1031 Exchanges also called ‘like kind’ exchanges and ‘tax-deferred’ exchanges are a process investors can use to defer paying capital gains tax, that they would normally pay on an ordinary sale, until some future date. 1031 exchanges are for investors only; homeowners have an even better option available to them- the homeowner’s capital gains exemption (IRC Section 121).
Some people mistakenly refer to 1031 Exchanges as ‘tax-free exchanges’. Capital gains taxes are postponed in a 1031, but not avoided. You transfer the tax liability of the previous property over to the new property. When the replacement property is sold (not as part of another exchange), the original deferred gain, plus any additional gain is subject to tax.
1031 exchanges get its name from the IRS internal revenue code Section 1031 – which describes how these exchanges work.
The IRS considers a qualifying exchange not as a sale but a trade, of like-kind property, and if all the conditions are met, the new asset is treated as if you’d owned it from day one— no gain, no loss, no taxable event taking place upon transfer.
1031 Exchanges are allowed in all states because it is federal tax law. You can sell a property in Texas and buy one in California as part of 1031 exchanges. Some states have special state laws affecting exchanges, so make sure you learn the state law before exchanging there. California follows the federal law. See Sections 18043 and 24941 of the California Revenue and Taxation Code. California doesn’t have any special tax rates for Depreciation Recapture or Capital Gains Tax, so your tax on these are the same as your California State Income Tax Rate. Questions about State laws for your 1031 exchange? Ask your 1031 exchange company.
Always talk with your accountant before deciding whether or not to do a 1031 exchange. If you are carrying a large business loss it might be better to write off the entire capital gain against the loss than do an exchange because you will be able to take more depreciation in the future and use up the tax benefits of the loss now.
If you are doing a 1031 exchange as a seller, put “buyer to cooperate with seller’s 1031 exchange” in the private listing remarks, and when you are the buyer, write in the purchase contract that you are buying the property “with proceeds from a 1031 exchange”.
Why Consider 1031 Exchanges?
-Defers Capital Gains Tax
-Defers Depreciation Recapture
-Allows you to Reinvest or “Roll” tax deferred dollars for increased buying power (interest free loan from IRS!)
-Penalty free way to move money from real estate investments to different markets or investment property types (ie move money from a management intensive property such as a vacation rental to a management free property such as a NNN Retail building)
-Remote possibility to eliminate Capital Gain Tax and Depreciation Recapture Tax entirely with Stepped up basis upon death through inheritance.
Let’s look at a detailed example of how much more buying power you get with a 1031 Exchange rather than selling and then buying:
You bought a 4 plex for $1M 10 years ago with 30% down and a 30 year fixed loan at 6% interest. Your original closings costs were $20,000. Other than doing routine maintenance, you made no capital improvements to the building while you owned it. Each year you held it you took the maximum depreciation (200K land value, 800K building- 800/27.5) of 29K per year. Over the ten years you held the investment, it appreciated 40% for a sale value of $1,442,000. You make over $250,000 a year in net income so your tax bracket is 12.3% CA and 39.6% Federal. You have just sold the property and plan to buying a bigger investment property that will produce more cashflow. The closing costs on this new sale are 6% of $1,442,000 = $86,520.
Original Purchase 10 Years Ago:
Original Down Payment
Original Mortgage @ 6% interest
New Sale @ 40% Appreciation over 10 years
New Closing costs @ 6% of $1,442,000 = $86,520
Depreciation taken 29K *10 years
Adjusted Basis $1,000,000 original purchase price + $20,000 original closing costs + $86,520 new closing costs – $290,000 depreciation
Amortization of Loan Balance, currently $584,532
$700,000 – $584,532 = $115,468
$625,480 ($335,480 Capital Gain + $290,000 Depreciation)
Capital Gains Tax @ 20% Federal + 12.3% CA + 3.8% Medicare Surcharge = 36.1%
$335,480 * 36.1% tax=
$121,108 Capital Gain Tax
Depreciation Recapture (12.3%CA + 25% Federal = 37.3%)
$290,000 * 37.3% tax =
Proceeds from Sale
Sale Price $1,442,000 – loan repayment $584,532 – New Closing Costs $86,520 – Capital Gains Tax $121,108 – Depreciation Recapture $108,170 =$541,670
Sale Price $1,442,000 – loan repayment $584,532 – New Closing Costs $86,520 =$770,948
Cash into replacement property
Purchase Price of Replacement property Downpayment 30%
To Summarize, the difference in buying power is:
Disadvantages of 1031 Exchanges:
-Can be hard to pull off
-Reduced basis in replacement property resulting from carryover of the basis of relinquished property.
-Lower Depreciation Deductions (not substantial if replacement property is more expensive)
-Business Losses can’t be used
1031 Exchanges Important Terms
Relinquished Property – The property that you sold to trade for the replacement property. It can also be called the downleg an exchange.
Replacement Property- The “second leg” of the exchange. It is the property you purchase to complete your exchange.
In a 1031 exchange the exchange must be like kind property. Like Kind means real estate for real estate. Any kind of real estate is considered “like kind” and can be exchanged for each other. For example you can trade vacant land, hotels and motels, farms, apartments, houses, office, retail, strip malls, gas stations, storage facilities, warehouses. Like Kind does not include personal property such as cars, machinery, patents.
To be eligible for a 1031 exchange, you may never “touch” the money, or your 1031 is void. You need a Qualified Intermediary (QI) to handle the money for you. They receive and disburse the proceeds of the sale. Most of the times your Qualified Intermediary is a 1031 exchange company. The IRS does not allow relatives, your accountant, attorney, real estate agent, or escrow company to be your QI.
Boot is the amount of profit and liabilities carried over from the previous property. You are not allowed to make a monetary benefit out of the exchange. Boot is taxed. To avoid being taxed, make sure the boot of the new property is equal to or larger than the boot of your old property. The IRS believes that if you are relieved from debt, or don’t reinvest 100% of the profits into the new property during an exchange that that is an economic benefit, and the difference is taxable. New boot needs to be greater than or equal to the old boot, or you pay taxes on the portion of boot that is uncovered. There are 4 types of boot: Price Boot, Cash Boot, Mortgage Boot, and Depreciation Boot.
Price Boot– you have to buy a property for the same selling price or higher.
Example (bought more expensive property), you sold a $500,000 property through an exchange and purchased a $700,000 property. There is no price boot.
Example (bought less expensive property), you sold a $500,000 property through an exchange and purchased a $350,000 property. $150,000 that is the difference in price is taxable.
Cash Boot- you have to reinvest all cash or you will be taxed on the remainder. Cash boot cannot be offset by Mortgage Boot.
Example You sold a $500,000 property through an exchange with $400,000 of Mortgage debt and received $100,000 cash. You purchased a $550,000 property with 10% down for $55,000. The Difference between the $100,000 in cash and the $55,000 reinvested would be taxable.
**IMPORTANT: If you want to take cash out let your QI know before you complete sale of the first property or you will have to wait until the end of the exchange (another 180 days) to get it.
Mortgage Boot– you have to take on an equal or larger amount of mortgage debt. Mortgage Boot CAN be offset by cash boot.
Example, You sold a $500,000 property through an exchange with $400,000 of mortgage debt and received $100,000 cash. You Purchase a $600,000 property with 50% down, for a $300,000 mortgage. Your mortgage boot is short $100,000 and would be subject to tax, except the cash boot of $100,000 can be used to offset and you will owe nothing.
Depreciation Boot– Since this property was an investment property, Depreciation has been taken. If the property you buy doesn’t have an equal or larger depreciable basis, you will be taxed for depreciation recapture of the difference.
Example, You have owned a $500,000 duplex for 10 years, that was $450,000 structure value and $50,000 land value. You were allowed to depreciate it $16,363 per year. In 10 years you took a total of $163,636 in Deprecation. You are exchanging this property in a $750,000 piece of vacant land. Since the land has $0 structure value, the depreciation boot will be recaptured and taxed at 25%. $163,636 x 25%= $40,909 in depreciation recapture tax.
Example 2, You have owned a $500,000 duplex for 10 years, that was $450,000 structure value and $50,000 land value. You were allowed to depreciate it $16,363 per year. In 10 years you took a total of $163,636 in Deprecation. You are exchanging this property in a $750,000 apartment building with $675,000 structure value. No Tax is due because $675,000 is greater than $450,000
Example 3 You have owned a $500,000 duplex for 10 years, that was $450,000 structure value and $50,000 land value. You were allowed to depreciate it $16,363 per year. In 10 years you took a total of $163,636 in Deprecation. You are exchanging this property in a $750,000 apartment building with $400,000 structure value. Since there is a $50,000 difference between the structure value, you will be taxed on Depreciation recapture on the $50,000.
How do I do a 1031 Exchange?
Make Sure that you are exchanging into a property that has a larger boot unless you are willing pay taxes.
Immediately after you close on your first relinquished property (if you are selling more than 1) the timeline begins on the 1031 exchange. The time periods are very strict and cannot be extended even if the deadline falls on a Saturday, Sunday, or legal holiday.
Identification Period 45 calendar days
You must identify the replacement property within 45 days of the sale of your relinquished property. This period of time is called the identification period. You can close on a property during the identification period which is why I always recommend starting writing offers as soon as you close.
Identification must be in writing, typically a 1031 exchange company has a property identification form that you fill out. It must be signed and delivered to the exchange company before the end of the 45 days. Verbal notice is not enough.
You have to buy a replacement property that was identified on your list to qualify. You may even identify property that is currently under construction.
3-Property Rule- You may identify up to 3 properties, of any value.
There are two rules that allow you to identify more replacement properties than 3 but you don’t want to!
200% Rule: You may identify as potential Replacement Property any number of properties provided the aggregate fair market value of all of the identified properties does not exceed 200% of the selling price of the relinquished Properties.
95% Rule: If you identify more Three properties that exceed 200% of the sale price of the relinquished property than you must buy at least 95% of the aggregate fair market value of all the identified Replacement Properties.
Exchange Period 180 days
One of the three identified replacement properties must close the earlier of 180 days from Relinquished property sale date or the due date (including valid extension) of the tax return for the year in which the relinquished property was transferred.
1031 Exchanges can cost between $1,000-$2,000.
A Warning on 1031 Exchanges
1031 Exchanges encourages investors to buy up because you can only identify 3 replacement properties total and you need to buy a bigger property to avoid being taxed on boot. If you go from exchange to exchange to exchange getting bigger and bigger each time, you risk having the maximum exposure in the real estate market right before it is going to crash. Sometimes it is better to cash out and pay the tax than to get yourself overextended.
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Depreciation is a loss in the value of an asset over time. The Federal tax code allows owners to take a deduction for depreciation on assets used for business purposes (like real estate investment property) each year to offset investment income and/or ordinary income. Depreciation can be taken for buildings, machinery, appliances, furniture, fixtures, cars, computers, anything with a useful lifespan of over 1 year, that does not last indefinitely, and is used for business.
Everything ages over time from wear and tear and frequent use; there is a corresponding drop in asset value the more the asset is used. Eventually, the asset wears out and reaches the end of its useful life and needs to be replaced. Depreciation is a theoretical tax method the Government uses to account for an asset’s loss in value. It is important to note that Depreciation is a theoretical tax method and not an actual appraisal of value. For tax purposes, the value of real estate at the end of its depreciable life of 27.5 years (Residential) or 39 years (Commercial), is zero or no value, while in reality, houses, duplexes, and apartment buildings last longer than that and still have actual value.
It is important to note, Depreciation is a deferral of tax, not forgiveness. Some Investors who are selling their first investment property are surprised by a larger than expected tax liability for a sale. Everyone always remembers Capital Gains Tax, but the first time investment seller often forgets to consider Depreciation Recapture Tax (see below) also.
One other general note I’d like to make about Depreciation is that whether youuse it or not on your annual income tax filings when you sell, the government assumes you took depreciation- so you still have to pay depreciation recapture tax! So if you own an investment property, make sure you are taking your depreciation each year. If you don’t use it you lose it.
Investors love depreciation because it is one of the X benefits of owning real estate and provides hefty tax deduction which increases the investment property’s after-tax cash flow or provides a tax shelter for the owner’s personal income.
I recommend talking with an accountant about Depreciation. Need a Los Angeles real estate accountant referral? Let me know and I am happy to provide one.
Land is indestructible and never gets used up so it is exempt from Depreciation. The only thing that is depreciable is the structure value.
This presents a challenge for property owners and tax professionals who want to determine the ratio of Land Value vs Structure Value for a property that’s purchase price included both costs.
Calculating Land Value vs Structure Value Ratio
Talking with several accountants there is no hard and fast rule of thumb for determining the ratio of land to structure value. The answer is – it depends. There are a bunch of different kinds of properties out there (oil pipelines, nuclear power plants, warehouses, retail stores, single-family houses, hotels etc) so you have to look at each property on a case by case basis.
To start- I like to look at the total amount of SQFT for structure and land, the more sqft of land the higher percent I’d expect for land value and the more sqft for structure the higher percentage I’d expect for Structure.
In some cases, it can be very easy to calculate the ratio. Vacant land is 100% land value. Mobile Homes are 100% structure. Condos are usually about 90% structure value (10% is common area interests in the land of the common areas). Suppose you are building new construction from the ground up- You can just depreciate your build cost.
However, for cases of buying an existing property, where the price includes the structure and the land it can get more complicated.
The More Structure the better for Depreciation
Investors have a vested interest in having the structure value be as large as possible to maximize the amount of Depreciation they can take. What ratio you choose to apply will depend on how aggressive or conservative you are financially or the advice you receive from your accountant.
For the majority of properties I see in LA I would expect at a minimum of 50% structure value ratio. The structure value can go as high as 80% in some cases, for single-family homes and apartments, but if there is a normal size (5,000 sqft) lot or larger I do not see any arguments for more than this. 50/50 structure to land and 60/40 structure to land are pretty conservative ratios. 70/30 structure to land and 80/20 structure to land are starting to push it.
If you are not certain of the values, you are allowed to use the tax assessors ratios to determine your depreciation. You can look up your tax assessor value here assessed value on the tax rolls.
To be honest, I have found the Los Angeles assessor records way off for land value vs structure value. They routine show less than 50/50 for structure value to land value. You don’t need to be that conservative. One of the issues I find is that the redevelopment potential is so much larger than the as built structure that you can get some pretty funky valuations. It is no secret that todays buyers want bigger houses. Before the 1960s which is when most of Los Angeles was built out, most of the homes built were single story 1500 sqft 3br / 2 ba homes built on 6,500 sqft lots. With the current building code you can build up to 4,000 sqft on that same lot. The Value of that 3br 1500 home on the westside currently is $1,500,000 to $1,600,000. The development potential of the lot could make a new construction house worth $4,500,000. As a result in the eyes of a builder that $1.6M is 100% land value, and they are willing to spend another $1M – $1.5M to build the bigger home. For a buyer who just wants to buy the home and live in it, the structure has value to them, and they aren’t coming with all the additional money to improve the lot. I find the assessor has a land bias to development potential on their assessor rolls which isn’t fair to regular folks.
1265 S Tremaine Ave
1265 S Tremaine Ave is a duplex that was listed for sale for $990,000. How much of the value is land vs structure according the assessor?
The Assessor shows that the current tax roll values are $249,622 for Land and $137,289 for improvements. $249,622 Land + $137,289 Improvements = $386,911 Total Assessed Value. Take the Improvement divided by Total value to get the ratio. $137,622 Structure/$386,911 assessed value = 35.5% building to land ratio. Take the new purchase price $990,000 * .355 = $352,137 value of Structure for depreciation. Again, I would use at least 50%- not a big fan of using the assessor rolls to calculate depreciation.
Depreciation Method – MACRS – GDS
Modified Accelerated Cost Recovery System (MACRS) is the standard method used for depreciation of investment real estate put into service after 1986. There are two different systems for MACRS, the General Depreciation System (GDS) and Alternative Depreciation System (ADS). You will be using GDS for investment property you own in the US. The Depreciation recovery periods are longer for ADS which is why you don’t want to use it. The recovery period for residential real estate under ADS is 40 years! As opposed to 27.5 years with GDS.
Real Estate Depreciation is calculated with the straight line method
All Real Estate depreciation must be calculated by the Straight Line Method (it is very easy). Personal Property has 150% and 200% declining Balance options for depreciation methods.
Straight-line Depreciation Equation
Made up Graph of straight-line depreciation, you deduct the same amount each year until there is zero basis.
I like this online depreciation calculator: click here.
GDS assigns Recovery periods for different assets:
MACRS GDS property classes
Personal Property (all property except real-estate)
Special handling devices for food and beverage manufacture
Special tools for the manufacture of finished plastic products, fabricated metal products, and motor vehicles
Automobiles, taxis, buses, trucks.
Appliances, carpets, furniture (residential real estate use)
Petroleum drilling equipment
Certain geothermal, solar, and wind energy properties.
Office furniture, fixtures, and equipment (such as desks, files, and safes)
Manufacturing Machinery and equipment (agriculture, mining, weaving, tobacco etc)
Boats, Barges, Tugs, and water transportation Equipment
Trees and vines that bear fruit
Improvements to Land (landscaping, fences, roads, sidewalks, bridges)
Wharves and Docks
Municipal sewage treatment plants
Oil and Gas Pipelines
Nuclear Power plant
Utility Service (Electric, Water, Gas)
Real Property (real estate)
Residential rental property (does not include hotels and motels)
Non-residential real property
This article is focused on real estate, so I won’t be going into how depreciating personal property works but its different. The most common personal property you run into is the Automobile that can be depreciated over 5 years. The MACRS system does not use Salvage value, although older depreciation systems used by the IRS did- if you are wondering the salvage value for real estate is zero.
Residential Real Estate has a shorter Depreciation timeline than Commercial Property.
Example Residential: You purchased a $500,000 Duplex in 2009, that had land value of $200,000 and a structure value of $300,000- how much depreciation can you deduct?
$300,000 structure value/ 27.5 years = $10,909 depreciation per year.
Example Commercial: You purchased a $500,000 5 Unit apartment building in 2009, that has a land value of $200,000 and a structure value of $300,000- how much depreciation can you deduct?
$300,000 structure value/ 39 years = $7,692 per year
What is the definition of Residential Property?
According to Internal Revenue Code §168(e)(2)(A)(i), “residential rental property” means any building or structure that 80 percent or more of the gross rental income is from residential dwelling units. A 10-unit apartment building is residential for depreciation purposes even though it is considered commercial for lending purposes.
How Do Improvements to Property Work for Deprecation?
Let’s suppose that in the example above with the duplex after five years of owning it- in 2014, you decided to build a 3rd unit on the property over the garage. The unit cost you $150,000 to build. Can you Depreciate it? Of course! Additions and New Construction is treated as Real Property and has either a 27.5 year schedule for residential and 39 year schedule for commercial. In 2014 when you build the extra unit the $150,000 of construction cost gets added to your basis. Here is a table of the deduction schedule:
If you claim depreciation on real estate, that property is considered 1250 property for federal tax purposes. When you sell 1250 property- if the property has a gain over its adjusted basis, the proceeds go in two separate buckets, you must pay Depreciation Recapture tax for the first bucket- and any gain beyond depreciation recapture is a capital gain and subject to capital gains tax and goes in the capital gains tax bucket, unless you defer both taxes with a 1031 Exchange.
The government allows you to reduce the asset value to zero with depreciation, but if you sell the property for more than its basis, this tells the government that it in fact, the building is not worthless, and they want to collect the “back taxes” on the ordinary income you offset over the years Depreciating with Depreciation Recapture.
The Tax rate for Depreciation recapture is 25%, which is slightly higher than the maximum capital gains tax currently of 20%, but probably still a lot lower than what you would have paid in ordinary income tax.
Let’s say an investor bought a rental property a few years ago for $100,000 and took $20,000 in depreciation.
Example 1. LossAssume the property sells for $70,000. The Adjusted basis in the property is $80,000 so this sale results in a loss and no tax is due. Depreciation Capture doesn’t carry over to a new property or follow the taxpayer. The depreciation capture tax liability is lifted once you sell the property.
Example 2. Just Enough Gain for Depreciation to be recaptured
Assume the property sells for $100,000. This is the same price as you bought it for several years ago, except now, the government views this sale as a gain of $20,000! You have to pay Depreciation recapture tax on the gain which is 25% or $5,000
Example 3. Gain large enough for depreciation capture + Capital gain
Assume the property sells for $150,000. Now you have $70,000 gain over your adjusted basis. $20,000 of the gain will be taxed at Depreciation Recapture rate of 25% ($5,000), and the remaining $50,000 gain will be taxed at Long Term Capital Gains tax rate, for this example, let’s say 20% ($10,000).
California State Depreciation Taxes
California doesn’t have any special tax rates for Capital Gains tax or Depreciation Recapture. On your California tax return, Depreciation Recapture and Capital gains are taxed like any other income at your state rate.
For very Large Commercial Properties, a Cost Segregation (“cost seg”) analysis may grant higher annual deductions.
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Can I depreciation my primary residence?
No, Depreciation is only for investment real estate.
I own a 2-4 unit residential income property and I live in one of the units, can I depreciate it still?
Yes, you are allowed to depreciate the percentage of the building being used for investment purposes. For example, with a side by side duplex, that are equally sized units, 50% of the structure would be depreciable. In 3 unit with equal size units 66%, and for 4 unit 75%.
I own a 5U Commercial Income Property- do I Depreciate on 27.5 years schedule for residential or 39 years for commercial?
According to the IRS rule if 80% or more of a building’s rental income comes from renting residential units than for Depreciation purposes it is considered residential and would be depreciated on 27.5 schedule.
Primary Residence can’t take losses for tax purposes, however investment property can. Losses are deductible from gross income. Homeowners have a capital gains exemption that can exclude up to $500,000 of capital gains. Investment Property owners have 1031 Exchanges that can defer capital gains until sometime in the future.
Short Term vs. Long Term Capital Gains
Held less than 1 year
Held longer than 1 year
Short Term Capital Gains are taxed at your Federal Ordinary income tax rate.
Long Term Capital Gains Tax is lower than ordinary income tax. The government from time to time has changed the Long-Term Capital Gains tax rate. In 2013, the capital gains tax rate maximum is 20% which is half the ordinary income tax maximum.
Federal Capital Gains Tax 2013
Long-Term Capital Gains Tax Rate
Single Federal Tax Bracket 2014
Married Filing Jointly Federal Tax Bracket
Starting January 1, 2014, the Medicare tax went into effect. It affects higher-income earners. If you make $200,000 as a single person or $250,000 as a couple then the 3.8% Medicare Tax will be added whether the Capital gain is long-term or short term.
Basis is a tax term that is used to calculate capital gains tax, capital gains exemption, depreciation, and boot in 1031 exchanges of real estate. When dealing with tax matters, talk with an accountant. Don’t have a Los Angeles accountant? I’m happy to provide referrals.
You want the property’s basis higher rather than lower, because you will have more depreciation to take, and lower capital gain. Refer to IRS publication 551 for more information on Basis.
Most of the time, the basis of your property is how much it cost you to buy it or build it.
EX: Tom, purchased a 8 plex in 1979 for $225,000. Tom’s basis is $225,000.
If you inherited property or receive it as a gift, depending on how title was held– you can receive a stepped up basis to fair market value as the new owner, or take the adjusted basis of the previous owner.
EX: Tom passed away in 1999 and left his 8 plex to his Daughter Sandy. In 1999, the 8 plex has a fair market value of $475,000 – this is now Sandy’s new stepped up basis.
Adjusted Basis: Over the years, the basis of a property can change. The two most common reasons for adjusting the basis are for Capital Improvements and Depreciation for investment property. Routine maintenance, such as replacing worn out carpet, or painting does not count as capital improvements or affect the basis.
Capital Improvements add to the original basis, and depreciation reduces from the original basis.
EX: Sandy spent $150,000 to build a 4 car garage for the 8 plex in 2004. That $150,000 can be added to her original basis of $475,000 to give Sandy a new basis of $625,000
EX: Sandy has taken a straight line depreciation for the property, land value is worth $200,000 and 8plex is worth $275,000. Sandy is allowed to depreciate the 8 plex $10,000 each year. In 2004, she has depreciated 5 years, totaling $50,000. Sandy’s new basis is $575,000.
Large, and sometimes surprising, Supplemental Tax assessments or supplemental tax bills are common with Remodels, New Construction, or longtime owner sales (lived there 20+ years). These types of sales typically have a large change in the tax value of the property after the sale which means a big jump in property taxes from the previous owner to the new owner. New Homeowners are sometimes tricked into thinking their property tax is very low, because they get the property tax bill for the previous owner in the mail and it’s less than what they owe. In most transactions the tax value of the property changes, and a supplemental tax bill will raise the property taxes to your new level.
Supplemental tax bills are regularly sent to first yearhome owners to readjust property tax to its new level, but sometimes they can also be refunds (if the tax value for the property was lowered — See Prop 60 & 90).
You don’t have to complete a sale to trigger a supplemental tax assessment. If you decided to add on square footage to your home, making it larger, this could trigger a reassessment by the tax collector, and will raise your property taxes.
In California, whenever a property is bought or sold- this triggers a reassessment of the property’s tax value or assessed value. The new annual property tax is calculated approximately by multiplying the sales price of the property by 1.25%.
Property taxes in Los Angeles are paid biannually. The property tax bills are mailed out each year in October, to be paid in two installments- once in November and once in February. Depending on when your sale closes in the year, there will be a proration of the property taxes between the seller and the new owner. For the state, the fiscal year runs from July 1 through June 30. A sale or new construction completion which occurs between January 1 and May 31 results in two supplemental assessments and two supplemental tax bills. A sale between July 1 and Dec 31 will have only one supplemental bill.
Sample Supplemental Tax Bill Calculation
Let’s assume a seller bought a fixer property for $500,000 January 1st and spent money to totally remodel it and sell it and the property sold for $800,000 April 1st to the new buyer.
Seller Assessed Value: $500,000
Sale Price: $800,000
Seller Current Property Tax: $6,250
New Property tax upon sale: $10,000
Proration of property tax: 2 months (May and June)
Buyer has purchased before July 1 so there will two supplemental tax bills. Take remaining months until July which would be 2. Take the difference between the two taxes ($10,000 – $6,250 = $3,750) and prorate it for two months ($3,750/12 months * 2 months = $625). $625 is supplemental tax bill #1. Supplemental tax bill #2 is $3,750 for the next year, and from then on your property taxes are $10,000 a year.
Too complicated? The assessor’s office has a supplement tax calculator to do it for you:
Supplemental tax Bills are mailed out about 6 months after you purchase your new home. Sometimes they can take as long as 9 months to show up in the mail.
It is important to note with mortgages that have an impound for paying your property tax for you, they do not pay your supplemental tax bill. This is because state law says that the supplemental tax bill must be sent to the owner, so the lender doesn’t know about it. If you assume your lender is handling it, and you don’t pay the Supplemental bill by the due date, you will incur a 10% fee as a penalty! This penalty will not be excused by the state, so make sure you pay on time or talk with your lender to alert them and make them aware of it.
There is a lot of great information on the city’s website about property taxes. You may need to look up your Assessor Parcel Number (APN) before visiting them, to have specific questions answered about your property, so it’s a good idea to look it up before you call.
How much are my California Property Taxes?
The state of California property Tax rate is ~1.25% of your property’s assessed value. We have one of the lowest property tax rates in the country (the tax savings stop there though- almost every other tax in California seems to be one of the highest!). Low property tax is a real benefit to property owners, it makes owning property more affordable and also raises property value.
How much do my California Property Taxes change each year?
The current California Property tax laws went into effect in 1978 with the passage of Proposition 13. In addition to a very low tax rate of 1.25%- proposition 13 placed a cap on the amount your taxes can be raised each year to a maximum of 2%. The Real Estate Market goes up and down. In years where the market is declining, it is possible to lower your annual property tax bill by using Proposition 8– the decline in value reassessment.
Historically, long term home appreciation in California has far out paced the 2% property tax cap (2% is less than annual average inflation in Los Angeles which averages 3%), and so for homeowners that have owned their property for a long time- 10 years, 20 years, 30 years, they experience big tax savings. Their property taxes are less than the current market value of their home. Over the years, this 2% cap adds up to huge tax savings!
When are my Property Taxes Due?
Nobody likes getting the property tax bill in the mail. For one thing, they are a big bill! Since Property taxes are not charged monthly, it is a good idea to plan ahead because you will be charged for 6 months of property tax at one time.
The City of Los Angeles starts its fiscal year for Property Tax July 1st.
Fiscal Year versus Calendar Year H3
Calendar Years always start January 1st and End Dec 31st. Fiscal Years on the other hand can start on any date. Fiscal Years are used for accounting purposes and the starting and ending date can vary by the industry of the business. The length of a Fiscal Year is always one year, so the end date will always be one year after the start date. That means that any Fisal Year start date other than January 1st will span a fraction of 2 different years.
The City of Los Angeles fiscal year for property taxes starts July 1st. The Federal Government’s fiscal year begins October 1st (Why Oct 1st? Because it allows newly elected officials to vote on the budget their first year).
Property taxes are paid in two equal installments each year. It’s ‘that time again’ in November, and February.
1st Property Tax installment
Bill sent November 1st, delinquent and subject to late penality if not post marked Dec 10th
2nd Property Tax installment
Bill sent February 1st, delinquent and subject to late penalty if not post marked April 10th.
How much is the late fee if I am late on my property tax?
You have 40 days to pay your property tax bill before it becomes delinquent. The Late fee is quite large- it’s a 10% late fee– ouch! If your biannual property tax bill is $5,000- the fee would be an additional $500.
What is a Supplemental Tax Bill?
For new owners, the first year that they own a property, they will more likely than not get a supplemental tax bill in addition to their normal biannual property tax bills. First year Homeowners sometimes wonder if this supplemental bill is a mistake, or if their property taxes have gone up. The answer is no, it is not a mistake, and no, their property taxes have not been raised. The Supplemental tax bill is just one extra payment in the first year to raise your property tax to it’s new level if it is higher than the previous owner’s tax, which it almost always is.
The Capital Gains Exemption, also commonly known as the home owner’s exemption, was created by Congress passing the Taxpayer Relief Act of 1997. The Bill added Internal Revenue Code 121 Principal Residence Sale Tax Exemption. IRS publication 523 is a great reference if you need more information on Homeowners Capital Gains Exemption. This exemption is one of the big tax breaks you get from owning real estate.
To Qualify for a Homeowners Capital Gains Exemption:
1. The home must be your primary residence.
2. You must have occupied the home as your primary residence for at least two years within the past five years. The two years need not be continuous.
For a single person, the Capital Gains Exemption is up to $250,000. For a married couple, only one spouse need hold the title, but to qualify for the $500,000 exemption both spouses must meet the two-year occupancy test and file a joint tax return.
Long-TermCapital Gains Tax rate is 15%-20% for the Federal taxes, plus 7.35% to 13.3% for California state taxes. In California, there is no special tax rate for capital gains, it is treated like ordinary income. If you held your investment for less than a year, then the gain is considered Short-Term. Capital Gain tax for Short Term Capital gains is 22%-37% and taxed at your federal income tax rate plus again the California state taxes of 7.35% to 13.3%.
If you owned and occupied your primary residence immediately for two years you qualify for the exemption. In theory, you could rent your home to tenants for up to three years afterward before losing your principal residence sale exemption eligibility. When you sell, you can do whatever you want with the proceeds.
Many homeowners think they have to own their homes at least five years before qualifying for this great tax break- that’s incorrect. You can qualify for the exemption in just two years if you move into your home immediately. You can utilize the capital gains exemption once every two years and there is no limit for how many times it can be used in one’s lifetime, but keep in mind, that it only works for your primary residence, and does not work for Investment Property. A 1031 Exchange is probably your best option to avoid capital gains tax for your investment properties.
Q: We are a married couple that qualify for home owner’s exemption and our Capital Gain on the sale of our house was $700,000- since it is larger than $500,000 what happens?
A: The first $500,000 is tax-free. You would be taxed on the remaining $200,000.
Q: I own two homes, one in New York and one in Los Angeles. From 2009 to present I have been living 7 months a year in Los Angeles, and the rest of the year in New York. I am leaving the US and want to sell both homes. Can I use the capital gains exemption on both homes? Does the capital gains exemption apply for second homes or vacation property?
A: No, the capital gains exemption only applies to your primary residence. The IRS considers whichever property you spend more time at as your primary residence, however, you can declare either property your primary residence for tax purposes- so long as you don’t claim them both. One idea would be to sell your primary residence with the capital gains exemption, wait two years and then sell the other as your new primary residence.
Q: Emily bought her house three years ago. Emily marries James in June 2012. She then sells her home in June 2013 for a gain of $300,000. Do Emily and James qualify for $500,000 capital gains exemption?
A: No, Emily and James are married, however only one of the couple has lived in the property for 2 years, James has only lived there one year. Emily can exclude up to $250,000 of gain and James can exclude nothing. It might be best for them to wait 1 year and then sell depending on the size of their gain.
Q: Are they any exceptions to meeting the 2-year requirement?
A: Yes, if you were sent overseas to serve the military or work for the government, disabled, or meet certain requirements. Take a look at IRS publication 523
Q: I own a home as a Tenant in Common with a friend. Do we each get to claim a homeowners capital gains tax exemption of $250,000 if we meet all the requirements?
Q: Amy bought her house five years ago. She moved in for a year, then rented it for 3 years, and moved back in last year. While she was renting the house she deducted $10,000 a year in depreciation. Now she is selling the house and has a gain of $200,000. Does Depreciation recapture affect her capital gains exemption?
A: Yes. Since Amy rented her house and took depreciation this is going to change the total amount that she can exempt from her capital gains exemption. You take the total number of years the property was rented (3 years) and divide it by the total number of years the property was owned (5 years) to get a ratio of how long the home was owned versus rented (60%). You subtract from the capital gain the deductions for depreciation ($200,000-$30,000= $170,000) and multiply that by the ratio ($170,000 *0.6= 102,000). Finally, you subtract from $170,000 the $102,000 to get your total capital gain exemption which in this example would be $68,000.
Probate is the court-supervised process created by California law to handle the distribution of a Decedent’s (the person who has died) estate. Probate is required whether the decedent died with or without a will. Probate can be bypassed with estate planning and using trusts. The word “probate”in latin means “proving”.
In short, probate is the process the state uses to determine who is the rightful person to receive the deceased person’s property when they died without leaving specific instructions, or to supervise that the property is distributed according to their will.
It is estimated about 70% of Americans die without either a will or an estate plan. That is high number! I can see why, people don’t like to talk or think about death. Unfortunately, if you leave it up to probate court, the disposition of your estate may take a year or more, you will incur fees for the cost of probate, and your estate may not be distributed the way you intended. For those reasons I recommend meeting with an estate planner and creating a trust.
How does probate process start?
Probate begins with the filing of a petition for probate at the Superior Court in the county where the decedent lived. One of the first things you should do as a family member when a relative passes away is consult with a probate attorney. They will help you prepare the petition. The petition should be filed by the person who wants to take responsibility for the estate by becoming executor or administrator.
An ‘executor’ is the person named in the will to represent the estate.
An ‘administrator’ is a person appointed by the court when there is no will, when the will does not name an executor, or when the named executor is unable or unwilling to serve. state law provides that the decedent’s closest relatives have the highest priority to become administrator of the estate.
Being executor can be a very difficult job. Administration of the estate includes managing the assets to prevent losses, paying bills for the estate, filing tax returns, preparing an inventory of the assets, locating heirs, posting public notice of important events, settle the estates debts, keep financial records, and dozens of other duties. The goal is to wrap up all of the loose ends of the decedent’s financial affairs and distribute the estate to the beneficiaries. Administration can be very technical and time consuming. As a fiduciary, if you screw up- you might find yourself financially liable!
Fortunately, as executor you do receive something for taking on this large task – a small fee from the estate as compensation for the hard work. Compensation is fixed by law and is based on the value of the estate.
Table 1 Executor Compensation Schedule
As executor, you will work very closely with the probate attorney. The probate attorney compensation is fixed by law and is the same rate as the executor from the table above.
To figure out the approximate cost for a probate – multiply the statutory fee of estate value in the table above by two (one fee for the executor and one fee for the probate attorney), add $5,000 for court filing fees and an additional 1/10 of a percent (0.1%) of the value of the estate for the probate referee. Probate is expensive! For a $1M estate probate will cost you $50,000 about 5% of the estates gross value (if that estate is an $800,000 property and $200,000 in bank accounts, and there is a mortgage on the property of $400,000 the estates net value is $600,000 but you will be charged on $1,000,000 making an effective cost for probate of ~10%). Probate costs usually ranges from 4%-10% the value of the estate.
The other thing to note about Probate is that it takes quite a long time to finish, 8-18 months.
The Probate Timeline
File Petition for Probate
Will VerifiedExecutor or Administrator AppointedProbate Case Opened
2-4 months(if not contested)
Give Notice to Creditors
Prepare Estate Inventory & Complete Real Estate Appraisal
Pay Debts & file tax return (due 9 months after death) Sell Property if necessary to raise funds
File Petition for Final Distribution and Accounting
Distribution of Assets to Heirs
Final Discharge Order (indicates close of probate case)
Final Distribution of Funds
When there is no will, probate determines the order of inheritance by intestate succession. The estate is divided into as many equal shares as there are living members in the ‘issue’. The issue order is:
Descendents Siblings (Uncles and Aunts)
Decedent’s Nephews and Neises
Escheat – estate reverts to the state if there no heirs can be found at all
Proposition 60 & 90 allows property owners to transfer their current property tax basis to a new primary residence (of equal or lesser value) when they move. This means that if you decide to move after retirement, that your annual property taxes won’t skyrocket.
Mr and Mrs Smith have lived in their home for 25 years and are over the age of 55. The current market value of their home is $2,000,000. Mr and Mrs Smith assessed value is $450,000 and they pay $5,600 a year in annual property tax. The house has many stairs, and is very large at 3,500sqft with costly annual maintenance. The Smiths want to downsize and move to a more convenient location.
The Smith’s sell their home for $2,000,000 and purchase a new full service condominium unit for $1,500,000. Instead of their taxes jumping from $5,600 a year to $18,750(!) they may transfer their assessed value using Proposition 60 and continue paying $5,600 a year.
REQUIREMENTS to be eligible for Proposition 60 & 90
-Only for Primary Residence
-Replacement property must be of equal or lesser value
-Replacement property must be purchased within two years (before or after) of the sale of the original property.
Proposition 60 & 90 have the same rules, the only difference between the two is that proposition 60 is for transfers within the same county and Proposition 90 is for transfers to another county in California. Since counties policies change, I recommend contacting the county to which you are planning to move to verify that it is eligible for Proposition 90 first before you move.
Visit the Los Angeles Assessor Office for the most up to date forms:
The California withholding tax is very similar to federal government’s FIRPTA withholding. The idea is that if you aren’t a California resident, and consequently file your income taxes somewhere else- California wants to make sure that you pay taxes on any potential gain on sale of your California property.
The franchise tax board form that is used to file California withholding tax is 593 California Withholding Tax form. The tax can be calculated two ways: 3 1/3% of the TOTAL sales price or 9.8% of the gain of sale. If you sold your property for $1,000,000 the CA withholding would be $33,000- no small number! The good news is that most sales are exempt from withholding, and if they are not, some careful forethought before the sale and meeting with an accountant can get around the withholding.
It is also important to note that the 3 1/3% withholding may turn out to be way more than your actual tax. This is common; the state of California mails you a rebate check for the difference. Attach form 593-B with your California Income tax return. I have no idea how long it takes for the state to send this rebate, I don’t think it would be quicker than six months. As you can imagine, you would rather avoid this withholding if possible.
Form 593-C, lists exemptions to California withholding tax. Exemptions are called certifications, don’t ask me why. Part II Certification 1 is the certification everyone knows- “If you have lived in the property as your primary residence for two or more years in a five year period you are exempt.” The certification that people miss is Part II certification 2, “the seller last used the property as their primary residence without regard to two-year time period.” This means that if you were living in the property before you sold it, you are exempt from withholding.
Part II section 2
I want to give a warning of caution. Escrow companies in their escrow instructions usually assign themselves the right to handle California Withholding Tax if it applies. Escrow people are not accountants, and don’t know any more than you or me about the tax code. I am sorry to say, but escrow companies withhold seller’s proceeds because of the California Withholding tax in ERROR every day, so be on guard.
If you qualify as exempt from California withholding tax, all that needs to be done is fill out form 593-C and escrow will keep the form on file with the rest of the transaction paperwork, and they can release the funds. Keep in mind that this doesn’t exempt you from paying taxes if there was a taxable gain- it just means that you won’t have a large portion of capital tied up due to withholding.
Here is an example of how the Withholding is calculated: