Real Estate Property Tax Planning Given the Added Complexities of 2020
Real estate property taxes can yield tax savings when deductible as rental expenses. Individual clients look to deduct the property tax on the residence as an itemized deduction.
If you’re not a dealer, realty sales may qualify for the long-term capital gains benefit. There are prospects that the 20 percent current federal capital gains rate (or lower, commonly 15 percent for many taxpayers) may increase significantly. Under Mr. Biden’s proposals, federal long-term capital gains rates could reach as high as 39.6 percent.
Like-kind exchanges rules continue to generally accommodate realty exchanges but Section 1031 was amended to generally exclude personal property. These rules wouldn’t apply to one’s personal residence.
One occasionally finds rulings that focus on what is realty for purposes of a particular code section, such as those defining real estate investment trusts (See PLR 202031001, Sec. 856). In our context, the issue that usually arises is more likely one of distinguishing, say, payments for services from the tax imposed on the realty.
Real estate property taxes on a residence are deductible as an itemized deduction, albeit the incremental deduction may well be limited. ** There is generally a $10,000 limit on deducting the sum of property taxes and state and local income taxes and sales tax. The $10,000 isn’t indexed annually for inflation as is common in many provisions. The limit is $5,000 when a married couple files separately.
**On Aug 6, the Wall Street Journal reported that there are efforts by the Democrats to remove the $10,000 limit on deducting state and local tax and that if enacted would be temporary, yet apply for 2020 and 2021.
Our current environment is one of somewhat higher standard deductions, which can effectively mean that paying real estate taxes on the residence doesn’t save tax. We don’t suggest that the deductibility of real estate taxes on the residence should weigh in heavily in deciding whether to sell a home, but it can be a factor. It should be part of the math if one is considering disposition.
Considerations Upon Purchase
When evaluating a purchase agreement, keep in mind that all assets acquired are considered in the allocation of purchase price. Was personal property acquired as well as realty? There are important purchase price allocation issues that distinguish land from depreciable realty (although home use isn’t depreciable).
One occasionally finds references to the property tax allocations between land and building being guides for accounting allocations. There may be the possibility of real estate property tax savings if the purchase price allocations can more accurately distinguish the personal property.
“Component property” studies may pull out costs that can be distinguished as personal property with a shorter depreciable life. Costs related to commercial realty are generally depreciable over 39 years, versus 27 ½ years for residential rental realty.
Component cost studies may get some costs allocated away from the building into shorter lives, typically 5, 7 and 15 years. Bonus depreciation rules have been liberalized so as to generally allow 100 percent write off after September 27, 2017.
One of the results of a component depreciation study may be to find more property eligible for bonus depreciation. Without suggesting one needs such involved studies in buying a home, we do emphasize keeping in mind – what is realty and what is personal property for purposes of local property tax assessments?
The Deductibility of Real Estate Property Taxes
One doesn’t want to be late in paying property tax on realty. However, there is tax planning that focuses on itemizing one year, using the standard deduction in the following year and doing this as a pattern. Real property taxes can be an element of such planning.
Our current environment is one of somewhat higher standard deductions compared to the past, so keep in mind that there is really no incremental savings when realty property taxes on the residence don’t translate into added deductions. Know also that payments need to go out to the taxing authority and those that go into escrow aren’t deductible until payments go toward taxes.
Another rule that can affect the result is the allocation of real estate property taxes to a home office when one is an employee. There is a rule that arose with the 2017 Tax Cuts and Jobs Act, effective through 2025, which disallows miscellaneous itemized deductions. This would appear to reach the portion of realty taxes allocable to an employee’s home office (Tax Cuts and Jobs Act, Conference Report to Accompany H.R. 1, 115th Cong., 1st Sess. House Report 115-466, December 15, 2017, p. 275, 276).
The payments need to reflect taxes rather than assessments for, say, street improvements. Additions to asset basis may or may not eventually yield tax savings. For example, additions to tax basis may not save tax if the gain on the house would be covered by the housing exclusion anyway.
If certain requirements are met, the federal rules in 2020 still exempt $250,000 in gain on the sale of a residence, $500,000 in gain on a joint return (Sec. 121). Also, the current rule is that basis generally becomes fair market value at death (Sec. 1014). However, additions to basis during one’s lifetime will translate into additional income tax basis and added basis may save taxes.
Point of Note: Do keep track of property tax assessments that increase a home’s basis because there is at least a good possibility these may eventually reduce income tax.
Also, a personal residence may be transferred to children during one’s lifetime to simplify deathtime transfers. Thus, there may be no step-up to fair market value at death because the residence wasn’t owned by the decedent at the time of death.
Using the standard deduction rather than itemizing does not affect the nature of the property tax and its deductibility. Actual property taxes cannot be added to basis just because the taxpayer doesn’t itemize.
If the adult child pays the property tax for the widowed mother it does not yield an added property tax deduction on the child’s return, assuming the child itemizes. The child cannot deduct a realty property tax as such in these circumstances because the payment is just a gift to the parent who owns the house.
Concluding Thoughts - Transfers and Property Taxes
Detailed planning of residential transfers within the family and issues of related-party rentals are beyond our immediate discussion. The 2020 environment with its COVID-19 concerns may have an effect on valuations relatively soon, depending on local economics and local law.
Property taxes are basically a matter of state and local tax law. There are also provisions that can arise, such as later-in-life relief provisions that may affect planning within the family.
Generally transfers, even transfers by gift within family members, may need to be reviewed with a view to gift and estate tax planning. Keep in mind the prospect of state and local law changes in your client’s jurisdiction.
As an example, in California, as we approach the latter part of 2020, there are proposed ballot measures aimed at increasing property tax collections on commercial property as well as valuation increases when there are certain transfers within the family. These provisions are triggering near-term transfer discussions with an eye to avoiding increased property tax if this becomes law.
Any type of realty transfer within the family needs to consider the property tax implications.
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Mike Pusey, CPA is National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in audit and...