Real Estate Taxation & Property Insurance

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Read this article if you are familiar with real estate transactions and you are a real estate investor, general contractor, land developer, lender, a member of the National Association of Realtors, the American Society of Home Inspectors, the National Association of Home Builders, or a financial planner working with clients in the real estate industry.

The benefits of owning real estate
The benefits of owning rental property are the tax breaks each property affords and the ability of the borrower to use OPM to create equity while adjusting the debts with appreciation and increased rents from the property. However, in order to enjoy those benefits and remain solvent, the owner(s) must be organized and they must operate the property like a business. They must have a system that is designed to record and monitor income and expenses and a plan that can help them maintain cash flow and adequate working capital.

Real estate tax planning issues
Lease vs. buy, repairs vs. capital improvements, cost segregation vs. total cost, cash vs. accrual method, vacancies, maximum interest deduction, amortization vs. depreciation, employee vs. independent contractor, maximum loss deduction, sell vs. section 1031 exchange, exclusions, recapture of depreciation, capital gains tax, foreclosure/repossession, IRS and state audits, etc.

Barry's Accounting Services has assembled a group of bookkeepers from the real estate and banking/mortgage industries to help real estate owners clean up and modernize their systems to meet lenders requirements and the IRS and state requirements if they are audited. Many of my clients own residential, mixed-use, commercial, and industrial real estate including condos, co-ops, vacation homes, undeveloped land, and other share equity ownerships in several states. It is not unusual for a client to file a complete tax return that is comprised of a federal tax return plus 4-6 states tax returns.

The focus is on real estate acquisition; adjusted basis, operation; sale-leaseback, leasehold improvement, lease inducement payment, lease-term contracts, uniform capitalization, passive loss, income from discharge of indebtedness, non-business bad debts, asset impairment, environmental remediation costs; exchange & transfer of rental property in marital dissolution; transfer of property from a parent to a child; Section 121 exclusion for sale of property; Section 1031 exchange of property; contract price; seller's concession; second mortgage; adjusted sale; recapture, installment method of reporting gain; and foreclosure or repossession of property.

Form(s) 1098 for residential & rental property you own —
You should receive this form from every bank or mortgage company that you paid during the year. The mortgage interest, property tax, town tax, school district tax, county tax, and/or village tax, and points (loan origination and loan discount fee) that you paid are tax breaks. If you did not receive a form 1098 statement by January 31, call the bank or mortgage company for the information. If you own a CO-OP and you paid the monthly maintenance fee, you are entitled to a proportionate share of the mortgage interest and real estate tax that the housing corporation paid on the building (IRC section 216). This is in addition to the mortgage interest and real estate tax deductions that you have received from your mortgage company or bank. You must report the actual figure on your tax return. Tax preparers are not allowed to use estimates of these amounts on your tax return.

For rental property —
You must report the amount of rent that you actually received or collected from each property during the year [IRC Sections 61(a)(5), 109, and 856(d)(1)], plus an itemized list of rental expenses that you paid during the year for each rental property you own (IRC Sections 163, 164, and 212), such as mortgage interest, property tax, school district tax, county tax, village tax, water, gas/oil, electricity, insurance, eviction fees, advertising vacant apartment(s), extermination, cleaning and maintenance, boiler repairs, carpeting, management fees, and travel to the property. Minor repairs for plumbing, electrical, and carpentry are deductible in full in the year paid (Treasury regulation 1.162-4). Equipment and capital improvement such as new boilers, refrigerators, stoves, central air conditioning, new bathrooms, complete renovation of apartments and kitchen, including structural improvements made to the property, such as a new roof, sidewalk, driveway, garage, fence, and basement are depreciated and deducted annually over a period of 5-15 years [IRC 262 and 280(A), and Treasury regulation (regs) 1.280A-3(d)(3)]. Lodging, meals, and utilities that you furnished to a Super and his dependents are treated as furnished as a condition of employment. These amenities are tax-free to the Super. They must not be included in his gross income and they are not deductible by you, the employer [IRC Section 119(a)(2)].

Sale, foreclosure, or destruction of your residence —
You do not have to pay tax on $250,000 or $500,000 of profit that you obtain from the sale or destruction of your principal residence by hurricane, tornado, threats of condemnation, or eminent domain if you own the property for at least five years and live in it for at least two years. You can claim this exclusion once every two years (IRC Sections 121 and 1033). You can receive a reduced exclusion if you sell your residence earlier and the sale was due to divorce, unemployment, poor health, acts of vandalism or terrorism, a change in employment, or self-employment status that makes it difficult for you to pay your mortgage and living expenses. A reduced exclusion is based on the number of days that you owned and occupied your residence divided by 730 days, or the number of months you owned and occupied your residence, divided by 24 months, multiplied by the exclusion of $500,000 or $250,000 based on your filing status at the time of the incidence or occurrence.

If your principle residence was destroyed or condemned, you may have to purchase a replacement property within two years to offset the recognized gains. If a lender has foreclosed on your property, your gain or loss for tax purposes is the difference between the net proceeds that the lender received at the auction and your adjusted basis in the property [IRC 856(e)(1) and 1001]. Your attorney or insurance company should give you copies of these settlement papers. Take the documents along with you at your tax interview.

You can deduct a maximum of $3,000 on your tax return annually if you paid a contractor or developer to build your house and you and other homebuyers lost your money because the contractor filed bankruptcy. This is a non-business bad debt [IRC Section 166(d)(1)(B)]. To qualify for this non-business bad debt deduction, you must show proof of contract, original cancelled check(s), and a letter from the bankruptcy court or from the contractor's attorney.

Note: You can avoid losing your money to a contractor or developer by checking their history for lawsuits and bankruptcies and ensuring that they carry contractor's general liability insurance (CGL) and Payment & Performance bonds and your name is endorsed on the policies. I am an insurance broker, so I know that.

Sale of rental or commercial property —
If you sold a rental/commercial property, you may have to pay capital gains tax on the profit or on the amount of the depreciation taken (IRC Sections 1231, 1245, & 1250). However, you can avoid paying tax on capital gains and instead pay tax on ordinary income if you sold your rental property to a relative (IRC 1239). If you are not qualified to use this method, then you may use the installment sales method to spread the capital gains and your overall tax burden over several years if you received a down payment from the buyer and you hold a note or second mortgage for the balance of the sale — Seller finance (IRC Section 453). You may also qualify for non-recognition of capital gains tax through a Section 1031 like-kind exchange transaction. This tax strategy allows you to reinvest your entire profit into a new property without paying capital gains tax. Section 1031 exchange transaction must be completed within 180 days (six months) after the transfer of the exchange property.

Section 1031 exchange, business, or investment property —
In a section 1031 exchange transaction, the property you give up and the property you receive must be held for investment or for use in your trade or business. Machinery, trucks, land, office buildings, and rental houses are examples of qualified property. You can exchange an apartment building for another apartment building, retail building, or industrial warehouse.

Section 1031 exchange, principal residence —
Section 1031 exchange rules do not apply to property that is used solely as a personal residence.

Tip: If you owned a personal residence for at least five years and lived in it for at least two years, and the residence was rented out to a tenant at the time of the exchange, then you can claim both the section 121 exclusion of $250,000 or $500,000 and the Section 1031 non-recognition of gain. Isn't this a nice loophole?

Section 1031 transactions are complex. It is important that you retain the services of a real estate attorney to construct your transaction within Section 1031 exchange rules because you can be audited and indicted for tax evasion. If you need help setting up a Section 1031 transaction, please call the following tax attorneys.

These attorneys write, teach, and practice this subject. They can refer you to other tax attorneys in your state or city if they are too busy to handle your assignment. You may also call:

Question #1
Hi Barry, I am single. I sold my 4-family building in January 2005. The market price was $800,000, but the contract price was $725,000. I also gave the buyer $30,000 to help pay the closing cost. I received the building from my parents in 2004. They bought it in 1982 for $52,000 and made improvements totaling $100,000 over the years. We lived in one apartment and rented out the other three apartments from 1982 to 2004. My parents filed their tax returns every year and they included the rents and the operating expenses of the building. They have taken $85,650 in depreciation deductions. Am I in trouble with the government?

Answer
You are not in trouble with the government. You just have to pay the government what you owe. Gain or loss from the sale or transfer of a property is the difference between the adjusted selling price and the adjusted basis (total cost) of the property sold. The basis that your parents had in the property and the depreciation they have taken over 22 years were transferred to you when you received the property. This situation also holds true if the property was transferred to you in a divorce settlement. You do not have to pay capital gains tax for the apartment where you lived. Your profit for your apartment is $135,750 = ($173,750 - $38,000) and your Section 121 exclusion is $250,000. However, you have to pay federal and state capital gains tax on the profit/gain of $492,900 you received from the three apartments that your parents rented out for 22 years. Your profit of $492,900 was arrived at after the selling price was adjusted to reflect the seller's concession, your basis was adjusted, and recapture of depreciation was added back. You may be able to postpone paying federal and state taxes on $492,900 profit if you plan to buy a commercial property within two years after the sale of your property.

Question #2
Hello Clemson, my wife and I purchased our home for $365,000 at the height of the market in 2003. The asking price was $380,000. We spent $17,200 on renovation and our mortgages totaled $390,000. The appraised value of the house is now $380,000. We could not keep up with the monthly payments so the lenders foreclosed on the house. The house was sold at auction for $390,000. Are we entitled to receive money from the foreclosure?

Answer
Foreclosures [IRC Sections 108(a), 856(e)(1), and 1001(a)].
The IRS and the tax court have ruled that the value of a property sold in foreclosure is the amount of money the seller received for it from the highest bidder. The foreclosure sale has generated a capital gain of $7,800 ($390,000 - $365,000 - $17,200). The capital gain is not taxable because your section 121 exclusion is $500,000. You are not entitled to receive money from the foreclosure sale because the total amount of your mortgages is equal to the amount the lenders received at the auction.

Question #3
Hi Clem, I own ten acres of prime land in a busy city. I paid $200,000 for the land in 1978. The current value of the land is $800,000. In 2004, the state acquired a portion of the land and built a highway through it. I received $80,000, but the market value of the land is $88,000. Can I take $8,000 as a credit or deduction on my tax return?

Answer
Condemnation or eminent domain [IRC Section 1033(a)(2)(E)(ii)].
Real estate can be purchased/acquired at fair market value or at its appraisal value. The $80,000 you received from the state may be the lower of the two value systems. Ask the state which value system was used to calculate your compensation or you can initiate legal proceedings against the state for the additional compensation of $8,000. Current tax rules do not allow you to take a tax deduction or credit for $8,000. The value of the land acquired by the state is 10% of the value of the ten acres you own ($80,000/$800,000). You received $80,000 and the land cost you $20,000 (10% x $200,000). You have to pay capital gains tax because the acquisition has created a net taxable gain of $60,000.

Question #4
Mr. Barry, I am planning to develop, subdivide, and sell 30 acres of land that I purchased and held in my name 12 years ago for $156,000. The value of each lot will vary significantly. The subdivision costs and fees will be approximately $80,000 and the estimated sales price will be $2,800,000. I plan to sell all the lots in five years. How should I structure my transactions to minimize my taxes?

Answer
IRC Section 1237.
As an individual owner, you should sell five lots of two acres each for three years. If you sell more than five lots in the same year, then 5% of the sales price of each lot in excess of five lots will be taxed as ordinary income. A five-year delay after the sale of the first five lots will qualify an additional five lots or the remaining lots for 100% capital gains tax. An individual owner who subdivides land and sells off lots or parcels cannot defer reporting gain until the entire cost is recovered. The proper procedure is for you to apportion the cost equitably among the lots so that gain or loss can be determined on the sale of each lot.

Note: You could save a lot of money if you established a C corporation for buying, holding, and selling real estate. You transfer, develop, and sell the land as part of the inventory of the corporation.

Question #5
Hi Clemson, I bought a beachfront residence with two acres of land for $1,200,000 in 1993. The value of the land was $125,000. My residence was damaged by a hurricane in 2003. I had a high insurance deductible and I properly deducted $20,000 as a casualty loss on my 2003 tax return. I made $80,000 repairs to the property in anticipation of converting it to a rental property. The house was rented out in January 2006. The market value of the property at the time was $1,100,000 and the value of the land was $100,000. What figure should I use to calculate the depreciation on the house for tax year 2006?

Answer
Treasury regulations (regs) 1.167(g)-1 and 1.168-2(j)(6). IRC Sections 1012 and 1016.
Your basis for depreciation is $1,000,000. When a personal residence (asset) is converted to business use, the basis for depreciation is the lower of the adjusted basis (total cost - land - loss) or the market value (FMV) when the property was converted. The adjusted basis is $1,135,000 ($1,200,000 - $125,000 - $20,000 + $80,000). Since the basis of the house is $1,135,000 and fair market value (FMV) is $1,000,000 ($1,100,000 - $100,000), the basis for depreciation is $1,000,000. You should use $1,000,000 to calculate the depreciation on your house.

Question #6
Hi Clem, a contractor wants to accept my residence as a trade-in and allowed me $340,000 towards a new residence priced at $400,000 that he owned in another state. I bought my house in 1990 and I have never rented it out. I have the following pieces of information:

What is the basis of my new residence in the exchange?

Answer
IRC Section 1034(a) and (e); Section 121.
The trade-in transaction you are talking about is Section 1034 transaction. Section 1034 rules were repealed in 1998. This transaction may cost you a small fortune in back taxes, interest, and penalty when the auditors pull your file three years later. Section 1031 like-kind exchange rule has been the new rule for several years and it does not cover property used solely as a primary residence. I strongly recommend that you take out a home equity line of credit to make a down payment on your new residence while you are searching for a buyer to purchase your current residence for $400,000. You can then use your tax-free profits or capital gains of $215,500 to reduce the balance owed on your new residence. Why tax-free? Because your Section 121 exclusion of $250,000 offsets your capital gains profit of $215,500.

Here is the answer to your Section 1034 trade-in transaction. IRC Section 1034(e) requires the basis of a new residence be reduced by the amount of gain realized on the sale of a former residence. The adjusted basis of your new residence is $246,500.

IRC Section 1034(a) has provided for the non-recognition of gain in the exchange. The adjusted basis of the new residence for future tax purposes is equal to the purchase price of $400,000 + $2,000 attorney's fee less $155,500 of non-recognized gain.

Question #7
Hi Barry, I bought a one-family residence in June 2005 for $315,000. I paid 3% down and closing costs of $19,800. The property valued $350,000 at closing. I received $35,000 cash back at closing and my mortgage was $340,000. I lost my job and I had difficulties paying my mortgage after my unemployment, severance pay, and savings ran out. I sold my residence in September 2006. The contract price was $380,000, but I had to give the buyer a seller's concession of $10,000 to qualify for a mortgage. I paid $29,200 in selling expenses including a 6% broker's fee. Am I entitled to receive some money back?

Answer
IRC Section 121.
You should have received a check for $800 at closing from the buyer's mortgage company. Your attorney would have your money in his/her escrow account. Your capital gains is $6,000. The taxing authorities have recognized your special circumstance and have exempted you from paying capital gains tax. You are covered under the reduced exclusion rules. Your reduced exclusion of $156,250 (15 months/24 months x $250,000) will offset your capital gains of $6,000. Here are the calculations:

The mortgage company should pay you ($380,000 - $39,200 - $340,000) = $800

Your tax-free capital gains is ($380,000 - $39,200) - ($315,000 + $19,800) = $6,000

Summary
My answers to the questions above can save you thousands of dollars in taxes. Please remember tax rules are subject to change. Please call me if you would like to have your tax returns prepared or if the government is auditing you. If I didn't convince you that I know real estate taxation, then nobody will be able to convince you that they know it.

"Your article on Real Estate Taxation is excellent. I have read bits and pieces of the subject in magazines, brochures, and handouts at seminars, but this is the most comprehensive article I have read on the subject. The answers you gave were well-researched."
           - Jan Davidson, General Contractor, Beverly Hills, California

"I used to live in New York and commute to work in New Jersey and Connecticut. I rented out my residence in New York and relocated to another residence I had in Georgia. I sold my residence in Georgia and relocated to California. I finally sold my residence in New York. Barry's tax planning advice saved me $18,000 in prepayment penalties, $30,000 in seller's concessions, and $5,900 in taxes. Barry has been preparing my tax returns and advising me for 20 years. I could not have chosen a better person to look after my interests."
           - Sylvia Fortune, District Sales Manager, Los Angeles, California

"We buy and sell real estate. Barry has been our tax advisor for 15 years. He has saved us an average of $15,000 in seller's concessions, $6,000 in prepayment penalties, and $5,000 in taxes per property."
           - Eva & Allan Hopkin, Real Estate Investors, Laurelton, New York

"I was audited and couldn't find my tax preparer. A friend referred me to Barry. Barry took my case and saved me $5,250. I have become more educated and realistic about who should prepare my tax returns. Thank you, Barry."
           - Ray McCloud, Real Estate Owner, Newark, New Jersey