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San Diego, California real estate is expensive compared to most other possessions. A person or business seldom has enough cash to buy the real estate outright, and therefore must borrow the necessary money to help finance the transaction. A buyer usually makes a cash down payment of 20% and must obtain a loan for the remaining 80% of the purchase price. Most buyers must finance at least part of the purchase, so a good rule to remember is, "If you can't finance a property, you probably can't sell it later." If a property can't be easily financed, don't waste time with it: find another, more easily financed, property.
Even buyers with large amounts of cash rarely purchase San Diego real estate outright. An investment principle known as "leverage" favors buying real estate using borrowed funds. LEVERAGE is the practice of purchasing real estate using a small amount of your own money and a larger proportion of borrowed funds. The more money borrowed to buy a property, the greater the leverage.
Example: If you buy a $300,000 house with 20% down, the down payment is $60,000. If inflation increases the value by 30% over 10 years, you have increased the market value by $90,000 on a $60,000 investment.
As you can see, employing leverage makes it possible for San Diego real estate investors to reap the same profits as those buying entirely with their own funds without having to tie up as much cash.
- Qualifying the borrower
- Qualifying the property
- Approving and processing the loan
- Closing the loan
- Servicing the loan
- Qualifying the borrower
In understanding lender requirements for qualifying borrowers, you should realize that lender requirements often are dictated by the secondary mortgage market. Unless a lender expects to hold on to a loan for the life of the loan, the lender wants the loan to meet the requirements of a holder in the secondary market, such as Fannie Mae (FNMA).
Lenders first ask prospective borrowers to complete an application form. Most applications ask for the borrower's employment record, credit references and a financial statement of assets and liabilities. To verify the accuracy of the information, the loan officer checks with past employers, requests verification of deposits from the bank(s) and contacts references. The loan officer also may obtain a Dun & Bradstreet report (in case of commercial loans) and a credit report by an outside agency, so there is no question of the borrower's ability to repay the loan.
In addition, most lenders use the "three Cs" - character, capacity and collateral - as a screening device to determine if the borrower meets the qualifications set by the lender.
Character. With regard to prospective borrowers' character, lenders consider their attitude toward financial obligations as evidenced by their track record of borrowing and repaying loans. Lenders also try to ascertain whether borrowers are honest in their dealings.
A borrower may have the capacity to make the payments but not the desire to make them in a timely manner. Late payments affect the lender's yield (profit). A ten-day-late payment means that the lender has lost ten days of interest on that money.
The desire to pay for San Diego real estate is very difficult to measure. There are methods used by a lender to determine the borrower's desire to make timely payments. Lenders will check the applicants' credit report to see if the borrowers have any late payments. If the borrower has a number of late payments, this usually means the borrower does not have a desire or cannot afford to make timely payments. Too many late payments can influence the lender to reject making a loan to the borrower.
In considering borrowers' capacity, lenders want to know their ability to repay the debt. Capacity is strengthened by an occupation that ensures a steady income. The level of present debts and obligations also is a factor; too much debt may prevent a borrower from discharging a new obligation.
Lenders will consider second job income if the applicant has a history of second job income.
Lending institutions sometimes take overtime wages into consideration. Other lenders will consider both spouses' wages in computing the gross income of the borrower, even if only one spouse is applying for the loan. Occasionally, a lender will request a cosigner - a person with additional capital who agrees to share liability for the loan - to strengthen the borrower's application. Lenders also might reduce down payment requirements with a cosigner.
When a lender qualifies a borrower, the lender is attempting to answer three questions:
- Can the borrower afford the payments?
- Will the borrower make the payments on time? (This refers to character)
- Can the Borrower afford the payments?
To determine whether the borrower has the capacity to make the monthly payments, the lender needs to answer these questions:
- Does the borrower earn enough to make the payments?
- Will the income be a steady source of income?
- Does the borrower have the down payment?
- Will the borrower make the payments on time?
The lender is going to verify the applicant's ability to make timely monthly payments and his or her employment history (steady stream of income). The lender will want to know the down payment on the San Diego real estate before determining the loan amount. This information is usually confirmed by the lender through the use of verifications of deposits and employment.
To qualify the borrower, we examine two ratios (percentages). The front-end ratio, also called top ratio (mortgage payment ratio), is the mortgage payment (PITI) divided by the borrower's gross income. Conforming loans require that the front-end ratio be approximately 28 percent or less. The reason it is called the top ratio is because it is at the top of the form (above the bottom ratio). The other ratio is the back-end ratio, or bottom ratio (total obligation ratio). This ratio should be approximately 36 percent or less to qualify for a conforming loan. Nonconforming loans may have different values for these ratios.
From the verification of employment and other financial information, the lender determines the borrower's gross income. Lenders require a signed statement from the borrower to permit a check with the borrower's employer to verify wages and length of employment. Gross income is defined as the income made by the borrower before taxes and deductions. For a husband and wife, the gross income for a loan is generally the total gross income of the husband plus the total gross income of the wife. Employment usually must be verified for two years.
The lender also needs to determine the monthly long-term rotating credit bills owed by the borrower. These include car payments, credit cards, furniture payments, student loans, and other bank or credit union loans, including mortgage loans. If a credit bill will be paid in less than ten months, it is not included.
After the loan is granted, the lender has to rely for a long time on the value of the security for the loan for the safety of the investment, should the borrower default. For this reason lenders consider it important to qualify the property as well as the borrower.
Because the underlying security for almost every property loan is the property itself, lenders require a careful valuation of the property. The value depends on the property's location, age, architecture, physical condition, zoning, floor plan and general appearance. The lender will have an appraisal done by the financial institution's appraiser or by an outside fee appraiser. Brokers who are familiar with lending policies of loan companies are in a good position to make accurate and helpful estimates.
Different lenders have different underwriting standards for different properties. An experienced agent will help clients select a lender whose standards match the San Diego, Ca real estate being purchased or refinanced.
Processing involves drawing up loan papers, preparing disclosure forms regarding loan fees and issuing instructions for the escrow and title companies. Loan papers include the promissory note (the evidence of the debt) and the security instruments (the trust deed or mortgage).
Closing the loan
Closing the loan involves signing all the loan papers and preparing the closing statements. First-time buyers, especially, are often confused by the various fees involved. Real estate agent's play a vital role in making this transition period smooth.
Servicing the loan
After the title has been transferred and the escrow closed, the loan servicing portion of the transaction begins. This refers to the record-keeping process once the loan has been placed. Many lenders do their own servicing, whereas others use outside sources. The goal of loan servicing is to see that the borrower makes timely payments so that the lender makes the expected yield on the loan, which keeps the cost of the entire package at a minimum.
Truth-in-Lending Act
The Truth-in-Leading Act (Regulation Z) is a key portion of the federal Consumer Credit Protection Act passed in 1969. The Truth-in-Lending Act applies to banks, S&L's, credit unions, consumer finance companies and residential mortgage brokers. This disclosure act requires that lenders reveal to customers how much they're being charged for credit in terms of an annual percentage rate. Customers can then make credit cost comparisons among various credit sources.
The act gives individuals seeking credit a right of rescission of the contract. This means that under certain circumstances a customer has the right to cancel a credit transaction up until midnight of the third day after signing. This right of rescission applies to loans that place a lien on the borrower's residence. The rescission rights do not apply to primary financing (first trust deed) to finance the purchase of the borrower's residence (purchase-money loan).
Real Estate Settlement Procedures Act
The regulations contained in the Real Estate Settlement Procedures Act (RESPA) apply only to first loans on one - to four - unit residential properties. Within three days of the date of the loan application a lender must furnish the buyer with an itemized list of all closing costs that will be encountered in escrow. This must be a good-faith estimate provided to every person requesting credit. Each charge for each settlement service the buyer is likely to incur must be expressed as a dollar amount or range. The lender also must furnish a copy of a special information booklet prepared by the secretary of the Department of Housing and Urban Development (HUD). It must be delivered or placed in the mail to the applicant no later than three business days after the application is received.
A controlled business arrangement (CBA) is a situation where a broker offers "one-stop shopping" for a number of broker-controlled services, such as financing arrangements, home inspection, title insurance, property insurance, escrow, etc. RESPA permits such controlled business arrangements as long as the consumer is clearly informed of the relationship between the broker and the service providers. Fees may not be exchanged between the companies simply for referrals. A broker-controlled mortgage company must have its own employees and cannot contract out its services or it would violate RESPA provisions that prohibit kickbacks for referral services.
It's the position of the Attorney General of California that a broker may not pay referral fees to a real estate salesperson for referral to broker-affiliated services.
Fair Credit Reporting Act
The Fair Credit Reporting Act affects credit reporting agencies and users of credit information. If a loan is rejected because of information disclosed in a credit report, the borrower must be notified and is entitled to know all the information the agency has in its file on the buyer, as well as the sources and the names of all creditors who received reports within the past six months.
In this day and age, income taxes play an important role in real estate owners' decisions, from buying or selling their personal residences to decisions involving the most exotic San Diego, California real estate investment properties. Because the tax laws are always changing, it is important to stay abreast of them. Some basic tax definitions and calculations stay the same from law change to law change. We will discuss income taxes as they relate to business and investment property as well as to a personal residence.
San Diego real estate held for business and investment has some distinct differences in federal income tax treatment from property used as a personal residence. We will begin with the concept of depreciation.
Depreciation
The two most obvious and important characteristics of real estate investments are income and expenses. San Diego real estate is one of those assets that benefit from a special accounting device for a special kind of expense called depreciation.
Depreciation is a method of accounting for the wear that results from the use of a capital good. A capital good, such as a piece of equipment or a building, does not last forever. As it is used, it wears out or becomes obsolete; at some point the owner must replace it or substantially repair it. Depreciation is used to reflect this replacement cost. The main reasons depreciation is allowed are to encourage investment in real estate and to reflect, in accounting terms, the real costs of property ownership. Only investment or income property may benefit from depreciation. (Today we use a recovery system instead of depreciation, but the word depreciation has been around for so long that it is still used.)
For depreciation purposes real estate can be divided into two categories:
- Residential property
- Nonresidential property
Residential property is where people live - for example, single-family residences, duplexes, triplexes, fourplexes and multiunit apartments. Nonresidential property is property that is not residential in nature - for example, industrial, commercial, and office buildings and other similar types of properties. Since January 1, 1987, all real property must use the straight-line method of depreciation.
Generally, residential rental property must use a useful life of 27.5 years and nonresidential property must use a useful life of 39 years. Either residential or nonresidential property may elect to use 40 years.
To explore the tax implications of investment properties, one must understand the concept of basis and know how to compute the original basis, depreciable basis and adjusted basis correctly. The original basis (OB) is used to determine the depreciable basis and adjusted basis. The depreciable basis (DB) is used to determine the amount of allowable depreciation. The adjusted basis (AB), which changes as time progresses, is required to calculate the gain on the disposition of a property.
Original basis
The original basis of a property is the sum of its purchase price and the buying expenses on acquisition. When a buyer purchases San Diego real estate, the escrow statement includes the sale price and a listing of other costs and expenses. These amounts can be classified into four basic groups:
- Purchase price (PP)
- Operating expenses (OE)
- Buying expenses (BE) (nonrecurring closing costs)
- Nondeductible items (ND) such as impound accounts
The purchase price
The purchase price (PP) is the amount the buyer is willing to pay and the seller is willing to accept in payment for the property. On the escrow statement the PP usually is on the top line and is called total consideration. Generally, the PP is financed in some manner. These loans do not affect the basis. Furthermore, if the buyer takes out a new loan, refinances or takes out a second mortgage, these loans also do not increase the basis.
Operating expenses
Operating expenses (usually recurring costs such as interest, insurance and taxes) are written off against the income produced by the property. Points (loan origination fees) are nonrecurring interest costs that are amortized over the life of the loan; they are not operating expenses.
Buying expenses
Buying expenses are defined as nonrecurring escrow costs (excluding points to obtain a loan). The buying expenses are added to the purchase price, making up the original basis. Points are never added to the basis.
Original basis = Purchase price + Buying expenses
Depreciable Basis
The depreciable basis is defined as the original basis multiplied by the percentage of improvements to land.
Depreciable basis = Original basis x Percentage of improvements to land
An alternative formula is Depreciable basis = Original basis - Land value
Investment San Diego, California real estate is composed of two items, the land and the structure; only the structure can be depreciated. Because land is not depreciable, its value must be subtracted from the total original basis to arrive at the depreciable basis, the improvements. Three methods for determining the percentage of improvements are the assessed value method, the appraisal method and the contract method.
Assessed Value Method
The county assessor's property tax statement now lists the full cash value of the land and the improvements. The value of the improvements for depreciation purposes is thus the assessor's determination of the part of the purchase price that represents the value of the improvements.
EXAMPLE: Ms Adams purchased San Diego real estate for $100,000 and received the following tax bill from the county assessor's office:
Assessed Value:
Land $30,000
Improvements $70,000
Total $100,000
The improvements give Ms Adams a depreciable basis of 70 percent of her purchase price plus buying expenses.
Appraisal Method
A real estate owner may secure the services of a professional appraiser to appraise the building and land. The appraisal method may give either a more or a less favorable ratio than the assessed value method. The taxpayer should compare the ratios from the two methods to verify which is more advantageous.
Contract Method
One other method of determining the percentage of improvements is the contract method. With this method the buyer and the seller determine the relative values of the improvements and land and designate these values in the contract, deposit receipt or escrow instructions. Note that the determination must be at arm's length and reasonable. Before using this method, we strongly suggest obtaining professional help.
Adjusted Basis
The adjusted basis is the amount that the client has invested in the property for tax purposes. In other words, the adjusted basis is equal to original basis, plus improvements made, less all depreciation taken.
Adjusted basis = Original basis + Improvements - Depreciation
It is extremely important that the homeowner or investor understand the relationship between the basis and the final sales price of the property, because basis is the beginning point for calculating the amount of gain or loss on the sale. Calculation of the basis is affected by how the property originally was acquired.
Basis by purchase is the price paid for the property, as described above.
Basis by gift is the donor's (gift giver's) adjusted basis plus the gift tax paid, not to exceed the fair market value at the time of the gift.
Basis by inheritance generally is the fair market value at the time of the owner's death.
Computing Gain
The basis is the beginning point for computing the gain or loss on the sale, but numerous adjustments to the basis always are made during the ownership period. Some of the costs that increase the basis are title insurance, appraisal fees, legal fees, cost of capital improvements and sales costs on disposition. Accrued (past) depreciation is deducted from the basis. The result is the adjusted basis.
Capital gains due to depreciation are now taxed at the regular capital gains tax rate (20 percent). (They were formerly taxed at a 25 percent rate.)
With the appreciation of San Diego, California real estate, many property owners do not want to sell and be required to pay the high taxes. An exchange allows the owner to save on taxes and thus have more money to invest in a new property. Because of refinancing, many owners are in a position where their equity is not sufficient to cover their tax liability. An exchange allows them to defer tax liability.
EXAMPLE: Ms. Overtaxed owns a ten-unit apartment house she wants to dispose of and plans to buy a 20-unit apartment building. Overtaxed ten-unit would sell for $600,000, with selling costs of $25,000 and an adjusted basis of $275,000. Her taxable gain would be:
Sales price $600,000
Selling costs $25,000
Net sales price $575,000
Adjusted basis $275,000
Taxable gain $300,000
If she sells the property, she will have to pay federal and state taxes on the gain. She would be taxed at the 20 percent capital gains rate as well as having California state tax liability on the gain. These taxes will have to be paid out of the proceeds from the sale. If she exchanged rather than sold, she would have her entire equity to invest in the new property and could defer any tax liability.
When a client becomes involved in a 1031 exchange, several questions must be answered:
- Does the transaction qualify for a 1031 exchange?
- What are the mathematics of the exchange?
- How are equities balanced?
- Who is giving or receiving boot?
- Is the exchange partially or totally tax-deferred, and what is the basis in the new property?
This section discusses the transactions that qualify for a 1031 tax-deferred exchange.
Who Prepares an Exchange? Most owners think of A exchanging with B. While this is essentially what happens, more often three parties are involved. The most widely used exchange is the buy-sell exchange, sometimes called a three-corner exchange or three-legged exchange. The three people involved are the exchanger (person wanting to exchange), the seller (a person who wants to sell property and doesn't want to retain any property) and the buyer (a person who wants property of the exchanger).
The exchange may be structured in two different ways. The buyer offers to buy the exchanger's property, but the buyer does not have any property to exchange. So the exchanger needs to find another property ("up-leg"), the property he or she wants to acquire. When the exchanger finds the up-leg, the buyer buys this property from the seller. Now the buyer has a property to exchange with the exchanger. Note that if the exchanger sold his or her property to the buyer and then bought the seller's property, this transaction would be a purchase and a sale. To satisfy the IRS, the buyer will buy the seller's property and exchange with the exchanger, and this is all done in escrow in a matter of minutes. A general rule of exchanging is that any person can be the center (hub) of the exchange except the person wanting the exchange. Sometimes this procedure is called the flashing of mirrors.
With the buy-up rule, to qualify for a totally tax-deferred exchange, the exchanger needs to trade up in value and put all of his or her equity dollars into the new property(ies).
Trade up means the new San Diego, Ca real estate must be equal to or greater in value than the old property. If the exchanger withdraws any cash, the cash withdrawn will be taxable. Withdrawing cash will not disallow the exchange, an exchange may be partial-but the client will not have a totally tax-deferred exchange.
EXAMPLE: Eric wants to complete a 1031 tax-deferred exchange. The market value of his real estate is $350,000; therefore, the property he is trading for must be valued at $350,000 or more. If Eric nets $150,000 and pulls out $50,000, he will pay taxes on $50,000; only the $100,000 he put into the new property will be deferred.
The Entity Rule
Three basic entities can hold San Diego real estate: individuals, partnerships and corporations. The entity rule can be stated as follows: The way the exchanger holds property going into an exchange is the way the exchanger must hold the property coming out of the exchange.
Although Section 1031 does not address the entity rule, the courts have addressed it. The question that is raised is whether the exchange is a "step transaction."
EXAMPLE: Partnership XY owns a building. Partner X is not getting along with partner Y, so they decide to dissolve the partnership. They exchange the building in the partnership for two other buildings, which they take in their own names as individuals. The question that will be asked is "Would they exchange the building for the two smaller buildings if they weren't going to dissolve the partnership?" The answer is no. Thus a step transaction has taken place. X and Y would not have made the exchange without the step of dissolving the partnership. In this example the partnership did not end up with the two buildings; each partner ended up with a separate building. So this transaction went from a partnership to two individuals. Therefore the entity rule was violated. The exchanging of one building by the partnership for two buildings is a valid exchange as long as it is not a step transaction.
In general, no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
Note: San Diego, California real estate that is a personal residence is not held for productive use in a trade or business or for investment. Therefore, a person cannot have a tax-deferred exchange of his or her personal residence for business or investment property.
Exception -This subsection shall not apply to any exchange of:
- stock in trade or other property held primarily for sale
- stocks, bonds, or notes
- other securities or evidences of indebtedness or interest
- interests in a partnership
- certificates of trust or beneficial interests
- contractual rights
It is clear from subsection 1. that inventory (stock in trade or property held for sale) cannot be exchanged. Therefore, the question is "What is inventory, and what is investment?" This question is a constant bone of contention between taxpayers and the IRS. Taxpayers would like to call all of their property investments. The IRS has a vested interest in classifying property as inventory. In some cases, there is no clear-cut answer. If a person makes a considerable portion of his or her income from buying and selling property, the IRS would likely consider that person a dealer and property exchanged as being inventory.
The answer to what is investment and what is inventory is determined by the taxpayer's intent and actions. For example, collecting rents and taking depreciation on San Diego real estate over two to three years show the intent and actions of investing. On the other hand, if a taxpayer built a fourplex and the day after it was finished he exchanged the fourplex, the IRS and the courts would consider it inventory. An asset built is considered inventory when it has not been held for two to three years to show the intent of investing.
EXAMPLE: Ms. Able and Mr. Flake have buildings that are held for investment. Mr. Flake knows that Mr. Bucks would like to acquire Ms. Able's property. So, Mr. Flake and Ms. Able exchange, and Mr. Flake then sells Ms. Able's property to Mr. Bucks. The results: Ms. Able's exchange is valid; Mr. Flake's exchange does not qualify, because his intent and actions clearly show that the property was not an investment but was purchased for resale (inventory).
Note in the example above that one person in a transaction can have a qualified exchange and the other person be disallowed the exchange.
Exchanges of real estate must observe the like-kind rule. In exchanging, property is categorized as either personal or real property. Personal property and real property are not like kind.
For personal property, like-kind property must be exactly the same in character or have the same nature, and this sometimes is very difficult to determine.
No gain or loss is recognized if (1) a taxpayer exchanges property held for productive use in his trade or business, together with cash, for other property of like kind for the same use.
For real property, like-kind property is simply any piece of real property exchanged for any other piece of real property.
The words "like kind" have reference to the nature or character of the property and not to its grade or quality.
Real property
To summarize, real properties include
- vacant land (unimproved real estate);
- improved real estate, such as farms, buildings, orchards and so on;
- leases that have a remaining term at the time of the exchange of 30 years or more (the 30 years may include all options); and
- mineral and water rights (if they are considered real property by the state, they are included)
Therefore, the general rule for real property is that any piece of real estate may be exchanged for any other piece of real estate, except for inventory and personal residences.
If an exchange qualifies as an exchange, it must be treated as an exchange. If the real estate transaction was structured as an exchange, the gain must be deferred (postponed). The no-choice rule can be stated simply: An exchanger who qualifies for a 1031 tax-deferred exchange has no choice; the exchanger cannot recognize the gain or loss.
The No-Loss Rule
In conjunction with the no-choice rule is a rule called the no-loss rule. If a San Diego, California real estate transaction qualifies as an exchange, a loss cannot be recognized. Losses must be deferred along with gains.
In general - no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. No loss can be recognized if the transaction is a tax-deferred exchange.
A Delayed Exchange allows the following characteristics:
REQUIREMENT THAT PROPERTY BE IDENTIFIED WITHIN 45 DAYS AND THAT EXCHANGE BE COMPLETED NOT MORE THAN 180 DAYS AFTER TRANSFER OF EXCHANGED PROPERTY--For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if:
(A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or
(B) such property is received after the earlier of': 1) the day which is 180 days after the date on which the taxpayer
transfers the property relinquished in the exchange, or 2) the due date (determined with regard to extension) for the transferor's return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.
45 days to
designate potential property
property
180 days to
close escrow on new property
property
April 15 - August 15
File an extension
- Compute the realized (indicated) gain. This is the potential tax gain. It is found by subtracting the exchanging costs and adjusted basis from the FMV (fair market value).
- Balance the equities. This is found by subtracting the loan amount from the FMV for each property and then determining who will pay whom boot (cash boot).
- Determine the recognized gain. This is the gain that will be taxed.
- Determine the new depreciable basis. This is the amount less the land value and the amount that will be depreciated.
Boot
Property that is not like kind and does not qualify for an exchange is called boot. In some exchanges, San Diego, Ca real estate will be given in an exchange that is boot. Boot is taxable to the person receiving it. It is important to understand that the property needs to qualify as like kind only to the person seeking the tax-deferred exchange.
Boot maybe classified as cash boot or mortgage boot. Cash boot is a result of the balancing of equities, which must be done in every exchange. It is defined as all other unlike properties: cash, paper (trust deeds or notes) and personal properties (cars, boats, planes, paintings, Jewels, etc.). Mortgage boot is the difference between the loans on the conveyed property and the loans on the acquired property. This is also called debt relief if the client assumes a mortgage larger than the one that he or she conveys, then he or she has paid mortgage boot. However, if he or she assumes a mortgage that is less than the one that he or she conveys, then he or she has received mortgage boot (debt relief).
Because of the inflationary appreciation of San Diego, California real estate, owners who purchased property in past years may hesitate to sell now because the increased value of their property makes them subject to significant taxes. If they paid their income tax on the full gain on the sale in one year, their tax could be so large that it would discourage investments in real estate.
By using an installment sale, the investor can spread the tax gain over two or more years. The following guidelines concern the use of the installment method of reporting deferred-payment sales:
- The total tax to be paid in any one year may be reduced by spreading the payment amount, and thus the gain, over two or more tax years.
- The seller pays tax in future years with cheaper, inflated dollars.
- The seller does not pay the entire tax until after receiving the entire amount of the purchase price.
- A provision of the prior law stating that no more than 30 percent of the sales could be received in the taxable year of the sale to qualify for installment sales treatment has been eliminated, but all depreciation recapture income is fully recognized in the year of sale, whether or not the principal is received in that year.
- The installment sales method is automatic unless the taxpayer elects not to have the installment sale treatment apply.
- Mortgage over basis will be considered a payment in the year of sale.
- Because higher income is taxed at higher rates (progressive tax), spreading the gain over a number of years could mean that the gain would be taxed at a lower rate.
Sale-Leaseback buyers and sellers can derive tax advantages through an arrangement in which San Diego real estate is sold with provisions for the seller to continue occupancy as a lessee. This form of transaction is called a sale-leaseback, purchase-lease, sale-lease, lease-purchase or leaseback.
With a sale-leaseback, seller/lessees gain the advantages of getting property exactly suited to their needs without tying up working capital in fixed assets. Often more capital can be raised than by borrowing. In addition, because leases are not considered long-term liabilities, rent is totally tax-deductible. Frequently, writing off total lease payments is better than depreciation, for the land portion of property cannot be depreciated.
Often only the land is sold and leased back because rent on land is a deductible expense, and improvements can be written off with depreciation deductions. If the lease term is longer than a mortgage term would be (for example, 99 years versus 25 years), the balance sheet looks better and credit is enhanced, because sellers can pay for their capital in the form of rent over a long period with constantly inflating dollars.
Buyer/lessors gain the advantage of obtaining a long-term carefree investment and appreciation in the value of the property. Usually the yield on a sale-leaseback is higher than on a mortgage.
The lease payments will pay off the original investment, and the lessor still will have title to the property. The investment will not be paid off pre- maturely (as mortgages often are through refinancing), so the investor will not have to go out seeking another good investment to replace the one pre- maturely paid off. In addition, the lease terms often give the lessor a claim against other assets of the lease in the event of a default, which is better security protection than a trust deed affords. Finally, a transaction usually requires a large amount of money. It costs the investor no more to service one large loan than it costs to service small mortgages.
Principal residence San Diego, Ca homes that constitutes a homeowner's personal residence receives special tax treatment. The term personal residence is generally understood to refer to the taxpayer's primary personal residence, the dwelling in which a taxpayer lives and which the taxpayer occupies most of the time. A taxpayer may have only one principal residence at a time, and it may be
- single-family San Diego homes
- houseboats
- mobile homes
- motor homes
- trailers
- condominiums
- cooperative housing
If you live in one unit of a multiple dwelling, that unit will be considered your principal residence.
Primary or Secondary Residence. The taxpayer's primary residence is the place occupied more often than any other. All other residences are termed secondary residences. One secondary residence will receive favorable income tax treatment, but unlike a primary residence, a secondary residence does not qualify for universal exclusion treatment.
Land
The term residence includes not only the improvements but also the Land. However, vacant land cannot be considered a personal residence. When a principal residence is located on a large tract of land, the question arises as to just how much of the land is included with the principal residence. There is no clear-cut answer to this question, but the courts have made the determination based on the use and the intent of the taxpayer rather than on the amount of land involved.
Universal Exclusion for Gain on Sale of Principal Residence. A seller of any age who has owned and used the home as a principal residence for at least two of the five years before the sale can exclude from income up to $250,000 of gain ($500,000 for joint filers meeting conditions). In general, the exclusion can only be used once every two years. More specifically, the exclusion does not apply to a home sale if, within the two-year period ending on the sale date, there was another San Diego real estate sale by the taxpayer to which the exclusion applied.
Married couples filing jointly in the year of sale may exclude up to $500,000 of home-sale gain if either spouse owned the home for at least two of the five years before the sale. Both spouses must have used the home as a principal residence for at least two of the five years before the sale.
One spouse's inability to use the exclusion because of the once-every-two- years rule won't disqualify the other spouse from claiming the exclusion. However, the other spouse's exclusion cannot exceed $250,000.
EXAMPLE: Barbara sells her principal residence in December 1999 at a $100,000 gain. She is single at that time, and qualifies for and claims the home sale exclusion. She marries Able in May 2000 and moves into the home that has been his principal residence for the 20 years of his bachelorhood. If Able sells the home the following July, up to $250,000 of his profit is tax-free.
The two-year occupancy need not be continuous. For example, an individual can occupy a property as a principal residence for 6 months and then rent out for a year but later moved back for an 18-month occupancy. If the total occupancy is 24 months during a five-year period, then the occupancy requirement will have been fully met.
A taxpayer may acquire a home by purchasing one from the current owner, by building his or her own home, by inheriting a home or by receiving one as a gift. Each of these has it's own tax implications.
Buying
Usually a purchaser of San Diego, California real estate will pay from 1 to 2 percent of the purchase price of the home in buying costs. These costs are found on the escrow closing settlement statement and may be classified as:
write-off itemized deductions, buying expenses added to basis or nondeductible expenses.
Itemized deductions include real property taxes, mortgage interest and points (loan origination fees) in the year paid. These are written off on the taxpayer's Schedule A.
Buying expenses are usually the nonrecurring closing costs. Some examples are appraisal fees, credit report, escrow fees, termite inspection, notary fees, recording fees and title insurance.
Nondeductible items are the closing costs that are neither a write-off nor a buying expense. These include impound accounts, homeowner's insurance and certain origination fees paid to obtain FHA or VA loans. Loan-origination fees on FHA or VA loans do not qualify as interest; they are considered to be a form of service charge.
Of particular interest to buyer's of San Diego, Ca homes is the original basis (OB) - purchase price plus allowable costs - of the residence. Someday the homeowner will want to dispose of the home, and the higher the basis, the lower the gain, resulting in lower taxes. As previously mentioned, the OB is equal to the purchase price (PP) plus the buying expenses (BE): OB = PP + BE Original basis = Purchase price + Buying expenses
Building
For taxpayers who build their own home, basis would be the total cost of building the home. This would include cost of the land, legal fees, permits, architectural fees, materials and so forth. The taxpayer would not include the value of his or her own labor if no compensation were actually paid for the labor.
EXAMPLE: Five years ago Ms. Bell decided to build her own personal residence, and she purchased the land for $20,000. This year she paid $3,000 for permits and plans. Materials cost her $77,000. Bell's basis in her new home is the total of these expenses, or $100,000.
Inheriting
For the taxpayer who inherits a home, the basis would be the market value at the time of the decedent's death. This is called the stepped-up basis. An alternative valuation date also can be used; it is beyond the scope of this text, but the agent should be aware that the method exists.
EXAMPLE: Mr. Hanson died and left his home to his son. His basis in the home was $10,000, but at the time of death it had a fair market value of $150,000. The son's basis in the home is $150,000.
The term acquisition indebtedness (AI) is defined as any indebtedness incurred in acquiring, constructing or substantially improving any qualified residence (primary principal or second residence) and secured by such residence. The starting point for the deductibility of residential interest is the acquisition indebtedness (loan balance of the acquisition loan).
Acquisition indebtedness is limited to $1,000,000 on both the principal and the second residences.
EXAMPLE: Ms. Jones purchased two San Diego, California homes this year, a personal residence with a first trust deed (loan) of $850,000 and a second residence with a first trust deed of $450,000. The two loans amount to $1,300,000 ($850,000 + $450,000). Only the interest on the first $1,000,000 will be allowed as acquisition indebtedness.
When a taxpayer takes out a loan to purchase the residence, the loan amount is called the acquisition indebtedness and is usually reduced by each payment of principal. The acquisition indebtedness is constantly changing and is found by looking at the loan balance on the initial acquisition indebtedness (initial or original loan).
EXAMPLE: Mr Hall purchased a home for $200,000 five years ago with a loan of $160,000. This loan of $160,000 is the acquisition indebtedness. Today Hall's loan balance is $150,000, so this amount is now the acquisition indebtedness. Five years from now, when the loan balance is $130,000, that amount will be the acquisition indebtedness. Acquisition indebtedness decreases with time.
There is a way to increase the acquisition indebtedness. It can be increased by substantial improvements that are financed. Notice in the following example that loans (indebtedness) increase the acquisition indebtedness and not the basis.
EXAMPLE: Ms. Hansen purchased San Diego real estate as a personal residence for $250,000 with a first trust deed of $200,000. Five years later the first trust deed has a balance of $180,000. The same year she adds a room that costs $75,000, financing $50,000 and paying $25,000 in cash. Her adjusted basis at this time is $325,000 ($250,000 + $75,000), her acquisition indebtedness is $230,000 ($180,000 + $50,000).
The acquisition indebtedness may be refinanced to take advantage of lower interest rates or other more favorable financing conditions. However, the acquisition indebtedness is limited to the amount of the original loan.
Taxpayer's who decide to build their San Diego homes may treat their residences under construction as a home for up to 24 months, but only if that residence becomes the taxpayer's home at the time the residence is ready for occupancy. In other words, the taxpayer must move into and occupy the new home.
EXAMPLE: Mr. Herns bought a lot on January 1 three years ago for $100,000 and financed the total amount. A year later he started construction of his home and borrowed $250,000. In the year of purchase he deducted the interest paid on the loan. In the second year he deducted the interest on $350,000 ($100,000 + $250,000). He completed the construction on December 31 of the third year. Because he did not complete the home in 24 months, he may deduct the interest for only the last two years (years two and three). He will have to go back and amend his tax return for year one to take off the interest deduction and pay the additional taxes and interest he owes.
Home equity indebtedness refers to loans made, using the home for security, for purposes other than purchase or home improvement. Equity indebtedness (EI) means any indebtedness (other than acquisition indebtedness) secured by a qualified residence (home) to the extent that the aggregate amount of such indebtedness does not exceed the FMV (fair market value) of such qualified residence minus the acquisition indebtedness with respect to such residence. The aggregate amount treated as home equity indebtedness for any period cannot exceed $100,000 for the interest to qualify as a deductible expense. To rephrase this definition, the equity indebtedness is limited to the lesser of $100,000 (whether there is one loan or multiple loans) or the FMV less the acquisition indebtedness.
Improvements on San Diego, Ca homes
Systematically recording amounts spent for home improvements and retaining any and all receipts are of great importance to the homeowner. Unfortunately, they are often neglected. Many homeowners are completely unaware of the ultimate tax implications of the home improvements or capital improvements that are added to their real estate through the years. These improvements may be added to the homeowner's basis, making the adjusted basis greater and reducing the gain at the time of sale. The adjusted basis (AB) is equal to the original basis (OB) plus home improvements (HI):
AB = OB + HI
Adjusted basis = Original basis + Home improvements
There is a great deal of misunderstanding about what items are classified as home improvements. The IRS defines improvements differently for homes than it does for rental property. Some examples of home improvements are:
- electrical wiring (new, replacement, rearrangement)
- floors
- heating units
- partitions (including removal)
- pipes and drainage (including replacement)
- roof
- walls (plastering, strengthening)
- room additions
- patios
- pools
- fencing
- landscaping (trees, shrubbery, grass seed, etc.) and sprinkler systems.
Maintenance items are not home improvements. Some examples are:
- painting
- papering
- carpeting
- drapes
- furniture
- replacement of built-in appliances (stoves, ovens, dishwashers, etc.)
EXAMPLE: Mr. Lopez purchased a home for $125,000 with buying expenses of $2,000. He has owned it for five years. During that time he has put in drapes ($1,400), a patio ($5,000), a fence ($2,000) and new plumbing ($1,000). The original basis is $127,000 ($125,000 + $2,000). Total home improvements are $8,000 ($5,000 + $2,000 + $1,000). The drapes are not a home improvement. The adjusted basis is $135,000 ($127,000 original basis + $8,000 home improvements).
A relief provision may apply to some taxpayers who sell their principal residence but fail to meet the once-every-two years rule for use of the exclusion. If the taxpayer's failure to meet the rule occurs because the home must be sold due to a change in the place of employment, health status, or-to the extent provided by regulations-other unforeseen circumstances, then the taxpayer may be entitled to a partial exclusion. Under these circumstances, the excludable portion of the gain that would have been tax-free had the requirements been met is based on the relationship that the (a) aggregate periods of ownership and use of the home by the taxpayer as a principal residence during the five years ending on the sale date or (b) the period of time after the last sale to which the exclusion applied and before the date of the current sale, whichever is shorter, bears to (c) two years.
The law does not specify whether the computation should use days or months.
EXAMPLE: Ms. Jones sells her real estate, which is her principal residence, because she has a new job in another city. On the date of the sale, she has used and owned her principal residence for the past 18 months. Ms. Jones has never excluded gain from another home sale. If she had used her principal residence for two years, the entire amount of the gain ($250,000) would be excluded. Although Ms. Jones fails to meet the use and ownership requirements for the full exclusion, because the sale is forced by employment, she is entitled to a partial exclusion. The amount of gain excluded by Ms. Jones cannot exceed the amount determined by the following computation (computed using months; see the observation above): Ms. Jones occupied her home for 18 of the 24 months required for the full exclusion. Therefore, she is entitled to a 75 percent exclusion from her gain (18/24 = .75) As a result, Ms. Jones may exclude $187,500 (250,000 x .75 = $187,500.) of her gain on the sale of her principal residence.
For income property, taxpayers can use real estate operating losses (passive losses) to offset real estate income without limit. Real estate losses also can be used, with limitations, to offset active income such as wages.
Taxpayers with an adjusted gross income of less than $100,000 can use real estate losses (which are considered passive losses) to shelter up to $25,000 of their active income. Taxpayers whose adjusted gross income is between $100,000 and $150,000, lose $1 of this $25,000 maximum for each $2 that their adjusted gross income exceeds $100,000.
If investors do not actively manage their San Diego, California real estate (active management includes hiring a property manager), however, then the taxpayer is precluded from sheltering active income. Because investors have no management responsibilities in investments such as limited partnerships, the investor cannot use such losses to shelter active income.
