Virtually every taxpayer knows that real estate taxes paid on his or her property are deductible on income tax returns. But many taxpayers overlook bonus deductions for property taxes and fees, especially in the year of purchase or sale of a property.
The basic rule is that state and local taxes paid on your home and other realty you own are fully deductible on your income tax returns. Property taxes paid on your personal residence are deductible if you itemize personal deductions. But property taxes paid on business property, such as farms, apartments and stores you own, should be deducted on Schedule E or C of your IRS Form 1040.
In states where a personal property tax is levied on household furniture, business equipment or inventory, these taxes are deductible in the same manner as real estate taxes.
Real and personal property taxes are deductible in the year the tax is remitted to the local teax collector. The date the tax accrues, sometimes called the lien date, is irrelevant (except for taxpayers who operate on an accrual accounting method).
Some taxpayerss erroneously think their property taxes are deductible in the year they make the payments to an escrow or impound account held by the mortgage lender. This is incorrect.
Although the lender may collect one-twelfth of the estimated property tax each month, that money doesn't become deductible to the property owner until the lender remits the money to the local tax collector. Fha, VA and PMI (private mortgage insurance) mortgages require these impound accounts for property taxes.
Special assessments made by local taxing agencies, such as for new streets or sidewalks which will directly benefit the taxpayer's property, are not deductible as real estate taxes. Such amounts should be added to the owner's basis for the property.
But if the special tax is to maintain civic improvements or to pay interest, then such property taxes are deductible on your income tax returns.
Many taxpayers overlook their entitlement to special deductions in the year they buy or sell realty. The reason is the sale year realty taxes are prorated between the buyer and seller. The other party often paid the property tax, so the taxpayer has no receipt and he forgets about the deduction.
Evidence of the pro-ration between buyer and seller, according to the number of days each owner owned the property, could be the closing statement prepared by an attorney or escrow officer. This is sufficient to entitle the taxpayer to the deduction.
The property transfer and recording taxes are often overlooked by taxpayers. If paid by the seller of the property, such fees are sales costs which are subtracted from the gross sales price to arrive at the "adjusted sales price" for computing the capital gains profit.
If paid by the property buyer, transfer and recording taxes should be added to the property's purchase price cost basis. This won't give any immediate tax savings to personal residence buyers, but purchasers of depreciable structures, such as apartments, thereby deduct these transfer and recording taxes as they depreciate their building over its useful life. Further details are available from your tax adviser.
When homeowners sell their personal residences they have two primary ways to avoid paying profit tax: (1) the rollover "residence replacement rule" if another residence is purchased and (2) the "over 55 rule" $100,000 home sale tax exemption.
But sellers of other types of property, such as farms, vacant land, apartments, warehouses, stores, and offices, can't use these rules. However, such property can qualify for a tax-deferred exchange which, thanks to new developments, is easier to accomplish than ever before.
Suppose you own an apartment house in which you have a $100,000 profit. If you sell, your profit will be taxed (as a long term capital gain if you owned the property over 12 months).
But many investors want to avoid paying tax on their profits because those tax dollars are gone forever. So they make a tax-deferred exchange for other property which better suits their investment needs. Investors who wish to use their equity to acquire more property especially enjoy the lack of tax erosion of their equity dollars since no tax is payable on a qualified exchange.
Not all property can qualify for a tax-deferred exchange authorized in Internal Reveune Code section 1031. Only properties held for either investment or for use in a trade or business qualify. Fortunately, this includes just about all property except (1) the taxpayer's personal residence and (2) a property dealer's inventory.
For example, it is posible to trade an apartment house for vacant land without paying tax on the profit in the apartment house. Similarly, it's possible to make a tax-deferred trade of vacant land for a warehouse.
To make the swap tax-deferred, the taxpayer must follow some simple rules: (1) trade like-kind property" (meaning keep your personal residence and dealer property out of the trade), (2) trade up to a more expensive property, and (3) don't take any "boot" (that's "un-like property" such as cash or net mortgage relief) out of the trade.
In addition to deferral of profit taxes, there are additional reasons for making property swaps. These include disposal of otherwise unsaleable property, avoidance of necessity to refinance the existing mortgages on property being traded, increase of depreciation deductions when trading up to a more valuabe building, and tax-deferred equity pyramiding.
Until 1979 many property traders thought that a tax-deffered exchange Circuit U.S.Court of Appeals decision in Starker v. U.S. (602 F.2d 1341) changed this and made exchanges easier than before.
This court decision held it was possible for a taxpayer to agree to sell his property, have the sale proceeds held in trust until a second property could be found to purchase to complete a trade, and still qualify for profit tax deferral. These exchanges are now called "Starker exchanges." Further enlightenment on the subject was added by IRS Private Letter Ruling 7938097 which approved use of a Starker-type transaction.
The net result of the Starker decision is that tax-deferral benefits similar to those available to principal residence sellers are now available to sellers of other types of property if they meet the simple Starker rules. This important new development promises to open new development promises to open new realty investment opportunities for earning tax-deferred profits.