What we learned about real estate taxation

2023/06/09

Summary

I explained the various ways real estate gets taxed on several occasions during the “beginners real estate” meetings we had at work. Since some questions tend to repeat, it leads me to believe that the real estate taxation topic is not widely understood. This leads me to think that it might be useful to have a handy text that explains in rough lines how real estate taxation works, so here goes. I am not a CPA, so take the points that follow as a starting point for asking informed questions to your tax professional of choice, not as a vetted truth.

Taxation when you buy

Your real estate tax adventure starts when you close your real estate transaction.

Some localities impose a transfer tax, usually expressed as a dollar amount per $100 of property value. For example, localities in Florida will charge you $0.75 per $100 dollars of value. This means that transferring the property could cost you $7,500 for a $1M property. Usually, this tax is paid by the seller, however, so make sure that you know your “customary” responsibles for various closing costs.

At property closing, the old value of the property tax is split fairly between the buyer and the seller. The end result is that the buyer ends up paying a prorated amount back to the seller to account for the fraction of the year that each held the property. For example, if the seller paid $1,000 of property tax for the first half of the year, but the property sells on April 1, the transaction will credit the seller, and debit the buyer $500, to account for the 3 months that the seller paid in property taxes, but during which the property will be owned by the buyer. The same mechanism works in reverse in case taxes are paid “in arrears” (i.e. you pay now, for a period that is in the past): in that case, the seller will credit the buyer for the taxes that buyer will pay for the period they didn’t own the property.

Another form of taxation that you deal with on sale (at least in California) is the so-called supplemental tax. The supplemental tax is connected to the way property taxes are assessed in California. Namely, when you buy property in California, your assessed property value automatically becomes the value at which the property was sold. As property market values in California generally rise, while assessed values have a maximum percentage increase year over year, usually the tax bill to the new owner will be higher than that of the old owner.

Looking at the same example as above, it could be that the seller paid $1,000 of the property value for the first half of the year. The buyer credits the seller $500 for their part of that period. But, since the new amount of the property tax is now, say, $2,000, this means that the buyer now owes another $500 to the local tax collector authority. The new owner will soon get a “supplemental tax bill” in the mail, requesting to pay the said $500 which resulted from the new, higher, tax rate.

Property taxes

Property taxes is the money paid by the property owner to the local taxation authority. Property taxes are used to fund schools, roads, emergency services, public works etc. The manner in which this tax is paid, as well as what happens if it is not paid, are established by the state the property is in. The rules and payment deadlines are different across US states. In addition, local tax authorities can have their own taxes as well.

For example, in California, property taxes are paid in two installments of which one is due in December, and another is due in April. In Ohio, taxes are paid in two installments, one of which is due in January, and the other in June. In Kentucky, taxes are paid in a single installment in November; but if you pay earlier you get a 2% discount. In Texas, taxes are paid in a single installment due in January. In Florida, taxes are paid in a single installment due in December.

Property taxes usually have two components: one component is called “ad valorem”, which is a fancy way to say “based on property value”; and a “fixed” component, which is either a collection of amounts that do not depend on the property value. To give an example for California, by law the “ad valorem” component is set to 1% of the assessed property value.

California, again, has a regulation commonly known as “proposition 13” (or “prop 13” for short) which says that property taxes may not increase more than 2% year-over-year. This allows long-time owners of a property to pay way less in taxes than recent owners of neighboring comparable properties. It is debatable whether prop 13 solves more problems than it creates, but for the time being it is the law.

California also has something called the “Mello-Roos” district, which is an additional tax that can be imposed on property owners to fund local public works. This tax is not subject to prop 13, which may mean a sharp increase in your property taxes if your property is inside such a district.

Other localities may have “municipal utility districts”. Those are tax districts which can, again, impose their own taxes. These are quite common in Texas exurbs (where these “MUDs” may exist to provide local public utilities), and are quite fun to keep track of.

Property taxes are re-assessed differently in each state. As we’ve seen before, in California, property is reassessed upon sale, and from then on prop 13 governs the change in taxes. For the better part of the 21st century, prop 13 meant that your California property taxes grew by 2% every year. In some other states, such as Ohio, taxes are reassessed on a periodic schedule every 3 years. Famously, in Texas, there is no upper limit to tax increase, so a reassessment can bring drastic changes to property taxes, which can happen every year. Usually in the upward direction, to the dismay of Texan property owners.

Real Estate and income taxes

Owning real estate has certain benefits when it comes to income taxation. For real estate investors, it is interesting to see what happens with the income produced by the owned property.

Most income produced by real estate through rental and related activities is considered as “passive” income for tax purposes. This has nothing to do with how much work you must put into the property, rather it is used to classify types of income one can earn. This tax classification sometimes causes confusion in beginner investors, leading them to think that real estate is a “passive” investment in the sense that it doesn’t need much oversight. But, the classification has to do with the income not coming from (active) employment, and not from the workload intensity, sadly.

Your passive income from real estate is taxed at your marginal tax rate, but before your taxes are calculated, you are allowed to make a number of deductions from that income amount.

As real estate ownership is often coupled with debt, such as a mortgage, this means you will usually be paying a certain amount to cover specifically the interest on a mortgage. Residential loans are usually fully amortized so you normally pay interest, plus a fraction of a principal each month. But for tax deduction purposes, only interest is relevant. You are allowed to deduct the yearly amount of the interest; or, if you haven’t owned your property for a full year, a prorated amount.

You are also allowed to claim depreciation. Depreciation is the decrease in “book” value of your property as time goes on. That is, each year, you are allowed to reduce your taxable passive income by the amount that your property “loses” over time. This is not related to the actual condition of your property, it is simply something you are allowed to do when reporting your taxes.

Depreciation is typically done using the appropriate depreciation schedule. Residential properties use a 27.5 year depreciation schedule, which means that you can claim about 1/27.5 of depreciation each year (or prorated, if you owned your property less than the entire year). Note, however, that only improvements may be depreciated - land value can not. This means, in order to claim depreciation you first need to separate out the land value from improvement value (building, equipment), then compute depreciation on the improvement value alone. Other types of properties have other depreciation schedules. Commercial property is depreciated on a 39 year long schedule, while industrial property is depreciated on a 31.5 year long schedule.

Investment properties can also claim bonus depreciation. Bonus depreciation allows you to separate out the value of the improvements into finer grained line items, each of which is then allowed to be depreciated on its own schedule. For example, until last year it was possible to claim 100% of depreciation on equipment (i.e. on a 1-year schedule). The approach by which the improvements are separated out is called cost segregation. The bonus depreciation rules are currently being phased out, so at the time of this writing you are allowed to depreciate 80% of equipment value in the first tax year of ownership.

Typically, your real estate income is reported on the Schedule E form (if individual). This is a worksheet where you get to list the above mentioned items, as well as other expenses, to arrive at the final taxable amount.

Depending on the circumstances, the final taxable amount could be less than zero, or greater or equal to zero. if your taxable amount is zero or greater, you will pay taxes at your marginal tax rate. If, however, your taxable amount ends up less than zero, a couple of scenarios are possible:

To be classified as a real estate professional, you must be able to pass the following tests:

This test pretty much ensures that, if you don’t actually work on real estate, you can’t pass this test. There are ways, however, for married couples to rearrange their responsibilities so that they can benefit from the real estate professional classification.

Short term rental taxation

Short term rental taxation is, perhaps somewhat surprisingly, actually not rental income. It is ordinary business income.

Which, on the one hand, means that it is not reported on Schedule E, but rather on schedule C.

And, since it is ordinary income, it can be used to offset active income for you, provided that you are materially involved in the operations.

To be materially involved, you must pass the test of:

Tax Basis

Property’s tax basis is the “remaining value” of the property once all depreciation is claimed, and once all capital expenditures are added.

Your property’s initial tax basis is its purchase price. Your tax basis gets automatically decreased each year based on your depreciation schedule. While you can choose not to claim depreciation when you report your taxes, your tax basis will decrease as if you did.

When you make a capital improvement to your property, your tax basis increases by the value of the capital improvement. (Note, if for example you put in a new roof, then you can depreciate the roof separately from the rest of the building.)

Your tax basis is important because it is possible to transfer it into a new property in a tax deferred exchange, such as a 1031 exchange. A 1031 exchange allows you to replace a property with one of greater value. When you do so, your tax basis is increased for the amount of additional investment you made to make the exchange.

When you die, the “step up” rule is activated. The tax basis to your heirs becomes the current market value of the property. (This makes real estate a great vehicle for building generational wealth. If you manage to die while holding property, your heirs will not need to pay capital gains on the property if they decide to sell it after you’re gone.)

Taxation of sale

When you sell your real property, you can be subject to two kinds of taxes.

One is the depreciation recapture. This is tax paid on the difference between your original tax basis, and your tax basis at the time of sale. In other words, you pay taxes on the total amount of depreciation that was allowed over the time you owned the property. Note again, it does not matter whether you actually claimed depreciation or not. And since it does not matter, it makes sense for you to claim it when you can. Depreciation recapture tax rate is your marginal tax rate. So you may find yourself paying up to 39% on the recapture.

Other is capital gains. This is the tax paid on the difference between your sale price and your purchase price. This part is taxed at capital gains rate, which usually means ~15% for gains achieved over a period of longer than 1 year.

As noted before in the context of 1031 exchanges, there are various ways to defer the payment of these taxes. However, 1031 exchanges are out of scope of this document.

Another noteworthy bit is that when selling a personal residence, an individual gets a tax break on the capital gains for the first $250k of the property’s value. For married couples, the amount is doubled to $500k.

Conclusion

This was a short run-down of taxation rules. It was intended to give you a rough idea of the ways your real property gets taxed. By all means if you want to go into details, and especially if you are about to actually file or pay your taxes, consult a knowledgeable CPA instead of some random guy on the Internet.