Ch7. Real Estate Taxation Deep Dive — Property Tax, Transfer Tax, and Income Tax

Property Tax (Ad Valorem Tax)

Property Tax:
Annual tax on real property assessed by local government (county, city, or special district)
Primary funding source for public schools, fire departments, and local government

Assessment Process:
Market Value (determined by assessor)
  × Assessment Ratio (% of market value subject to tax)
= Assessed Value
  × Tax Rate (mill rate)
= Annual Property Tax Bill

Timeline (typical):
January 1: Lien date — property tax lien attaches for current year
March–May: Assessment notices mailed
July–August: Appeal deadline (Board of Equalization / Board of Review)
October–December: Tax bills mailed
December 31: Payment deadline (varies by state)

Transfer Tax (Documentary Stamp Tax)

Transfer Tax:
Imposed when real property is conveyed by deed
Collected at closing / deed recording
Rate: typically per $100 or per $500 of sale price

Federal vs. State:
No federal real estate transfer tax
State rates vary widely:
  Low-tax states (e.g., TX, MT): no state transfer tax
  Moderate states (e.g., CA): $1.10 per $1,000 of value + county additions
  High-tax states (e.g., PA, DE): 2–4% of sale price

Calculation:
Sale Price $500,000; Rate $1.10 / $1,000 value:
Transfer Tax = ($500,000 / $1,000) × $1.10 = $550

Who pays:
Negotiable in the purchase contract
Custom varies by state:
  Seller pays in most states
  Split buyer/seller in some states (PA, FL)
  Buyer pays in some localities

Property Tax: Assessment Mechanics

Assessment Ratio:
Many jurisdictions assess at less than 100% of market value
Common ratios: 70%, 80%, 100% (depends on state law)

Example:
Property market value: $600,000
Assessment ratio: 80%
Assessed value: $480,000
Mill rate: 20 mills (= $20 per $1,000 assessed)
Annual tax: $480,000 / $1,000 × $20 = $9,600

Equalization:
State process to ensure uniform assessment ratios across counties
Prevents under-assessment in some counties from distorting state-level distribution

Common Exemptions:
Homestead: $25,000–$50,000 reduction in assessed value (primary residence)
Senior citizen freeze: Assessment locked at a base year for qualified seniors
Veteran exemption: Partial or full exemption for qualifying veterans
Disability exemption: Reduced assessment for disabled homeowners
Religious / nonprofit: Complete exemption for qualifying organizations

Capital Gains Tax on Real Estate

Capital Gains Tax:
Federal income tax on the profit from selling real property

Basis:
Original purchase price + capital improvements + acquisition costs
Example: Purchased for $300,000; added $50,000 kitchen remodel
Basis = $300,000 + $50,000 = $350,000

Capital Gain:
Sale Price − Basis − Selling Costs = Capital Gain
Example: Sale price $600,000 − Basis $350,000 − Commission $18,000 = $232,000 gain

Tax Rates (federal):
Short-term (held < 1 year): Ordinary income rates (10–37%)
Long-term (held ≥ 1 year): 0% / 15% / 20% (based on taxable income)
High earners: 3.8% NIIT (Net Investment Income Tax) surcharge

Primary Residence Exclusion (§121):
Exclude $250,000 (single) or $500,000 (MFJ) of gain if:
  Owned AND used as primary residence for 2 of last 5 years
  Not used the exclusion in prior 2 years

Depreciation of Investment Property

Depreciation:
IRS allows a deduction for the "wearing out" of income-producing improvements
Does NOT apply to land (land is not depreciable)

Depreciation Life:
Residential rental property: 27.5 years (straight-line)
Commercial / non-residential: 39 years (straight-line)

Annual Depreciation Deduction:
= Building Value (not land) / Depreciation Life

Example: Property purchased for $400,000
  Land value: $80,000; Building value: $320,000
  Annual depreciation: $320,000 / 27.5 = $11,636/year

Depreciation Recapture:
When a depreciated property is sold, the IRS "recaptures" past depreciation
Recaptured depreciation taxed at 25% (unrecaptured Section 1250 gain)
This is a significant tax cost for long-term hold investors

1031 Exchange (Like-Kind Exchange)

Section 1031 of the Internal Revenue Code:
Allows deferral (not elimination) of capital gains tax when:
  Investment or business property is exchanged for like-kind investment property

"Like-kind" definition:
  Broader than it sounds — any real property for any real property
  Apartment building → office building = qualifies
  Farmland → rental condo = qualifies
  Personal residence → investment property = DOES NOT qualify

Critical Timeline Rules:
  45-Day Identification Rule:
    Must identify potential replacement properties within 45 days of closing
    Up to 3 properties (3-property rule) regardless of value
    OR unlimited properties if total value ≤ 200% of relinquished value
  
  180-Day Exchange Rule:
    Must close on replacement property within 180 days of closing on old property
    Both deadlines run from the date the relinquished property closes

Qualified Intermediary (QI):
  A neutral third party who holds the exchange funds
  Seller may NOT receive the cash; QI holds it during the exchange period
  No approved QI = disqualified exchange → capital gains tax due

Boot:
  "Boot" = cash or non-like-kind property received in the exchange
  Boot is taxable to the extent of gain realized

Property Tax Lien Date = January 1 ★★★★★ : In most states, the property tax lien attaches on January 1 of the tax year. Exam tip: The owner on January 1 is responsible for that year’s taxes; prorate at closing

§121 Exclusion: 2-of-5-year rule ★★★★★ : Must own AND use as primary residence for 2 of the last 5 years before sale. Exam tip: $250,000 single /$ 500,000 married filing jointly; not available for rentals

1031 Exchange deadlines: 45 / 180 days ★★★★☆ : Identify within 45 days; close within 180 days of the sale of the relinquished property. Exam tip: Extensions not available; missing either deadline triggers full capital gains tax

Practice Questions

Q. Why do property tax liens have higher priority than first mortgage liens?

Property tax liens are statutory liens created by law and represent the government’s paramount claim on property to fund essential public services. By statute in all states, property tax liens have super-priority over all other encumbrances, including recorded mortgages. A mortgage lender’s due diligence requires verifying tax status at closing and maintaining an escrow impound for ongoing taxes.

Q. What is the primary risk of receiving “boot” in a 1031 exchange?

Any boot (cash or unlike property) received is taxable to the extent of realized gain. If a seller receives $50,000 cash in an exchange (e.g., the replacement property is worth less), that$ 50,000 is taxable even though the exchange otherwise qualifies. To fully defer all gain, the replacement property must be of equal or greater value AND all equity must be re-invested.