TEXAS REAL ESTATE LAW 11E
Charles J. Jacobus
Chapter 21
Real Estate Taxation
2
Real Estate Taxation
• The tax laws affecting real estate are very complex.
• This chapter will provide the foundation for further
research.
• Tax advice is not within the scope of most licensees’
employment.
• Advice from a competent tax lawyer or CPA is
indispensable.
• The only areas of taxation considered here are ad
valorem and certain provisions of income taxation
that have application to real estate.
3
Ad Valorem Taxes
• In these times the most fundamental concepts of ad valorem taxation
are often questioned.
• It is a system that will not easily be changed since there are numerous
statutes and constitutional provisions dealing with ad valorem taxation.
4
Constitutional Provisions
• Ad valorem is a Latin phrase that translates to “according to value.”
• The tax is based on the property’s fair market value.
• The Texas Constitution states: “all property in this state, . . . shall be
taxed in proportion to its value,”.
• It also provides that the taxes shall be “equal and uniform”.
• Each county elects an assessor-collector (or sheriff in small counties).
• The tax is a prior lien which arises automatically the first of each year.
• The constitution provides for seizure of property for delinquent taxes.
• The constitution also provides for certain exemptions.
• Texas has abolished ad valorem taxes for state purposes.
5
Statutory Provisions
• The constitutional provisions have several enabling statutes
authorizing the legislature to pass further tax laws.
• Specifically, procedures for assessment, foreclosure, determination of
market value, tax equalization, and collecting delinquent accounts.
• In 1979 the legislature adopted the Tax Code.
6
The Math of Property Taxation!
Assessed Value x Tax Rate = Tax Payment
• The assessed value may not exceed the market value and tax rates are
set by the taxing authorities in determining their budgets each year.
• Rates are expressed as an amount per $100 of value.
• So it would really be more accurate to say that the formula is:
Assessed Value ÷ $100 x Tax Rate = Tax Payment
7
The Math of Property Taxation – Example
A property is taxed by these taxing authorities at the following rates
(remember that rates are expressed at an amount per $100 of value):
City – 65¢
County – 79¢
School District – $1.43
Total Tax Rate = $2.87
Assume the property has a market value of $385,000.
$385,000 ÷ $100 x $2.87 = $11,049.50 annual property tax due.
8
Assessed Value
• Appraised values are now standardized through the establishment of a
State Property Tax Board and county appraisal districts (CAD).
• The appraisal district is responsible for appraising property in the
district for ad valorem tax purposes.
• This requires all school districts, levee districts, water districts, and
other taxing authorities to use the same appraised value.
• The chief appraiser shall deliver a written notice to the property owner
indicating the appraised value of his property if the value is increased.
• A taxpayer may protest and have his value reviewed by an Appraisal
Review Board.
• Beyond this appeal, his case can be reviewed by the local district court.
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Tax Rate
• The tax rate is set by the taxing authority in accordance with a formula
set out in the Texas Property Tax Code.
• The tax rate only operates as a function of what the taxing authority
needs for operations in the current year.
Total $ needed
for budget
÷
Number of $100s in
total taxable value
=
Tax
Rate
If a taxing body needs $10,000,000 for its budget and the total value of the
taxable property in that district is $400,000,000 then the tax rate is $2.50.
$10,000,000 ÷ 4,000,000 = $2.50 Tax Rate
(Total value of taxable property is $400,000,000. Divided by $100 is 4,000,000.)
• The governing body may not adopt a tax rate that, if applied to the total
taxable value, would impose an amount of taxes that exceeds last
year’s levy until it has had a public hearing.
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Tax Payment
• Once due and appeals exhausted, there is no provision for reduction.
• The taxing authority may allow a specified discount for early payment.
• Taxes are due upon receipt of bill and delinquent Jan 31 of each year.
• Delinquent tax incurs a penalty of 6% for the first month plus 1% for
each additional month prior to July 1.
• A tax delinquent on July 1 incurs a total penalty of 12%.
• This means a total penalty of 18%, plus interest, for only five months!
• Taxes may be paid in semiannual installments.
• Can pay half by Dec 1 and half by June 30 without penalty or interest.
• A taxpayer at least 65 may pay in quarterly installments.
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Transfer of the Tax Lien
• Foreclosure of the tax lien must be by judicial foreclosure.
• The tax lien may be transferred to anyone that pays the tax at the
request of the owner.
• The holder of the transferred lien may foreclose non-judicially.
• Owner may redeem within one year after this foreclosure by paying
attorney’s fees, judgment, costs, plus interest not greater than 18%.
• Otherwise the owner of a homestead may redeem within two years by
paying the purchaser the amount paid, recording fees, taxes, penalties,
interest, and costs, plus 25% during the first year, or 50% in the second.
• If not the owner’s homestead owner may redeem within six months.
• The tax deed vests good and perfect title subject to redemption.
12
Tax Exemptions and Deferrals
• Homestead Old Age and Disability Tax Deferral exempts from forced
sale for taxes property that is occupied by a person 65 years or older.
• All that is required is to file an affidavit containing the following:
1. The birth date of the affiant.
2. Legal description of the homestead.
3. Signature of the affiant, with an acknowledgment.
• This exemption also extends to surviving spouses aged 55 or older.
• The taxes and interest (calculated at 8% per annum) continue to exist
as a prior lien against the property, and the taxing unit can foreclose
when the homestead is no longer held by the claimant.
• A disabled veteran who receives 100% disability compensation due to a
service-connected disability is entitled to exempt the total appraised
value of the veteran’s residence homestead.
13
Appraisal Exemptions
• An exemption of $3,000 on the homestead.
• An exemption by a school district of $15,000 on the homestead.
• If 65 or older, an exemption of $10,000 on the homestead.
• Another over 65 exemption freezes taxes on a homestead for school
purposes. This exemption extends to the surviving spouse at least 55.
• Another exemption from appraised value is for disabled veterans for
varying types of disability, age, and for the veteran’s surviving spouse.
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Appraisal Exemptions
• One of the more significant exemptions is for agricultural use.
• The land must be devoted principally to agricultural or timber use for at
least five of the seven preceding years.
• However, tax rollback provisions apply.
• If the land changes use and no longer qualifies, the taxing authority
may collect up to five years’ preceding taxes as if the land was not
exempt.
• The fair market evaluation of the property “rolls back” for five years.
• The new owner may be surprised when asked to pay this amount.
• If the use changes, the owner has to notify the appraisal office.
• If he does not, the chief appraiser can back-assess the
property for 10 years with penalty and interest.
15
Exempt Property
• Certain properties are totally exempt from ad valorem taxation and
include land owned by:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
the state or political subdivisions of the state.
the Permanent University Fund.
the Texas Community Housing Development Organization.
the county for the benefit of public schools.
lands exempted by federal law.
cemeteries.
charitable organizations.
youth spiritual, mental, and physical development associations.
religious organizations.
schools.
historic sites.
16
Federal Income Taxation
• In 1986, Congress passed the Tax Reform Act of 1986.
• It was a sweeping change of income taxation, attempting to eliminate
some inequities in the existing structure and encourage simplification.
17
Income
The 1986 tax law separates income into three categories:
(1) active income
(2) passive income
(3) portfolio income
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Active Income
• Active income is from a primary source of employment.
• This includes salaries and income or loss from the conduct of a trade
or business in which the taxpayer materially participates.
• Materially participating means the taxpayer is involved in the
operations on a regular, continuous, and substantial basis.
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Passive Income
• Any activity in which the taxpayer does not materially participate.
• Rental activity is deemed passive regardless of level of participation.
• There are two exceptions. The first is for an individual taxpayer who
actively participates in real estate rental activities. Passive losses can
be offset against active income up to $25,000 per year.
• Real estate professionals can deduct unlimited real estate activity
losses from active income and portfolio income if:
(1) more than half of all services they perform are for real property
trades or businesses in which they “materially participate”.
(2) they perform more than 750 hours of service per year in those real
estate activities.
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Portfolio Income
• Income that is not active income or passive income.
• Interest, dividends, annuities, royalties, or a gain or loss from the
disposition of property producing interest, and dividends or annuities
that are held for investment are some examples of portfolio income.
• Expenses directly allocable to the property can be applied against
portfolio income.
• The most significant change under the Tax Reform Act of 1986 is that
the passive and portfolio losses cannot offset active income.
21
Special Tax Treatment for Real Estate
1. Depreciation.
2. Accelerated Cost Recovery.
3. Capital gains tax treatment.
4. Tax-deferred exchanges.
5. Installment sales.
6. At-risk rules.
7. Homeownership benefits.
22
Depreciation
• The federal government recognizes the intrinsic loss of value of
improvements (not land) and allows these decreases in value to be
deducted from gross income before the income is taxed.
• This, in effect, reduces the amount of taxes the taxpayer will pay, even
though he has made no actual or “out-of-pocket” expenditures.
• Depreciation is often used synonymously with the term “tax shelter”
because it is a deduction from gross income even though:
(1) no payment is made.
(2) no actual loss is suffered.
(3) depreciation is allowed in excess of the owner’s equity invested.
• Since land cannot be depreciated, an allocation of the purchase price
must be made between the improvements and land purchased.
• The most common allocation method used is the ratio of fair market
value of the component to the total value.
23
Depreciation
• There are now three systems involved in the computation of
depreciation:
(1) MACRS for property placed in service after 1986.
(2) ACRS for property placed in service after 1980 but before 1987.
(3) the straight-line or declining-balance method based on salvage
value and useful life if the property is placed in service before 1981.
• Depreciation is limited to commercial (industrial and office space) and
investment (residential rental) property.
• One’s primary residence cannot be depreciated.
• Depreciation can no longer be deducted against “active income” if it is
a “passive loss” from an activity in which the taxpayer does not
materially participate.
• Virtually all rental activities are treated as passive activities.
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Straight-Line Method
• The one type of depreciation that can always be used.
• First establish the correct useful life of the asset.
• Then take the basis (cost or value of the improvement) less any salvage
value and divide the remainder by the number of years of economic life.
25
Declining-Balance Method
• Can apply 200% or 150% of the straight-line rate.
• Assuming a property costs $30,000 and has a five-year life, the straightline-method depreciation rate would be 20% of the cost value of the
asset in the first year, or $6,000.
• The 200% declining-balance method, therefore, would give the taxpayer
the right to deduct double the straight-line rate (40%, or $12,000).
• The 150% declining balance would be 30%, or $9,000.
• The basis (cost or initial value of the improvement) is reduced by the
sum of depreciation claimed in years prior to the current year, so the
amount to be depreciated is reduced each year.
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Methods of Depreciation
Methods of Depreciation
Year
Straight Line
200%
150%
1
$ 6,000
$12,000 $ 9,000
2
6,000
7,200
6,300
3
6,000
4,320
4,410
4
6,000
2,592
3,088
5
6,000
1,556
2,160
Total Depreciation $30,000
Straight Line
vs.
200%
vs.
150%
$27,668 $24,958
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Classes of Property
5-year property: Telephone switching equipment.
7-year property: Most personal property normally associated with the
building, such as furniture, fixtures and equipment, carpet, exterior
lighting, exterior signage, movable wall partitions, truck bay doors,
ornamental fixtures, and pictures.
15-year property: Most land improvements, such as pavements,
landscape sprinkler systems, fences, and excavations for lagoons.
27.5-year property: Residential real estate.
39-year property: Non-residential real estate.
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Recapture
• When depreciation is computed using an accelerated method, the
excess amount over straight-line must be reported as ordinary income
upon disposition of the property.
• The amount of recapture depends on the type of asset, either personal
or real property, and the amount of gain realized on the disposition.
• All depreciation must be recaptured on the sale of personal property.
• Since residential rental and nonresidential property placed into service
after 1986 are limited to straight-line, recapture is unlikely to occur.
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Accelerated Cost Recovery System (ACRS)
• Low-income housing is permitted to be depreciated under the 200%
method, while other 15-year real estate may use the 175% method.
• Clearly sets out how much can be deducted in each year.
• Eliminates the need for useful life determination , as all property is
written off over the applicable 15-year period.
• No salvage value, so taxpayer may write off the entire cost.
• If placed in service after 3-15-84, use a recovery period of 18 years.
• If placed in service after 5-8-85, and before 1-1-87, use 19 years.
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Modified Accelerated Cost Recovery System (MACRS)
• Applies to all tangible property placed in service after Dec 31, 1986.
• Whereas the MACRS establishes new depreciation guidelines for
certain assets, real estate is limited to two classes:
1. Nonresidential real property which is depreciated over 31.5 years.
If placed in service after 5-12-93, the write-off period is 39 years.
2. Residential rental property is depreciated over 27.5 years.
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Capital Gains Tax Treatment
• A special tax rate paid on profits from the sale of capital assets.
• Long-term capital gain is gain on the sale of an asset held for more
than one year and a short-term capital gain is held less than one year.
• In 1997 the maximum rate was lowered to 15% from 28% (5% for
individuals in the 15% tax bracket).
• The tax to be paid is applied to the profit made, which is calculated as
the sales price less the adjusted basis.
• Basis is generally considered to be of two types:
1. original basis, which is the original cost of the asset.
2. adjusted basis, which is the original basis plus the cost of capital
improvements less any allowances for depreciation.
• Original Basis + Capital Improvement Depreciation= Adjusted Basis
32
Tax-Deferred Exchanges
• Exchanging has become popular because trades can be accomplished
without large amounts of cash and because you can trade without
paying taxes on the profit in the first property at the time of the trade.
• The phrase tax-deferred exchange is often used instead of trading.
• The tax deferred exchange rules apply to investment properties only.
• Owner-occupied dwellings are treated differently.
• The Internal Revenue Service permits a homeowner to sell their home
and exclude all gains with the specified limits.
33
Trading Up
• Real estate exchanges need not involve properties of equal value.
• If you own a small office building worth $100,000, you could trade it for
a building worth $500,000 with $400,000 of mortgage debt against it.
• If the building you wanted was priced at $600,000 with $400,000 in debt
against it, you could offer your building plus $100,000 in cash.
• The majority of exchanges consist of 3 transactions: two conveyances
and an escrow agreement with a qualified intermediary (QI).
• The QI maintains control over the funds and the closing documents.
• A delayed exchange allows seller to designate a replacement property
after closing provided:
(1) the replacement property is identified within 45 days.
(2) title to the replacement property is acquired within 180 days.
(3) the replacement property is received before the
designating party’s tax return is due.
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Reverse Exchanges
• What if sale of the exchange property is delayed and the seller has to
acquire the replacement property before selling the existing property?
• The QI may become an Exchange Accommodation Title Holder.
• The taxpayer transfers the ownership of the Replacement Property to
the Accommodation Title Holder and then the Accommodation Title
Holder will hold title until the exchange property can be sold.
• The seller, in effect, “parks” the replacement property with the
Accommodation Title Holder until a buyer can be found for the
exchange property.
35
Installment Sales
• One of the simplest major tax advantages of owning real estate is the
installment sale benefit.
• It applies to all types of real estate, including residential property.
• There must be at least two payments, the first being in the year of sale.
• The remainder of the income is taxed as it is received over future years.
• This allows the taxpayer to report the gain over a period of years.
• “Dealers” in real estate (developers and brokers engaged in buying and
selling of real estate in the normal course of business” no longer have
this option.
36
At-Risk Rules
• After 1986 the taxpayer’s deductible losses for any year are limited to
the amount that the taxpayer has at risk in that particular activity.
• The amount at risk is the sum of the following items: cash, the adjusted
basis of the property, and amounts borrowed for use.
• One major exception is that the taxpayers are not subject to these rules
to the extent they use arm’s-length, third-party, commercial financing
secured solely by the real property.
37
Homeownership Rules – Deductibility of Interest
• Home mortgage interest for acquisition indebtedness and home equity
indebtedness continue to be deductible.
• Limited to the first and second residences.
• The amount of acquisition indebtedness may not exceed $1,000,000
(or $500,000 for a married individual who files a separate return).
• The amount of home equity indebtedness may not exceed $100,000
(or $50,000 for a married individual who files a separate return).
• Acquisition indebtedness cannot be increased by refinancing.
38
Homeownership Rules – Gain on Sale of Principal Residence
• Must own and occupy the principal residence at least 3 of last 5 years.
• A taxpayer can exclude $250,000 from the sale of a principal residence.
• There is a $500,000 exclusion for married couples filing jointly, if:
(1) either spouse meets the ownership test.
(2) both spouses meet the use test.
(3) neither spouse is ineligible for exclusion by virtue of sale or
exchange of residence within the last two years.
• This exclusion is allowable each time the homeowner meets the
eligibility requirements, but no more frequently than every two years.
• The IRS no longer receives notification of any home sales of $250,000
or under $500,000 for married taxpayer.
39
Questions for Discussion
1. Explain the ad valorem tax system in Texas.
2. What is the Homestead Old Age and Disability Tax Deferral?
3. What are rollback taxes?
4. Explain the three types of income under the federal tax code.
5. Explain the tax benefits of homeownership.
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