser the amount paid, recording fees, taxes, penalties, interest, and costs, plus 25% during the ﬁrst year, or 50% in the second. If not the owner’s homestead owner may redeem within six months. The tax deed vests good and perfect title subject to redemption.
13 Tax Exemptions and Deferrals Homestead Old Age and Disability Tax Deferral exempts from forced sale for taxes property that is occupied by a person 65 years or older. All that is required is to ﬁle an afﬁdavit containing the following: 1. The birth date of the afﬁant. 2. Legal description of the homestead. 3. Signature of the afﬁant, with an acknowledgment. This exemption also extends to surviving spouses aged 55 or older. The taxes and interest (calculated at 8% per annum) continue to exist as a prior lien against the property, and the taxing unit can foreclose when the homestead is no longer held by the claimant. A disabled veteran who receives 100% disability compensation due to a service-connected disability is entitled to exempt the total appraised value of the veteran’s residence homestead.
14 Appraisal Exemptions An exemption of $3,000 on the homestead. An exemption by a school district of $15,000 on the homestead. If 65 or older, an exemption of $10,000 on the homestead. Another over 65 exemption freezes taxes on a homestead for school purposes. This exemption extends to the surviving spouse at least 55. Another exemption from appraised value is for disabled veterans for varying types of disability, age, and for the veteran’s surviving spouse.
15 One of the more signiﬁcant exemptions is for agricultural use. The land must be devoted principally to agricultural or timber use for at least ﬁve of the seven preceding years. However, tax rollback provisions apply. If the land changes use and no longer qualifies, the taxing authority may collect up to ﬁve years’ preceding taxes as if the land was not exempt. The fair market evaluation of the property “rolls back” for ﬁve years. The new owner may be surprised when asked to pay this amount. If the use changes, the owner has to notify the appraisal ofﬁce. If he does not, the chief appraiser can back-assess the property for 10 years with penalty and interest. Appraisal Exemptions
16 Exempt Property Certain properties are totally exempt from ad valorem taxation and include land owned by: 1.the state or political subdivisions of the state. 2.the Permanent University Fund. 3.the Texas Community Housing Development Organization. 4.the county for the beneﬁt of public schools. 5.lands exempted by federal law. 6.cemeteries. 7.charitable organizations. 8.youth spiritual, mental, and physical development associations. 9.religious organizations. 10.schools. 11.historic sites.
17 Federal Income Taxation In 1986, Congress passed the Tax Reform Act of 1986. It was a sweeping change of income taxation, attempting to eliminate some inequities in the existing structure and encourage simpliﬁcation.
18 Income The 1986 tax law separates income into three categories: (1) active income (2) passive income (3) portfolio income
19 Active income is from a primary source of employment. This includes salaries and income or loss from the conduct of a trade or business in which the taxpayer materially participates. Materially participating means the taxpayer is involved in the operations on a regular, continuous, and substantial basis. Active Income
20 Passive Income Any activity in which the taxpayer does not materially participate. Rental activity is deemed passive regardless of level of participation. There are two exceptions. The ﬁrst is for an individual taxpayer who actively participates in real estate rental activities. Passive losses can be offset against active income up to $25,000 per year. Real estate professionals can deduct unlimited real estate activity losses from active income and portfolio income if: (1) more than half of all services they perform are for real property trades or businesses in which they “materially participate”. (2) they perform more than 750 hours of service per year in those real estate activities.
21 Portfolio Income Income that is not active income or passive income. Interest, dividends, annuities, royalties, or a gain or loss from the disposition of property producing interest, and dividends or annuities that are held for investment are some examples of portfolio income. Expenses directly allocable to the property can be applied against portfolio income. The most signiﬁcant change under the Tax Reform Act of 1986 is that the passive and portfolio losses cannot offset active income.
22 Special Tax Treatment for Real Estate 1. Depreciation. 2. Accelerated Cost Recovery. 3. Capital gains tax treatment. 4. Tax-deferred exchanges. 5. Installment sales. 6. At-risk rules. 7. Homeownership beneﬁts.
23 Depreciation The federal government recognizes the intrinsic loss of value of improvements (not land) and allows these decreases in value to be deducted from gross income before the income is taxed. This, in effect, reduces the amount of taxes the taxpayer will pay, even though he has made no actual or “out-of-pocket” expenditures. Depreciation is often used synonymously with the term “tax shelter” because it is a deduction from gross income even though: (1) no payment is made. (2) no actual loss is suffered. (3) depreciation is allowed in excess of the owner’s equity invested. Since land cannot be depreciated, an allocation of the purchase price must be made between the improvements and land purchased. The most common allocation method used is the ratio of fair market value of the component to the total value.
24 Depreciation There are now three systems involved in the computation of depreciation: (1) MACRS for property placed in service after 1986. (2) ACRS for property placed in service after 1980 but before 1987. (3) the straight-line or declining-balance method based on salvage value and useful life if the property is placed in service before 1981. Depreciation is limited to commercial (industrial and ofﬁce space) and investment (residential rental) property. One’s primary residence cannot be depreciated. Depreciation can no longer be deducted against “active income” if it is a “passive loss” from an activity in which the taxpayer does not materially participate. Virtually all rental activities are treated as passive activities.
25 Straight-Line Method The one type of depreciation that can always be used. First establish the correct useful life of the asset. Then take the basis (cost or value of the improvement) less any salvage value and divide the remainder by the number of years of economic life.
26 Declining-Balance Method Can apply 200% or 150% of the straight-line rate. Assuming a property costs $30,000 and has a ﬁve-year life, the straight- line-method depreciation rate would be 20% of the cost value of the asset in the ﬁrst year, or $6,000. The 200% declining-balance method, therefore, would give the taxpayer the right to deduct double the straight-line rate (40%, or $12,000). The 150% declining balance would be 30%, or $9,000. The basis (cost or initial value of the improvement) is reduced by the sum of depreciation claimed in years prior to the current year, so the amount to be depreciated is reduced each year.
27 Straight Line vs. 200% vs. 150% Methods of Depreciation
28 Classes of Property 5-year property: Telephone switching equipment. 7-year property: Most personal property normally associated with the building, such as furniture, ﬁxtures and equipment, carpet, exterior lighting, exterior signage, movable wall partitions, truck bay doors, ornamental ﬁxtures, and pictures. 15-year property: Most land improvements, such as pavements, landscape sprinkler systems, fences, and excavations for lagoons. 27.5-year property: Residential real estate. 39-year property: Non-residential real estate.
29 Recapture When depreciation is computed using an accelerated method, the excess amount over straight-line must be reported as ordinary income upon disposition of the property. The amount of recapture depends on the type of asset, either personal or real property, and the amount of gain realized on the disposition. All depreciation must be recaptured on the sale of personal property. Since residential rental and nonresidential property placed into service after 1986 are limited to straight-line, recapture is unlikely to occur.
30 Accelerated Cost Recovery System (ACRS) Low-income housing is permitted to be depreciated under the 200% method, while other 15-year real estate may use the 175% method. Clearly sets out how much can be deducted in each year. Eliminates the need for useful life determination, as all property is written off over the applicable 15-year period. No salvage value, so taxpayer may write off the entire cost. If placed in service after 3-15-84, use a recovery period of 18 years. If placed in service after 5-8-85, and before 1-1-87, use 19 years.
31 Applies to all tangible property placed in service after Dec 31, 1986. Whereas the MACRS establishes new depreciation guidelines for certain assets, real estate is limited to two classes: 1. Nonresidential real property which is depreciated over 31.5 years. If placed in service after 5-12-93, the write-off period is 39 years. 2. Residential rental property is depreciated over 27.5 years. Modiﬁed Accelerated Cost Recovery System (MACRS)
32 Capital Gains Tax Treatment A special tax rate paid on proﬁts from the sale of capital assets. Long-term capital gain is gain on the sale of an asset held for more than one year and a short-term capital gain is held less than one year. In 1997 the maximum rate was lowered to 15% from 28% (5% for individuals in the 15% tax bracket). The tax to be paid is applied to the proﬁt made, which is calculated as the sales price less the adjusted basis. Basis is generally considered to be of two types: 1.original basis, which is the original cost of the asset. 2.adjusted basis, which is the original basis plus the cost of capital improvements less any allowances for depreciation. Original Basis + Capital Improvement Depreciation= Adjusted Basis
33 Tax-Deferred Exchanges Exchanging has become popular because trades can be accomplished without large amounts of cash and because you can trade without paying taxes on the proﬁt in the ﬁrst property at the time of the trade. The phrase tax-deferred exchange is often used instead of trading. The tax deferred exchange rules apply to investment properties only. Owner-occupied dwellings are treated differently. The Internal Revenue Service permits a homeowner to sell their home and exclude all gains with the speciﬁed limits.
34 Trading Up Real estate exchanges need not involve properties of equal value. If you own a small ofﬁce building worth $100,000, you could trade it for a building worth $500,000 with $400,000 of mortgage debt against it. If the building you wanted was priced at $600,000 with $400,000 in debt against it, you could offer your building plus $100,000 in cash. The majority of exchanges consist of 3 transactions: two conveyances and an escrow agreement with a qualiﬁed intermediary (QI). The QI maintains control over the funds and the closing documents. A delayed exchange allows seller to designate a replacement property after closing provided: (1) the replacement property is identiﬁed within 45 days. (2) title to the replacement property is acquired within 180 days. (3) the replacement property is received before the designating party’s tax return is due.
35 Reverse Exchanges What if sale of the exchange property is delayed and the seller has to acquire the replacement property before selling the existing property? The QI may become an Exchange Accommodation Title Holder. The taxpayer transfers the ownership of the Replacement Property to the Accommodation Title Holder and then the Accommodation Title Holder will hold title until the exchange property can be sold. The seller, in effect, “parks” the replacement property with the Accommodation Title Holder until a buyer can be found for the exchange property.
36 Installment Sales One of the simplest major tax advantages of owning real estate is the installment sale beneﬁt. It applies to all types of real estate, including residential property. There must be at least two payments, the ﬁrst being in the year of sale. The remainder of the income is taxed as it is received over future years. This allows the taxpayer to report the gain over a period of years. “Dealers” in real estate (developers and brokers engaged in buying and selling of real estate in the normal course of business” no longer have this option.
37 At-Risk Rules After 1986 the taxpayer’s deductible losses for any year are limited to the amount that the taxpayer has at risk in that particular activity. The amount at risk is the sum of the following items: cash, the adjusted basis of the property, and amounts borrowed for use. One major exception is that the taxpayers are not subject to these rules to the extent they use arm’s-length, third-party, commercial ﬁnancing secured solely by the real property.
38 Homeownership Rules – Deductibility of Interest Home mortgage interest for acquisition indebtedness and home equity indebtedness continue to be deductible. Limited to the ﬁrst and second residences. The amount of acquisition indebtedness may not exceed $1,000,000 (or $500,000 for a married individual who ﬁles a separate return). The amount of home equity indebtedness may not exceed $100,000 (or $50,000 for a married individual who ﬁles a separate return). Acquisition indebtedness cannot be increased by reﬁnancing.
39 Homeownership Rules – Gain on Sale of Principal Residence Must own and occupy the principal residence at least 3 of last 5 years. A taxpayer can exclude $250,000 from the sale of a principal residence. There is a $500,000 exclusion for married couples ﬁling jointly, if: (1) either spouse meets the ownership test. (2) both spouses meet the use test. (3) neither spouse is ineligible for exclusion by virtue of sale or exchange of residence within the last two years. This exclusion is allowable each time the homeowner meets the eligibility requirements, but no more frequently than every two years. The IRS no longer receives notiﬁcation of any home sales of $250,000 or under $500,000 for married taxpayer.
40 Questions for Discussion 1. Explain the ad valorem tax system in Texas. 2. What is the Homestead Old Age and Disability Tax Deferral? 3. What are rollback taxes? 4. Explain the three types of income under the federal tax code. 5. Explain the tax benefits of homeownership.