Taxation of Domestic and
International Real Estate
Property Tax Deduction and Income Tax
February 8, 2011
John Gillingham
Why is property tax related to income
tax important?
• The amount of property tax owed annually is a
major determinate for the ongoing cost of
home ownership.
• Income tax treatment of property tax changes
the true net cost of ownership.
• Tax policy has an effect on real property
values.
Basic Property Tax Deductions, USA
• “Local, state, and foreign real property taxes are generally
deductible only by the person upon whom they are
imposed in the year in which they were paid or accrued
(Code Sec. 164(a)(1); Reg. SS1.164-1(a)”
• Tax imposed by state and local authority may be deductible
if three conditions are met:
1. Tax must be ad valorem (substantially in proportion to the
value of the property)
2. Imposed on an annual basis
3. Imposed with respect to personal property (Reg. SS1.1643c) (1021 Master Tax Guide)
• The deduction dates from 1913, at the inception of the
federal income tax.(Cordes, Ebel, Gravelle pg. 367)
Property tax statistics
(Cordes, Ebel, Gravelle pg. 368)
Improvement taxes not deductible
• Any tax that in reality an assessment for local
benefits such as streets, sidewalks, and similar
improvements is note deductible by a
property owner unless for repair and
maintenance (Code Sec. 164c; Reg. SS1.1644).
• For example, an assessment to replace
standard curves with granite curves in a given
neighborhood would likely not be deductible.
Why are improvement taxes not
generally deductible?
• Such a tax policy changes the affordability of
neighborhood tax policy.
• Such improvements would otherwise result in
tax deductible improvements to a personal
residence.
http://www.secretsofbeingunstoppable.com/
Form 1040 – Itemized Deductions
Schedule A – Itemized Deductions
Qualified Deductible Property Tax
• State, local or foreign real property tax (Coded
Sec. 264(a))(1021 Master Tax Guide).
• Note that when a taxpayer falls into
Alternative Minimum Tax, the benefit of the
tax deduction may be lost.
http://opencda.com/?p=5755
Why is property tax generally
deductible from income?
• Taxes paid are generally deducted from income in
order to avoid double taxation.
• “Theory suggests that taxpayers are willing to
accept higher state and local rates, and thus, a
higher livel of state and local public spending
because they pay less federal income tax “
(Cordes, Ebel, Gravelle pg. 367)
• Interesting note: 29% of property tax deductions
are due to New York and California residents.
(Cordes, Ebel, Gravelle pg. 367)
Example of how property tax deduction can
make home ownership more affordable:
• Assume: Taxpayer itemizes deductions due to other
reasons outside of property tax, 30% marginal
combined State and Federal tax bracket, property tax
of $5,000 per year.
• Effect: The $5,000 pre-tax cost of property tax would
be equivalent to $7,142 of after tax money if the
property had not been deductible. In basic terms, the
tax deduction when a person is in a 30% bracket results
in making the cost of property tax 30% more affordable
in dollar amounts.
But what if the property tax deduction
increases the dollar value of homes?
• If the property tax deduction increases the affordability of
home purchase, it is possible that the underlying value and
assessment of the home would also increase.
• Increased property values result in larger tax assessments
which could reduce or eliminate the benefit of the property
tax deduction.
• According to Steven Maguire of the Congressional Research
Service, “If the property tax deduction were eliminated,
taxpayers would gradually reduce their housing
consumption and thus the size of their property tax bill.”
(Cordes, Ebel, Gravelle pg. 368)
Who benefits the most from the
property tax deduction?
• Taxpayers who have taxable income
• Taxpayers who itemize deductions
– Typically high property tax and high state income
tax
– High mortgage interest
– High charitable giving
http://www.coastalhawaii.com/hawaii_property_taxes.htm
Who benefits the least from the
property tax deduction?
• Taxpayers with low or negative taxable income
– Low fixed income taxpayers
– Retirees
– Those that do not itemize deductions
• Why?
– If property tax deduction results in greater
affordability, the market price of homes may increase.
– Greater property values generally result in higher tax
assessments, which in this case, could not be fully
utilized by the taxpayer.
Special cases when taxpayer falls into
Alternative Minimum Tax (AMT):
• “State, local and foreign taxes on real
property, personal property, as well as income
and sales taxes may not be claimed” (Code
Sec. 56(b) (1)(A)(ii)) (1425 Master Tax Guide)
• High income taxpayers typically fall into the
AMT and have property tax deduction benefit
reduced or eliminated.
http://comicshop.blogly.net/no-more-amtshirt-235443657138370191.html
AMT Result
• Effective double taxation of income for taxpayers.
• Wealthy may be less prone to purchase additional
property without any of the tax benefits of owning
personal property.
http://www.ceceretax.com/amt.htm
Property tax deduction, the business
perspective
• Deducting property tax and other related
property ownership deductions to the extent
that deductions exceed income can be
challenging.
• Deductions often cannot offset ordinary
taxpayer income unless specific criteria can be
met.
Why so many rules?
• Property ownership often produces tax losses
due to the high cost of property maintenance,
tax, and depreciation expense.
• Tax rules are structured so that only taxpayers
who are real estate professionals or actively
participate can take tax losses on a year to
year basis.
• Attempt to prevent abusive tax shelters or
income deferrals.
What if there were no rules?
• Real estate ownership would be used even more as an asset
to produce losses against earned income and to defer realized
gains to the distant future or even heirs.
(Image used for educational purposes only)
What if no rules? Example:
• High income earner makes $1,000,000 per year and is
in a hypothetical 50% tax bracket.
– Such a person could purchase a multi-million dollar
building with several other partners, also employing the
use of debt.
– Absent the passive loss rules, the partners could enjoy
substantial tax deductions which make the investment
effectively more affordable.
– Ultimately the asset could be sold when the partner is in
retirement or low income phase.
– The property could also be exchanged via code section
1031.
– The taxpayer could even use the property for vacations.
The tax code limits the amount of
losses that such a tax payer can utilize
– Under the current laws, taxpayers often cannot
deduct losses produced in excess of income in the
current year.
– Losses, however, could offset income of other
passive activities.
– Losses may be able to offset gains if and when the
property is disposed of.
http://www.greenlightoffice.com
Results of limiting property tax
deduction
– The result of limiting property tax and other
deductions on business property is that investors
are less prone to invest based upon tax reasons.
– Tax shelters and deferrals are more difficult due to
the passive loss rules.
– Speculation may be tempered because
investments are typically funded with what
amounts to after tax dollars (unless in retirement
vehicle).
Criticism of property tax deduction
limits
– Disallowing losses on property investments may limit the
amount of risk that investor would otherwise take.
– A taxpayer could lose large amounts of after tax income
which could not be realized until many years later.
– So many rules make it very complicated to properly report
such items on the tax return or properly track partnership
basis.
– Large timing differences are realized as partnership and
property interests are disposed.
– Because passive losses are realized upon disposition of the
property, manipulation of timing differences is still
possible.
Schedule E, Supplemental Income and
Loss: Deduction may be limited
http://www.sonofthesouth.net/unclesam/stop-whining.htm
Real Estate Professional Classification,
no deduction limits
• In order for a taxpayer to deduct all losses from rental
real estate (treatment of rental real estate activities as
nonpassive (Code Sec. 469c(7)) (2064 Master Tax
Guide), the classification for real estate professional
must be met.
– More than one-half of personal services performed in
trades or business during the year must involve real
property trades or businesses in which the taxpayer
participates.
– Perform more than 750 hours of related service.
– Essentially such a person is treating the real estate
activities as almost a full time job and therefore can
deduct losses against regular income.
Court Decisions Bailey v.
Commissioner
U.S. Tax Court
• Court ruled against Bailey and disallowed real estate professional
status and deductions against earned income.
• “The following factors further diminish the credibility and accuracy
of the summary report prepared by petitioner: (1) The number of
hours claimed appears excessive in relation to the tasks described;
(2) petitioner testified that she usually combined a trip to the rental
properties with a trip related to her law practice; (3) the Elderwood
properties were vacant during 1997; (4) the Elderwood properties
and Indian Wells properties were for sale during 1997; and (5)
petitioner had a commission agreement with Shirley Baughan and
Associates to manage the rental of the Indian Wells condominium
during 1997. “
Active Participation in Rental Real
Estate Activities
• Most taxpayers who own real estate will not be a real estate
professional. They may simply own one or more properties in which
are rented to tenants. In some cases, losses can be taken.
• Active participation requirement may be met if the taxpayer
participates in management decisions.
• If the single or married filing joint taxpayer qualifies, losses up to
$25,000 may be deducted against ordinary income reduced, but not
below zero, by 50% of the amount by which adjusted gross income
exceeds $100,000. The $25,000 loss is completely phased out when
the modified adjusted gross income reaches $150,000. (Code Sec.
469 (i) (3)) 616 Master Tax Guide.
• Excess losses are carried forward following passive loss rules.
http://www.expatify.com/spain/10-things-you-didnt-knowabout-spain-until-you-live-here.html
Passive Participation:
• If no management decisions are being made,
the activity is likely a passive activity.
• Losses due to the deduction of property tax or
otherwise are treated as passive loss
carryovers until the year of disposition.
http://www.comparestoreprices.co.uk/chairs/la-z-boy-cool-chair-massage-recliner-as-seen-on-friends-.asp
Other rental property rules:
• If the rental is less than 15 days, no deductions attributable
to such rental are allowable and no rental income in
includible in gross income (Code Sec. 280A(d)(2))(966
Master Tax Guide).
• Rental deductions may be limited to gross rental income if
the home is used by the taxpayer for personal purposes for
the greater of (a) 14 days or (b) 10 percent of the number
of days during the year for which the home is rented at a
fair market rental.
– Such rules help prevent taxpayers for using rental real estate for
personal use and still realizing a deduction against regular
income.
– Absent of such rules a taxpayer could be tempted to make home
expenses otherwise not deductible, deductible.
Sources
• 2008 US Master Tax Guide, Illinois, CCH Publishing,
2007.
• www.IRS.gov
• Andrew McNaughton, interview, San Francisco
California, 2/4/2011.
• Joseph J. Cordes, Robert D. Ebel, Jane Gravelle,
Encyclopedia of taxation and tax policy, Washington
DC: The Urban Institute Press. Copyright 2005.
• Court Decisions Bailey v. Commissioner, U.S. Tax Court
No. 3293-00, T.C. Memo. 2001-296
(http://www.novoco.com)