If you are not a merchant, real estate sales may qualify for the long-term capital gains benefit. Chances are that the current federal capital gains rate of 20% (or less, typically 15% for many taxpayers) could increase significantly. Under Mr. Biden’s proposals, federal long-term capital gains rates could reach 39.6%.
The like-kind exchange rules continue to accommodate real estate exchanges generally, but Section 1031 has been amended to generally exclude personal property. These rules would not apply to personal residence.
Rulings are sometimes found that focus on what is real estate for the purposes of a particular section of the code, such as those defining real estate investment trusts (See PLR 202031001, Sec. 856). In our context, the question that generally arises is rather that of distinguishing, say, the payments for services from the tax imposed on the immovable.
Property taxes on a residence are deductible as an itemized deduction, although the additional deduction may be limited. ** There is generally a $10,000 limit on the deduction of the sum of state and local property and income taxes and sales tax. The $10,000 is not indexed annually for inflation, as is often the case with many provisions. The limit is $5,000 when a married couple files separately.
**On August 6, The Wall Street Journal reported that Democrats were working to remove the $10,000 limit on state and local tax deductions and that if enacted it would be temporary, but would apply for 2020 and 2021.
Our current environment is characterized by somewhat higher standard deductions, which may effectively mean that paying property taxes on residence does not save tax. We’re not suggesting that the deductibility of residential property taxes should weigh heavily in deciding whether or not to sell a home, but it can be a factor. This should be part of the calculations if you consider the layout.
Considerations when buying
When evaluating a purchase agreement, keep in mind that all assets acquired are taken into account in the allocation of the purchase price. Were personal assets acquired at the same time as real estate? There are significant purchase price allocation issues that distinguish land from depreciable real estate (although domestic use is not depreciable).
There are sometimes references to property tax distributions between land and building as guides for accounting distributions. There may be an opportunity for property tax savings if purchase price allocations can more accurately distinguish personal property.
Studies of “constituent assets” may reveal costs that can be distinguished as personal assets with a shorter amortization period. Costs related to commercial real estate are generally depreciated over 39 years, compared to 27 and a half years for residential rental real estate.
Component cost studies can help attribute some non-building costs to shorter lifespans, typically 5, 7, and 15 years. Premium amortization rules have been liberalized to generally allow 100% write-off after September 27, 2017.
One of the results of a component depreciation study may be to find more assets eligible for bonus depreciation. Without suggesting that one needs such complex studies to buy a house, we insist on keeping in mind – what is real estate and what is real estate? staff for the purposes of local property tax assessments?
The deductibility of property taxes
We do not want to be late in paying the property tax on real estate. However, there is tax planning that focuses on allocating one year, using the standard deduction the following year, and doing that as a template. Property taxes can be part of this planning.
Our current environment is one of somewhat higher standard deductions than in the past, so keep in mind that there really aren’t any additional savings when property taxes on residence don’t result in deductions. additional. Also be aware that payments must be remitted to the tax authority and those that are blocked are not deductible until the payments are applied to taxes.
Another rule that can affect the result is the allocation of property taxes to a home office when one is employed. There is a rule that arose from the Tax Cuts and Jobs Act 2017, in effect until 2025, which prohibits various itemized deductions. This would appear to reach the portion of property taxes attributable to an employee’s home office (Tax Cuts and Jobs Act, Conference Report to Accompany HR 1, 115th Cong., 1st Sess. House Report 115-466, December 15, 2017, p. 275, 276).
Payments should reflect taxes rather than assessments for, for example, street improvements. Additions to the asset base may or may not eventually generate tax savings. For example, additions to the tax base may not save tax if the gain on the house would be covered by the housing exclusion anyway.
If certain conditions are met, federal rules in 2020 still exempt $250,000 gain on sale of residence, $500,000 gain on joint filing (Second. 121). Also, the current rule is that the basis generally becomes the fair market value at death (Second. 1014). However, additions to the base over the lifetime will result in an additional income tax base and an additional base can save taxes.
Point to note: Keep track of property tax assessments that increase a home’s base, as there’s at least a good chance that these could eventually reduce income tax.
Additionally, a personal residence can be transferred to children while alive to simplify transfers upon death. Thus, there may be no increase in fair market value at death because the residence did not belong to the deceased at the time of death.
The use of the standard rather than itemized deduction does not affect the nature of the property tax and its deductibility. Actual property taxes cannot be added to the base simply because the taxpayer does not itemize.
If the adult child pays property tax for the widowed mother, this does not result in an additional property tax deduction on the child’s return, assuming the child details. The child cannot deduct property tax as such in these circumstances, as the payment is only a gift to the parent who owns the house.
Final Thoughts – Property Transfers and Taxes
Detailed planning of residential transfers within the family and tenancy issues between relatives are beyond our immediate discussion. The 2020 environment with its COVID-19 concerns could have a relatively quick effect on valuations, depending on the local economy and local legislation.
Property taxes are primarily a matter of national and local tax law. There are also provisions that can arise, such as relief provisions later in life that can affect planning within the family.
Generally, transfers, even transfers by gift within family members, may need to be reviewed for gift and estate tax planning. Keep in mind the prospect of changes in state and local laws in your client’s jurisdiction.
As an example, in California, as we approach the end of 2020, ballot measures are being proposed aimed at increasing property tax collections on commercial properties as well as assessment increases where there are has certain transfers within the family. These provisions trigger short-term transfer discussions in an effort to avoid a property tax increase if it becomes law.
Any type of property transfer within the family should consider property tax implications.