Taxation of Domestic and International Real Estate

Property Tax Deduction and Income TaxFebruary 8, 2011John Gillingham

Why is property tax related to income tax important?

• The amount of property tax owed annually is a major determinate for the ongoing cost of home ownership.

• Income tax treatment of property tax changes the true net cost of ownership.

• Tax policy has an effect on real property values.

Basic Property Tax Deductions, USA• “Local, state, and foreign real property taxes are generally

deductible only by the person upon whom they are imposed in the year in which they were paid or accrued (Code Sec. 164(a)(1); Reg. SS1.164-1(a)”

• Tax imposed by state and local authority may be deductible if three conditions are met:

1. Tax must be ad valorem (substantially in proportion to the value of the property)2. Imposed on an annual basis3. Imposed with respect to personal property (Reg. SS1.164-3c) (1021 Master Tax Guide)• The deduction dates from 1913, at the inception of the federal

income tax.(Cordes, Ebel, Gravelle pg. 367)

Property tax statistics

(Cordes, Ebel, Gravelle pg. 368)

Improvement taxes not deductible

• Any tax that in reality an assessment for local benefits such as streets, sidewalks, and similar improvements is note deductible by a property owner unless for repair and maintenance (Code Sec. 164c; Reg. SS1.164-4).

• For example, an assessment to replace standard curves with granite curves in a given neighborhood would likely not be deductible.

Why are improvement taxes not generally deductible?

• Such a tax policy changes the affordability of neighborhood tax policy.

• Such improvements would otherwise result in tax deductible improvements to a personal residence.

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Form 1040 – Itemized Deductions

Schedule A – Itemized Deductions

Qualified Deductible Property Tax

• State, local or foreign real property tax (Coded Sec. 264(a))(1021 Master Tax Guide).

• Note that when a taxpayer falls into Alternative Minimum Tax, the benefit of the tax deduction may be lost.

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Why is property tax generally deductible from income?

• Taxes paid are generally deducted from income in order to avoid double taxation.

• “Theory suggests that taxpayers are willing to accept higher state and local rates, and thus, a higher livel of state and local public spending because they pay less federal income tax “ (Cordes, Ebel, Gravelle pg. 367)

• Interesting note: 29% of property tax deductions are due to New York and California residents. (Cordes, Ebel, Gravelle pg. 367)

Example of how property tax deduction can make home ownership more affordable:

• Assume: Taxpayer itemizes deductions due to other reasons outside of property tax, 30% marginal combined State and Federal tax bracket, property tax of $5,000 per year.

• Effect: The $5,000 pre-tax cost of property tax would be equivalent to $7,142 of after tax money if the property had not been deductible. In basic terms, the tax deduction when a person is in a 30% bracket results in making the cost of property tax 30% more affordable in dollar amounts.

But what if the property tax deduction increases the dollar value of homes?

• If the property tax deduction increases the affordability of home purchase, it is possible that the underlying value and assessment of the home would also increase.

• Increased property values result in larger tax assessments which could reduce or eliminate the benefit of the property tax deduction.

• According to Steven Maguire of the Congressional Research Service, “If the property tax deduction were eliminated, taxpayers would gradually reduce their housing consumption and thus the size of their property tax bill.” (Cordes, Ebel, Gravelle pg. 368)

Who benefits the most from the property tax deduction?

• Taxpayers who have taxable income• Taxpayers who itemize deductions– Typically high property tax and high state income

tax– High mortgage interest– High charitable giving

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Who benefits the least from the property tax deduction?

• Taxpayers with low or negative taxable income– Low fixed income taxpayers– Retirees– Those that do not itemize deductions

• Why?– If property tax deduction results in greater affordability, the

market price of homes may increase.– Greater property values generally result in higher tax

assessments, which in this case, could not be fully utilized by the taxpayer.

Special cases when taxpayer falls into Alternative Minimum Tax (AMT):

• “State, local and foreign taxes on real property, personal property, as well as income and sales taxes may not be claimed” (Code Sec. 56(b) (1)(A)(ii)) (1425 Master Tax Guide)

• High income taxpayers typically fall into the AMT and have property tax deduction benefit reduced or eliminated.

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AMT Result

• Effective double taxation of income for taxpayers.• Wealthy may be less prone to purchase additional

property without any of the tax benefits of owning personal property.

http://www.ceceretax.com/amt.htm

Property tax deduction, the business perspective

• Deducting property tax and other related property ownership deductions to the extent that deductions exceed income can be challenging.

• Deductions often cannot offset ordinary taxpayer income unless specific criteria can be met.

Why so many rules?

• Property ownership often produces tax losses due to the high cost of property maintenance, tax, and depreciation expense.

• Tax rules are structured so that only taxpayers who are real estate professionals or actively participate can take tax losses on a year to year basis.

• Attempt to prevent abusive tax shelters or income deferrals.

What if there were no rules?

• Real estate ownership would be used even more as an asset to produce losses against earned income and to defer realized gains to the distant future or even heirs.

(Image used for educational purposes only)

What if no rules? Example:

• High income earner makes $1,000,000 per year and is in a hypothetical 50% tax bracket.– Such a person could purchase a multi-million dollar building

with several other partners, also employing the use of debt.– Absent the passive loss rules, the partners could enjoy

substantial tax deductions which make the investment effectively more affordable.

– Ultimately the asset could be sold when the partner is in retirement or low income phase.

– The property could also be exchanged via code section 1031.– The taxpayer could even use the property for vacations.

The tax code limits the amount of losses that such a tax payer can utilize

– Under the current laws, taxpayers often cannot deduct losses produced in excess of income in the current year.

– Losses, however, could offset income of other passive activities.

– Losses may be able to offset gains if and when the property is disposed of.

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Results of limiting property tax deduction

– The result of limiting property tax and other deductions on business property is that investors are less prone to invest based upon tax reasons.

– Tax shelters and deferrals are more difficult due to the passive loss rules.

– Speculation may be tempered because investments are typically funded with what amounts to after tax dollars (unless in retirement vehicle).

Criticism of property tax deduction limits

– Disallowing losses on property investments may limit the amount of risk that investor would otherwise take.

– A taxpayer could lose large amounts of after tax income which could not be realized until many years later.

– So many rules make it very complicated to properly report such items on the tax return or properly track partnership basis.

– Large timing differences are realized as partnership and property interests are disposed.

– Because passive losses are realized upon disposition of the property, manipulation of timing differences is still possible.

Schedule E, Supplemental Income and Loss: Deduction may be limited

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Real Estate Professional Classification, no deduction limits

• In order for a taxpayer to deduct all losses from rental real estate (treatment of rental real estate activities as nonpassive (Code Sec. 469c(7)) (2064 Master Tax Guide), the classification for real estate professional must be met.– More than one-half of personal services performed in trades

or business during the year must involve real property trades or businesses in which the taxpayer participates.

– Perform more than 750 hours of related service.– Essentially such a person is treating the real estate activities as

almost a full time job and therefore can deduct losses against regular income.

Court Decisions Bailey v. Commissioner U.S. Tax Court

• Court ruled against Bailey and disallowed real estate professional status and deductions against earned income.

• “The following factors further diminish the credibility and accuracy of the summary report prepared by petitioner: (1) The number of hours claimed appears excessive in relation to the tasks described; (2) petitioner testified that she usually combined a trip to the rental properties with a trip related to her law practice; (3) the Elderwood properties were vacant during 1997; (4) the Elderwood properties and Indian Wells properties were for sale during 1997; and (5) petitioner had a commission agreement with Shirley Baughan and Associates to manage the rental of the Indian Wells condominium during 1997. “

Active Participation in Rental Real Estate Activities

• Most taxpayers who own real estate will not be a real estate professional. They may simply own one or more properties in which are rented to tenants. In some cases, losses can be taken.

• Active participation requirement may be met if the taxpayer participates in management decisions.

• If the single or married filing joint taxpayer qualifies, losses up to $25,000 may be deducted against ordinary income reduced, but not below zero, by 50% of the amount by which adjusted gross income exceeds $100,000. The $25,000 loss is completely phased out when the modified adjusted gross income reaches $150,000. (Code Sec. 469 (i) (3)) 616 Master Tax Guide.

• Excess losses are carried forward following passive loss rules.http://www.expatify.com/spain/10-things-you-didnt-know-about-spain-until-you-live-here.html

Passive Participation:

• If no management decisions are being made, the activity is likely a passive activity.

• Losses due to the deduction of property tax or otherwise are treated as passive loss carryovers until the year of disposition.

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Other rental property rules:

• If the rental is less than 15 days, no deductions attributable to such rental are allowable and no rental income in includible in gross income (Code Sec. 280A(d)(2))(966 Master Tax Guide).

• Rental deductions may be limited to gross rental income if the home is used by the taxpayer for personal purposes for the greater of (a) 14 days or (b) 10 percent of the number of days during the year for which the home is rented at a fair market rental. – Such rules help prevent taxpayers for using rental real estate for

personal use and still realizing a deduction against regular income.– Absent of such rules a taxpayer could be tempted to make home

expenses otherwise not deductible, deductible.

Sources

• 2008 US Master Tax Guide, Illinois, CCH Publishing, 2007.• www.IRS.gov• Andrew McNaughton, interview, San Francisco

California, 2/4/2011.• Joseph J. Cordes, Robert D. Ebel, Jane Gravelle,

Encyclopedia of taxation and tax policy, Washington DC: The Urban Institute Press. Copyright 2005.

• Court Decisions Bailey v. Commissioner, U.S. Tax Court No. 3293-00, T.C. Memo. 2001-296 (http://www.novoco.com)