Tax Benefits

of Ownership
Realty Publications, Inc.
Inc
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Tax Benefits
of Ownership
Fourth Edition
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 Table of Contents i

Table of Forms ................................................................................................................iv Table of

Contents
Glossary .............................................................................................................................301

Chapter 1 The mortgage interest deduction (MID), a subsidy

Two residences, alternative deductions. . . . . . . . . . . . . . . . . . . . . . 1 Principal
Chapter 2 Deduction of mortgage points by homebuyers Residence
Prepaid interest exception allows write-off . . . . . . . . . . . . . . . . . .9
Deductions
Chapter 3 The principal residence profit exclusion
Tax-free sale up to $250,000 per homeowner . . . . . . . . . . . . . . . . 19
and Exclusions
Chapter 4 Home office expenses as deductions from fees
Qualifying for the home office deduction . . . . . . . . . . . . . . . . . . 31

Chapter 5 The sales price

Different views, different analysis, different results. . . . . . . 41
Income
Chapter 6 Income categories set the AGI Categories
The many types of income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
for Business
Chapter 7 Avoiding dealer property status
Classification of property based on the owners use . . . . . . . . 55
and Investments
Chapter 8 Mortgage interest write-offs on business and investment
properties
Mortgage funds used to purchase, improve, or
carry costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Chapter 9 Depreciation deductions mature as an unrecaptured gain tax

Cost of improvements recovered: a return of invested
capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Chapter 10 Commingling rental losses with other income

— via work-arounds
The part-time landlord and full-time real estate agent. . . . . 81
The Taxation
of Profit
Chapter 11 $25,000 ceiling on rental loss deduction
Subsidizing annual operating losses. . . . . . . . . . . . . . . . . . . . . . . . 91

Chapter 12 Taxable income taxed in descending order of rates

The batching and taxing of gains. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Chapter 13 The tax rates in application

Tax rates put to your seller’s best use . . . . . . . . . . . . . . . . . . . . . . 107
ii Tax Benefits of Ownership, Fourth Edition

Chapter 14 Inflation, appreciation, and taxes

Uncle Sam creates his share — mostly. . . . . . . . . . . . . . . . . . . . . 115

Chapter 15 Short payoff on negative equity property

The short-sale discount: income, profit, or loss?. . . . . . . . . . . 123

Chapter 16 Option money tax consequences

When exercised, expired or assigned. . . . . . . . . . . . . . . . . . . . . . 131

Chapter 17 Seller financing shifts profit taxes to other years

Seller Untaxed profits increase after-sale earnings. . . . . . . . . . . . . 137

Financing Chapter 18 Profit on modification of a trust deed note

No taxation on modification of a carryback note . . . . . . . . . 149
Defers Taxes
and Creates Chapter 19 Lease-option sale triggers profit reporting — it’s a carryback
Ownership deductions for the buyer. . . . . . . . . . . . . . . . . . . . . . 157
Income
Chapter 20 The foreclosing mortgage holder’s profits and losses
Planning the tax-free, note-for-property exchange . . . . . . . 165

Chapter 21 The §1031 reinvestment plan — educating real estate

investors
Introduction Determining what an investment property
to §1030 owner wants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

Chapter 22 Tax aspects advice as a potent aid

Analyzing a transaction’s tax aspects. . . . . . . . . . . . . . . . . . . . . 177

Chapter 23 A formal exchange of properties

Structuring a comprehensible transaction . . . . . . . . . . . . . . . 187

Chapter 24 §1031 like-kind property by intended use

§1030 Qualified to sell or buy as §1031 like-kind property. . . . . . . 195

Fundamentals Chapter 25 The delayed purchase of replacement property

Replacement property purchased as a §1031
reinvestment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

Chapter 26 Tax deferred installment sale coupled with a §1031

exemption
Profit tax deferred and tax-exempt profit as the plan. . . . . 211

Chapter 27 Vacation home sales — talk taxes

Held for investment and personal use. . . . . . . . . . . . . . . . . . . . 219
 Table of Contents iii

Chapter 28 A delay in the §1031 reinvestment

Identification and acquisition periods run from closing...225 §1030
Chapter 29 The §1031 trustee in a delayed reinvestment Reinvestment
Control over the disbursement of funds . . . . . . . . . . . . . . . . . . . . 239 Scenarios
Chapter 30 The §1031 Profit and Basis Recap Sheet
Offsets on reinvestment eliminate profit taxes on sale . . . 249

Chapter 31 The cost basis for the replacement property

The annual depreciation deduction offsets income. . . . . . . . 269

Chapter 32 Change of ownership and assessment of replacement home

Property taxes geared to base year value assessment . . . . . 281

Chapter 33 Parent-to-child transfers of family home and farm cap

property taxes
Base year value reset on change of ownership
under Prop 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291

Defines key terms and supplies page references for further study. . . . . . . . . 301 Glossary
iv Tax Benefits of Ownership, Fourth Edition

Table of For full-size, fillable copies of forms cited in this book plus our entire

Forms
library of 400+ legal forms, go to www.realtypublications.com/
forms.

No. Form Name Page

Full 172-2 Supplemental Escrow Instructions��������������������������������������������������������242
Forms 172-3 Instructions to Trustee to Fund Acquisition��������������������������������������246
172-4 Declaration of Trust for §1031 Proceeds������������������������������������������������244
173-2 Supplemental Escrow Instructions — Part Cash, Part Paper������207
174 §1031 Property Identification Statement��������������������������������������������228
223 Supplemental Truth-in-Lending Section 32 Disclosure���������������������6
274 Short Sale Addendum: Loan Discount Approval����������������������������125
306 Property Expense Report ������������������������������������������������������������������������������ 44
351 Individual Tax Analysis (INTAX)������������������������������������������������������������100
353 Comparative Analysis Projection (CAP) ������������������������������������������������ 93
354 §1031 Profit and Basis Recap Sheet��������������������������������������������������������253
355 §1031 Basis Allocation Worksheet ����������������������������������������������������������274
406 Deed in Lieu of Foreclosure������������������������������������������������������������������������127
425 Modification of the Promissory Note����������������������������������������������������152
431 Assumption Agreement: Unsecured and Subrogated ������������������260
596 Assignment of Lease: by Tenant/Lessee�������������������������������������������������� 79

310 Good Faith Estimate of Seller’s Net Sales Proceeds

Partial — On Sale of Property ����������������������������������������������������������������������������������109
Forms 506 Independent Contractor Employment Agreement
— For Sales Agents and Broker Associates�������������������������������������������� 34
 Chapter 1: The mortgage interest deduction (MID), a subsidy 1

Chapter

1
The mortgage interest
deduction (MID), a subsidy

After reading this chapter, you will be able to: Learning

• advise homebuyers on the mortgage interest deduction (MID),
the subsidy available to them when they use purchase-assist and
Objectives
equity financing to buy a first or second home;
• explain the distinction between itemized personal deductions
and the standard personal deduction; and
• identify requirements for a homebuyer to qualify for use of the
MID.

itemized deduction qualified interest Key Terms

mortgage interest
deduction (MID)

A long-standing policy of the federal government is to encourage residential

tenants to favor mortgaged homeownership, not renting, for their monthly Two
expenditures on shelter. To shape this bias, the government uses the tax code
to deliver an annual subsidy to buyers who finance the purchase of their
residences,
principal residence or a vacation home. The social policy is propagandized alternative
through the news media using the slogan “The American Dream.”
deductions
The homebuyer receives this mortgage subsidy in the form of an annual
mortgage interest
reduction in their income taxes allowed by the mortgage interest deduction (MID)
deduction (MID) rules. Tenants have no equivalent personal subsidy for An itemized personal
the cost of their shelter. deduction permitted
for interest accrued
and paid on mortgages
The MID creates an incentive to permanently own a residence, bound secured by a
to it by title and a 30-year mortgage debt. One downside is the mortgaged homeowner’s principal
homeowner and family have reduced job mobility and impaired financial and second residence.

flexibility.
2 Tax Benefits of Ownership, Fourth Edition

itemized deduction Homeowners process the MID as an itemized personal deduction

Deductions taken subtracted from their adjusted gross income (AGI). The result is a reduced
by a homeowner for amount of taxable income, and in turn reduced tax liability.
allowable personal
expenditures such
as mortgage interest When a mortgaged homeowner prepares their tax return, they have two
(MID) and state alternatives for reporting personal deductions:
income and local
property taxes (SALT) • itemize and total all their deductible expenditures — charitable gifts,
as itemized on
Schedule A which medical expenditures, state income taxes, property taxes and home
reduce their taxable mortgage interest; or
income and tax
liability. Contrast with • take the standard deduction (a fixed amount set at $12,000 for
the standard personal individuals, $18,000 for heads of household and $24,000 for married
deduction.
individuals filing jointly).1
When the amount of permissible itemized expenditures exceeds the amount
of the standard deduction, it is beneficial for the homeowner to itemize their
deductions.

The real estate-related itemized deductions a homeowner takes — reported

on Schedule A — fall into two categories:
• the MID, a deduction of interest accrued and paid, limited to interest
on up to $750,000 of combined mortgage principal;2 and
• homeowner property taxes combined with state income tax, together
limited to a total of $10,000.3
As a subsidy, the MID incentivizes individuals to own and finance the
purchase or improvement of their principal residence and second home
rather than renting. No mortgage financing, no interest deduction. Implicitly,
mortgage payments are the economic equivalent of rent paid as tenants.
However, tenants have no tax incentive to rent.

For a residential tenant considering a plan to minimize their future income

taxes, the monthly payment on a purchase-assist mortgage as implicit rent
goes beyond that of a mere substitute for renting. When itemized, mortgage
interest paid reduces their taxable income – the reduction being the subsidy
for homeownership.

The amount of reduction in taxes due to mortgage homeownership depends

on the homeowner’s tax bracket, which ranges from 10% to 37%. The tax
bracket rate sets the subsidy amount received as the taxes avoided at the
homeowner’s tax rate on income equal to the mortgage interest paid on
principal up to $750,000.

With the MID, interest accrued and paid on a home mortgage is deductible
from income when the mortgage:
• funded the purchase price or the cost of improvements for the owner’s
principal residence or second home; and
• is secured by either the owner’s principal residence or second home.4
1 Internal Revenue Code §63(c)(7)(A)]
2 IRC §163(h)(3)(F)
3 IRC §164(b)(6)
4 Internal Revenue Code §163(h)(3)(B)
 Chapter 1: The mortgage interest deduction (MID), a subsidy 3

The MID reduces the property owner’s taxable income under both the
standard income tax (SIT) and the alternative minimum tax (AMT)
rules for setting the owner’s income tax liability. The AMT is a supplemental
income tax analysis targeting high-income earners who have a high ratio of
SIT deductions.

Interest paid on lender and carryback sales mortgages which fund the Purchase/
purchase or substantial improvement of an owner’s first or second
home is deductible on combined mortgage principal up to $750,000 for improvement
an individual and couples filing a joint return. The mortgage balances are
limited to $375,000 for married persons filing separately.
mortgages
Thus, when principal collectively exceeds $750,000 for mortgage funds used
to acquire, construct, or further improve a principal residence or second
home, only the interest paid on the first $750,000 is deductible.

New improvements paid for with mortgage funds need to be substantial

for interest on the mortgage to qualify for the MID. To qualify for MID,
improvements must:
• add to the property’s market value;
• prolong the property’s useful life; or
• adapt the property for residential use.
Mortgage funds used to repair property and maintain its good condition do
not qualify for funding of substantial improvements.5

Homeowners often refinance an existing purchase-assist/improvement Refinancing

mortgage, especially during recessionary periods with lowered mortgage
rates. Here, interest on the principal portion of the refinancing used to fund limitations
payoff of a MID mortgage qualifies for MID treatment. Conversely, interest
paid on principal generated by refinancing which exceeded the payoff
amount for the existing purchase-assist/improvement mortgage(s) does not
qualify for the MID.

For example, a homeowner takes out a $500,000 mortgage to fund the

purchase of their principal residence. The mortgage principal balance is
now paid down to $400,000. The owner needs cash funds and refinances
the residence, paying off the original purchase/improvement mortgage. As
intended, the proceeds from the refinancing exceed the amount of the payoff
demand on the MID mortgage.

In this scenario, interest on only $400,000 of the refinancing qualifies for

MID reporting, unless the excess funds generated by the refinance funded
substantial improvements to the residence.

5 T204783
4 Tax Benefits of Ownership, Fourth Edition

For interest on purchase-assist or improvement mortgage funds to be itemized

as MID, the mortgages must be secured by the homeowner’s principal
residence or second home.

A principal residence is an individual’s home when:

Qualifying
• the homeowner resides in it a majority of the year;
the principal
• the home is located close to the homeowner’s place of employment
residence and banks which handle the homeowner’s accounts; and
and second • the home’s address is used for tax returns.6
home A second home is any residence selected by the owner. The selection may be
changed from year to year and includes mobile homes, recreational vehicles
and boats or real estate.

Second homes are often rented out during the year. When rented, the
mortgage interest paid qualifies to be itemized as a MID when during the
year the owner occupies the property for the greater of:
• more than 14 days; or
• at least 10% of the number of days the residence is rented.7
When the owner does not rent out their second home during the year, the
property qualifies for the MID whether the owner occupies it or not.8

Any rental income the owner receives from a tenant occupant of the second
home is reported as investment/portfolio income when the owner
qualifies for the MID by occupying the property in excess of the 14-day/10%
rule.

The owner may not treat a second home they have rented to tenants as a
passive income category rental property when the owner’s family occupies
the property for more than the threshold 14 days or 10% of the days rented
during the year. With the family use exceeding the threshold, the second
home is reported as a portfolio income category asset and the home mortgage
interest qualifies for the MID treatment.

Conversely, the owner may not report the property as a passive income
category investment to write off interest on principal in excess of $750,000.
Further, they may not take depreciation deductions on the second home
much less deduct the cost of repair and maintenance. A property which
qualifies as a second home is not a passive income category asset though it is
a portfolio category investment.9

However, a second home, when purchased for personal use while held for
a profit on resale, qualifies as investment (like-kind) property for exemption
from profit taxes under IRC §1031.10

6 IRS Publication 523

7 IRC §280a(d)(1)
8 IRC §163(h)(4)(A)(iii)
9 IRC §§163(h)(4)(A)(i)(II); 280a(d)(1)
10 IRC §1031; IRS Private Letter Ruling 8103117
 Chapter 1: The mortgage interest deduction (MID), a subsidy 5

The MID is only allowed for interest which accrued and was paid during the
tax year, called qualified interest.11
Taking the
deductions
Procedurally, an owner deducts interest on first and second home mortgages
from their adjusted gross income (AGI) as an itemized deduction to set
their taxable income and thus their tax liability. In contrast, interest paid
on business, passive/rental or portfolio investment mortgages reduces the
owner’s AGI as interest offsets income from assets and services within each
income category before setting the AGI.

When a homeowner takes the standard deduction, the MID is not involved
as it is taken only as an itemized deduction.12

Consider a homeowner who mortgages the equity in their home to fund

the down payment on the purchase of an income-producing property. They
The home as
execute a note as evidence of a money debt owed a lender or carry-back seller additional
who extends credit in lieu of a larger cash down payment.
security
The homeowner wants to avoid the MID limitation on mortgages secured by
the principal residence or second home. They want to be able to write off all
the interest paid on the note against future income from the property they qualified interest
purchased by executing the note. Mortgage interest
accrued and paid on up
to $750,000 of mortgage
To do this, the homeowner negotiates with the lender or carry-back seller to principal used to fund
secure the note by two separate trust deeds: one as a lien on the home and the acquisition or
improvement of the
the other as a lien on the property purchased. This is not a blanket trust deed homeowner’s principal
covering two parcels, but two trust deeds each for a different properties for residence or second
the same debt. home. The interest is
itemized on Schedule
A as an itemized
The lender or carry-back seller is satisfied with the financial risk regarding personal deduction
the loss of principal. They view the home secured by the trust deed as the which reduces the
primary source of recovery should the owner default on the note. homeowner’s taxable
income and tax
liability.
In addition to the owner’s home, the note is secured by a second trust deed
on the property purchased. The buyer needs justification for writing off the
entire interest accrued and paid on the mortgage against income from the
property purchased with the loan or carryback mortgage. Here, the home
equity is used as additional security under a separate trust deed from the
one secured by the investment property purchased to avoid the MID taint.

Only one debt for which there is one note, but two trust deeds each referencing
the same debt owed. However, arranging a blanket trust deed describing
both properties risks imposition of MID limitations which the owner wants
to avoid.

While purportedly created to encourage low- to-middle-income households Economic

to become owners and benefit financially, the MID is mostly limited to
disproportionately increasing the wealth of high-income homeowners. effects of the
11 IRC §163(h)(3)(A) MID
12 IRC §63; IRC §163(h)(3)(F)
6 Tax Benefits of Ownership, Fourth Edition

Form 223

Supplemental
Truth-In-Lending
Section 32
Disclosure

High-income earners — who are more likely to own a home and have a
greater sum of personal deductions — itemize their deductions instead of
claiming the standard deduction.

Additionally, the size of the subsidy is directly proportional to the amount

of the mortgage, and thus the associated property value. The wealthier the
homeowner the greater the price they pay for a home and the larger the
mortgage, and in turn the bigger the tax savings.

However, consider the ultimate beneficiaries of the MID as lobbyists for

its continuance to include homebuilders, sellers, brokers and lenders.
Without the income tax reduction for itemizing interest as the MID, the
 Chapter 1: The mortgage interest deduction (MID), a subsidy 7

typical homebuyer overextends themselves to pay the price a seller asks for a
property. Thus, without the MID refund, buyers are going to pay less for the
same property as sellers are confronted with buyers who have no subsidy.

The MID operates to directly inflate home prices. Buyers taking out purchase-
assist mortgages have more disposable income to spend on the same property
due to the MID reduction in their income taxes. Essentially, buyers are
reimbursed for overpayment to sellers by reduced income taxes through the
MID.

However, most homebuyers have insufficient financial posture to be able to

benefit by itemizing their deductions. Thus, most mortgaged homeowners
of low-to-mid-tier priced housing no longer receive the subsidy, or as much
subsidy, depending on the level of their wealth.

Worse for availability of the subsidy, the 2018 increase in the standard
deduction greatly increased the likelihood most current or prospective
homeowners will take the standard deduction, as opposed to itemizing their
deductions. This shift decreases the availability of MID to benefit low- and
middle-income households, a condition which tends to lower the price they
can pay. This factor, while working to depress home prices, is offset by any
trend in lower mortgage interest rates that increases the buyer’s ability to
borrow more mortgage money based on the same income.

To encourage homeownership, the federal government offers an annual Chapter 1

subsidy to homeowners called the mortgage interest deduction (MID).
Summary
When a mortgaged homeowner prepares their tax return, they can
either itemize their deductions The MID is an itemized personal
deduction taken for interest accrued and paid on mortgages secured by
a homeowner’s principal and second residence.

Itemized Deductions are deductions taken by a homeowner for

allowable personal expenditures such as mortgage interest and state
and local property taxes (SALT) as itemized on Schedule A which reduces
their taxable income and tax liability.

Homeowners process the MID as an itemized personal deduction

subtracted from their adjusted gross income (AGI). The result is a reduced
amount of taxable income, and in turn reduced tax liability.

When the amount of permissible itemized expenditures exceeds the

amount of the standard deduction, it is beneficial for the homeowner
8 Tax Benefits of Ownership, Fourth Edition

to itemize their deductions. When a homeowner takes the standard

deduction, the MID is not involved as it is taken only as an itemized
deduction. The MID operates to directly inflate home prices.

Chapter 1 itemized deduction......................................................................... pg. 2

mortgage interest deduction (MID)............................................ pg. 1
Key Terms qualified interest............................................................................. pg. 5
 Chapter 2: Deduction of mortgage points by homebuyers 9

Chapter

2
Deduction of mortgage
points by homebuyers

After reading this chapter, you will be able to: Learning

• analyze the income tax deductions a homebuyer or homeowner
may take for the mortgage points and origination fees incurred on
Objectives
a purchase-assist, improvement or refinance mortgage.

adjusted gross income nominal interest rate Key Terms

(AGI) operating expenses
alternative minimum tax par rate
(AMT)
personal-use mortgage
deduction
portfolio property
life-of-loan accrual
prepaid interest
mortgage origination fee
principal residence
net operating income
(NOI)

Interest paid on mortgage principal accrues daily over the life of a mortgage. Prepaid
In contrast, payment of a mortgage holder’s penalty charge accrues in its
entirety as a lump sum amount, a bonus extracted by a lender due to the interest
occurrence or failure of an event such as a prepayment or late payment
penalty charge.
exception
allows write-
Mortgage interest accrued and paid by a property owner to be written
off against income must qualify as either an expense or deduction, an off
accounting process which reduces the owner’s taxable income. Tax reporting
is structured with three sets of income category, each category with rules to
determine whether interest payments on a mortgaged property qualify as an
expense or deduction to reduce the owner’s taxable income:
1. trade or business category income;
10 Tax Benefits of Ownership, Fourth Edition

2. passive category income; and

3. portfolio category income
For example, consider a mortgage which funds the purchase or improvement
net operating of a property used to house the owner’s trade or business activities. The
income (NOI) business owner’s payment of accrued interest on the mortgage principal is
The net revenue classified as an operating expense of the owner’s trade or business. As an
generated by an
income producing operating expense, the interest qualifies to be directly written off against the
rental property income of the business to determine the net operating income (NOI) of
before accounting for
mortgage PI payments
the business the owner operates.
or the depreciation
allowance. NOI is Now consider a mortgage originated to fund the purchase, improvement or
calculated as the sum carrying costs of a rental property – residential or commercial. The owner
of a rental property’s
total operating income manages the property as the landlord or through a property manager. Tenants
less the property’s occupy the property under gross lease or rental agreements. As the Income
operating expenses. property investment requires management it is classified as rental property
[See RPI Form 352 §4]
and reported as a passive income category asset.

deduction The payment of accrued interest on the property mortgage is written off as a
An expenditure or deduction from the rental property’s NOI – as is the depreciation allowance
allowance offsetting
net operating income - to calculate the reportable income or loss from property operations and
(NOI) or subtracted ownership. [See RPI Form 352]
from adjusted gross
income, both lowering
the amount of taxable
The mortgage debt on a rental property is not incurred for the owner to occupy
income. and operate a business on the property as occurs in their trade or business.
With a rental, the property produces income and operating expenses, not
the efforts of the owner. Thus, it is classified as a passive income category
operating expenses
The total annual costs asset.
incurred to maintain
and operate a property Further, consider the third type of property, one held primarily for long-
for one year. [See RPI
Form 352 §3.21]
term profit, such as a parcel subject to a ground lease, management-free net
leased income property and unimproved land. This type of management-
free investment property is classified and reported as a portfolio income
category asset.

Accrued interest paid on a mortgage debt originated to fund the purchase,

portfolio property improvement or carrying costs of a portfolio property is written off as a
Property held for
investment that is
deduction against income and profit from all investments within the portfolio
management free, income category. Unlike passive income property, portfolio income category
such as stocks, bonds, rules do not limit the interest (or depreciation) deduction to only the income
savings, notes, land
not used in a trade or from rental properties, a passive income reporting process called tracking.
business, and rental
properties under net The reportable income or loss for each of the income categories includes
leases. amounts of mortgage interest accrued and paid, whether classified as an
expense item or an allowable deduction within each category. Importantly,
adjusted gross the accounting within each of the three different income categories (business,
income (AGI) passive and portfolio) are separately maintained before used to establish
Gross income the owner’s adjusted gross income (AGI). As separately reported, the
remaining from
the three income reportable income or loss within one category is not directly commingled
categories after with income or loss from any other category, until calculating the property
taking expenses and
deductions.
owner’s adjusted gross income.
 Chapter 2: Deduction of mortgage points by homebuyers 11

A homeowner’s payment of accrued interest on a home mortgage is not The

classified as within any of the income categories for business, passive or
portfolio purposes. A mortgage that funds the purchase or improvement of homeowner’s
an owner’s principal residence or second home is classified as a personal-
use mortgage.
mortgage
interest is
Remember, interest paid on a personal-use mortgage is not tax deductible,
with one major exception: a homeowner’s mortgage interest deduction a personal
(MID). Again, the MID exception is an itemized personal deduction for deduction
interest paid on mortgages made in connection with the purchase or
improvement of a principal or second residence. [See Chapter 1] personal-use
mortgage
Itemized personal deductions allow interest accrued and paid on the A mortgage which
first and second home mortgages to be written off against the owner’s AGI funds a personal use
such as the purchase
when calculating a homeowner’s taxable income. The home mortgage or improvement of
interest is processed as a Schedule A itemized deduction and subtracted from an owner’s principal
the homeowner’s AGI. These deductions directly reduce the owner’s taxable residence or second
home, or the payoff of
income, but not their AGI. personal debt such as
costs of education and
Recall that governments subsidize mortgaged homeownership through healthcare or credit
cards.
the MID is equal in value to only the amount of reduction in annual income
taxes the homeowner pays. The amount of tax savings ranges from 10% and
12% of the interest itemized by low-income homeowners, to 37% for high- alternative
minimum tax (AMT)
income homeowners. A supplemental
income tax paid by
Thus, the wealthier a person is, with limitations, the greater the subsidy taxpayers in higher
for mortgaged homeownership. Homeowners whose AGIs exceed $500,000 income tax brackets.

have limitations imposed on their itemized deductions due to alternative

minimum tax (AMT) restrictions on allowable deductions.1 nominal interest
rate
The interest rate
The housing policy, implemented by use of the MID, also benefits agreed to between
governments as homeowners typically require less government assistance a homebuyer and a
in their elder years than renters. In theory, homeowners become more lender as stated on a
promissory note, also
responsible local citizens as ownership restricts job mobility compared to called the note rate. To
renters and installs a pride-of-ownership tenants other than the very wealth be contrasted with par
rate of interest.
do not have.

Points paid to a lender to originate a mortgage, sometimes called discount Points of

points, “buy down” the mortgage’s par rate for the life of the mortgage to an
interest rate negotiated and stated as the nominal rate in the note. “Points” interest to
is a distracting misnomer, as the charge is actually prepaid interest. A
mortgage with no points means a higher nominal interest rate is stated in
homebuyers
the note, the par rate or higher premium rate. originating a
As prepaid interest, the property owner annually deducts a percentage of the mortgage
points paid as they accrue during each month over the life of the mortgage,
called the life-of-loan accrual, with one exception — the mortgaged life-of-loan accrual
housing subsidy. When the mortgage principal is prepaid, any remaining The monthly accrual of
unaccrued prepaid interest — points — is deducted in the year of the payoff. mortgage origination
fee over the life of a
mortgage.
1 IRC §55(d)(4)(A)(ii)
12 Tax Benefits of Ownership, Fourth Edition

principal residence The exception to the life-of-loan accrual reporting applies to mortgages
The residential used to fund the purchase or improvement of an individual’s principal
property where the residence, but not a second home.2
homeowner resides a
majority of the year.
The entire amount of the points paid on origination of a principal residence
mortgage is, like the MID, reported as a personal itemized deduction in
the year paid. The immediate deduction of all points paid in connection
with a mortgage originated to finance the purchase or improvement of the
taxpayer’s primary home is a further government subsidy. The national
housing policy, implemented by the tax code, is intended to encourage
mortgaged homeownership in lieu of all-cash purchases or renting.

As a further refinement, the deductibility of the mortgage points in the year

paid depends on who paid the points — the buyer, the seller or the mortgage
holder.
prepaid interest
Interest paid which For example, a homebuyer applies for a mortgage to fund the purchase of a
has not yet accrued.
property they will occupy as their principal residence. The home will be the
security for repayment of the mortgage. The mortgage holder is paid points
— prepaid interest — for making a purchase-assist mortgage at an interest
par rate
The lender’s base
rate below the par rate. The mortgage holder will not withhold the points
interest rate without from the mortgage proceeds — a discount — or add them to the principal
any positive or balance of the mortgage.
negative adjustments
producing a variation
set as the nominal Instead, the points are paid by either the homebuyer from their separate
interest rate in a funds, or by the seller from their net proceeds of sale as a condition in the
promissory note. purchase agreement negotiated by the buyer’s agent.

In these buyer or seller payment situations, the homebuyer may write off
the points paid to the mortgage holder as a current itemized deduction
from their AGI. The deduction lowers their taxable income - the subsidy –
reported for the year of acquisition, since:
1. the mortgage proceeds are used to purchase or improve the buyer’s
principal residence;
2. the mortgage is secured by the principal residence, with or without
additional security;
3. the Closing Disclosure statement lists the points paid in non-
economic terms such as “points,” “mortgage origination fees,”
“mortgage discount” or “discount points,” when computed in amount
as a percentage of the mortgage;
4. the points were paid by the seller or from the buyer’s separate funds,
not by the lender as a discount or add-on to the mortgage principal;
5. the payment of points is an established business practice of mortgage
holders in the area; and
6. the points paid do not exceed the amount generally charged for points
in the surrounding area.3

2 IRC §461(g)(2)
3 Internal Revenue Service Publication 936
 Chapter 2: Deduction of mortgage points by homebuyers 13

When a mortgage funds the purchase or improvement and is secured solely Mortgage
by property other than the buyer’s principal residence, such as business or
investment property, the points are deducted pro rata over the life of the points for
mortgage.
business or
Likewise, points paid to finance the purchase or improvement of a second investment
home are deducted annually as they accrue over the life of the mortgage. For
example, points are paid on a purchase-assist mortgage for a vacation home, properties
payable monthly with a 30-year amortization. Here, the points are deducted
at the rate of 1/360th for each month annually as the prepaid interest —
points — accrues.

Now consider the homeowner who takes out a home improvement mortgage
secured by their principal residence. The homeowner pays the mortgage
lender 2.5 points from their separate funds. One of the points is called a
mortgage origination fee and is an amount paralleling the fee charged by mortgage
origination fee
other mortgage lender. A fee paid to a
mortgage holder for
The owner also pays mortgage charges itemized by the mortgage holder to originating a mortgage
include administrative fees, processing fees, appraisal fees and title expenses. at a below-par
interest rate, taxwise
These charges are separate from the mortgage origination points. Itemized considered prepaid
mortgage origination charges are service fees paid the mortgage holder to interest.
originate the mortgage, not points paid to buy down the note interest rate
from the market’s par rate to produce lower monthly mortgage payments.

May the homeowner also deduct these itemized mortgage service fees in the
year they are paid?

No! Itemized mortgage fees reimburse the mortgage holder for costs incurred
to originate the mortgage. Mortgage origination costs reimbursed by the
borrower are not prepaid interest. Accordingly, they are not deductible either
at the time paid or over the life of the mortgage.4

However, the mortgage service fees paid by the buyer when originating a
purchase-assist or improvement mortgage on any type of real estate are
capitalized, not expensed or deducted as are points. As capitalized, mortgage
service fees are added to, and become part of, the buyer’s cost basis in the
property. Mortgage service fees are non-recurring costs incurred to acquire
or improve property through mortgage funding, not daily recurring interest
which is expensed or deducted when paid and accrued.5

Capitalized costs for originating a mortgage on property, other than the first
and second home, are partially recovered as (tax-free) capital through the
annual depreciation deduction. The capitalized amount allocated to land or
otherwise not recovered through depreciation deductions is recovered as a
return of invested capital when reporting the sale of the property.

Consider a homebuyer who lacks sufficient funds or the willingness pay

the points required to originate a mortgage. During the buyer’s negotiations
Seller-paid
4 IRC §163; Rev. Proc. 94-27
points
5 Lovejoy v. Commissioner of Internal Revenue Service (1930) 18 BTA 1179
14 Tax Benefits of Ownership, Fourth Edition

conducted by their broker and as a provision in their written offer submitted

to purchase the property, the seller agrees to pay the points as requested by
the buyer.

Here, the homebuyer may deduct the points the seller pay on the buyer’s
purchase-assist financing. However the purchase agreement or escrow
instructions are worded, the seller does not actually pay the mortgage
lender. Instead, the seller reimburses the buyer, indirectly. Procedurally,
the homebuyer receives cash back from the seller when the seller agrees to
pay the points. Here, the buyer receives a cash credit through escrow from
funds accruing to the seller on closing so the buyer has funds in their escrow
account to pay the points. Thus, the payment of points is treated as though
the cash came from the buyer’s separate funds.6

Further, in a cash back situation the buyer has actually paid less for the
property in the amount of the cash back. To account for the cash back
on the price paid, the buyer’s cost basis in the residence is reduced by the
dollar amount of the cash back, as shown on the escrow closing statement.
Conversely, the seller who paid the points expenses the amount as part of
their transactional costs of the sale. Thus, the seller’s sales expense lowers
their low-tax profit, not high-tax ordinary income by an interest deduction.
Here, profits and ordinary income with their divergent rate brackets produce
different tax amounts.

Lender-paid Consider a homebuyer who lacks sufficient funds to pay the points demanded
by a mortgage holder. The seller refuses to advance the points without
points increasing the purchase price to cover any cashback.

To originate the mortgage, the lender agrees to increase the mortgage amount
and withhold the points from the mortgage proceeds, a discount. Handled
another way, the mortgage holder may advance the points and treat them as
an add-on to the principal of the mortgage.

May the homebuyer deduct points paid or added on by the lender in the year
the points are paid?

No! The homebuyer did not pay the points from separate funds, whether
drawn from their own funds or received as cash back from the seller. The
points were paid as a discount, or an add-on amount, to the mortgage. The
points being prepaid interest arranged to be “paid” by the mortgage holder,
may only be deducted annually as they accrue over the 360-month life of the
30-year mortgage.

Deduction Consider a homeowner who refinances a mortgage that funded the

purchase or improvement of their principal residence. They pay the points
of points on for the refinancing from their separate funds.
refinancing
6 Rev. Proc. 94-27
 Chapter 2: Deduction of mortgage points by homebuyers 15

Here, the refinancing did not fund the purchase or improvement of the
residence, even though it funded the payoff of a purchase or improvement
mortgage. As a result, the points are written off annually over the life of the
mortgage.

Occasionally, a homeowner pulls cash proceeds out of a refinance of their

principal residence when using their separate funds to pay the lender
origination points. The homeowner uses the excess mortgage proceeds to
pay for home improvements. Here, the homeowner deducts a pro rata share
of the points — equal to the percentage of the mortgage funds used to pay for
improvements — in the year the points are paid.7

Later, when the homeowner sells their residence or refinances again, the un-
accrued points paid on the existing mortgage which remain to be deducted
are then deducted — itemized on Schedule A as a MID — as interest paid in
the year of the sale or refinance. This deduction treatment applies on a sale
whether the mortgage is assumed or paid off - satisfied.

Now, consider a homeowner who refinances their principal residence for the
purpose of reducing their monthly payment and providing more disposable
income. The monthly savings are then spent on home improvements, such as
a roof replacement and remodeling of the kitchen and bathrooms (as occurs
more frequently during a recession).

The homeowner deducts all the points they paid for refinancing in the year
they refinanced as an itemized deduction on their federal income tax return.
They claim the refinancing freed up money for the improvements and was
thus a property improvement mortgage.

The Internal Revenue Service (IRS) disallows the deduction, claiming

the refinancing merely funded the payoff of an existing mortgage on the
property with no net mortgage proceeds for payment of improvements.

However, in this scenario, the deduction of all the points paid to refinance
the existing mortgage is permitted. The refinancing was a mortgage the
homeowner incurred in connection with the improvement of the property.
The reduction in payments caused the homeowner to have funds to pay for
the improvements they then made on the property.8

A homebuyer executes a note secured by a trust deed lien on their principal

residence to finance a portion of the purchase price paid for the residence.
Refinancing
The note is either for a private loan or a seller carryback. The note calls for a short-term
balloon payment with a three-year due date for final payoff of the mortgage.
This short-term mortgage is a swing loan which must be refinanced as the financing
buyer intends for the home to be their long-term residence.

When the note becomes due, the homebuyer obtains permanent long-term
financing. The short-term note is paid off with the proceeds of the permanent
financing.
7 Revenue Ruling 87-22
8 Tax Court Summary Opinion 2005-125 (non-precedent)
16 Tax Benefits of Ownership, Fourth Edition

The homebuyer deducts the entire amount of the points paid to originate the
long-term refinancing in the year paid. They claim the permanent financing
was part of their original scheme to finance the long-term ownership of their
principal residence and was not mere refinancing.

The IRS claims the homebuyer may not deduct the points paid on the
permanent financing since, to be entitled to an immediate deduction
as a mortgage made in connection with the acquisition of the principal
residence, the points must be paid on a mortgage which directly funds the
actual purchase or improvement of the principal residence.

Here, the points paid on the long-term refinancing of a short-term balloon

payment note are deductible in their entirety in the year the points are paid.

The existence of a short-term due date in the note originated as a purchase-

assist mortgage was evidence that the homebuyer contemplated refinancing
the short-term note in connection with their retaining the residence for
long-term ownership.9

Any indebtedness incurred in connection with the purchase or

improvement of a homeowner’s principal residence qualifies the points
paid up front to originate the mortgage for immediate deduction in the year
paid.10

9 Huntsman v. Commissioner of Internal Revenue (8th Cir. 1990) 905 F2d 1182
10 IRC §461(g)(2)

Chapter 2 Over the life of a mortgage, interest paid on mortgage principal accrues
daily. Mortgage interest accrued and paid by a property owner to
Summary be written off against income must qualify as either an expense or
deduction, an accounting process which reduces the owner’s taxable
income.

Taxwise, three sets of income category rules determine whether interest

payments on a mortgaged property qualify as an expense or deduction
to reduce the owner’s taxable income: trade/business income, passive
income and portfolio income.

Each of the three different income categories are separately maintained

before used to establish the owner’s adjusted gross income. The reportable
income or loss for each of the income categories includes amounts of
mortgage interest accrued and paid, whether classified as an expense
item or an allowable deduction within each category.
 Chapter 2: Deduction of mortgage points by homebuyers 17

Points paid to a lender to originate a mortgage, sometimes called

discount points, “buy down” the mortgage’s par rate for the life of the
mortgage to an interest rate negotiated and stated as the nominal rate
in the note. “Points” is actually prepaid interest.

A mortgage with no points means a higher nominal interest rate is stated

in the note, the par rate or higher premium rate. As prepaid interest, the
property owner annually deducts a percentage of the points paid as they
accrue during each month over the life of the mortgage, called the life-
of-loan accrual, with one exception — the mortgaged housing subsidy.
When the mortgage principal is prepaid, any remaining unaccrued
prepaid interest — points — is deducted in the year of the payoff.

adjusted gross income.................................................................. pg. 10 Chapter 2

alternative minimum tax............................................................ pg. 11
deduction......................................................................................... pg. 10
Key Terms
life-of-loan accrual ....................................................................... pg. 11
mortgage origination fee............................................................. pg. 13
net operating income (NOI)........................................................ pg. 10
nominal interest rate.................................................................... pg. 11
operating expenses ....................................................................... pg. 10
par rate.............................................................................................. pg. 12
personal-use mortgage................................................................. pg. 11
portfolio property.......................................................................... pg. 10
prepaid interest.............................................................................. pg. 12
principal residence....................................................................... pg. 12
Notes:
 Chapter 3: The principal residence profit exclusion 19

Chapter

3
The principal
residence profit
exclusion

After reading this chapter, you will be able to: Learning

• identify the profit on a sale of a homeowner’s past or present
principal residence which is excluded from taxation;
Objectives
• recognize when a selling homeowner is eligible for a partial profit
exclusion; and
• understand occupancy-to-ownership ratios as a reduction in the
$250,000 exclusion.

§1031 reinvestment plan principal residence profit

exclusion
Key Terms
cost basis
imputed owner unforeseen circumstances
occupancy-to-ownership unrecaptured gain
ratio
partial exclusion

Consider the sale of a residential property the seller occupies or previously Tax-free
occupied, in whole or in part, as their principal residence. The price is far
greater than the price the seller paid for the property, their cost basis in the sale up to
property.
$250,000 per
The cost basis is used to determine the amount of profit — both capital gains homeowner
and unrecaptured gains — a seller realizes on the sale of a property. An
owner’s cost basis comprises:
• the price and transactional costs the seller paid to acquire the property;
20 Tax Benefits of Ownership, Fourth Edition

cost basis • the costs they incurred to renovate and improve the property; and
The cost incurred to • any adjustments for depreciation deductions during periods the
acquire and improve
an asset subject to property was rented to tenants or a portion was dedicated for use as a
adjustments for home office.
destruction and
depreciation, a term The seller’s listing agent is typically proactive about a client’s tax issues on
used primarily for tax
reporting. the sale of a property. Being the seller’s principal residence, the agent checks
the public records for the number of years the seller has owned the property
and whether the seller has a homeowner’s property tax exemption.

The agent establishes:

• the seller has been the vested owner of the property for more than
five years;
• the seller has used the property as their principal residence for at least
two of the past five years; and
• the public records reflect the seller has a homeowner’s property tax
exemption.
As a result, the agent informs the seller that each owner-occupant is qualified
to take up to $250,000 in capital gains profit on the sale tax-free due to the
principal residence principal residence profit exclusion.1
profit exclusion
A tax reporting Each owner-occupant occupied a portion or all of the property as their
exclusion of profit
realized on the sale of principal residence for at least two years during their last five years of
the owner’s principal ownership. Thus, the $250,000 profit exclusion is available even when:
residence limited to
a maximum dollar • the seller originally acquired the property as a rental but has since
amount and by
an occupancy-to-
occupied it;
ownership ratio. • the seller having occupied the property now rents the property to
tenants;
• the seller has taken depreciation deductions as their home office or
rental property; or
• the property consists of two or more residential or mixed-use units.
The listing agent also checks out the availability of the §1031 exemption
for profits allocated to a home office (business use) or separate rental space
(investment property) on the property, or due to the property’s present
status solely as a rental. These analyses indicate whether the seller needs to
consider the acquisition of another property to avoid the adverse tax impact
on the net proceeds from the sale.

The §121 Questions the agent considers when advising on the tax aspects of a sale of
property that is or was the seller’s principal residence include:
profit
• On the closing date of the sale, will the property qualify as the owner’s
exclusion’s principal residence under the two-out-of-five-year principal
array of tax residence requirement?2

issues 1 Internal Revenue Code §121

2 IRC §121(a)
 Chapter 3: The principal residence profit exclusion 21

• Who among the co-owners qualifies for up to $250,000 in profit partial exclusion
exclusion as an owner and occupant for two out of the five years A prorated portion
preceding the close of the sale under the principal residence rule?3 of the principal
residence profit
• When only one spouse is the vested owner, does the non-vested exclusion available
to a homeowner who
spouse qualify as an imputed owner by having occupied the property sells due to personal
under the principal residence owner-occupant rule?4 difficulties.

• Is any homeowner disqualified due to a profit exclusion taken on

the sale of a different principal residence which closed escrow within occupancy-to-
two years before the close of the sale on their current residence?5 ownership ratio
A ratio of the years
• When the period of owner-occupancy is less than two years, will the a homeowner has
profit on a sale be eligible for a partial exclusion because of personal occupied a property
as their principal
difficulties which arose: residential to the years
they have owned it.
o prior to completing two full years of ownership and Used by the seller of
occupancy; or a residential property
to calculate the
o within two years after taking a profit exclusion on the sale of a percentage of profit
prior principal residence?6 realized on the sale
which qualifies for the
• What percentage of the profit taken on the sale based on the principal residence
occupancy-to-ownership ratio qualifies for the $250,000 exclusion? profit exclusion.

• Did the homeowner originally acquire their residence as a rental

property to replace other property in a §1031 reinvestment plan, §1031 reinvestment
then later convert it to their principal residence, triggering a five-year plan
A sales transaction
holding period to qualify for the exclusion?7 of like-kind property
• Has the homeowner depreciated a portion of the residence or the which generates net
sales proceeds, some or
property as their home office or as a rental and if so, will the owner use all of which the seller
some or all of the sales proceeds to purchase like-kind §1031 property to will use to purchase
like-kind replacement
avoid reporting unrecaptured gain?8 property under
• Is the owner an unmarried surviving spouse who has not owned and Internal Revenue Code
§1031. The cost basis
occupied the property as a principal residence for the two-year period and unrecaptured
but can qualify by tacking the deceased spouse’s period of ownership gains are carried
forward to the property
and occupancy to the surviving owner’s?9 purchased and the
• Has the owner been placed in a government-licensed facility due to seller avoids reporting
some or all of the
their physical or mental incapacity to care for themselves after residing capital gains realized
on the property for a period of at least one of the past five years and on the sale.
thus qualify by tacking the time spent in the facility during their
ownership of the property to their actual occupancy to satisfy the
principal residency rule?10

Occasionally, wealthier couples will have two or three residences they

occupy at different times during the year, such as a seasonal or vacation
Principal
home. residence
3 IRC §121(b)
exclusion, not
4
5
IRC §§121(b)(2), 121(d)(1)
IRC §121(b)(3) for second
residence
6 IRC §§121(c)(1), 121(c)(2)
7 IRC §121(d)(10)]
8 IRC §121(d)(6)
9 IRC §121(d)(2)
10 IRC §121(d)(7)
22 Tax Beneifits of Ownership, Fourth Edition

Recall that profit on a sale of any home qualifies for the principal residence
profit exclusion when the seller has:
• owned the property for at least five years; and
• occupied the property as their principal residence for at least two years
during the five-year period prior to closing the sale.11
Factors which identify a property as the owner’s principal residence include
its:
• location near the owner’s employment;
• use as the address listed on state and federal tax returns; and
• proximity to banks and professional services used by the owner.12

Profit The amount of profit taken — realized — as a capital gain on a sale of real
estate is set by subtracting the price and transactional costs paid to acquire
exclusion for the property from the net sales price they receive on its sale.
one or more Consider an individual who owns and occupies a property as their principal
owners residence for no more than 23 months before closing a sale of the residence
at a profit. No personal difficulties triggered their need to sell the property.

Does the individual qualify for the profit exclusion?

No! The individual did not occupy the property for a total of two of the five
years preceding the sale and no personal difficulties existed to shorten the
qualifying time.13

Exclusion A married couple owns and occupies a property as their principal residence
for at least two of the five years prior to closing a sale of the property. Unless
available to disqualified by other situations, they exclude an aggregate amount of up to
a married $500,000 in profit taken on the sale, i.e., $250,000 per person.14

couple Alternatively, a husband and wife, one of which is the sole owner of a home
as separate property, both occupy the property as their principal residence.
Here, they jointly qualify for a combined $500,000 profit exclusion on the
sale of the residence, when:
• both occupy the property for two years or more within the five-year
ownership period prior to the sale;
• the couple files a joint return as a married couple for the year of the
sale; and
• neither spouse has taken a profit exclusion on another principal
residence within two years prior to the sale.15

11 IRC §§121(a)
12 IRS Publication 523
13 IRC §121(a)
14 IRC §121(b)(2)(A)
15 IRC §121(b)(2)
 Chapter 3: The principal residence profit exclusion 23

However, one spouse is individually disqualified when they applied the

principal residence profit exclusion to profits on the sale of a residence they
sold within the two-years prior to closing the sale of their current residence.
Here, the combined exclusion of up to $500,000 is not available. However,
when the other spouse separately qualifies for an individual profit exclusion
up to $250,000, they may claim the exclusion whether or not they are a vested
owner.16

For example, the sole owner of a residence held as separate property and
their spouse have both occupied the property as their principal residence for
more than two of the five years preceding the sale of the residence.

Neither spouse claimed a profit exclusion on the sale of a principal residence

which closed escrow within two years prior to closing the sale of their current
residence. The couple files a joint return for the year of the sale.

Does each spouse qualify for the combined exclusion allowing the couple
to exclude up to $500,000 of profit taken on the sale of the residence solely
imputed owner
owned by one spouse? Someone who for tax
purposes is deemed
Yes! The spouse who holds no ownership interest in the residence is classified to be a coowner of a
as an imputed owner. Thus, the couple qualifies for the $500,000 profit principal residence
but does not have a
exclusion since one spouse owns the residence and both occupied it as their vested interest in the
principal residence. property.

Consider a husband and wife who each independently owned and occupied The
separate principal residences during the two-year period immediately prior
to their marriage. exclusion’s
On marriage, both the husband and wife vacate their prior residences and
spousal
relocate to a different residence. Each spouse now needs to sell their prior entanglements
residence.
with two
The husband sells his prior residence, realizing a profit. The couple files a properties
joint return for the year of the sale.

Does the couple, now married, qualify for the combined exclusion of up to
$500,000?

No! Only the husband qualifies to take the individual profit exclusion of
up to $250,000 on the couple’s joint tax return. The wife did not need to be a
vested owner of the husband’s residence to qualify the couple for the $500,000
profit exclusion. However, the wife was disqualified for failure to occupy the
property as a principal residence for two of the five years prior to its sale.

Now consider a situation where the wife closes the sale on her prior residence
within two years after the husband closes the sale on his. The husband does
not qualify for any part of the exclusion on the wife’s sale. The husband and
wife file a joint return for the year the wife’s residence sold, claiming the
wife’s $250,000 individual profit exclusion.
16 IRC §121(b)(2)(B)
24 Tax Beneifits of Ownership, Fourth Edition

Here, the wife qualifies to claim the individual profit exclusion on the
couple’s joint return. The husband’s prior claim of an individual $250,000
profit exclusion within two years of the wife’s sale does not disqualify the
wife’s claim to the individual exclusion. [IRC §121(b)(3)]

In contrast, consider a husband who, either prior to or after getting married,

closes escrow on the sale of a solely owned principal residence and realizes
a profit.

The husband owned and occupied the principal residence for more than two
years during the five years prior to closing the sale. Here, the husband alone
qualifies for and claims the profit exclusion on the sale.

Since their marriage, the husband and wife have occupied the wife’s separate
property as their principal residence for at least two years during the past five
years.

Within two years after the husband closed the sale on which he took a profit
exclusion, the residence owned by his wife is sold and escrow closed.

May the couple file a joint return and qualify for the combined profit
exclusion of up to $500,000?

No, not both! Only the wife qualifies for an individual profit exclusion of up
to $250,000 on their joint return.

Even though the husband met the (imputed) ownership and (actual)
occupancy requirements for the property sold by his wife, the husband
previously took a profit exclusion on the sale of his prior principal residence
which closed within the two-year period preceding the closing of the sale of
the wife’s residence.17

Similarly, had the second residence sold been community property and not
separately owned by the wife, only the wife would be allowed to take a profit
exclusion on their joint return.

Here, the seller’s agent needs to determine whether the closing of the sale on
the residence they both occupied needed to be delayed to a date more than
two years after the sale closed on the husband’s residence. Had the close of
escrow on the second sale been delayed, the couple would have qualified for
the combined profit exclusion.

An individual or married couple need not occupy a property as a principal

Residence residence when they purchase the property or when they sell it to qualify
unoccupied for the $250,000 or combined $500,000 profit exclusion.
at time of Consider a married couple who acquires a property and occupies it
sale continuously as their principal residence for over two years.

17 IRC §121(b)(3)
 Chapter 3: The principal residence profit exclusion 25

Later, the couple buys another home and moves in, occupying it as their
principal residence. The couple rents the old residence to a tenant, converting
it into a rental property, and takes their annual depreciation allowance
deduction.

Within three years of moving out of their prior residence, the couple closes
a sale on the prior residence and takes a profit consisting of both capital gain
unrecaptured gain
and unrecaptured gain (depreciation). The couple files a joint tax return for The accumulated
the year of the sale. annual adjustments
to a property’s cost
basis for depreciation
Here, the couple may take a $500,000 profit exclusion on the sale even though deductions which on a
they did not occupy the property at the time of the sale. The couple owned sale of the property are
and occupied the prior residence as their principal residence for at least reported and taxed at
greater rates than the
two of the last five years. However, the amount of recaptured gain due to rates for capital gain.
depreciating the property during the period it was rented is taxed on the sale.

At times, individuals or couples sell due to personal difficulties but do Partial

not meet the two-out-of-five-year ownership and occupancy requirement
needed to claim the full amount of the profit exclusion. When personal exclusion on
difficulties bring about the decision to sell, closing the sale before two years
of owner-occupancy, the homeowner qualifies for a prorate share of the
a sale due
$250,000/$500,000 profit exclusion as a partial exclusion. to personal
The partial exclusion allows a homeowner to exclude from taxes all profit difficulties
on the sale up to a prorated portion of the $250,000/$500,000 profit exclusion.
The ceiling amount for partial exclusion is set by a ratio based on the fraction
of the two years they were owner-occupants of the residence. Importantly,
the proration is not applied to the amount of profit realized on the sale. The
ratio is applied only to the total amount of profit excludable — a reduction
of the $250,000/$500,000 exclusion ceiling, not a reduction in the profit
available for exclusion.

To qualify for a partial exclusion, a change in circumstance due to personal

difficulties needs to be the primary reason for sale of the property. Qualifying
personal difficulties include:
• a change in employment, based on the seller’s occupancy of the
residence at the time of the job relocation and the financial need to
relocate for the employment;
• a change in health, such as advanced age-related infirmities, severe
allergies, or emotional problems; or
• unforeseen circumstances, such as natural or man-made disasters, unforeseen
circumstances
death or divorce.18 Events not reasonably
foreseeable by a
Thus, when a homeowner sells due to personal difficulties, all profit taken homeowner which
on the sale is excluded from taxation up to the ceiling amount of the partial qualify the profit
on the sale of a
exclusion.19 residential property
for partial exclusion
from taxation, such
as a natural disaster,
18 IRC §121(c)(2)(B); Revenue Regulations §1.121-3 divorce or death.
19 IRC §121(c)(1)
26 Tax Beneifits of Ownership, Fourth Edition

However, when the principal residence is the subject of an exclusion and was
acquired as a rental property in a §1031 transaction using §1031 money or in
exchange, a five-year holding period exists before the principal residence
profit exclusion is available.

The change of Factors used to determine whether the primary reason for the sale is a change
in circumstance which qualifies the sale for a partial exclusion include:
circumstances • the need compelling the homeowner to relocate and sale of the
as reasons to principal residence both need to occur during the period of occupancy;
sell • a material change makes the property unsuitable as the principal
residence;
• the homeowner’s financial ability to carry the residence requires the
residence be sold;
• the need to relocate arose during the occupancy of the residence sold;
and
• the need to relocate was not foreseeable by the homeowner when they
acquired and first occupied the principal residence sold.20
For example, a change in employment may qualify a homeowner for the
partial exclusion even when the owner has not owned and occupied their
principal residence for the full two-year period.

Employment compelling the homeowner to relocate can be based on:

• a required job relocation by their current employer;
• the commencement of employment with a new employer; or
• the homeowner is self-employed and they relocate of the place of
business or commence a new business.
A sale is deemed to be due to a change in employment when:
• the new job location is more than 50 miles farther than the old job from
the previous principal residence; or
• the seller was formerly unemployed, and the job location is at least 50
miles from the residence sold.21
For example, a homeowner is forced by their employment to relocate out of
the area.

The homeowner has owned and occupied their principal residence for one
year and six months — 75% of the necessary two-year occupancy period.

The homeowner sells their residence, taking a $40,000 profit.

When filing their tax return, the homeowner is eligible to exclude the entire
$40,000 profit from taxation. Here, the entire profit realized is less than the

20 Rev. Regs §1.121-3(b)

21 Rev. Regs. §1.121-3(c)
 Chapter 3: The principal residence profit exclusion 27

$187,500 partial exclusion (75% of the $250,000 full exclusion). The same ratio
applies to a couple’s maximum $500,000 profit exclusion under the same
circumstances.22

Chronic health issues which compel the homeowner to sell may also
qualify the sale for a partial exclusion.

To qualify for health reasons, the owner seeking the exclusion is selling to
facilitate the diagnosis, cure, or treatment of an illness or injury, or obtain or
provide medical or personal care, for any of the following persons:
• the owner;
• the owner’s spouse;
• a co-owner of the residence;
• a co-occupant residing in the owner’s household as their principal
place of abode; or
• close relatives, generally those descended from the owner’s
grandparents.
The owner’s sale is also deemed to be due to health reasons when a physician
recommends a change of residence.23

Unforeseen circumstances may be the primary reasons for the sale of the
owner’s principal residence, allowing use of the partial exclusion. Events
classified as unforeseen circumstances do not include events the owner could
have reasonably anticipated before they owned and occupied the residence.

The mere preference of the owner to own and occupy another property
as their principal residence or the financial improvement of the owner
permitting acquisition of a more affluent residence does not qualify the sale
for the partial profit exclusion.

However, the sale is deemed to be due to unforeseen circumstances when:

• the residence is taken by involuntary conversion; or
• disaster (natural or man-made) or acts of war/terrorism affect the
residence.
Further, the homeowner’s sale is deemed to be due to unforeseen
circumstances which are experienced by the owner, owner’s spouse, co-
owners, co-occupants, who are residents and members of the owner’s
household or close relatives, including:
• death;
• loss of employment resulting in unemployment compensation;
• inability to pay housing costs and basic living expenses for the owner’s
household;
• divorce or separation by court decree; or

22 IRC §121(c)
23 Rev. Regs. §1.121-3(d)(2)
28 Tax Beneifits of Ownership, Fourth Edition

• pregnancy with multiple births.24

Owned but An overriding limitation reduces by a percentage the amount of profit

to which the exclusion ceiling applies when a property owner does not
not always occupy the property as their principal residence during the entire period of
ownership. The profit limitation apples even when the principal residence
occupied requirement is met. The result is only a prorate portion of the profit realized
on the sale is excluded, while the $250,000/$500,000 exclusion is not altered.

The percentage of the profit that can be excluded on a sale is based on an

occupancy-to-ownership ratio covering the entire period of ownership,
not just five years.

Periods the owner is considered to have occupied the property as their

principal residence include:
• any period of ownership prior to January 1, 2009;25
• any period of use as the owner’s principal residence after January 1,
2009 prior to the sale; and
• any period after terminating their use of the property as a principal
residence within five years prior to the sale.26
Consider an owner who purchases a property on January 1, 2005 for use as a
second home. They begin occupying it as a principal residence on January 1,
2011. They move out on January 1, 2013, terminating their use of the property
as their principal residence. The owner closes a sales escrow disposing of the
property on January 1, 2015, taking a $300,000 profit.

How much of the $300,000 in profit can the owner exclude under the
occupancy-to-ownership ratio since they did not continuously occupy the
property during their 10 years of ownership?

On analysis, the owner meets the initial two-out-of-five-year principal

residence requirement.

Further, the period of ownership of the property by the seller is ten years.

Of the ten years of ownership, the period of occupancy of the property as

the owner’s principal residence is eight years, based on:
• the four years prior to January 1, 2009, even though they did not occupy
the property;
• the two years after January 1, 2009 when they actually occupied the
property as their principal residence; and
• the two years after terminating their occupancy of the property as their
principal residence up to the closing of the sale, even though they did
not then occupy the property.

24 Rev. Regs. §1.121-3(e)

25 IRC §121(b)(5)(C)
26 IRC §121(b)(5)(C)(ii)
 Chapter 3: The principal residence profit exclusion 29

Thus, the occupancy-to-ownership ratio is 8:10, representing the eight years

of occupancy over the ten years of ownership.

Here, eight-tenths (80%) of the $300,000 profit on the sale is $240,000, the
portion of the profit to which the exclusion is applied. As the exclusion
ceiling amount of $250,000 is available to the owner, the occupancy-to-
ownership ratio portion of the profit being less in amount is excludable from
the owner’s gross income.27

27 IRC §121(b)(1)

A sale of any home qualifies for the principal residence profit exclusion Chapter 3
when the seller has owned the property for at least five years and
occupied the property as their principal residence for at least two years Summary
during the five-year period prior to closing the sale.

The amount of profit taken — realized — as a capital gain on a sale of

real estate is set by subtracting the seller’s cost basis in the property from
the net sales price they receive. A partial exclusion is a prorated portion
of the principal residence profit exclusion available to a homeowner
who sells due to personal difficulties.

To qualify for a partial exclusion, a change in circumstance needs to be

the primary reason for sale of the property.

Qualifying personal difficulties include: a change in employment, a

change in health or unforeseen circumstances.

The mere preference of the owner to own and occupy another property
as their principal residence or the financial improvement of the owner
permitting acquisition of a more affluent residence does not qualify the
sale for the partial profit exclusion.

§1031 reinvestment plan ............................................................ pg. 21

Chapter 3
cost basis.......................................................................................... pg. 20
imputed owner............................................................................... pg. 23 Key Terms
occupancy-to-ownership ratio .................................................. pg. 21
partial exclusion............................................................................ pg. 21
principal residence profit exclusion........................................ pg. 20
unforeseen circumstances.......................................................... pg. 25
unrecaptured gain......................................................................... pg. 25
Notes:
 Chapter 4: Home office expenses as deductions from fees 31

Chapter
4
Home office expenses
as deductions from fees

After reading this chapter, you will be able to: Learning

• identify the qualifying factors for a real estate licensee to write off
direct and indirect expenses related to their home office;
Objectives
• determine deductions available for mortgage interest and
depreciation; and
• undertake the brokerage activities needed to classify a home office
as a licensee’s principal place of business.

direct expense indirect expense Key Terms

exclusive use principal place of business
home office deduction regular use

Real estate licensees often work from their home when rendering brokerage Qualifying
services. Whether they rent or own, they may qualify to expense the costs
of maintaining their home office as an offset against their trade/business for the
income for services they render. Thus, they reduce their taxable income. home office
An active licensee qualifies for the home office deduction when: deduction
• a portion of the home is used exclusively and regularly for the licensee’s
brokerage business; and
• the use of the home office meets one of three business activity standards.

For tax purposes, a real estate licensee is considered self-employed, a fiction Independent
called an independent contractor, when:
brokers,
• they are licensed as a broker or sales agent;
broker-
associates, and
sales agents
32 Tax Benefits of Ownership, Fourth Edition

home office
• the compensation they receive is based on completed transactions,
deduction such as sales and other brokerage services (called contingency fees),
A deductible in contrast to an hourly wage or salary; and
expense resulting
from business use of • the sales agent or broker-associate has a written agreement with their
a taxpayer’s home.
employing broker stating the licensee is an independent contractor for
income tax purposes.1
Both broker-associates and sales agents employed as independent contractors,
direct expense
A deductible as well as independent brokers, qualify for the home office deduction under
expense attributable the same rules. When the licensee qualifies for the home office deduction,
to the home the deductible home office expenses include:
office area used
exclusively for
business.
• the direct expenses attributable to the home office area used
exclusively for business; and
• indirect expenses limited in amount to the percentage figure
indirect expense
An expense incurred
representing the portion of the square footage in the residence used as
in the upkeep the home office.
and operation of a
taxpayer’s entire Direct expenses, deductible as a brokerage business expense, include the cost
residence, a part of of decorating and repairs made in the portion of the residence exclusively
which is deducted
as a business used as a home office.
expense, the
amount deductible All direct expenses are deductible from business income without allocation
based on the
percentage of the
for the personal use of the remaining space in the residence.
area in the residence
exclusively used as Indirect expenses are costs incurred in the upkeep and operation of the entire
a home office. residence. They are prorated and include:
• rent paid as a tenant;
• mortgage interest;
• real estate taxes;
• home insurance;
• utilities; and
1 Internal Revenue Code §3508(b)(1); see Figure 1

Equipment purchased in connection with a business, even when the licensee operates
Deducting the business out of a home office, is fully deductible in the year purchased. The
Business equipment needs to be both ordinary and necessary to operate the home office. To be
Expenses classified as necessary, equipment need not be indispensable. For example, a licensee
purchases a printer for use in their home office. It is used to print contracts, disclosures,
and other documents. The printer is both ordinary and necessary for the licensee’s
business. Thus, the cost of purchasing the printer is fully deductible.
Extraordinary expenses such as the purchase of a car for use during the course of
business, are not fully deductible in the year the expense is made. Rather, costs for
extraordinary expenses are recovered over a few years taking annual depreciation
deductions.
However, when a car is used exclusively for business purposes, expenses such as gas
and oil, repairs, insurance, or registration fees are deducted the year the expense is
paid. [Internal Revenue Service Publication 535]
 Chapter 4: Home office expenses as deductions from fees 33

• maintenance.
The portion of indirect expenses deductible as a business expense is calculated
based on the percentage of the square footage in the residence used as a home
office.

For example, a licensee exclusively uses 300 square feet of their residence as
their home office. The total area of the residence is 1,800 square feet. Thus, the
licensee’s home office is 16.7% of the total square footage of the residence.

The licensee’s indirect annual expenses — incurred as ownership and

operating expenses on the entire residence — include:
• $15,000 in mortgage interest;
• $2,000 in real estate taxes;
• $3,600 in utility payments; and
• $900 in insurance costs.
The total amount of indirect expenses is $21,500.

The licensee may write off $3,590.50 as indirect business expenses, 16.7% of
the $21,500 residence expenses.2

In lieu of ownership expenses, when the licensee is a tenant in a home or

apartment they use in part as their office, they write off a pro rata amount of
the rent as a business expense.3

Expenses outside of the dwelling incurred for lawn care, pool maintenance
or tree trimming cannot be deducted as business expenses. Further, expenses
unrelated to the home office area incurred inside the house — such as the
remodeling or maintenance of any area other than the home office area —
are not deductible.4

Conversely, when the licensee paints and carpets only the home office area,
the entire cost is deductible as an expense directly related to the home office.

However, before the licensee may deduct any of the home office costs as
business expenses, the home office area needs to be used exclusively and
regularly for their business.5

Lastly, and important, the cost to purchase or improve the residence which
is allocate to improvements is recoverable as a business depreciation
deduction allowed for the pro rata portion of the residence used as the
business office. The depreciation deduction while reducing taxable annual
income becomes unrecaptured gain which is taxed when the residence is
sold, unless a replacement property is acquired with the sales proceeds in a
§1031 reinvestment plan.

2 Internal Revenue Service Publication 587

3 Visin v. Commissioner (2003) 86 TCM 279
4 IRS Pub. 587
5 IRC §280a(c)(1)
34 Tax Benefits of Ownership, Fourth Edition

Figure 1
INDEPENDENT CONTRACTOR EMPLOYMENT AGREEMENT
For Sales Agents and Broker-Associates

Form 506 NOTE: This form is used by an employing broker when entering into an agreement employing a sales agent or a broker
on terms calling for the employee to be treated for tax purposes as an independent contractor, to establish the duties of
the broker and agent, earned fees and how the fees due the employee will be allocated and shared.
DATE: , 20 , at , California.
Items left blank or unchecked are not applicable.

Independent
1. Broker hereby employs Agent as a real estate sales agent or broker-associate, until terminated by either party, on the
following stated terms.
1.1 Agent to be treated as an independent contractor for tax purposes.
2. AGENT agrees:

Contractor
2.1 To maintain a real estate license in the State of California.
2.2 To provide brokerage services only on behalf of Broker.
2.3 To follow the Broker’s policy manual and any directions orally given by Broker.
2.4 To use only those real estate forms authorized by Broker.
2.5 To make complete and immediate disclosure to Broker of any correspondence or document made or received.

Employment
2.6 To immediately deliver and account to Broker for funds received by Agent in the course of this employment.
2.7 To participate in educational programs and meetings specified by Broker.
2.8 To fully inspect the physical conditions of any property to be sold or bought for clients.
2.9 To obligate Broker to no agreement without Broker’s prior consent.

Agreement
2.10 To expose Broker to no liability to any third party without Broker’s prior consent.

For a full-size, fillable copy of this or

2.11 To furnish their own transportation and carry a liability and property damage insurance policy in an amount
satisfactory to Broker with a policy rider naming Broker as co-insured.
2.12 To faithfully adhere to the Real Estate Law of the State of California.
2.13 To join and pay fees for membership to professional organizations in which Broker is a member.
2.14 To contribute to the defense and settlement of litigation arising out of transactions in which Agent was to or shared
fees, in an amount equal to Agent’s percentage share of the fees.
2.15 Social Security Number ______/______/______
any other form in this book that may
2.16 Other ___________________________________________________________________________________
3. BROKER agrees:
3.1 To maintain a real estate Broker’s license in the State of California.
be legally used in your professional
practice, go to realtypublications.com/
3.2 To maintain office(s) with proper facilities to operate a general real estate brokerage business.
3.3 To maintain membership in the following professional organization(s):
� Multiple Listing Service
� Local Branch of the California Association of Realtors and National Association of Realtors

3.4
3.5
� ______________________________________________________________________________________
To maintain listings.
To provide advertising approved by Broker.
forms
3.6 To provide worker’s compensation insurance for Agent.
3.7 To maintain the following insurance coverages for Agent:
� Errors and Omissions � Life � Health � Dental
3.8 To pay Agent as specified in the Broker’s fee schedule.
3.9 To notify the DRE in writing of the employment and termination of the employee if they are being hired as a
broker-associate. [See RE Form 215]
3.10 Other____________________________________________________________________________________
4. General Provisions:
4.1 Agent has the right to purchase any properties listed by Broker on full disclosure to the seller of the Agent’s
activities as a principal, and without diminution of fees to Broker.
4.2 Broker has the right to reject any listing or retainer obtained by Agent.
4.3 Broker to determine whether any litigation or dispute involving Broker, or their business and third parties, arising
from Agent’s activities, will be prosecuted, defended or settled.
4.4 Arbitration: Any dispute between Agent and Broker or with any other Agent employed by Broker that cannot be
settled by Broker, or resolved by the State Labor Commission or by non-binding mediation, will be arbitrated
under the rules of the American Arbitration Association.
4.5 � See addendum for additional provisions. [See RPI Form 250]

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - PAGE 1 OF 2 — FORM 506 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - PAGE 2 OF 2 — FORM 506 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

5. Broker’s Fee Schedule:

5.1 Broker is to pay Agent a fee for participating in a sales transaction evidenced by a purchase agreement which
confirms Agent is acting as an agent for the Broker and Broker receives a brokerage fee on the transaction.
Broker is to disburse Agent’s fee as soon as practical after Agent's completion and submission of the transaction
file generating the fee.
5.2 The amount of fee due Agent is ______% of the funds remaining from the brokerage fee received by Broker
under sections 5.1 or 5.10b after first deducting the following amounts:
a. Payment to other brokerage offices of sums due them for their participation in the transaction;
b. Payment to Broker’s franchisor of the fee due the franchisor from the transaction;
c. Payment to Broker of one-half of the then remaining funds if another Agent of Broker is entitled to a fee for
negotiating the other end of the transaction;
d. Other deductions ____________________________________________________________________.
5.3 From each fee due Agent and before disbursement, Broker will deduct the following amounts and any amounts
otherwise due Broker from Agent:
a. An advertising or promo charge of $_______________.
b. An errors and omissions insurance coverage charge of $______________.
c. A charge of $_______________ for ____________________________________________________.
d. Disbursement to another Agent of the Broker, transaction coordinator or finder with whom Agent agreed to
share the fee due under section 5.2.
5.4 The percentage participation by Agent in the funds remaining under sections 5.2 is adjusted to ______% on the
following event ____________________________________________________________________________,
and will apply until _____________, 20______.
5.5 Agent is to pay Broker, on the first of each month of employment, a desk fee of $_______________.
5.6 Any expenses incurred by Broker in a transaction negotiated by Agent, such as travel expenses, meals, attorney
fees, printing, listing service fees, etc., will be deducted from the fee due Agent.
5.7 If all or part of the fee is received in property other than cash, Agent is to obtain Broker’s prior approval. In this
event, Broker will make one of the following determinations for disposition of the property:
a. Divide the property between Broker and Agent in kind, based on the fee schedule; or
b. Pay Agent their dollar share of the fee in cash; or
c. Retain the property in the names of Broker and Agent, or their trustee, and thereafter dispose of it when
and on terms Broker and Agent previously agree. Any ownership income and expenses will be shared
between Broker and Agent in proportion to their share of ownership.
5.8 On termination, Agent to be paid as follows:
a. Closed Transactions: Agent will receive their share of fees on all transactions which are closed before
termination.
b. Pending Transactions: Agent will receive their share of fees on all pending transactions which close after
termination, subject to fee limitations under section 5.9.
c. Unexpired Listings and Retainers: Agent will receive their share of fees if the client enters into a transaction
during the written listing or retainer period. Agent will not earn a fee under any extension of the listing or
retainer obtained after termination, subject to fee limitations under section 5.9.
5.9 Fee Limitation: If on termination Agent has pending transactions under section 5.1 or unexpired listings or
retainers procured by Agent which require further services normally rendered by Agent, Broker will direct another
employed Agent or himself to perform these services. For these services after termination, a reasonable share of
the fee will be deducted from the fee due Agent.
5.10 Compensation From Prior Employment: Monies received by Broker from Agent's prior employing brokers
representing fees earned by Agent while employed by that broker are to be disbursed by Broker as follows:
a. � Agent to receive 100% of the monies received by Broker.
b. � The monies are to be shared with Agent at the percentage set in section 5.2.
c. � Broker and Agent, respectively, to share the monies _____________ : _____________.
I agree to render services on the terms stated above. I agree to employ Agent on the terms stated above.
Date: , 20 Date: , 20
Agent's Name: Broker's Name:
DRE #: DRE #:

Agent's Signature: Broker's Signature:

Address: Address:

Phone: Cell: Phone: Cell:

Email: Email:

FORM 506 09-18 ©2018 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517

Exclusive use Consider a licensee who uses a family room as their home office. The
licensee’s family also uses the family room to watch TV in the evenings and
means no occasionally entertain guests on weekends.
other use at Thus, the area in the licensee’s residence set aside for the home office is not
any time used exclusively for the brokerage business. Even though the personal use of
the area occurs after office hours, no home office deduction is allowed.
exclusive use
The use of a The area dedicated to home office work does not need to be cordoned off or
designated area in partitioned to qualify for exclusive use. One or two rooms, and possibly an
a residence only
as an office, one extra bathroom, may serve as space for the home office.
of two conditions
needed to qualify
for a home office
deduction.
 Chapter 4: Home office expenses as deductions from fees 35

In addition to the home office area being dedicated exclusively to business

activities, the home office also needs to be used regularly by the licensee for
conducting their business.

Consider a licensee who maintains both a home office and an office in a Regular
commercial building. The licensee works, keeps their files, conducts most of
their real estate sales business and is assisted by a part-time secretary or team use of the
member at the commercial office. residence
However, the licensee uses the home office four or five days each month for most
in the evening to catch up on work they were unable to complete at the
commercial office, such as reading real estate journals and studying course brokerage
materials for license renewal or becoming a broker. activity
Here, no deduction may be taken for home office expenses. The area used as
the home office is not regularly used in the course of the licensee’s business.
That it is used exclusively for their business is not decisive since exclusive regular use
The consistent
use needs to be coupled with regular use. repeated use of an
area of a residence
However, to take the home office deduction, the licensee’s business conduct as a home office, one
still needs to meet one of three standards: of two conditions
needed to qualify
• the home office is the principal place of business for the licensee; for a home office
deduction.
• the home office is used as a place of business to meet or confer with
clients; or
principal place of
• the home office is located in a separate structure not attached to the business
residence.6 The location where
a broker or agent
A licensee who claims they use their home office when they regularly conducts the
majority of, or the
meet and confer with clients needs to document the client conferences in a most significant
calendar or logbook, including: activities related to
their business.
• their clients’ names;
• the date of each client meeting; and
• what they discussed or acted on.
A home office when located in a structure separate from the licensee’s
residence also qualifies for the deduction of business expenses. Examples
include a garage apartment, casita, outbuilding or granny flat.

To qualify for the deduction of home office expenses based on its use as their Principal
principal place of business, the licensee needs to perform most all or at least
the most important of their brokerage activities while working in the place of
home office, such as: business
• prepare agreements, information disclosures, and marketing material;
• organize and schedule brokerage activities by email or phone;
• video conferencing marketing sessions; and

6 IRC §280A(c)(1)(A-C)
36 Tax Benefits of Ownership, Fourth Edition

• regroup after collecting information, investigating property and

records, and meeting with licensees, clients, and customers during the
course of business.
The question becomes: among the different locations used by the licensee to
perform business-related services, which is their principal place of business?

The location of the principal place of business is determined by comparing

the significance of the real estate services performed as a licensee at various
locations.

For doctors, treating patients is the most important aspect of their practice.
Thus, the location where they treat patients is their principal place of
business, which might be a laboratory, hospital, or care center.7

Consider a self-employed licensee who has no other office but their home
office. They claim a home office deduction for the expenses incurred to
operate an office out of a portion of their residence based on its use as their
principal place of business.

The licensee calls clients, agents, and providers to schedule brokerage

services from the home office. They also prepare, send, and receive all listing
agreements, purchase agreements, other contracts, and disclosure documents
at the home office. All the licensee’s records and files plus their computer and
other office equipment are located in the home office.

Regarding clients, the licensee meets them at their offices or residences, at

restaurants or at the location of the real estate involved. Personal face-to-face
meetings with clients are for reviewing documents, discussing the condition
of the property – physical, title, operations, location, and disclosures – and
the status of transactions, as well as obtaining signatures.

Other business activities conducted outside the home office include

previewing property, attending marketing sessions and meeting with title
officers, escrow officers, mortgage loan originators, home inspectors, property
managers, maintenance services, government agencies and attorneys and
accountants who represent clients. All of these activities are conducted at
various places but are scheduled from the home office.

Does the licensee qualify to deduct their home office expenses as expenses
incurred at their principal place of business?

Yes! Home office costs are an allowed expense deductible based on the use of
the home office as the broker’s principal place of business. The most important
aspects of a brokerage practice are soliciting and coordinating client contacts,
preparing agreements and disclosure statements, analyzing property data,
and maintaining files and records, all of which are performed in the home
office.

Obtaining signatures on documents, inspecting property, and meeting with

others at locations outside the home office are essential, but not the most
important aspects of the licensee’s business.
7 Soliman v. Commissioner of Internal Revenue (1993) 506 US 168
 Chapter 4: Home office expenses as deductions from fees 37

A licensee with both a home office and a commercial office may qualify for Two offices
the deduction of home office expenses.
— one for
Consider a licensee who maintains desk space in a downtown office with
several other licensees, sometimes called a “cubby.” The licensees using the public
the downtown office share its maintenance and operating costs, such as
employing a receptionist, contributing to rent, and paying for janitorial
services and utilities for the premises.

The licensee pays a pro rata share of the costs based on the percentage of
the space they use. The office provides the licensee with a “public” business
address and a professional environment for meeting clients rather than
coffee shops or the client’s office or residence.

The licensee also has a home office. All their phone solicitations and contacts
with clients and others while performing their brokerage services are made
from the licensee’s home office or while on the road. All agreements and
disclosure forms are prepared at the home office and all of their records, files
and office equipment are located at the home office.

Appointments to meet with clients or real estate affiliates or to show property

are also made from the licensee’s home office. They only use the downtown
office as a “window” to meet clients before showing property, confer with
them in person, or obtain their signatures on documents.

Here, the licensee qualifies to deduct expenses incurred at their home office
from their business income. The importance of activities conducted at the
home office and the time spent on carrying out those activities establishes
the home office as their principal place of business.

Even though they have a commercial office for professional reasons, the
most important parts of their work take place at the home office.8

Now consider a licensee who makes more substantial use of their commercial
office than of their home office.
Two offices
— main
The licensee maintains a downtown office they use daily to solicit, make
appointments with and meet clients. The licensee also arranges property office is
inspections, escrow and title information, prepares agreements and downtown
disclosures, and maintains files at the downtown office.

The licensee’s home office is used for bookkeeping, maintaining a real estate
library. and studying. The licensee occasionally phones clients, receives calls
and reviews documents at their home office. They spend one or two hours
most evenings working in the home office.

Here, the licensee’s use of the home office is insufficient to qualify the home
office as their principal place of business.

8 Beale v. Commissioner TC Memo 2000-158

38 Tax Benefits of Ownership, Fourth Edition

The licensee’s most important activities — client contacts in person and by

phone, creating marketing packages, and preparing agreements — take place
and are filed primarily at the downtown office.

While bookkeeping and studying in the home office are essential to the
licensee’s ability to continue conducting a brokerage business, they are not
the most important part of the business. Rendering services in the practice of
real estate brokerage on behalf of clients is most important, and these services
for the most part do not occur at the licensee’s home office.9

Although many brokers work independent of other licensees, broker-

Licensees associates and sales agents always work as employees of the broker who
and the hired them. Typically, they are provided desk space at their broker’s office.
However, the broker’s employment and supervision of a licensee, mandated
home office by state law, does not limit the ability of the broker-associate or sales agent to
qualify for the home office deduction.

A prerequisite to qualifying for home office tax treatment requires a sales

agent or broker-associate to be employed as an independent contractor with
their broker. The independent contractor tax status of a broker-associate or
sales agent is established by a written employment agreement between
the licensee and the employing broker. The agreement states the licensee
is considered an independent contractor and pays their own income taxes
without the broker withholding. Nothing more is required to establish
their independent contractor status, a concept limited in application to tax
purposes only. [See Figure 1, RPI Form 506]

Limitations Consider a real estate licensee who uses their residence as their principal
place of business. Each year, the agent writes off their home office expenses
on deductions as a deduction from their brokerage income.
to fees for The agent’s real estate business suffered a net loss during the past year. Their
services business operating loss includes home office expenses.

rendered When real estate business losses include home office expenses, the deduction
of the loss is limited. Business losses cannot be taken to the extent they
include home office expenses. Thus, no portion of the business loss reported
may include home office expenses.10

9 Beale, supra
10 King v. Commissioner TC Memo 1996-231
 Chapter 4: Home office expenses as deductions from fees 39

Real estate licensees who work out of their homes, whether rented or Chapter 4
owned, may qualify to expense the costs of maintaining their home
office as an offset against their trade/business income for the brokerage Summary
services they render.

An active licensee qualifies for the home office deduction when a

portion of their home is used exclusively and regularly for the licensee’s
brokerage business and the use of the home office meets one of the three
business activity standards. A direct expense is a deductible expense
attributable to the home office area used exclusively for business.

An indirect expense is an expense incurred in the upkeep and operation

of a taxpayer’s entire residence which may in part be deducted as a
business expense, the amount deductible based on the percentage of the
area in the residence used as a home office.

The equipment needs to be both ordinary and necessary to operate

the home office. Direct expenses, deductible as a brokerage business
expense, include the cost of decorating and repairs made in the portion
of the residence exclusively used as a home office. The entire amount of
direct expenses is deductible from business income without allocation
for the personal use of the remaining space in the residence.

However, to take the home office deduction, the licensee’s business

conduct still needs to meet one of three standards: the home office must
be the principal place of business for the licensee, used as a place of
business to meet or confer with clients or located in a separate structure
not attached to the residence.

direct expense ................................................................................ pg. 32

Chapter 4
exclusive use .................................................................................. pg. 34
home office deduction ................................................................ pg. 32 Key Terms
indirect expense............................................................................. pg. 32
principal place of business ........................................................ pg. 35
regular use ...................................................................................... pg. 35
Notes:
 Chapter 5: The sales price 41

Chapter
5
The sales price

After reading this chapter, you will be able to: Learning

• categorizes the many components which comprise the sales price
of real estate.; and
Objectives
• understand how the sales price for income-producing property is
determined.

book value gross equity Key Terms

capital investment market value

A seller’s agent, as good practice, discloses the amount of net proceeds

the seller can expect on a closing at the sales price under consideration. To
Different
accomplish this pricing disclosure as a critique for sales, the seller’s agent views,
initially prepares a seller’s net sheet for review with the seller when
presenting the listing agreement. The agent’s calculations are based on the
different
listing price the agent and seller agree upon for marketing the property. analysis,
Later, the agent repeats the net sheet analysis for each listing price different
modification approved by the seller, including submission of a buyer’s
purchase agreement offer.
results
To aid in preparing an estimate of the dollar amount of net proceeds a seller
can expect to receive on a particular sales price, the agent fills out a form
called a seller’s net sheet. [See RPI Form 310]

Is the seller’s awareness of the amount and nature of net proceeds they will
receive on closing the only financial consequence the seller will experience
on a sale? Is the amount of net profit on the sale the same as the seller’s net
proceeds?
42 Tax Benefits of Ownership, Fourth Edition

Net proceeds The answer to both questions is no. The seller’s profit or loss reported on a
sale is always different in amount and unrelated to net proceeds received
and profits on the sales price paid by a buyer. However, the sales price is the common
figure to begin calculating both net proceeds of a sale and the profit or loss on
are unrelated a sale. While the seller takes the net proceeds of a sale to the bank, the sales
concepts price may contain profit which creates a tax liability for the seller which
diminishes the net proceeds — unless the profit is tax exempt, excluded from
taxes or tax deferred.

Uninformed sellers frequently believe their profit is somehow related to the

amount of net proceeds they receive on a sale; that their net equity in the
property equals their profit. It does not. Typically, the net proceeds are greater
than the amount of profit. However, the positive spread between the amount
of net proceeds and profit is reduced or reversed by cash-back refinancing, as
the debt on the property increased during ownership. While the equity in
the property shrinks due to increased mortgage debt the profits remain the
same.

The distinction: the seller’s equity in a property and their profit on a sale are
each derived by applying different data to the sales price — the mortgage
debt and the seller’s cost basis, respectively. On a sale, debt and basis are
never the same.

Before breaking down the sales price into its component parts for tax
reporting, several economic fundamentals of real estate ownership must first
be understood:
• capital investment — made to acquire ownership and improve a
property, evidenced by cash contributions, funds from loans, and
cost basis carried forward from a sale in a §1031 reinvestment plan
which comprise the owner’s cost basis in the property from which
depreciation deductions are made. In contrast, an owner’s capital
interest in a property is its current market value.
• annual operating data — ongoing property operations that generate
income (rents) and expenses which are reported annually.
• tax consequences — brought about by acquisition, on-going ownership,
and disposition of the property.
A property’s sales price, also considered its market value and the owner’s
market value
The highest price a
capital interest, is the only term common to all economic analysis regarding
property will bring in a ownership of a home, business-use property or investment property (rental
competitive and open real estate and land held for profit on resale).
market between a
buyer and seller given
time to act prudently Agents advise and counsel clients on material facts enveloping a transaction
and knowledgeably. they are negotiating. Material facts are aspects of a real estate transaction
that if known might alter the economic behavior and decisions of the client.

Consider a first-time buyer of any type of property. Due to lack of knowledge

and familiarity, they tend not to be inquisitive about:
• acquisition costs, though known and familiar to the broker;
• operating expenses, known to sellers and obtainable on request; and
 Chapter 5: The sales price 43

• income taxes, known to brokers and salesagents.

The conduct of a first-time buyer is in direct contrast to the conduct of repeat
buyers of a home, business-use property, or investment property. [See Form
306 accompanying this chapter; see RPI Form 311] gross equity
The portion of the
market value of a
In any real estate transaction, a thoughtful agent gives their client advice on property calculated
the tax consequences of the sale. This advice is, of course, limited to what is by subtracting the
amount of mortgage
known by the agent, issues that might cause the client to consider further or debt, unpaid property
different arrangements in a transaction. taxes and any bonded
indebtedness secured
Taking a profit that is not exempt or excluded from taxation creates a present by the property from
the property’s market
or deferred tax liability on a sale. These are material facts. The payment of any value.
profit taxes triggered by a sale diminishes the after-tax amount remaining
from the net proceeds received on the sale.
capital investment
The capital invested
in a property,
A seller interested in disposing of a property quickly breaks out their sales comprising cash and
mortgage proceeds
price into debt and equity, flipsides of the capital interest coin. It is the used to purchase,
equity in the property the seller is cashing out, no matter how the buyer improve or carry the
might be funding payment of the sales price. property, as well as
any adjusted cost basis
carried forward in the
To calculate the seller’s gross equity in the property, the amount of debt disposition of other
encumbering the property is deducted from the sales price. Again, mortgage property in a §1031
reinvestment plan.
debt is not used to determine the seller’s profit on a sale (except for short sales
in negative-equity situations). [See Figure 1]

In another distinction, a seller’s present capital interest in a property is Capital

synonymous with the determination of the property’s current market value.
Brokers advising an income property owner logically determine the amount components
of the owner’s capital interest in the property by, well, capitalizing the of the sales
property’s NOI at current rates of return experienced by like-type property
— an appraisal approach. The resulting capitalized value of the property price
becomes the price the seller seeks from a buyer, representing the total sum of
the seller’s capital interest in the property.

An owner’s capital interest is defined as either:

• the sum of the dollar amount of the property’s current mortgage debt
and perceived equity; or
• the property’s current fair market value set at the current annual rate of
return on like-type properties — say, 6.5% — when inflation is low and
investment opportunities are not readily available – called a seller’s book value
The value of an
market. asset expressed for
accounting purposes
The seller’s capital interest in a property today is neither equivalent nor as the original cost
related to the seller’s previous capital investment in the property made of acquisition and
capital improvements,
years earlier. A seller’s capital investment is the amount they paid for minus accumulated
the property, comprised of cash and mortgage proceeds used to purchase, depreciation and
improve or cover negative cash flow to carry the property, as well as any cost destruction, also
known as cost basis.
basis carried forward in a §1031 reinvestment plan. Capital invested sets the Contrast with current
cost basis in a property and is also called book value. market value.
44 Tax Benefits of Ownership, Fourth Edition

Form 306

Property
Expense Profile

Tax Taxwise, the seller, in discussions with their agent, breaks down the sales
price into basis and profit, flip sides of the tax coin. With the profit figure,
components the agent can determine the income tax liability created by the sale they are
in the sales negotiating. The short formula for setting profit: price minus basis equals
profit.
price
As an economic function, a tax analysis of a property’s price contributes
nothing to the process for setting the price. It is a lagging event, precipitated
as a consequence of the sale. Neither a seller’s remaining basis nor the
profit sought plays any role in setting the market price a buyer may be willing
 Chapter 5: The sales price 45

to pay for a property. However, profit does, all too often, play a peculiar role
of seller reminiscence. This environment creates a money illusion, which
frequently distorts the seller’s opinion of current market value.

Buyers deciding on a price to pay are not concerned with the seller’s basis
and profit. These are elements of state and federal tax reporting affecting
only the seller as a taxpayer when property is disposed of. A buyer never
acquires the seller’s basis, and a seller’s basis (or profit) never aids a seller or
buyer when establishing a property’s value.

Again, a seller’s remaining cost basis in a property is never equal to the

remaining mortgage debt. But deducting basis from the net sales price does
set the seller’s profit.

On acquiring property, its cost basis is established as the total of all the
expenditures related to the purchase of the property and the improvements
necessary to use it or attract tenants, called placing the property in
service. During the period of ownership prior to resale, a property’s cost
basis is adjusted periodically due to depreciation, hazard losses and further
improvements.

Taxwise, the cost basis remaining at the time of resale is deducted from the
net sales price to determine whether a profit or loss has been realized by the
seller. Whether the profit realized is taxed, called recognized, is a separate
issue.

Editor’s note — When the purchase price paid for a property includes the
equity or net sales proceeds from disposal of §1031 like-kind real estate, the
basis in the property purchased is set by the remaining cost basis in the
property sold (not its sales price) which is carried forward and adjusted for
additional contributions or the withdrawal of money (net cash boot) and
differences in the amount of existing debt (mortgage boot) on the properties.

Additional improvements made by an owner of rental property, sometimes

called sweat equity, contribute to a property’s value when they bring about
Value altering
an increase in rents. Thus, expenditures for the cost of improvements are activities
added to the basis in the property. Conversely, expenditures by the owner for
upkeep, maintenance, repair, and operations of the property are operating
expenses deducted from rental income. While operating expenses add
nothing to the cost basis in the property, they do maintain — and often
increase — the amount the owner can demand for rent. However, the value
of the owner’s capital interest in the property is often increased by value-
creating maintenance they write off and, for a sale, the price increased and
with it the profit (the owner’s time and effort taxed at a lower rate).

Net cash proceeds from refinancing or equity financing which are not used
to purchase or improve property do not contribute to the cost basis (or affect
the property’s value).

The depreciation allowance reducing the cost basis represents an annual

return to an owner (from rents) of a percentage of their capital contributions
46 Tax Benefits of Ownership, Fourth Edition

allocated to improvements on the property. Accordingly, the cost basis,

being the total of all capital contributions, is reduced each year by the
recovery of capital from rents through the annual depreciation allowance
deducted from the NOI to report income or loss from operations.

Chapter 5 A seller’s agent discloses the amount of net proceeds the seller can
expect on a closing at the sales price under consideration. To accomplish
Summary this pricing disclosure as a critique for sales, the seller’s agent initially
prepares a seller’s net sheet for review with the seller when presenting
the listing agreement. The agent’s calculations are based on the listing
price the agent and seller agree upon for marketing the property.

The seller’s profit or loss reported on a sale is always different in amount

and unrelated to net proceeds received on the sales price paid by a buyer.

The seller’s equity in a property and their profit on a sale are each derived
by applying different data to the sales price — the mortgage debt and
the seller’s cost basis, respectively.

On a sale, debt and basis are never the same. A property’s sales price,
also considered its market value and the owner’s capital interest, is the
only term common to all economic analysis regarding ownership of a
home, business-use property or investment property (rental real estate
and land held for profit on resale).

Market value is the highest price a property will bring in a competitive

and open market between a buyer and seller given time to act prudently
and knowledgeably. In any real estate transaction, a thoughtful agent
gives their client advice on the tax consequences of the sale.

This advice is, of course, limited to what is known by the agent, issues
that might cause the client to consider further or different arrangements
in a transaction.

Chapter 5 book value ...................................................................................... pg. 43

capital investment........................................................................ pg. 43
Key Terms gross equity..................................................................................... pg. 43
market value................................................................................... pg. 42
 Chapter 6: Income categories set the AGI 47

Chapter
6
Income categories set
the AGI

After reading this chapter, you will be able to: Learning

• identify the three income categories for segregating the income,
profit and loss resulting from property ownership;
Objectives
• apply the rules for offsetting net income and losses in each
category; and
• discuss a client’s adjusted gross income (AGI) derived from their
income category results.

active management suspended loss Key Terms

passive income category tracking
passive ownership trade or business income
portfolio income category category

To analyze an owner’s annual reporting of real estate operations, financing, The many
and sales, it is essential to understand the three income categories for income
tax reporting, sometimes referred to as income pots. Each category sets the types of
accounting and reporting procedures for the income, profit and loss incurred
by properties classified as within the category. Collectively, income, profit
income
and loss are called income. [See Figure 1]

When an agent’s estimate of the owner’s annual income tax liability is trade or business
prepared, the owner’s income from all sources needs to first be classified as income category
Income, profits
belonging in one of three income categories: and losses from the
taxpayer’s trade or
• The trade or business income category – income from professional owner-operated
trade or owner-operated business opportunities, which includes real business, sales
estate owned and used to operate the trade or business;1 inventory, and real
estate used to operate
the trade or business.
1 Internal Revenue Code §469(c)(6)
48 Tax Benefits of Ownership, Fourth Edition

passive income • The passive income category – income and profits from managed
category rental property investments and business opportunities owned or co-
Income, profits and owned but operated by others;2 and
losses from rental
real estate operations • The portfolio income category – income and profits from
and sales, and from
businesses not
management-free investments.3
operated by the owner
or co-owner. Each income category encompasses a separate classification of real estate
based on its type and use for generating income, profit, or loss. The particular
vesting employed by the owner or co-owners to hold title does not determine
income category. Thus, vesting is not relevant for category classification,
unless a C corporation, taxable trust or the estate of a deceased person is
the owner-operator. These are taxed separately from their owners who are
shareholders and beneficiaries.

For example, the ownership of a rental (e.g., the average tenant occupancy
exceeds 30 days) by a limited liability company (LLC) is not a trade or business
of the LLC or its owners, called members. Each member of the LLC reports
their pro-rata share of the income from a rental operation as passive category
income, since an LLC is a pass-through entity, also called a disregarded
entity.

An LLC is treated as a partnership unless it elects to be taxed as a C Corporation,

which eliminates any pass-through entity treatment. Thus, as in any
partnership, income of an LLC is “passed through” to the members, who are
in turn liable for any income tax.4

Conversely, property management services rendered by an individual who

is a broker on behalf of rental owners constitute a trade or business category
activity for the broker. Not so for the owner, as the property is a passive
investment no matter who manages it.

Mutually The three income categories are mutually exclusive of one another. Simply
put, losses from one category cannot be used — commingled — to directly
exclusive offset income or profit in another category. Each category is annually tallied
income for no separately to establish the end-of-year income or loss within that category.

commingling The reportable end-of-year income or profit within all income categories
are, before considering any reportable losses, initially added together to start
with losses the process of establishing the owner’s adjusted gross income (AGI). The
handling of reportable annual loses as an adjustment to AGI is different for
each income category.

For a business income category, all reportable losses are fully subtracted to
reduce the AGI in the year incurred. No limitation or carryforward treatment
exists for trade or business losses.

In contrast, reportable losses in the passive income category do not

automatically reduce the AGI the year they are incurred. Unless the owner

2 IRC §469(c)(1)
3 Revenue Regulations §1.469-2T(c)(3)
4 IRC §701
 Chapter 6: Income categories set the AGI 49

otherwise qualifies, passive losses are carried forward within the category, suspended loss
allocated only to the properties generating the category loss for use in future An operating loss
years, called a suspended loss. incurred on passive
income category rental
property that is not
Suspended rental operating losses are deductible in future years when used recognized in the tax
to offset operating income or sales profit from the property which generated year incurred but is
carried forward for use
the loss, called tracking. in future years to offset
operating income or
When a sale of rental property occurs and the suspended loss carried forward profit on a sale only
is greater than the profits on the sale, the operating loss remaining spills over from the property
incurring the loss.
to reduce the AGI. This lack-of-profit situation may exist when a property
becomes obsolete or is subject to extensive reduction in local population of tracking
renters. The separate
accounting record
However, and critically, the owner of passive category rental property may of the operating
income, expenses, and
write off the loss in the year it occurs when the owner’s activities qualify deductions for each
rental losses for either: assessor-identified
parcel of real estate
• a real estate related business loss adjustment to lower their AGI; or classified as passive
category property.
• a $25,000 rental loss deduction from AGI to lower their taxable
income. [See Chapter 7]
The tracking of operating income or loss for each assessor-identified parcel
of passive category property owned by the taxpayer is unique to the passive
income category. No commingling of income from one property with the
losses of another property is allowed. With tracking, each separately assessed
parcel of rental property the investor owns is accounted for independent of
all other parcels of rental property the investor owns, except for multiple
ownerships within the same complex or project.

Tracking maintains the integrity of requiring suspended losses to only offset

future income or profit from the property generating the operating loss.
The tracking requirement does not exist in the business or portfolio income
categories.

In contrast, portfolio investments — such as management-free income Portfolio

property with net leases and unimproved land held for profit on resale — are
batched to calculate the annual income from all properties in the portfolio losses remain
category. The portfolio category also includes intangibles such as stocks,
bonds, and mortgages.
portfolio
losses
When assets in the portfolio category collectively produce an annual
operating loss, that operating loss is carried forward within the category
to offset portfolio category income or profits in future years. An end-of-year
portfolio category loss cannot be subtracted to reduce the owner’s AGI, but for
a $3,000 amount. However, unlike passive income accounting, no tracking of
operating losses for each separate property takes place. Portfolio assets are
commingled within the category for simplified accounting.
50 Tax Benefits of Ownership, Fourth Edition

Figure 1 Trade or Business

Adjusted Gross Personal Income
Income (AGI) • Hotels/Motels
Categories • Boarding Houses
• Active Bus. Ops.

Dealer
Property

Passive
Income, profit
or loss Bus. ops.

Rentals
$25,000 Loss Deduction

Business related rental

operating losses

Vacation
Home
Income, profit or
resale loss spillover

Investment

Portfolio Income
Income, profit or • Interest and Bonds
AGI capitol loss
• Dividends and Stock
($3,000 loss cap)
• Land and Ground Leases

Deductions from AGI

1. $25,000 rental loss
2. Interest/taxes on 1st/2nd homes

Again, for offsetting between categories, the end-of-year income, profits and
losses are first totaled within each category. The totals from each category are
then brought together (subject to limitations on passive or portfolio losses) to
establish the owner’s AGI.

For the owner’s agent to analyze and estimate the owner’s annual income
tax liability resulting from a sale of real estate, two major tax components
need to be estimated:
• the owner’s AGI, derived from net annual operating income and sales
profits generated within each income category, less permissible losses;
and
 Chapter 6: Income categories set the AGI 51

• the owner’s taxable income, derived by subtracting from their AGI the
owner’s itemized or standard personal deductions, exemptions, and
any $25,000 rental property operating loss deduction.5

Trade or business income includes: The trade

• earnings from an individual’s trade or business and real estate used to or business
operate their trade or business, including ordinary income from the
sale of parcels held in inventory as a subdivider, builder, or dealer;6 income
• income and losses from the individual’s business opportunity (sole category
ownership, partnership, LLC or S corporation) and the real estate owned
and used in the business, when the individual is a material participant
in the management of the business;7 and
• income and losses from the individual’s owner-operated hotel, motel,
or inn operations (sole ownership, partnership, LLC or S corporation)
with average occupancies of 30 days or less, when the individual is a
material participant in management.8

An individual’s income property operations (excluding business category

hotels, motels, inns, and portfolio income from management-free net leases),
The passive
referred to by the IRS as rental income, are accounted for within the passive category
income category.
for rentals
The passive income category includes: actively
• rents, expenses, mortgage interest, depreciation from annual operations, managed
and profit and losses from sales of residential and commercial rental
real estate with an average occupancy of more than 30 days (inclusion active management
of a property’s income requires active management under rental or The responsibility of a
gross lease agreements); and rental property owner
under a rental or gross
• income or losses from business opportunities owned or co-owned, lease agreement to
but not operated or managed by the owner or co-owner, called passive care for and maintain
their rental real estate,
ownership.9 needed to qualifying
a property’s income
Income received from rental operations is often referred to as passive income. and expenses to be
Ironically, for income property to be a rental, and thus reported in the passive classified as passive
category income.
income category, the owner needs to be obligated to actively manage the
property.
passive ownership
To be considered involved in the active management of a property, the Ownership of a
landlord needs to have some legal responsibility to care for the property business without
under their rental or lease agreements, typically called gross leases. When materially
participating in its
the landlord has no contractual responsibility for care and maintenance of management.
the property the income property becomes a portfolio category property. This

5 IRC §469(i)
6 IRC §469(c)(6)(A)
7 IRC §469(c)(1)
8 Rev. Regs. §1.469-1T(e)(3)(ii)(B)
9 IRC §469(c)
52 Tax Benefits of Ownership, Fourth Edition

occurs in a long-term net lease agreement where the tenant agrees to care
for and maintain the property and structures and pay all property operating
expenses.

And for active management of a rental property, the owner who further
qualifies as a material participant in its management may write off all rental
operating losses for the year against income from all categories. The passive
losses written off by a material participant reduce their AGI and, in turn, their
taxable income.10 [see Chapter 8]

The portfolio Investment income, profits and losses taken by an individual, referred to as
portfolio income by the IRS, includes:
category
• interest earned on bonds, savings accounts and secured or unsecured
notes (such as carryback trust deeds notes, trust deed loans, and interest
portfolio income
category
on delayed §1031 reinvestment funds);
Unearned income • annuities, dividends, and royalties from personal property investments
from interest on
investments in bonds, (such as stocks, bonds, and commodities); and
savings, stocks and
mortgage notes,
• income from the ownership of land subject to ground leases,
and income, profits, management-free net leased real estate, and unimproved land held for
and losses from profit on resale.11
management-free net-
leased income property 10 IRC §469(c)(7)
11 IRC §469(e)(1)(A)
and unimproved
land held for profit on
resale.

Chapter 6 Collectively, income, profit and loss are called income. When an agent’s
estimate of the owner’s annual income tax liability is prepared, the
Summary owner’s income from all sources needs to first be classified as belonging
in one of three income categories:
• the trade or business income category – income from professional
trade or owner-operated business opportunities, which includes
real estate owned and used in the owner’s trade or business.
• the passive income category – income and profits from managed
rental property investments and business opportunities owned or
co-owned but operated by others
• the portfolio income category – income and profits from
management-free investments.
Each income category encompasses a separate classification of real
estate based on its type and use for generating income, profit, or loss.

The three income categories are mutually exclusive of one another.

Simply put, losses from one category cannot be used to directly offset
income or profit of another category.
 Chapter 6: Income categories set the AGI 53

Each category is annually tallied separately to establish the end-of-

year income or loss within that category. The reportable end-of-year
income or profit within all income categories are, before considering
any reportable losses, initially added together to start the process of
establishing the owner’s adjusted gross income (AGI).

The handling of reportable annual losses as an adjustment to AGI is

different for each income category. Suspended rental operating losses
are deductible in future years when used to offset operating income or
sales profit from the property which generated the loss, called tracking.

When a sale of rental property occurs and the suspended loss carried
forward is greater than the profits on the sale, the operating loss
remaining spills over to reduce the AGI. Tracking maintains the integrity
of requiring suspended losses to only offset future income or profit from
the property generating the operating loss.

active management ..................................................................... pg. 51 Chapter 6

passive income category............................................................. pg. 48
passive ownership........................................................................ pg. 51 Key Terms
portfolio income category........................................................... pg. 52
suspended loss................................................................................ pg. 49
tracking............................................................................................ pg. 49
trade or business income category........................................... pg. 47
Notes:
 Chapter 7: Avoiding dealer property status 55

Chapter
7
Avoiding dealer
property status

After reading this chapter, you will be able to: Learning

• distinguish ordinary income assets, such as dealer property
inventory, from real estate classified as investment property or
Objectives
trade or business assets.
• understand how to avoid dealer property treatment for a property
sold.
§1031 investment property liquidation theory Key Terms
alter ego ordinary income asset
capital asset trade or business asset
cash-out transaction

Real estate held by an owner primarily for investment and profit is classified Classification
as a capital asset. Capital assets include real estate:
of property
• actively operated as a rental property investment, a passive income
category property; based on the
• held as a management-free investment for income or profit, a portfolio owner’s use
income category property; and
• the owner’s principal residence, a portfolio category property.1 capital asset
Real estate held by
Capital assets do not include trade or business assets or inventory. Property an owner as their
principal residence
classified as a trade or business asset includes real estate: or for investment,
excluding properties
• used to house or facilitate the operation of a trade or business; held as inventory for
• qualified for depreciation when improved; and sale to customers or
for productive use in a
• owned for more than one year. trade or business.

1 Internal Revenue Code §1221

56 Tax Benefits of Ownership, Fourth Edition

trade or business Capital assets, excluding a principal residence and trade or business assets,
asset are also classified as investment properties which qualify as like-kind
Real estate used to property for §1031 profit exemption treatment. The sole distinction between
house or facilitate the
ongoing operation of a §1031 investment property and §1031 trade or business property is that
trade or business. property used in the operations of a business is subject to a one-year holding
period before it qualifies as §1031 property.

§1031 investment Real estate which qualifies as §1031 property, whether held for investment or
property for productive use in a business, may on the sale of the property be replaced
Business-use and
investment real estate without taxation of profit by the acquisition of other §1031 property — rather
which qualifies the than cashed out — called a §1031 reinvestment plan. Participation in a §1031
owner to exempt profit
realized on its sale
reinvestment plan by the seller of §1031 property exempts the profit realized
from income taxes by on its sale from taxation.2
acquiring like-kind
property in a §1031 On the other hand, real estate held as inventory for sale to customers of the
reinvestment plan.
owner’s trade or business is an ordinary income asset, more commonly
called dealer property.3
ordinary income
asset An ordinary income asset typically includes inventories bought and actively
Real estate held by sold for income in a business. Inventory includes:
an owner primarily
as inventory for sale • properties actively managed as subdividable land;
to customers in the
ordinary course of • lots sold in cash-out sales by a developer (versus a carryback sale); or
the owner’s trade or
business, called dealer • properties acquired by an individual with the intent to routinely resell
property. them rather than hold for long-term investment purposes.
Ordinary income assets are properties acquired with the intent to resell them
as an ongoing buy-and-sell transactional activity. Typically, this buy-and-
sell conduct involves flipping properties acquired at foreclosure sales or short
sales, or in a market driven by momentum.4

When dealer property is sold at a price exceeding its cost the owner receives
taxable ordinary income. Dealer property is inventory, not a capital
investment, and its turnover by sale at a price exceeding costs generates
ordinary income, not profits. Earnings from properties the owner intends to
resell in an ongoing entrepreneurial activity do not constitute capital gains.
Dealer property and other inventory items sold as merchandise in a trade or
business are not classified as §1031 like-kind property.5

In a tandem result, dealer property sold on credit in a seller-financed

carryback sale does not qualify for installment sale deferred reporting of
profit since earnings on the sale of inventory produce ordinary income, not
capital gains. Thus, ordinary income is reported and taxed in the year the
carryback sale closed, with exceptions for deferral of ordinary income on the
carryback sale of:
• farms;
• vacant residential lots; and

2 IRC §1031
3 IRC §64, §1231(b)(1)(B)
4 Little v. Commissioner of Internal Revenue (9th Cir. 1997) 106 F3d 1445
5 IRC §1031(a)(2)
 Chapter 7: Avoiding dealer property status 57

• short-term time shares.6

Conversely, the profit taken on a carryback sale of investment or business
property is prorated and allocated between the amount of cash sales proceeds
and the principal amount of the carryback note. The remaining cost basis in
the property sold is likewise prorated. The taxation of the profit allocated cash-out transaction
to the note’s principal is deferred, leaving calculation of the tax liability to Selling a like-kind
§1031 property
future years when principal on the note is received.7 [See Chapter 16] without a concurrent
reinvestment plan for
Typically, IRS challenges asserting dealer property treatment arise when an acquiring a like-kind
§1031 replacement
individual sells multiple properties in a recurring process structured as cash- property to exempt
out transactions rather than as a continued investment in replacement profit realized on the
real estate in the form of a §1031 reinvestment plan. sale from taxes.

Whether real estate is dealer property or an investment or business asset Dealer

depends on the circumstances existing throughout the entire period of
ownership, from the purchase to the ultimate resale of a property. property vs.
Also, the ownership of property vested as an individual’s is analyzed investment
differently for dealer property status than the ownership vested in an or business
entity (LLC, limited partnership, or corporation) co-owned as a syndicated
investment by two or more individuals. When an entity is the vested owner assets
of a property, such as land held for investment, the entity’s intentions and
conduct during its ownership are tested using the factors which determine
dealer property status.

Individuals who benefit from the entity’s earnings do not own the property,
though they certainly control its activities. With a separate vesting, an
individual’s business activities with dealer or investment property are not at
issue when establishing the entity’s intentions and conduct.

Ownership factors which distinguish dealer property from investment

property include:
Properties
• the owner’s intentions when acquiring the property (to either cash
managed by
out/profit on its resale as soon as possible or hold it as a long-term the owner
investment opportunity for income);
as dealer
• the owner’s intentions as manifested while owning and operating the
property; property
• the duration of ownership period before advertising or listing the
property for sale;
• use of the property at the time of sale;
• the frequency, continuity, and substance of the vested owner’s sales of
other properties;

6 IRC §453(l)
7 IRC§§453(b)(2)(A)
58 Tax Benefits of Ownership, Fourth Edition

• the extent of advertising for buyers, listing the property for sale, other
promotional sales activities, and earnings from the sale of similar
properties by the owner;
• the time and effort devoted to the sale of the property by the owner;
• the extent of subdividing, construction of improvements, planning,
zoning efforts, arranging to bring in utilities, etc. for the property; and
• the nature and extent of the owner’s regular business as related to the
sale of the property.8
The initial takeaway: No single factor is conclusively for or against dealer
status. The frequency and substantiality of the owner’s sales of comparable
properties play the most important role. Is the owner in the business of
selling this type of real estate to cash-paying customers?

For example, an owner sells several single-family residences (SFRs) in cash-

out sales over an extended period of time. Each property sold was held by the
owner for a relatively short period of time. Here, the real estate is more likely
to receive dealer status — since it resembles inventory sold to consumers
— rather than be classified as property held for income or as an appreciable
investment (no-sweat equity enhancement) before a cash-out sale occurs.9

The more frequently the owner demonstrates they intend to buy, build (or
renovate) and sell property for a quick cash sale, the more likely real estate
sold under these conditions will be considered dealer property. Think flipping
as an occupation. [Little, supra]

Conversely, when an owner intends to buy, build, and maintain a continuing

investment in real estate for a period of years, the real estate is a capital
asset. Its resale for cash after a few years of ownership qualifies the earnings
on the sale to be reported as profit, not ordinary income.

Again, the dealer property issue arises only on a cash-out or carryback sale
of the property. The dealer property taint is eliminated when proceeds from
the sale are reinvested in a §1031 reinvestment plan. Buying like-kind
replacement property continues the owner’s investment in real estate.

An individual’s original motivation for purchasing a property is one of the

The intended factors used to classify the property as either a capital asset or inventory.
purpose for For example, a trust deed (TD) investor bids at a foreclosure sale to acquire title
acquiring a to property on which they hold a trust deed. As the high bidder, the investor
becomes the owner. The property consists of two or more parcels. The TD
property investor as the new owner decides to sell the property as individual parcels
in a piecemeal disposition. The sale of parcels separately is their best way to
receive the highest price to recover cash on a failed trust deed investment.

8 Mathews v. Commissioner of Internal Revenue (6th Cir. 1963) 315 F2d 101
9 Suburban Realty Company v. United States (5th Cir. 1980) 615 F2d 171
 Chapter 7: Avoiding dealer property status 59

The TD investor’s primary plan was to foreclose, acquire the property if the
high bidder, then resell the property to liquidate their security interest under
the trust deed lien they held on the property. Thus, they avoid operating
lender-owned real estate (REO) properties.

Does the sell-off of the real estate as separate parcels mean the real estate was
held as dealer property?

No! The trust deed investor’s intention on acquisition of the property was
to protect and preserve their security interest in the property represented by
the trust deed they held. The investor promptly resold the property to obtain
cash and remain as an investor in trust deed notes, not to acquire real estate
for resale to consumers.10

Use of real estate during the period of ownership is likewise a significant

indication of the property’s status as inventory or an investment or business
Ownership
asset when it is sold. intentions
For example, a builder buys a parcel of real estate and constructs an apartment and
complex on it. The property now produces income for the builder, who takes management
depreciation deductions.
of a property
After owning and operating the apartment, the builder sells the property and
acquires a larger complex as a replacement property in a §1031 reinvestment
plan.

Here, the real estate built and sold is a capital asset, not dealer property. The
builder’s purpose at both the time of purchase and throughout their period of
ownership is evidence of their intent to buy, build and operate the property
as an income-producing investment.

Most importantly, the seller reinvested the net sales proceeds from the sale
to acquire a like-kind §1031 property as a replacement. They did not cash out
and use their net sales proceeds to buy land, construct improvements and
sell the completed project to replicate the trade or business of a developer and
builder.

That the builder constructs improvements on the property to alter or enlarge

its use does not throw the property into the dealer category without more
evidence of dealer activity, such as its early liquidation in a cash-out sale.11

When an owner continuously buys, constructs improvements and sells the

properties after they attain the level of occupancy necessary to successfully
market them and cash out, the real estate is dealer property. The improvement
and sale of properties as a source of annual earnings constitutes inventory
available for purchase by customers of the builder’s trade or business.12

Tract development of lots and construction of residential property for sale to

the public are classic dealer property situations. In contrast, an owner who
10 Malat v. Riddell (1966) 383 US 569
11 Heller Trust v. Commissioner of Internal Revenue (9th cir. 1967) 382 F2d 675
12 Bush v. Commissioner TC Memo 1977-75
60 Tax Benefits of Ownership, Fourth Edition

acquires real estate as a rental investment expends little time and effort to sell
it compared to the time they spend actively managing their ownership of it.
By the time they cash out and realize a profit, the period of management by
the owner compared to the short marketing effort demonstrates the property
is held as a capital asset for operating income, not as inventory to generate
earnings by selling it.

Dealer income is derived from the activities of a business, such as continuously

acquiring properties in foreclosure or at foreclosure sales, fixing them up or
refinancing the debt, then “flipping” them in a resale as soon as earnings can
be realized.

With flipping, the owner’s earnings are mostly derived from improvement
or activities to cure deferred maintenance or obsolescence to prepare the
property for resale. The property’s value increased due to the owner’s value-
adding activities. The increased value was not due to asset inflation and local
appreciation which flow to a property owned and operated over the long
haul.

Consider an investor who acquires ownership of a property at a price

Acquired to significantly below current market value or in a §1031 reinvestment plan. The
resell and property was acquired under one of the following purchase arrangements:
reinvest • the exercise of an option to purchase or a right of first refusal held by
the investor;
• the liquidation of a development corporation owned solely by the
investor;
• a purchase agreement with a distressed seller; or
• as a §1031 replacement for property the investor sold after years of
depreciation deductions.
Before acquiring the property, the investor determines they are unwilling to
retain ownership and the property will be resold quickly in its condition at
the time of purchase. The investor lacks the ability (or willingness) to finance
their long-term ownership or to develop the property to its highest and best
use and increase its value. Thus, the investor takes a profit resulting from
their low-cost basis compared to current market value.

To accomplish a prompt resale, the investor lists the property for sale with
their broker, who originally assisted them in the purchase of the property.
Importantly, the listing states any purchase agreement entered into is to be
conditioned on locating and acquiring suitable replacement property for a
§1031 reinvestment.

The broker locates a buyer willing to purchase the property on listed terms and
conditions. Within a few months after the owner enters into an agreement
to sell the property, the broker locates an investment property suitable for the
investor to acquire. As a result, the owner closes the sales escrow based on
instructions calling for the investor’s net sales proceeds to be made payable
 Chapter 7: Avoiding dealer property status 61

and delivered to either a purchase escrow they have opened to acquire

a replacement property or a §1031 trustee. The contingency calling for the
purchase of other property is waived. [See RPI Form 172-2]

Escrow closes. The investor has accomplished their goal by completing

the prompt resale of the property they decided not to keep as a long-term
investment, realizing a profit on its resale as intended.

After closing the sale and within 180 days, the investor acquires ownership
to a replacement property they had identified prior to expiration of the 45-
day §1031 replacement property identification period.

The investor reports the two transactions on their tax return for the year of
the sale, a requirement, as a reinvestment of their net sales proceeds from the
sale of §1031 property “held for investment.” They report the profit realized
on the sale was exempt from taxation under IRC §1031.

When a property is owned for a very short period of time, and held from the
moment of acquisition with the intent to sell it for a profit and use the sales
proceeds to buy a replacement property, does the property sold qualify as
§1031 property? Is the profit realized exempt from tax reporting?

Yes to both! The investor both owned and possessed the property and did not
construct improvements from the moment they closed escrow on its purchase.
Further, and most importantly, they reinvested the sales proceeds in §1031
real estate and did not liquidate their investment in the real estate by cashing
out on the sale. Thus, the property sold was not part of a business conducted
to sell property to customers. It was to continue owning real estate, just not
the property the investor had acquired and deemed unacceptable to retain.

To be §1031 properties, the investor needs to have held the property sold and
to hold the property purchased:
§1031
• for investment (either passive or portfolio income category property);
property has
or no holding
• for productive use in a trade or business, qualifying as §1031 property period
on holding ownership for one year.
In a §1031 transaction, investment property ownership has no holding
period before it may be sold or exchanged to qualify as §1031 like-kind
property. To hold property which qualifies as §1031 like-kind property
requires the person selling and conveying it to merely own and possess the
property for any length of time.

The requirement that §1031 property be owned for investment purposes is

satisfied by:
• avoiding a cash-out sale, called liquidation; and
• reinvesting the sequestered net sales proceeds by the timely
identification and acquisition of like-kind property.
62 Tax Benefits of Ownership, Fourth Edition

The required continuation of an investment in real estate necessary to qualify

for the §1031 profit tax exemption is manifested by acquiring ownership of
a replacement property with the intent to make money as its owner, called
investment real estate.13

Segregating Consider a real estate dealer who maintains a business of buying and selling
real estate for their own account. They now want to qualify the profit taken
investment on the sale of some properties they own for capital gains treatment. The
properties are rentals and have been held as investments.
property
To be considered capital assets, the properties need to have been segregated
in all manner possible from their dealer inventory. To meet this objective,
it is helpful that the investment properties are a type distinguishable from
their dealer property inventory, e.g. single family residence (SFR) inventory
vs. apartments or commercial properties or land. Segregation begins at the
time a property is acquired by taking steps to establish ownership activities
consistent with a long-term investment property.

To this end, dealer properties the operator acquires are vested in the name
of an entity solely owned by the dealer, such as an LLC, limited partnership,
corporation, or brokerage DBA (“doing business as”). On the other hand, title
to rental and investment properties are vested in the owner’s name or the
name of a separate LLC formed solely with the stated purpose in the LLC’s
operating agreement to hold title on acquisition of investment property.

To further support the segregation of titles and accounting, the operator

needs to hold ownership of the investment properties for several years before
their sale, not just the one year holding period threshold required to convert
the earnings on the sale of a capital asset from short-term to long-term capital
gains — profit taxed at differing rates.

Improvements which increase the market value of the property are to be

made when the property is acquired or during the early period of ownership,
if at all. When improvements are made at or near the time of resale, the seller
appears to have made them in contemplation of a sale, with the intent to
convert ordinary income from construction efforts (or sweat equity) into
profits for capital gains treatment. Recent property improvements subject the
property to dealer property status.

Meanwhile, the dealer continues to actively market their dealer properties

for sale in their real estate business. In contrast, the investment properties
are not listed for sale, not marketed for sale, and in no way held out for sale
until obvious investment intent has been established. When the properties
are sold, the net proceeds are reinvested in replacement properties as a
continuing investment in real estate under a §1031 reinvestment plan.
Reporting the sale of a property and purchase of a replacement property for a
§1031 exemption from profit taxes demonstrates the properties were treated
as capital assets.

13 Bolker v. Commissioner (9th Cir. 1985) 760 F2d 1039

 Chapter 7: Avoiding dealer property status 63

Separate bank accounts, accounting records, business entities (for vesting)

and management records also help distinguish property held for investment
purposes from those held as dealer inventory.

Consider an owner who advertises to locate a buyer to acquire property The

the owner held for investment. Here, any staging of the property needed
to successfully market and sell it does not automatically deny capital gains liquidation
treatment when the history of ownership demonstrates it has been held for
investment.
theory for
capital gains
A liquidation theory provides an exception to the rule prohibiting an
owner’s time and effort spent improving or developing investment property treatment
so it may be disposed of (which normally produces ordinary income) to be
liquidation theory
converted into profit for capital gains treatment. When, to facilitate
the sale of investment
The subdivision of land or buildings into lots or units, the construction of property, the owner
minor capital improvements, sales promotion or frequent and continuous develops it only as
necessary to cash out
sales will not result in dealer status for a property when: their capital interest
in the property and
• the owner’s original investment intention or business use of the still qualify the profit
property has been established; for capital gains
treatment.
• the owner’s developmental activities are reasonably necessary for an
orderly disposition of the property; and
• the development, improvement and promotional actions are not
excessive as the minimum activities necessary to dispose of the
property.14
To apply the liquidation theory to the sale of an investment or business
use property, the owner needs to avoid a level of activity that may be
characterized as having the sole purpose of increasing the property’s market
value rather than simply making the property marketable. These efforts
may be improvement activities such as the conversion of a building by
simply mapping it as a condominium subdivision and concurrently selling
off individual units without also upgrading or adding amenities or other
renovation. Liquidation activities are simply basic necessities required
to induce a buyer or buyers to acquire the property through piecemeal
disposition when no market for the property otherwise exists.

Development and promotional activities beyond those necessary to fully

realize a property’s inherent investment value —- the owner’s capital interest
in the property — will jeopardize treatment of profit as a capital gain.

Consider the owner of a parcel of real estate with a final subdivision map. Use of semi-
The owner enters into an agreement with a building contractor to develop
and promote the sale of finished lots. The owner retains title to the property, independent
but supplies all construction funds the builder needs to complete the developers

14 Oace v. Commissioner (1963) 39 TC 743

64 Tax Benefits of Ownership, Fourth Edition

grading and offsite improvements. On completion of the grading and offsite

improvements, the lots are sold. The owner conveys title directly to buyers
and cashes out.

The builder never holds title but performs all construction work and
conducts all marketing activities. Under the joint venture agreement, the
owner receives a set dollar amount as the price for each unimproved lot and
a return of the construction funds advanced with interest. The remainder of
the sales proceeds goes to the builder.

The owner claims their conduct avoids dealer status for the property since
the owner did not personally perform any value-increasing activities and
the risk of added value due to the improvements was with the builder.

Here, the builder is acting as the owner’s agent, whether under contract or
a joint venture, partnership, or other profit-sharing arrangement. The dealer
activities of an agent or partner are imputed to their principal or partner —
here the owner of the property. Thus, the development of property for sale to
costumers is inventory in the hands of the owner – dealer property – due to
the conduct of the owner’s agent barring earnings from sales to qualify for
capital gain treatment.15

A better method for ensuring a property the owner intends to develop and
Use of a sell qualifies as a capital asset is to sell the property to a corporation controlled
controlled by the owner.

corporation An owner sells investment property to their controlled corporation at a

price that includes a profit for the owner. The profit is reported and taxed as
a capital gain. The corporation on acquiring title to the property undertakes
the development and promotes the sale of developed parcels to members of
the public. The property, by its improvement to create additional value, is
dealer property.

The corporate business is to earn income from construction done solely for
the purpose of immediately reselling property. The net income realized by
the corporation, however, is limited by its high cost basis in the property, a
result of the corporation’s purchase of the property from the owner.

In these arrangements, the corporation needs to be adequately capitalized

by the issuance of stock (for cash), purchase-assist financing or a construction
loan. It may not be a shell used to provide the owner with limited liability for
the risks of construction and borrowing.16

Any corporate stock issued to the owner must be for consideration other than
the property they have sold to the corporation, such as cash. The stock may
not be issued in payment for any portion of the sales price of their property
(which is an IRC §351 tax exempt exchange).

15 Pointer v. Commissioner (1969) 419 F2d 213

16 Bradshaw v. U.S. (1982) 683 F2d 365
 Chapter 7: Avoiding dealer property status 65

When the corporation is wholly owned and controlled by the property owner,
or corporate formalities are ignored, the corporation is arguably the owner’s
alter ego. Earnings by an alter ego corporation from the development of alter ego
a property are attributed to the owner. Thus, the two-step transaction (sale A corporation or LLC
whose earnings and
and development/resale) is collapsed into one ownership activity and all assets are used directly
earnings are taxed as the owner’s self-employment trade or business income. for the personal
advantage of its
Corporate formalities, such as shareholder meetings and meetings of the owner, resulting in
insufficient separation
board of directors, need to be carried out regularly. between the owner
and the corporation
Also, the purchase price paid by the corporation for the yet-to-be-developed or LLC to shield the
owner from personal
property needs to reflect the property’s current appreciated value — the liability for the entity’s
owner’s capital interest in the property before development — not the debts.
value to be added by any future development and promotional activities of
the corporation. An excessive sales price — exceeding the value set by an
appraiser of the undeveloped property — may result in the owner being
charged with receiving the increase in value brought on by development.
Thus, the corporation will be characterized as the owner’s agent, and its
activities imputed to the owner to disallow capital gain treatment.

Once the property is developed, the corporation receives, reports, and

pays taxes on the ordinary income generated by the improvements and
promotionally increased value of the property. The owner does not report
any part of the sales price paid by the corporation for their property as
ordinary income. Conversely, any income they receive from corporate
development activities is for holding stock they acquired by investing cash
in the corporation.

Capital assets are real estate held by an owner primarily for investment Chapter 7
and profit and do not include trade or business assets. Real estate held
as inventory for sale to customers of the owner’s trade or business is an
Summary
ordinary income asset, more commonly called dealer property.

Inventory includes:
• properties actively managed as subdividable land;
• lots sold in cash-out sales by a developer (versus a carryback sale);
or
• properties acquired by an individual with the intent to routinely
resell them rather than hold for long-term investment purposes.
Whether real estate is dealer property, or an investment or business asset
depends on the circumstances existing throughout the entire period of
ownership, from the purchase to the ultimate resale of a property. No
66 Tax Benefits of Ownership, Fourth Edition

single factor is conclusively for or against dealer status. The frequency

and substantiality of the owner’s sales of comparable properties play the
most important role. An individual’s original motivation for purchasing
a property is one of the factors used to classify the property as either a
capital asset or inventory.

Chapter 7 §1031 investment property ...................................................... pg. 56

alter ego............................................................................................ pg. 65
Key Terms capital asset..................................................................................... pg. 55
cash-out transaction..................................................................... pg. 57
liquidation theory......................................................................... pg. 63
ordinary income asset.................................................................. pg. 56
trade or business asset.................................................................. pg. 56
 Chapter 8: Mortgage interest write-offs on business and investment properties 67

Chapter
8
Mortgage interest write-
offs on business and
investment properties

After reading this chapter, you will be able to: Learning

• apply the different interest expense and deduction rules peculiar
to each income category for the reporting of interest paid on a
Objectives
mortgage; and
• discuss when mortgage interest is expensed or deducted.

aggregating net investment income (NII) Key Terms

capital expenditure paid and accrued rule

A paid and accrued rule requires interest an owner pays on a mortgage to

accrue before it may be written off against income. Prepaid interest may not
Mortgage
be written off until the year it accrues.1 funds used
The only exception to the paid and accrued rule applies to points paid for to purchase,
mortgages which funded the purchase or improvement and encumber the improve, or
borrower’s principal residence.2 [See Chapter 2]
carry costs
The mortgage interest write-off rules are concepts based in part on the
subtle accounting distinction between whether interest, when written off,
is expensed or deducted from some or all income within a category. For
example, interest accrued and paid on a mortgage which funded a trade or paid and accrued
business category property is expensed from total income within the category rule
Interest paid on a
as a business operating item to establish the net operating income (NOI) for mortgage needs to
the business. accrue before it may be
expensed or deducted
from income.
68 Tax Benefits of Ownership, Fourth Edition

For passive category rental property mortgages, interest accrued and paid
is deducted only from the encumbered property’s NOI due to tracking. It is
not an expense incurred to operate a rental property. For mortgages which
funded a portfolio category property, interest accrued and paid is deducted
from the portfolio category’s net investment income (NII) after the NII has
been established, the same treatment as the interest deduction from a rental
property NOI.

A property owner’s ability to write off interest involves questions about the
tax treatment of interest, including:
• Which expenditures incurred on a mortgage constitute the payment
of interest?
• Which property’s income or when category income may be offset by
the payment of interest?
• What other income is offset by a net operating loss caused by the
payment of interest?

Points An investor or business owner pays a lender charges to originate a purchase-

assist mortgage. To pay the mortgage origination charges, the investor or
upfront as business owner has three available sources:
prepaid • funds they hold as the buyer;
interest • funds accruing to the seller on the sale of the property; or
• a discount or addition by the lender to the principal amount of the
mortgage.
Recurring and non-recurring charges an investor pays on a mortgage include:
• mortgage origination fees and closing costs;
• points; and
• interest.
The fees and costs a buyer pays to originate a mortgage are non-recurring
capital expenditure costs. They are incurred to acquire capital to fund the purchase or improve
An expenditure property, called capital expenditures.
incurred to fund
the purchase, As costs of acquisition or improvement, capital expenditures incurred to
improvement, or
carrying costs of real originate a mortgage are added to the buyer’s cost basis in the property, a
estate. treatment called capitalizing. The expenditure is a cost incurred to acquire
funding to buy the property, not to operate it.

As capitalized, acquisition costs are added to the property’s cost basis and
recovered by the buyer as a tax-free return of invested capital through:
• a depreciation allowance taken by the owner annually over a capital
recovery period as an operating expense from gross income or deduction
from net operating income; or
• a deduction from the net price received on a sale of the property for any
cost basis remaining to determine profits on the sale.3
3 Lovejoy v. Commissioner (1930) 18 BTA 1179
 Chapter 8: Mortgage interest write-offs on business and investment properties 69

In contrast, mortgage points are a prepaid interest charge. The amount of

the points represents the present worth of a portion of the total interest
otherwise paid by the owner over the life of the mortgage at the par rate of
interest when originated. [IRC §461(g)]

To write off interest prepaid up front as points, a pro rata amount of the
points is written off annually over the life of the mortgage as it accrues.
An exception exists for points paid on mortgage funds used to purchase or
improve a principal residence. The homebuyer may deduct from their AGI
the entire amount paid as points in the year of purchase. [See Chapter 2]

The payment of points —regardless of who paid them — is treated the same as
any other prepaid interest. The portion of prepaid points accruing annually is
written off against income.

To avoid a conflict with the lender’s annual 1098 interest paid filing, an owner
reports the points separately from the reporting of other interest payments.

Economically, the interest write off shifts liability for income taxes from
the property owner to the mortgage holder for the portion of the mortgaged
property’s income used to pay interest.4

Since mortgage points are written off prorate as they accrue over the life of the
mortgage, a cash-poor buyer, such as a first-time homebuyer, might logically
negotiate to add the points to the mortgage balance, amortized and paid in
future years when personal income is higher. Thus, the buyer retains their
cash for another day. The adding of points to the mortgage balance is either
directly by the lender or indirectly by the seller kicking back the amount
from the purchase price funded by the lender.

Interest paid and accrued on a mortgage does not directly offset the owner’s The use of
personal income. The source of income offset by writing off mortgage interest
payments is determined by the income category of the property purchased, mortgage
improved or carried by the mortgage funds. funds
To write off the payment of mortgage interest, the mortgage proceeds need to controls
be used in connection with a property in one of the three income categories:
the trade of business income category, passive income category, or portfolio expensing or
income category.5 deducting
Mortgage proceeds may be used to fund:
• property acquisition;
• property improvement;
• carrying costs of ownership; or
• refinancing an existing mortgage.
The expenditure of mortgage proceeds to accomplish personal objectives
disqualifies interest payments as a write off against any income. However,
an exception exists for interest paid on mortgage funds used to purchase or
improve a first or second home. [See Chapter 1]
4 26 CFR §1.163-8T(a)(4)
5 26 Code of Federal Regulations §1.163-8T(c)
70 Tax Benefits of Ownership, Fourth Edition

Occasionally, the only connection a property has with a mortgage is to

provide security for funds advance to pay for obligations unrelated to the
property. Here, the mortgage proceeds do not fund a use connected with the
secured property. To determine the income category in which the interest
may be written off, identify the property purchased, improved or refinanced
using the mortgage funds.

Rental Interest paid on a debt — such as a mortgage that funded the purchase,
improvement or carrying costs of rental property — is deductible only from
property the NOI produced by the rental property purchased, improved, or carried by
interest the mortgage funds. Interest, along with depreciation, is deducted annually
from the rental property’s NOI to establish the property’s reportable operating
deductions income or loss. The debt may be unsecured, or it may be secured by any
property including the owner’s personal residence or second home.6

To deduct interest from a rental property’s NOI, the mortgage proceeds or

carryback debt need to be used in connection with the property.7

Interest is deductible annually from a rental property’s NOI based on the

percentage of the mortgage proceeds or principal in a carryback note used to
fund:
• the purchase of the rental;
• the improvement of the rental;
• the carrying costs of operating the rental, called negative cashflow
property; or
• the refinancing of the principal balance remaining on existing
mortgages which funded the purchase, improvement or carrying costs
of the property.8
While deducted from NOI, passive category interest deductions are not
limited to the amount of the property’s NOI. Thus, interest deducted from
the NOI may bring about an annual reportable loss for ownership — even
more likely when added to amounts of capital recovered by the depreciation
deduction.

Interest paid on debts used in connection with a rental property is fully

deductible from the property’s NOI. When the interest amount deducted
exceeds the NOI, a reportable loss is incurred on the property.

Further, an annual reportable loss resulting from rental property ownership

offsets reportable operating income from other passive category assets.
The sum of the reportable operating income and losses of all assets within
the passive income category is the category’s total income. Totaling profit
or loss for the year from all sources within the passive category is called
aggregating
Combining the aggregating.
reportable operating
income and losses
from all sources within
the passive income 6 Alexander v. Commissioner, TC Summary Opinion 2006-127
category. 7 26 CFR §1.163-8T(c)
8 IRC §163(h)(2)(B)
 Chapter 8: Mortgage interest write-offs on business and investment properties 71

Interest paid on mortgages used to fund the purchase, improvement, or Portfolio

carrying costs of portfolio properties is deductible from investment category
income.9 category
In application, interest paid on mortgages and carryback notes which investment
funded the purchase, improvement or carrying costs of portfolio category property
investments, such as land held for profit and management-free, net-lease
income property, is written off as a deduction from net investment income interest
(NII). As a result, mortgage interest offsets interest earned on savings deductions
accounts, trust deed notes or bonds, stock dividends and profits and rents
from ground leases to lower reportable income in the portfolio category.10
net investment
Annual portfolio reportable losses may not be used as an adjustment to reduce income (NII)
Income less expenses
the investor’s AGI. Like suspended losses in the passive income category, related to portfolio
portfolio operating losses are carried forward but unlike suspected losses category assets. For
real estate investors,
offset any portfolio income in future years. However, portfolio losses do not
this includes income,
offset income or profits from the business or passive income categories.11 profits and losses from
the operations and
Further, portfolio operating losses are not tracked like suspended losses, sales of management-
free, net-leased rental
which limit use of the suspended losses to offset future income only from the property, land held for
property which generated the suspended loss.12 profits on resale, and
interest-bearing assets.
The NII for portfolio category reporting is the sum of gross income less
expenses. Interest accrued and paid, and any property depreciation allowance
are not expenses incurred by portfolio investments. They are deductions
from the NII to determine the portfolio income or loss for the year.13

In an owner’s trade or business, interest paid on mortgages used to purchase

or improve property, conduct the business, or carry real estate held or used in
Trade or
the business is a business expense. Here, as a cost of doing business, interest business
accrued and paid is subtracted — expensed — from gross income to reduce
the NOI of a business operation. interest
Interest paid in a business is not a deduction from NOI as it is for mortgages
expense
on passive category and portfolio category investment properties. There,
mortgage interest is treated as an expense of capital borrowed to purchase
an investment. For a business, borrowed money represents the business’s
working capital to maintain inventory and receivables.14

Business operations include the use of real estate in the production of

business income unlike ownership of a rental property which itself generates
income in the rental market. No limitations or ceilings are imposed on the
amount of interest charges a business may expense — unlike suspended
losses on passive category property and reportable losses carried forward in
the portfolio category, brought on by interest write-off limitations.

9 IRC §163(d); 26 CFR §1.163-8T(a)(4)(i)(E)

10 IRC §163(c)
11 Talchik v. Commissioner TC Memo 2003-342
12 IRC §163(d)(2)
13 IRC §§163(d)(4), 469(e)(1)(A)(i)(III)
14 26 CFR §1.163-8T(a)(4)
72 Tax Benefits of Ownership, Fourth Edition

Finally, any aggregate trade or business category loss reduces the owner’s
AGI without limitation. When a business loss exists, the entire business
loss offsets other income and profits reported in the passive and portfolio
categories for the year to establish the owner’s AGI.15

15 IRC §163(h)(2)(A)

Chapter 8 The mortgage interest write-off rules are concepts based in part on the
subtle accounting distinction between whether interest, when written
Summary off, is expensed or deducted from some or all income within a category.

A property owner’s ability to write off interest involves questions about

the tax treatment of interest, including:
• Which expenditures incurred on a mortgage constitute the
payment of interest?
• Which property’s income or when category income may be offset
by the payment of interest?
• What other income is offset by a net operating loss caused by the
payment of interest?
Interest paid and accrued on a mortgage does not directly offset the
owner’s personal income. The source of income offset by writing off
mortgage interest payments is determined by the income category of
the property purchased, improved or carried by the mortgage funds.

To write off the payment of mortgage interest, the mortgage proceeds

need to be used in connection with a property in one of the three income
categories: the trade of business income category, passive income
category, or portfolio income category.

Chapter 8 aggregating..................................................................................... pg. 70

capital expenditure....................................................................... pg. 68
Key Terms net investment income (NII)..................................................... pg. 71
paid and accrued rule................................................................... pg. 67
 Chapter 9: Depreciation deductions mature as an unrecaptured gain tax 73

Chapter
9
Depreciation deductions
mature as an
unrecaptured gain tax

After reading this chapter, you will be able to: Learning

• advise clients on the purpose of depreciation deductions allowed
an owner of improved property to withdraw invested capital from
Objectives
income;
• explain the distinction between the two classes of profits taken on
a sale of improved property; and
• discuss the unrecaptured gain an owner takes on the sale of
improved property and reports as taxable due to depreciation
deductions.

annual property operating depreciation deduction

data sheet (APOD) Key Terms
depreciation schedule
appreciable asset
property appreciation
depreciation

Owners of improved investment property or property used in a trade or Cost of

business annually recover a portion of the acquisition and improvement
costs they allocate to the improvements as a write off against operating improvements
income. The annual recovery is called a depreciation deduction.
recovered:
The deduction is an allowance for the decline in a property’s value — the a return of
owner’s capital interest — brought on by age, physical deterioration, or
functional or economic obsolescence of its improvements.1 invested capital
1 Internal Revenue Code §167(a)
74 Tax Benefits of Ownership, Fourth Edition

depreciation Depreciation deductions from income is both:

deduction
The annual before- • an investment fundamental; and
tax withdrawal from
income, deducted from
• a tax reporting activity.
the NOI of a rental
property, expensed Depreciation is often conceptualized by investors and their brokers as
from trade of business converting a portion of a property’s NOI into tax-free spendable income —
income, or deducted disposable earnings for the owner produced by an investment in improved
from the NII for
portfolio investments, property. The perception depreciation produces tax-free earnings is an
to provide a return extension of the belief real estate always increases in value over time. But if
of invested capital
allocated to property
property did, depreciations deductions serve no purpose except as a loophole
improvements for income to escape taxes.
which reduces the
owner’s cost basis in However, the viewing of depreciation as providing the owner with spendable
the property. To be
distinguished from a income, not as an untaxed withdrawal of invested capital, overlooks the
return on capital. economic function of depreciation. Capital invested to purchase improved
property or improve a property needs to be withdrawn over a period to time
to mitigate the uninsurable risks of loss inherent in any immobile asset such
depreciation
Loss of property as improved property.
value brought on
by age, physical Climate change, natural disasters, out-migration, shifting demographic
deterioration, or the
functional or economic
demands for use or occupancy of property are risks depreciation is intended
obsolescence. to cover. An annual recovery of capital — not rents labeled spendable income
— is dictated by prudence to be set aside by an investor as capital for further
reinvestment.

Also misleading in the context of the withdrawal of capital are the unrelated
aspects of asset inflation and property appreciation. These monetary
property
appreciation and demographic driven rises in the value of a property are commonly
The portion of the viewed as fully offsetting the dollar value of actual physical obsolescence
increase over time in
a property’s market
and deterioration of property improvements.
value exceeding the
rate of inflation. Realistically, the aging of property absolutely has an adverse effect on
a property’s comparative value and is the economic underpinning for
depreciation schedules. And yes, they may well during periods of prosperity
annual exceed the adverse effect of aging on the property. But this mixes the
need for recovery of invested capital with profit from a property’s increase in
value. They are different, and the owner is entitled to both – though the profit
might not be realized the depreciation deduction is always there.

Consider that over time, the tandem effects of inflation and appreciation
factors tend to drive up the amount of rental income for a property
competitively maintained and located in an area with stable or rising
demographics. To distinguish between these two valuation factors, rental
income increases for some properties rise beyond the rate of annual consumer
inflation which is due to the appreciation factor.

Inflation is a monetary measure tied to the decline in purchasing power

of the dollar. It simply buys less from year to year. When all economic
conditions remain the same for a location, personal income and amounts
paid as rent tend to keep pace with consumer inflation. In turn, as rents go
up, so goes property value, a function of applying capitalization rates to a
property’s NOI.
 Chapter 9: Depreciation deductions mature as an unrecaptured gain tax 75

When rent increases exceed inflation, the excess is brought about solely by
local demographics, not the decline in the purchasing power of the dollar. As
rents experience an annual increase beyond the rate of consumer inflation,
the property appreciates in value. Rather than because of inflation, the rent
increased because of an increase in the number of people living in the area
or simply because the rise of personal income in the area exceeded the rate of
inflation. Thus, the rent, and in turn the property price, not only keep up with
consumer inflation, but enjoyed appreciation by more dense and wealthier
locate population.

This dual, hyper-inflated rent situation is especially observable, and likely

justified when a property is excessively maintained or renovated which sums
are typically expensed, not capitalized. Rent increases lift the dollar value of
the property in tandem. As pricing is a function of applying capitalization rates
to NOI, a rental property investor does not unreasonably label the untaxed
return of capital via the depreciation deduction as spendable income. That is,
until the day a risk of loss becomes apparent and trends reverse, as during a
recessionary period or out-migration condition (again, demographics).

Personal property used in the production of business income or provided

with rented property best demonstrates the effect of depreciation. While
personal property quickly depreciates over time, improved property is
usually managed and maintained to eliminate any wear, decay or outdated
features which when not corrected contribute to a decline in the property’s
rental income and thus its dollar value. appreciable asset
A tangible collectible,
such as property held
In contrast to the defined purpose of depreciation deductions, properly for investment or
maintained rental property is correctly considered an appreciable asset by productive use in a
investors. Historically, property tends to be a hedge against future declines business, the value
of which increases
in the purchasing power of the dollar. Especially in California with its value- over time at a rate
enhancing infrastructure and institutions, mild climate, unique geography, greater than the rate of
and use-restrictive zoning. In contrast, personal property is often referred to consumer inflation.

by investors as a depreciable or wasting asset.

Each separately assessed parcel of improved property has its own Depreciation
depreciation schedule. The depreciation schedules for different types
of improved property apply identically to property in all three income schedules
categories. All depreciable property, whether owned by an individual,
partnership, limited liability company (LLC) or corporation, uses the same depreciation
depreciation schedules. schedule
The number of years
over which an owner’s
However, an owner of a residential dwelling used as the owner’s principal capital investment in
residence – a personal use - does not have a depreciation schedule and may a trade or business,
not take depreciation deductions on the dwelling. Without depreciation passive, or portfolio
category property
deductions, a homeowner may not reduce their taxable income to recover is recovered as an
any part of the price they paid when they own a principal residence or annual expense or
second home. deduction from
income, limited to the
portion of cost basis
allocated to property
improvements.
76 Tax Benefits of Ownership, Fourth Edition

Two classes of depreciable property have been established to determine the

use of depreciation schedules:
• residential; and
• commercial.2
Further, the depreciable residential class of properties is divided into two
categories:
• vacation residences rented to transient guests when occupied during
the year by the owner’s family for no more than 14 days or 10% of the
days rented, whichever is greater; and
• all other residential rentals.
• The other class, improved commercial properties, includes:
• trade or business property;
• rental property other than residential rentals; and
• depreciable portfolio category property other than residential rentals.3
Lastly, two sets of depreciation schedules exist and apply to all depreciable
property:
• a standard depreciation schedule (SDS) for use with standard income
tax (SIT) reporting; and
• an alternative depreciation schedule (ADS) for use with alternative
minimum income tax (AMT) reporting.

SIT vs. AMT All depreciation tables used to report income are fixed annual figures which
set the scheduled life of the improvements, called the straight-line method.
depreciation The two IRS depreciation schedules for each SIT and AMT reporting are
mandated for use based on the type of property involved:
schedules
• residential rental property — the 27.5-year SDS or the 40-year ADS; and
• commercial property — the 39-year SDS or the 40-year ADS.4

annual property
Consider a broker preparing an annual property operating data sheet
operating data sheet (APOD) to figure a buyer’s after-tax benefits during their first 12 months
(APOD) of ownership for the proposed purchase of an income-producing property.
A worksheet used
to gather income
Typically, the broker uses the 27.5-year SDS for residential and 39-year SDS
and expenses on the for commercial property, not the 40-year ADS for both. The SDS produces
operation of an income a faster and thus greater annual recovery of the investment than the ADS,
producing property
for an analysis of the resulting in greater tax benefits and if you want, greater spendable income
property’s suitability sought be investors.
for investment.
An owner using the SDS reporting schedule for their SIT calculations may
switch to the ADS at any time during their ownership of any improved
parcel of property. However, once the 40-year ADS schedule is chosen, the
owner may not revert to the SDS for depreciating the parcel.5

2 IRC §168(e)(2)
3 World Publishing Company v. Commissioner (1962) 299 F2d 614
4 IRC §§168(c), 168(g)(2)
5 IRC §168(g)(7)
 Chapter 9: Depreciation deductions mature as an unrecaptured gain tax 77

A rental property owner who does not qualify as being in a real estate-related
business uses the ADS in place of the SDS to reduce or avoid a buildup of
suspended operating losses. These losses are limited for future use to offsetting
income from only the single property generating the loss.

The owner with a highly leveraged acquisition of a rental property typically

incurs an operating loss during the first years of ownership. The owner
with no reportable operating income from other rental properties or passive
business ownership is, unless otherwise qualified, unable to use the new
acquisition’s annual reportable operating loss in the year of the loss. [See
Chapter 8]

On a passive category property, a rental property operating loss may not be

used as an adjustment to lower the owner’s AGI, again unless otherwise
allowed. This bar prevents commingling a passive loss with income from
business or portfolio categories, unless the owner qualifies for either:
• the real estate-related business adjustment which permits rental losses
to reduces the AGI; or
• the $25,000 rental loss deduction which is subtracted from the adjusted
gross income when setting the taxable income. [See Chapter 6]
The use of the SDS produces less reportable income (or a greater loss) than the
use of the AMT 40-year depreciation schedule.

As always, the purchase of fee ownership in a parcel of improved property Land and
includes both land and buildings. However, only the cost of depreciable
improvements may be deducted for capital recovery through depreciation improvement
schedules. The buyer’s cost of acquisition allocated to land is not depreciable.6
[See RPI Form 355]
allocation
On the purchase of improved property, an allocation of the cost of acquisition
and improvements – cost basis – is made between land, improvements and
any personal property acquired in the transaction. The amount allocated to
improvements is recovered annually over 27.5, 39, or 40 years as previously
reviewed.

Consider a resident farmer. The amount paid for the farm is allocated based
on the ratio of the respective values of the farmhouse occupied by the owner
as their residence and the land and improvements that will be used in
their agri-business. The farmhouse as their principal residence may not be
depreciated. The portion of the cost of acquisition allocated to a farmhouse
receives the same non-depreciable treatment given to the cost of land, but
for a different reason — the farmhouse residence is for the personal use of the
farmer.7

To recover the entire cost of an investment property acquisition through

depreciation deductions, a buyer acquires a leasehold ownership interest as
a tenant under a ground lease, not a fee ownership interest in the property.
6 26 CFR §1.167(a)-5
7 Revenue Regulations §1.167(a)-6(b)
78 Tax Benefits of Ownership, Fourth Edition

Typically, further improvements are constructed by the tenant on land they

leased. Occasionally, existing improvements are occupied by the current
tenant under a ground lease or master lease. An investor purchases the
tenant’s leasehold right under an assignment of the tenant’s possessory
interest in the lease. [See Form 596 accompanying this chapter]

Taxwise, the tenant’s entire price paid to acquire the ground lease plus the cost
to construct any leasehold improvements, is depreciable under the applicable
residential or commercial schedule of 27.5, 39 or 40 years. Depreciation begins
mid-month for the month the improvements are purchased or completed.8

The depreciation of trade fixtures owned by a business is controlled by

personal property depreciation schedules, not real estate schedules.

On the sale of depreciable property, the profit taken is set by the formula:
Depreciation
recaptured net price – basis = profit

on a sale When an improved property is sold, the depreciation deductions taken

during ownership transform into taxable profit, but not a type of profit that
taxed up to is a capital gain.
25% Thus, on a sale the remaining cost basis is deducted from the net sales
price producing two types of profits, called gains. These gains are taxed at
different rates. The portion of the profit on a sale resulting from accumulated
depreciation is classified as unrecaptured gain, taxed at ordinary income
rates up to a maximum rate of 25%.9

Any amount of profit remaining beyond the price originally paid for the
property and cost of improvements is classified as capital gains. Obviously,
the amount of depreciation reported on a sale as unrecaptured gain is limited
to the total profits on the sale.10

For example, a property purchased years ago for $500,000 has a depreciated
(remaining) cost basis of $100,000. The owner sells it for $1,000,000, generating
a profit of $900,000.

Here, the $900,000 profit represents:

• the $400,000 in depreciation deductions taken, which reduced the cost
basis below the original cost of acquisition and improvements; and
• $500,000 in actual dollar value increase in the sales price over the
original cost of acquisition and improvements.
Thus, on a sale at a price exceeding the remaining cost basis, the profit taken
up to the price originally paid for the property ($400,000 in depreciation) is
taxed as unrecaptured gain up to 25%.11

8 IRC §§168(d)(2), 168(i)(6)(A)

9 IRC §§1(h)(6), 1250(c)
10 IRC §§1(h)(1)(E), 1250(c)
11 IRC §§1(h)(1)(E), 1250(c)
 Chapter 9: Depreciation deductions mature as an unrecaptured gain tax 79

RECORDING REQUESTED BY
Form 596
AND WHEN RECORDED MAIL TO Assignment of
Name Lease
Street
Form 305
Address

City &
State
Agency Law
SPACE ABOVE THIS LINE FOR RECORDER'S USE Disclosure
ASSIGNMENT OF LEASE
By Tenant/Lessee Page 1 of 2
NOTE: This form is used by an escrow officer or tenant when the buyer of a tenant’s leasehold interest in a property takes
possession and assumes the tenant’s rights and obligations under a rental or lease agreement, to transfer ownership of
the tenant’s leasehold interest to the buyer.
DATE: _____________, 20______, at _________________________________________________________, California.
Items left blank or unchecked are not applicable.
1. This assignment transfers the Lessee’s interest in the lease dated _________________________, 20__________,
1.1 entered into by ____________________________________________________________, as the Lessor, and
1.2 ____________________________________________________________________________, as the Lessee,
1.3 recorded on ___________________________, ______, as Instrument No. ____________________________,
in the records of ____________________________________________________________ County, California,
1.4 regarding real estate referred to as ____________________________________________________________
________________________________________________________________________________________.
AGREEMENT:
2. Lessee hereby assigns all of Lessee’s interest in the above described lease to
_______________________________________________________________________________, as the Assignee.
3. Assignee hereby assumes and agrees to timely perform all Lessee's obligations under the lease.
3.1 This assumption by Assignee is made for the benefit of Landlord under the lease.
3.2 If Assignee or its successors default in performance of this assumption and Lessee not be released from Lessee
liability on the lease, the amount of the default will be a lien in favor of Lessee on the Lessee’s interest and Lessee
may elect to foreclose on the interest assigned to Assignee under California Civil Code §§2924 et seq.
3.3 The Assignee will indemnify Lessee against any claim, liability, loss, costs, attorney fees, and other damages
incurred by Lessee under the lease.
3.4 If an action is instituted to enforce this assumption the prevailing party to receive their attorney fees.
I agree to the terms stated above. I agree to the terms stated above.
� See attached Signature Page Addendum. [RPI Form 251] � See attached Signature Page Addendum. [RPI Form 251]
Date: _____________, 20______ Date: _____________, 20______

Lessee: ________________________________________ Assignee: _______________________________________

A notary public or other officer completing this certificate verifies only the identity of the individual who signed the document to which this certificate is
attached, and not the truthfulness, accuracy, or validity of that document.
STATE OF CALIFORNIA
COUNTY OF ____________________________________________________________________________________________________________
On ____________________________ before me, ______________________________________________________________________________
(Name and title of officer)
personally appeared ________________________________________________________________________________________________________,
who proved to me on the basis of satisfactory evidence to be the person(s) whose name(s) is/are subscribed to the within instrument and acknowledged
to me that he/she/they executed the same in his/her/their authorized capacity(ies), and that by his/her/their signature(s) on the instrument the person(s),
or the entity upon behalf of which the person(s) acted, executed the instrument.
I certify under PENALTY OF PERJURY under the laws of the State of
California that the foregoing paragraph is true and correct.
WITNESS my hand and official seal.

Signature: _________________________________________________
(This area for official notarial seal) (Signature of notary public)

FORM 596 03-15 ©2016 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA

The profit taken that represents the dollar increase in the price of the property
over the original cost of acquisition and improvements is taxed at the current
15% and 20% long-term capital gains tax rates, controlled by the owner’s tax
bracket for the year of sale. The capital gain is not adjusted for inflation to
reflect lost purchasing power and is taxed as the nominal dollar of profit
realized on the resale price of the property.12

12 IRC §1(h)(1)]
80 Tax Benefits of Ownership, Fourth Edition

Chapter 9 Depreciation is the loss of property value brought about by age,

physical deterioration, or functional or economic obsolescence. Owners
Summary of improved rental property or property used in a trade or business
annually recover a portion of the acquisition and improvement costs
they allocate to the improvements as a deduction taken from the
property’s net operating income (NOI).The annual recovery is called a
depreciation deduction.

Depreciation deductions from income is both: an investment

fundamental and a tax reporting activity. Depreciation schedules are the
number of years over which an owner’s capital investment in a trade or
business, passive, or portfolio category property is annually recovered
as an expense or deduction from income, limited to the portion of cost
basis allocated to property improvements. Each separately assessed
parcel of improved property has its own depreciation schedule.

The depreciation schedules for different types of improved property apply

identically to property in all three income categories. All depreciable
property, whether owned by an individual, partnership, limited liability
company (LLC) or corporation, uses the same depreciation schedule.
Two classes of depreciable property have been established to determine
the use of depreciation schedules: residential and commercial.

Chapter 9 annual property operating data sheet (APOD)...................... pg. 76

appreciable asset........................................................................... pg. 75
Key Terms depreciation.................................................................................... pg. 74
depreciation deduction............................................................... pg. 74
depreciation schedule.................................................................. pg. 75
property appreciation.................................................................. pg. 74
 Chapter 10: Commingling rental losses with other income 81

Chapter
10
Commingling rental
losses with other income
– via work-arounds

After reading this chapter, you will be able to: Learning

• advise on the use of rental operating losses to offset business
income, portfolio income and profits by implementing qualifying
Objectives
activities; and
• distinguish rental operating losses qualified to reduce the AGI
from rental losses qualified as a deduction from AGI to reduce
taxable income.

material participant owner-operator Key Terms

occupancy rule reportable operating loss

Consider a real estate licensee who owns rental properties and renders The part-time
services to clients as an agent in a brokerage business. The licensee works 30
hours a week on their brokerage activities, including preparing and advising landlord and
clients and interacting with others on behalf of clients. The licensee also
spends an average of ten hours a week on management and overseeing the
full-time real
care and maintenance of rentals the licensee owns. estate agent
The licensee’s management activities as owner of the rentals include
advertising, interviewing prospective tenants, checking tenant credit,
reviewing prior rental history, and preparing and signing lease agreements.
The licensee also collects rents and arranges for others to make all repairs and
maintenance.

At the end of the year, the licensee has a reportable net operating loss from
rental activities — a passive income category loss.
82 Tax Benefits of Ownership, Fourth Edition

May the licensee use the passive category loss from their rental operations to
offset reportable income from their brokerage business and interest earned
on savings and notes they hold?

Yes! An owner who renders services acting either for their own account as a
landlord, investor, developer or builder, or on behalf of others as a real estate
licensee, qualifies for their rental operating losses to offset their business
income and portfolio income. The passive category loss used to offset income
in another category reduces the owner’s adjusted gross income (AGI).1

The rental Recall that residential and commercial income property with an average
occupancy of more than 30 days, called rental property, is classified as
operating passive income category property. All rental property income, expenses and
loss glitch deductions from operations and ownership, plus any profit or loss on a sale,
while tracked separately for each property are aggregated and reported in the
overcome passive income category.

Operating losses reported for one rental property in the passive category first
offset operating income and sales profits reported by other rental properties.
Any operating loss not offset by income from other properties in the passive
category spills over within the category to offset income from pass-through
business opportunities. Pass-through business income is received from
partnerships, limited liability companies (LLC) or S corporations operated by
someone other than the owner or co-owner of the businesses.

When rental operating losses remain after offsetting income from all sources
within the passive category, the rental operating losses are reallocated pro-
rata back to the rental properties generating the losses, called suspended
losses. Suspended losses may only offset income or profit from operations or
sale of the property carrying the suspended losses. Thus, the suspended losses
may not offset future reportable operating income generated by another
property.

However, the rental property owner avoids the suspension of rental losses
by annually qualifying to use the rental losses as either:
reportable operating
loss • an adjustment to reduce their AGI; or
A passive category
loss resulting from • a deduction from the AGI of up to $25,000 annually to reduce taxable
operating expenses, income.
depreciation
deductions and Consider a married couple who incurs a reportable operating loss on
interest deductions
for passive category
their rental property, a mixed-use property of residential and commercial
properties, which rentals. Neither spouse is in a business related to real estate. The spouse who
exceeds income in is unemployed manages the couple’s rentals.
the category is carried
forward as a suspended
loss unless the owner Because the couple’s AGI exceeds $150,000, the couple does not qualify to
qualifies to offset deduct any part of their loss from their AGI using the capped $25,000 annual
income in trade or operating loss deduction rules. If they qualified, the loss would reduce their
business and portfolio
category income or taxable income.2
reduce taxable income
as a deduction. 1 Internal Revenue Code §469
2 IRC §§469(i)(3)(A)
 Chapter 10: Commingling rental losses with other income 83

However, either spouse, independent of the other, may separately qualify owner-operator
their rental operating loss as an adjustment reducing the AGI in their joint An owner of rental
return. With one spouse qualifying for the loss writeoff, any professional property in the passive
income category who
income they report on their joint return is offset by the rental property renders professional
operating loss.3 real estate services,
manages property, or
invests in real estate
To begin to qualify their rental operating losses to reduce their AGI, the for their own accounts
unemployed spouse first needs to assume all duties as the manager of and collectively spends
the couple’s rentals. To qualify, the spouse needs to spend sufficient time a minimum amount of
time on real estate-
performing real estate activities as both: related activities.

• an owner-operator of a real estate-related business; and

• a material participant in the management of the rental property they
own.4

For a landlord to be in a real estate-related business, they must be: A real estate-
• an owner-operator of their rental properties acting on their own related
behalf and not through an agent;
• an agent representing clients in real estate transactions; or
business is
• a builder. your future
Real estate activities qualifying as a real estate-related business include:
• development or redevelopment;
• construction or reconstruction;
• acquisition;
• conversion;
• renting;
• operation;
• management;
• leasing; or
• brokerage.5
A landlord qualifies as the owner-operator of a real estate-related business
by meeting two criteria:
• the business renders professional real estate services, or manages,
invests in or develops real estate for their own account; and
• the landlord spends a threshold amount of time in the real estate-
related businesses. [See Figure 1]
Consider a landlord who spends sufficient time acquiring, managing, or
leasing their own rentals. Although the landlord qualifies as working in a
real estate-related business, operating income or losses related to their rental
properties are still classified in the passive category, even when they are an
owner-operator of rental property.
3 IRC §469(c)(7)(B)
4 IRC §469(c)(7)(B)
5 IRC §469(c)(7)(C)
84 Tax Benefits of Ownership, Fourth Edition

Figure 1
Landlord with rental operating losses
Landlord
with rental
operating losses

Material Owner/operator of real-estate-

participant as related trade or business.
owner of real
estate.

or
Categories include real estate
services in:
500 hours
annually in • development
management • construction
decisions.
• acquisition
• conversion
or
• rentals
• operation
100 hours
annually, but not • management
less than other • leasing
co-owner or
manager. • brokerage

or

750 hours spent annually in all

Substantially all
real-estate-related business
management
(including landlording).
decisions.

or

More than one half of the time

Qualify during spent in all trade or business
any 5 of the is spent in real-estate-related
preceding 10 businesses
years. (including landlording)

Rental operating loss is included in Adjusted Gross

Income (AGI) if an individual qualifies as both a
material participant in rentals and an owner/operator
or real- estate-related trade or business.
 Chapter 10: Commingling rental losses with other income 85

As rental activities, the owner need do nothing more than own the rentals
under gross lease arrangements to be a material participant in their operations.
However, when the owner is extensively involved in any rental operations,
they are further classified as in a real estate-related business – which is not a
business activity but is a rental activity).

When the landlord’s business and rental activities qualify as real estate-
related, adjustments allowed to the AGI include their rental operating losses.
Without the real estate-related business classification, rental property losses
resulting in a passive category reportable loss become suspended losses,
available only to offset future income from the property generating the loss
and are barred as an adjustment to AGI. However, when the landlord spends
sufficient time on their duties as a landlord, their rental operations alone will
qualify them as in a real estate-related business. [See RPI Form 351]

In practice, the landlord may use their rental operating losses to offset
business or portfolio category income when they:
• spend more than half their total time spent rendering all types of
services rendering real estate-related services (property management,
development, or general brokerage); and
• spend more than 750 hours of the entire year in real estate-related
businesses (a 15-hour weekly average).6
To determine whether an individual spends sufficient time in businesses
related to real estate, they combine time spent in all their various real estate-
related activities.

Consider a medical professional who is married and owns several rentals.

The individual averages 30 hours weekly attending to patients and 15
The
hours weekly tending to their rental properties. The individual’s spouse is disqualifying
uninvolved in the acquisition and management of the rentals.
ratio of
While the professional has an annual reportable income from their trade, the services
rentals produce an overall reportable operating loss.
unrelated to
Does the individual qualify to offset other income with the rental operating
loss? real estate
No! The individual did spend 750 hours during the year (15 hours weekly)
actively participating in a real estate-related business. However, the amount
of time spent as a landlord was not more than half of the total time spent
tending to patients and managing rentals, called rendering services.

Also, time spent overseeing one’s portfolio category investments (trust deed
notes, management-fee net leased properties, land held for profit) does not
qualify as professional services, much less services rendered in a real estate-
related business.

6 IRC §469(c)(7)(B)
86 Tax Benefits of Ownership, Fourth Edition

The Now consider a practicing professional who is married and owns several
rentals as community property. The professional’s spouse works more than
landlord’s 15 hours weekly acquiring and managing the rentals. The spouse has no
material other job and the couple files a joint return.

participation Does the couple qualify as owner-operators in a real estate-related business

due to the spouse’s rental property activity?
grab bag
Yes! For married couples filing jointly, one spouse may independently satisfy
the material participation requirements. Separately, one spouse can
material participant qualify the couple as owner-operators of a real estate-related business.
An owner of rental
property in the passive However, to use the couple’s rental operating losses to offset other income,
income category who
participates in its the unemployed spouse, as the manager of the rentals, needs to materially
management or a real participate as a landlord in the rental operations, in addition to rental
estate profession on a
regular and substantial
ownership activities.
basis.
To qualify as a material participant, the managing spouse meets one of the
following criteria:
• time spent handling the rentals exceeds 500 hours annually (about ten
hours weekly);
• time spent handling the rentals exceeds 100 hours annually (about 2
hours weekly), but is not less than the amount of time spent by any
other co-owner or property manager;
• the managing spouse’s rental activities includes substantially all
management of the rentals; or
• either spouse individually qualified during any five of the preceding
ten years.7
In this ownership example, the managing spouse makes all decisions in
connection with the management of the rentals, establishing material
participation by meeting any one of the criteria for material participation.
Thus, the couple uses the operating loss to reduce their AGI and offset
professional income earned by the employed spouse. The result is a reduction
in their taxable income, and amount of taxes owed.

Consider an income property owner whose primary occupation is not a real

Material estate-related business. The property owner participates in the operation
participation of their rental property, and also spends time “on call” when they are not
actively managing the rental property. When “on call,” the owner remains
— the call ready to do emergency work for the operation of their rental property.
for action The property owner keeps a log of time spent operating the rentals, totaling
750 hours for the year, including “on call” time.

Is the property owner entitled to report rental income losses under the passive
income category to offset other income by an adjustment to their AGI?

7 26 Code of Federal Regulations §1.469-5T(a)

 Chapter 10: Commingling rental losses with other income 87

No! “On call” activity does not qualify as material participation in the
operation of rental property. Thus, the property owner is left with less than
the 750 required hours needed to qualify as a material participant and write
off rental losses as a reduction in AGI.8

Consider a real estate licensee who works full time conducting their brokerage The 500-hour
business and co-owns rental properties with a small group of investors in a
syndicated pass-through entity. landlord
The licensee reviews and approves tenants, prepares lease agreements and
collects and deposits rents. Time spent managing the rentals is at least ten
hours weekly on average. While they have no property managers, one of the
investors spends more time than the licensee does in the management of the
rentals.

The rentals generate a reportable operating loss for the year, due to
depreciation, interest deductions and vacant units.

May the licensee write off their share of the rental operating loss to offset
their brokerage income even though the co-owner is more involved in
management than the licensee?

Yes! First, as a licensee operating a real estate brokerage service, they qualify
as rendering services in a real estate-related business. Secondly, the licensee
qualifies as a material participant in the operation of the rentals since they
separately spend more than 500 hours of the year on the management of
their units — no matter how the equity ownership is structured or financed.

Thus, the licensee applies their share of the rental losses as a reduction to their
AGI offsetting brokerage income — an adjustment to AGI, not the $25,000
limit deduction. The co-owner, for the same reason, also qualifies to write off
their share of rental loss against other income.

Now consider a licensee who owns rentals and works 40 hours weekly in
their brokerage business. The licensee reports their brokerage income for tax
The over-100-
purposes as an independent contractor. hour landlord
The licensee handles all aspects of management and operation of the rentals
and arranges for maintenance and repair. The licensee spends an average of
six hours weekly operating the rentals.

The licensee also employs an on-site resident manager who averages less
than six hours a week — deciding what repairs to make and which potential
tenants qualify to lease.

May the licensee write off rental operating losses against their real estate
sales income?

8 Moss v. Commissioner (2010) 135 TC 365

88 Tax Benefits of Ownership, Fourth Edition

Yes! Employment in real estate as an independent contractor, whether acting

on their own or as an employee of a broker, qualifies as rendering services in
a real estate-related business.

Also, the licensee’s landlord activities meet one of the standards which alone
establishes material participation. The licensee as an owner worked more
than 100 hours annually on their rentals. Critically, the resident manager
does not spend more hours actively managing the rentals (“on call” or doing
repairs and maintenance does not count as management time) than the
licensee does.

Now consider a licensee who owns both a brokerage business and income-
producing real estate. The licensee works approximately 40 hours weekly on
their brokerage business.

The licensee’s time spent on the management and maintenance of the rental
is relatively minimal, averaging six hours monthly. The licensee handles
all aspects of the management and operation of the rentals, except for
maintenance and repairs, which a handyman does. The handyman works
more hours monthly on maintenance of the rentals than the licensee does
managing them.

May the licensee use any rental operating loss to offset other income from
their brokerage business?

Yes! The licensee may use any rental operating loss to offset other income as
an adjustment to their AGI. Here, the licensee performed substantially all the
management of the units. Maintenance and repairs, which the handyman
performs, are not management activities.

Five out of Consider a developer who owns several rentals. In most years, the developer
works an average of 25 hours weekly on development projects and 15 hours
ten years weekly managing their rentals.
spent The developer qualified as a material participant in the management of their
landlording rentals during each of the past four years. However, they did not qualify for
one year before that and qualified in the two prior years — a total of six out
of the last ten years.

In the current year, sales of new houses were up. Consequently, the developer
worked 40 hours (or more) weekly on their development business. A property
manager was hired to operate the rentals, leaving the developer only
marginally involved in their operations. The developer’s business showed
a reportable income for the year, but their rentals produced a reportable
operating loss.

May the developer use their rental operating loss to offset their business
income?
 Chapter 10: Commingling rental losses with other income 89

Yes! Although the developer was not a material participant in the day-to-day
decision-making process of managing their rentals this year, they did qualify
as a material participant in the operations of the rentals during at least five
of the last ten years.

To be classified as passive income category property, rentals need to be

occupied by tenants for an average of more than 30 days. The 30-day
The $25,000
occupancy rule, coupled with the owner’s active participation in its limited
operations, locks reporting of a property’s income, expenses, interest, and
depreciation in the passive income category as rental income. [See IRS Form
deduction –
1040, Schedule E] there when
When rental operating losses remain after aggregating all income and profits all else fails
within the passive category, a landlord qualified as an active participant in
the management of their rentals may deduct the rental losses from their AGI occupancy rule
in amounts up to $25,000 annually to reduce their taxable income. This is not Rental properties
a reduction in the AGI amount, but a deduction from AGI for a reduction in are passive income
category property
taxable income and thus the year’s tax liability. when tenant
occupancies average
To be an “active” participant means a landlord by contract is primarily — more than 30 days.
and legally — responsible for performance of services, maintenance, and
management of the rentals. This arrangement is typically agreed to with a
tenant under rental or gross lease agreements.

Also, a brokerage firm may exclusively handle all the rental activities as
the agent of the landlord leaving the landlord uninvolved in the property
operations. Here, the landlord by contractually agreeing to perform any
level of maintenance under agreements with the tenant qualifies the rental
property as a passive income category asset. Thus the landlord may use the
$25,000 deduction to reduce their taxable income.

When a management-free net lease situation exists as in, say, an industrial

income property, the agreement shift all property care and maintenance to
the tenant. The agreement leaves the landlord with no active management to
perform. This lack of landlord management responsibility places the income
property in the portfolio income category. To report an income property in
the passive income category the landlord needs to enter into a gross lease
agreement with the tenant.

The $25,000 rental operating loss deduction which reduces taxable income
is available to landlords who do not qualify as material participants for
the passive category rental operating loss adjustment to the AGI. However,
the landlord does not need the $25,000 loss deduction when they qualify
as a material participant since they use their rental operating losses as an
adjustment to reduce their AGI.
90 Tax Benefits of Ownership, Fourth Edition

Chapter 10 An owner who renders services acting either for their own account as a
landlord, investor, developer or builder, or on behalf of others as a real
Summary estate licensee, qualifies for their rental operating losses to offset their
business income and portfolio income.

The passive category loss used to offset income in another category

reduces the owner’s adjusted gross income (AGI). For rental properties
to be passive income category property, the tenants need to occupy it for
an average of more than 30 days.

Residential and commercial income property with an average

occupancy of more than 30 days, called rental property, is classified as
passive income category property.

Rental property income, expenses and deductions from operations and

ownership, plus any profit or loss on a sale, are aggregated and reported
in the passive income category.

Operating losses reported for one rental property in the passive category
first offset operating income and sales profits reported by other rental
properties. When rental operating losses remain after offsetting income
from all sources within the passive category, the rental operating losses
are reallocated pro-rata back to the rental properties generating the
losses, called suspended losses.

material participant ..................................................................... pg. 86

Chapter 10 occupancy rule.............................................................................. pg. 89
Key Terms owner-operator.............................................................................. pg. 83
reportable operating loss............................................................. pg. 82
 Chapter 11: $25,000 ceiling on rental loss deduction 91

Chapter
11
$25,000 ceiling on
rental loss deduction

After reading this chapter, you will be able to: Learning

• advise budding landlords on the availability of the annual
$25,000 deduction to subsidize passive income category losses due
Objectives
to rental operations; and
• explain how phase-out rules reduce the maximum loss deductible
as a landlord’s personal income rises beyond thresholds.

active participant Key Terms

Recall that losses remaining in the passive income category due to rental Subsidizing
operating losses are treated as one of the following:
annual
• an adjustment reducing the owner’s AGI, permitted when the owner
qualifies as being in a real estate-related business [See Chapter 10]; operating
• a deduction from the AGI to lower the owner’s taxable income, permitted losses
when the owner qualifies for the $25,000 rental loss deduction; or
• a suspended loss remaining on the books of the rental properties
generating the passive category loss.
To annually deduct up to $25,000 of a passive category operating loss from
their AGI, an investor needs to qualify as an owner-operator of rental
property.

To qualify as an owner-operator for use of the $25,000 deduction, an investor

needs:
• an aggregate passive income category loss resulting from owning and
operating income properties at a loss;
92 Tax Benefits of Ownership, Fourth Edition

active participant • status as an active participant in the management of the rental

An owner-operator of property; and
rental property who
owes a duty to tenants • an AGI of no greater than $150,000.1
under rental and gross
lease agreements Landlords who fail to qualify as material participants to reduce their AGI,
for the care and such as failing to classify as in a real estate-related business, are allowed to
maintenance of the
property and retains reduce their taxable income up to $25,000 of their the passive category rental
ultimate authority operating loss though use of the rental operating loss deduction. A landlord
over key landlord with the status of a material participant in management of their rentals does
decisions.
not need the $25,000 loss deduction. They take their rental operating losses as
an adjustment to reduce their AGI.

Rental loss However, to qualify for the rental loss deduction from AGI an investor needs
to actively participate in the management of their rentals as an owner-
deduction operator.2
qualifications To be an active participant, the investor need only be contractually obligated
for an owner for the care and maintenance of the property and retain control over key
landlord decisions. This responsibility does not require daily, weekly, or
monthly contact with the properties or never when a property manager is
employed by the investor.

Rental and gross lease agreement provisions used by a property manager

impose a duty on the investor to maintain the property which duty may be
delegated to a manager to perform as the investor’s agent. Gross leases require
the investor to provide services as well as maintain the property.

When a management-free net lease situation exists as in, say, an industrial

income property, the agreement shifts the obligations of ownership to the
tenant for maintenance, utilities, insurance premiums and property taxes.
The agreement leaves the landlord with no active management to perform
by themselves or a property manager. Thus, the investor merely receives
monthly rent or serves 3-day notices to collect delinquent rent. However,
the lack of landlord management obligations places the income property in
the portfolio income category along with interest bearing assets.

Any property management agreement an owner enters into with a property

owner is an agency agreement. In spite of any prior notice provisions it may
contain, the investor may terminate it at any time. Thus, the investor has no
loss of control over management’s duties imposed by gross lease agreements
to manage the property.

Also, the investor’s ownership interest may be vested in joint tenancy,

tenancy-in-common, community property, a partnership, or an LLC.
However, the investors with a fractional co-ownership interest of less than
10% does not qualify for the loss deduction, regardless of how the ownership
is vested.3

1 IRC §469(i)
2 IRC §469(i)(6)
3 IRC §469(i)(6)(A)
 Chapter 11: $25,000 ceiling on rental loss deduction 93

Form 353
COMPARATIVE ANALYSIS PROJECTION (CAP)
Comparative
Prepared by: Agent ____________________________ Phone ___________________________
Broker ____________________________ Email ____________________________ Analysis
NOTE: This sheet contains confidential information for clients who own or are acquiring income property.
For Owners: This illustrates the effect of different loan amounts and projects the tax benefits and rate of return. Projection (CAP)
For Buyers: This compares available properties to one another.
The conclusions and projections developed on this form depend on the accurate preparation of backup sheets.
DATE: _____________, 20______. Prepared by ___________________________________________________________.
CLIENT: _____________________________________. Client's Property:_______________________________________
A. PURPOSE: B. BACKUP SHEETS ATTACHED:
a. Property selection/comparison a. Annual Property Operating Data Sheet [See ft Form 352]
b. Ownership projection for years b. Estimate of Seller's Net Proceeds [See ft Form 310]
c. Debt leverage by refinance c. ____________________________________________
d. Equity performance review
–A– –B– –C–
1. PROPERTIES ANALYZED . . . . . . . . . . _______________ _______________ _______________
1.1 Year analyzed . . . . . . . . . . . . . . . . . . . . 20_____________ 20_____________ 20_____________
2. PROPERTY VALUATION:
2.1 Fair market value . . . . . . . . . . . . . . . . $_______________ $_______________ $_______________
2.2 Less loan . . . . . . . . . . . . . . . . . . . . . ()$_______________ ()$_______________ ()$_______________
2.3 Less sales costs . . . . . . . . . . . . . . . . ()$_______________ ()$_______________ ()$_______________
0.00
2.4 NET EQUITY(§2.1 – §2.2 and – §2.3 ) . . . . . . . $_______________ 0.00
$_______________ 0.00
$_______________
3. SPENDABLE INCOME/DEFICIT: (annual)
3.1 Gross operating income . . . . . . . . . . . $_______________ $_______________ $_______________
3.2 Operating expense . . . . . . . . . . . . . ()$_______________ ()$_______________ ()$_______________
0.00
3.3 Net operating income (§3.1 – §3.2) . . . . . . $_______________ 0.00
$_______________ 0.00
$_______________
3.4 Loan payments . . . . . . . . . . . . . . . . . ()$_______________ ()$_______________ ()$_______________
3.5 SPENDABLE
INCOME/DEFICIT (§3.3 – §3.4). . . . . . . . . . . $ 0.00 $0.00 $ 0.00
4. INCOME-TO-VALUE: (annual)
4.1 Fair market value (§2.1) . . . . . . . . . . . . . $_______________ $_______________ $_______________
0.00
4.2 Net operating income (§3.3) . . . . . . . . . . . . $_______________ $_______________
0.00 0.00
$_______________
4.3 RATE OF RETURN (§4.2 ÷ §4.1) ______% ______% ______%
5. REPORTABLE INCOME/LOSS: (annual)
0.00
5.1 Net operating income (§3.3) . . . . . . . . . . . $_______________ 0.00
$_______________ 0.00
$_______________
5.2 Interest . . . . . . . . . . . . . . . . . . . . . . . $_______________ ()$_______________ ()$_______________
5.3 Depreciation . . . . . . . . . . . . . . . . . . . )$_______________ ()$_______________ ()$_______________
5.4 REPORTABLE
INCOME/LOSS . . . . . . . . . . . . . . (+or$ 0.00 (+or$ 0.00 (+or-)$ 0.00
6. CLIENT INCOME TAX ASPECTS:
6.1 Reportable
0.00
income/loss (§5.4) . . . . . . . . . . . . . (+or$_______________ 0.00
(+or$_______________ 0.00
(+or$_______________
6.2 Client’s tax bracket (x) ______% (x) ______% (x) ______%
6.3 TAX LIABILITY OR
REDUCTION. . . . . . . . . . . . . . . . . (+or$ 0.00 (+or$ 0.00 (+or$ 0.00
7. RETURN ON EQUITY: (annual)
7.1 Spendable
0.00
income/deficit . . . . . . . . . . . . . . . . (+or$_______________ 0.00
(+or$_______________ 0.00
$_______________
(§3.5)
0.00
7.2 Loan principal reduction . . . . . . . . . . . . . . (+)$_______________ 0.00
(+)$_______________
0.00
(+)$_______________
(§3.4 - §4.2)
0.00
7.3 Income tax liability . . . . . . . . . . . . (+or$_______________ 0.00
(+or$_______________ 0.00
(+or$_______________
(§6.3; reverse the + or )
7.4 Annual fair market value
adjustment . . . . . . . . (_____% of §2.1) (+)$_______________ (+)$_______________ (+)$_______________
(estimated appreciation/inflation)
7.5 DOLLAR RETURN
ON EQUITY(after taxes) . . . . . . . . . . . . . . . . $ 0.00 $0.00 $ 0.00
7.6 Percent return on net equity ______% ______% ______%
(§7.5 ÷ §2.4)

FORM 353 03-11 ©2011 first tuesday, P.O. BOX 20069, RIVERSIDE, CA 92516 (800) 794-0494

For low-income housing, an owner need not be obligated by leasing

agreements to actively participate in operations of the rental to qualify for
the loss deduction. The low-income housing rule is designed to encourage
ownership and construction of low-income housing by using the tax code
to subsidizing wealthier, risk-averse investors in syndicated ownership
vehicles.4

Partners of a limited partnership or members of an LLC who report using

Form 1065 do not qualify as active participants.5
Partnership
tax treatment
4 IRC §469(i)(6)(B)
5 IRC §469(i)(6)(C)
94 Tax Benefits of Ownership, Fourth Edition

By definition, a limited partner or LLC member is an uninvolved passive-

investor, not an operator burdened with the contractual responsibility of
active management.

Unlike general partners, LLC managers and tenants-in-common (TIC) co-

owners, investors not obligated to participate in the operation of the rental
units are also denied use of the rental loss deduction.

Similarly, a syndicated TIC ownership, promoted and controlled by the

promoter as a “cradle-to-grave” investment arrangement managed by the
promoter, does not qualify the investors as active participants.

Also, owners of property leased out to tenants on ground leases — or other

net-lease agreements without some care and maintenance imposed on the
owner — do not qualify for the loss deduction. Remember, these properties
are portfolio category income properties, not owner-operated passive
category properties.

Phase out of Finally, a phase out of the entire $25,000 amount leaves the highest income
earner without use of the deduction. To qualify for the maximum benefit
the deduction of the $25,000 rental operating loss deduction, the investor’s AGI may not
exceed a threshold of $100,000. For owners of low-income rentals, however,
the $100,000 annual threshold rises to $200,000.6

When the investor’s AGI exceeds the $100,000 threshold, the amount
permitted as the deduction drops by 50% of each dollar of AGI exceeding the
$100,000 threshold. Thus, an investor with a $150,000 or greater AGI may not
use any part of the $25,000 as an operating loss deduction.7

For example, a person with an AGI of $125,000 - $25,000 above the $100,000
threshold amount – may deduct up to $12,500 of their rental property
operating losses. Any loss remaining which is not deductible becomes
suspended losses allocated pro rata and retained on the books of the rental
properties generating the operating losses – for use as a write off in future
years against those property’s income.

6 IRC §469(i)(6)(B)
7 IRC §469(i)(3)
 Chapter 11: $25,000 ceiling on rental loss deduction 95

To annually deduct up to $25,000 of a passive category operating loss Chapter 11

from their AGI, an investor needs to qualify as an owner-operator of
rental property. To qualify as an owner-operator for use of the $25,000 Summary
deduction, an investor needs:
• an aggregate passive income category loss resulting from owning
and operating income properties at a loss;
• status as an active participant in the management of the rental
property; and
• an AGI of no greater than $150,000.
However, to qualify for the rental loss deduction from AGI an investor
needs to actively participate in the management of their rentals as an
owner-operator. An active participant is an owner-operator of rental
property who is contractually responsible to tenants for the care and
maintenance of the property and retains authority over key landlord
decisions.

To be an active participant, the investor need only be contractually

obligated for the care and maintenance of the property and retain
control over key landlord decisions. This responsibility does not require
daily, weekly, or monthly contact with the properties or never when a
property manager is employed by the investor.

active participant ......................................................................... pg. 92 Chapter 11

Key Terms
Notes:
 Chapter 12: Taxable income taxed in descending order of rates 97

Chapter
12
Taxable income taxed in
descending order of rates

After reading this chapter, you will be able to: Learning

• explain the process for determining profits and taxes on property
sales;
Objectives
• identify the differing tax rates for income and profits in real estate
ownership and sales; and
• inform clients in sales transactions about tax reporting
consequences.

carryback sale net profit Key Terms

Individual Tax Analysis taxable income
(INTAX)

Income tax knowledge by real estate agents is an engaging and personal tool The batching
for assisting clients with their decision to sell a property they do not want
to own. Specifically, an agent’s tax knowledge passed on to clients becomes and taxing of
business goodwill, an indicia of the agent’s brand. In turn, the earning power gains
of goodwill generates further employment by members of the public, i.e.,
superior listings, larger dollar transactions and expanded clientele.

Counseling a client on the tax aspects of a sale, purchase, or reinvestment

in the early stage of an agency relationship typically excites an ongoing tax
discussion. Tax consequences are of constant concern to all participants in
real estate transactions – a material fact grooming their decisions.

Of course, the objective of a discussion on taxes is to achieve the most favorable

tax result available to the client without altering the financial underpinnings
98 Tax Benefits of Ownership, Fourth Edition

and risks deemed acceptable in a sale (or purchase). While material, tax
consequences is the least important in the hierarchy of fundamentals when
making decisions in a real estate transaction.

The earlier in the client relationship an agent begins the tax discussion, the
likelier the client will consult with other competent professionals about
their agent’s tax-related discussions. The agent’s discussion becomes the focal
point influencing the client’s conversations with other advisors, professional
carryback sale
Financing provided by or otherwise. A client’s early consultation with others allows the client to
a seller of real estate follow up on their agent’s advice, such as a carryback sale or the purchase
by extending credit of replacement property in a §1031 reinvestment plan, or as here, the
to a buyer for the
deferred payment of magnitude of unrecaptured and capital gains taxes.
a portion of the sales
price, typically repaid Encouraging a client to discuss the transaction with other advisors available
monthly with accrued
interest — also known
to the client – or the client authorizing the agent to do so – results in increased
as an installment sale. coordination between the client and agent.

When a client involves other professional advisors, the agent’s duty of care
owed a client is not relinquished to their other advisors. The agent’s duty is to
present their client with information about a transaction the agent believes
may impact the client, information the client needs to consider when making
decisions. The agent’s counseling might well be contrary to advice given to
the client by others, such as the client’s attorney or accountant, which then
needs to be resolved.1

Although an agent’s opinion is not conclusive, it is relevant and important.

Further, agents negotiating a transaction need to maintain influence over
a client’s decisions so the client’s goals known to the agent are attained.
Changing market conditions and the innuendos and nuances of real estate
negotiations are best known and managed by agents. Agents are regularly
involved in real estate transactions, clients not so much. Agents are likely
more often involved in transactions than other advisors of a client’s other.
Also, agents giving advise routinely develop professional relationships with
individuals from other professions who will remember the agent long after
the transaction is closed.

Finally, an agent’s failure to coordinate activity in a transaction with the

client’s other advisors can prove detrimental for the agent. An agent who
persuades a client to rely on their advice to the exclusion of contrary (and
correct) advice of other professionals is liable for any losses suffered by the
client due to the agent’s unsound advice. It is best to let the client sort out all
the advice they receive (including the agent’s) and make their own decision
regarding whose advice to follow.2

Disclosures As most agents and sellers know, the sale of every parcel of real estate, except
dealer property, produces a profit (or loss as the flip side of that coin) for a
benefit the seller when the price exceeds the seller’s cost basis in the property. And
agents know a sale at a price above the cost basis produces a tax liability. [See
agent Chapter 3]

1 Brown v. Critchfield (1980) 100 CA3d 858

2 In re Jogert, Inc. (1991) 950 F2d 1498
 Chapter 12: Taxable income taxed in descending order of rates 99

However, an agent handling a one-to-four unit residential property is not

obligated to mention tax consequences or disclose any part of their tax
knowledge to their buyers or sellers of this class of properties. The exculpatory
provisions in the state mandated agency disclosure law eliminate any duty
to affirmatively disclose the tax aspects in one-to-four unit transactions. This
permissive non-disclosure is part of the dumb-agent rules for one-to-four
unit sales dear to large SFR brokerage operations. [See RPI Form 305]

However, an agent with knowledge of the tax aspects of real estate

transactions does not leave their buyer or seller to their own devices, nor
need they, not even on one-to-four residential units. Consider that an agent’s
interests are best served when they assist their client by:
• giving tax advice on the transaction to the best of their knowledge with
the understanding tax-related information is confidential;
• disclosing the basis for their opinion as the advice given;
• encouraging (or requiring) the client to consult other advisors about
the tax advice given; and
• conditioning the transaction on the client’s right to cancel the purchase
agreement by including a further-approval contingency provision
regarding clearance of the transaction’s tax consequences.

Before entering into a tax discussion with your seller about a proposed sale,
you need to think through the preparation of an Individual Tax Analysis The individual
(INTAX) form for review with the seller. By using it, you break down the Tax Analysis
profit taken on a sale into the two types of gains, called batching. Without
first batching the gains, you are unable to develop an accurate estimate of (INTAX)
the seller’s tax liability generated by closing a sale you negotiated. [See Form
351 accompanying this chapter]
Individual Tax
During a review of the profit tax liability estimated on the INTAX form, you Analysis (INTAX)
need to discuss variations for the client to consider on a sale to exclude or An estimate of a seller’s
exempt profit from taxes or to defer profit reporting and taxes on the proposed tax liability incurred
due to unrecaptured
sale. and capital gains
realized on a proposed
Thus, the seller who initially sought only to “cash out” their ownership of sale of a property.
real estate they no longer want, might consider a §1031 reinvestment plan
and acquire a replacement property — with your assistance. Alternatively,
the seller might see good reason to structure a sale as a carryback transaction. taxable income
Thus, the seller retains the earning power of their profits, untaxed, until years The amount of an
individual’s income
later when the deferred profit from the sale is reported and taxed. subject to tax,
determined as adjusted
The top half of the INTAX form is a review of the seller’s taxable income gross income (income
and profits less
and profit or loss. You need the client’s estimate of their taxable income allowed losses from
before you can estimate the profit tax on a sale. Further, the client’s estimated all income categories)
ordinary income is needed to determine how much of the client’s taxable minus deductions.

income remains to be taxed at the lower unrecaptured and capital gains rates.

The profit review first takes place at the listing stage, and again when a
purchase agreement offer or counteroffer is submitted and reviewed. Your
100 Tax Benefits of Ownership, Fourth Edition

Form 351
INDIVIDUAL TAX ANALYSIS (INTAX)
Individual Tax
Prepared by: Agent
Analysis (INTAX) Broker
Phone
Email
NOTE: This form is used by an agent when negotiating a sale or partial §1031 transaction for a client, to prepare an
estimate for review and provide advice on any income tax liability generated by the proposed transaction.
Date: , 20
Client:
Prepared by:

Standard Income Alternative Minimum

Items
Tax (SIT) Tax (AMT)

1. ADJUSTED GROSS INCOME (AGI):

1.1 Salary/professional fees/wages (+) $ (+) $
1.2 Trade or business income/loss (+/-) $ (+/-) $
1.3 Sale of business property profit/loss (+/-) $ (+/-) $
1.4 Rental operating income and profit (+) $ (+) $
1.5 Business related rental operating loss (-) $ (-) $
1.6 Loss spillover of rental sales (-) $ (-) $
1.7 Investment category income and profits (+) $ (+) $
1.8 Investment category capital losses (up to $3,000) (-) $ (-) $
1.9 Retirement, pension and annuity plans (-) $ (-) $
1.10 ADJUSTED GROSS INCOME $ 0 $ 0

2. REAL ESTATE RELATED DEDUCTIONS:

2.1 First/second home interest ($750,000 loan cap) (-) $ (-) $
2.2 $25,000 rental loss deduction (-) $ 0 (-) $ NONE
2.3 TOTAL REAL ESTATE RELATED DEDUCTIONS (-) $ 0 (-) $ 0

3. OTHER DEDUCTIONS AND EXEMPTIONS:

3.1 Medical and dental (-) $ (-) $ NONE
3.2 Other deductions (charitable contributions, etc.) (-) $ (-) $ NONE
3.3 Personal deduction (-) $ NONE
3.4 AMT exemption (-) $
3.5 TOTAL OTHER DEDUCTIONS AND EXEMPTIONS (-) $ 0 (-) $ 0

4. TAXABLE INCOME (line 1.10 minus lines 2.3 and 3.5) $ 0 $ 0

5. TAX BATCHING:
5.1 Net profits and short term losses (+/-) $ $
(line 4 minus income in line 1.10 not a gain)
5.2 Ordinary income
(line 4 minus line 5.1 but not less than zero) $ 0 $ 0

(a) Tax: Use SIT and AMT tax bracket rates $ $

5.3 Unrecaptured depreciation gain $
(b) Tax: Use further SIT and AMT tax rates up to 25% $ $
5.4 Long-term capital gain (line 5.1 minus line 5.3) $
(c) Tax: Use threshold tax rates when line 4 is >$87,500 $ $
(2021 thresholds for couples: line 4 > $87,500 use 15%; >$496,600 use 20%)
0 0
6. INCOME TAX: The total of lines a, b, and c $ $
(Tax amount due is the larger of the SIT or AMT at line 6)
Additional taxes are due for state income taxes and possible NIIT.

FORM 351 04-21 ©2021 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517

tax discussion with the seller on each occasion may be limited to the amount
of profit on the sale, the batching of the gains, and any tax liability exposure
due on those gains. Also, a seller who is a high-income earner is more likely
to respond favorably to a tax discussion than a low-income earner.

Two formats The INTAX worksheet contains separate columns for calculating the amount
of profit taxes: one for the standard income tax (SIT) and the other for the
for setting alternative minimum income tax (AMT).
tax liability AMT rates can increase the seller’s tax liability on income from their business,
professional, and investment sources. However, the distinction has no
 Chapter 12: Taxable income taxed in descending order of rates 101

impact on the profit tax rates on the sale of a capital or business asset. The tax
rate for gains (profit) on a sale remains the same for SIT and AMT no matter
the amount of ordinary income and itemized deductions of a high-income
earner.

Thus, a tax discussion with a seller of investment or business-use property is

limited to the types of gains contained in the profit on the sale, and the tax
due on those gains, not the SIT or AMT tax consequences. [See Form 351 §§5.3
and 5.4]

In contrast, you do not use the INTAX form to assist a buyer of real estate on
their selection of property based on the tax consequences of a purchase. The
Annual Property Operating Data (APOD) sheet provides the depreciation
schedule covering the only tax benefit available to a buyer during the buyer’s
ownership and operation of their property. [See RPI Form 223]

Further, the increase or decrease in the buyer’s annual taxes brought on

by the purchase of a property is calculated on a Comparative Analysis
Projection (CAP) worksheet, not the INTAX form which is designed solely
for sales. [See RPI Form 353 §5.3]

When a seller acquires like-kind replacement property in a §1031

reinvestment plan, they avoid profit taxes on some or all the profit realized
on the property sold. In §1031 situations, an agent need only prepare a Profit
and Basis Recap Sheet to calculate the profit tax the client avoids. [See RPI
Form 354; see Chapter 30]

Occasionally, the seller’s §1031 reinvestment plan might qualify them for
a partial §1031 exemption. Their withdrawal of cash, receipt of a carryback
note, or a reduced amount of mortgage debt on the reinvestment causes
part of the profit they realize to be taxed. Items withdrawn before acquiring
all replacement property cannot be offset and the profit allocated to them
is taxed. Here, the INTAX form section for batching taxable profit includes
profit taxed in the partial §1031 transaction.3

When the amount of the net sale price of business-use or investment real estate Capital gain
is greater than the price the seller paid for the property and improvements,
the seller takes a capital gain as part of their profits. Capital gains are broken tax rate set
down into either short-term capital gains when held less than one year and
treated as ordinary income, or long-term capital gains when held for more
by taxable
than one year. income
From a different analysis of profits, the net profit on a sale is the difference thresholds
between the net sales price (gross price less transactional costs) and the seller’s
net profit
remaining cost basis in the property sold (price minus basis equals profit). Gains on the sale
of business-use
Net profit is taxed, but at different rates from ordinary income, unless exempt, and capital assets
excluded, deferred, or reduced by offsets for losses and deductions. calculated as the
sales price minus
transactional costs
minus the remaining
cost basis.
3 Internal Revenue Code §1031(b)
102 Tax Benefits of Ownership, Fourth Edition

Critically, net profit consists of two types of gain — unrecaptured gain and
capital gain — each with different sets of tax rates and priorities for computing
taxes on taxable income, specifically:
• unrecaptured gain, represented by the accumulated amount of
depreciation deductions taken on the property sold, is taxed up to the
maximum rate of 25%;4 and
• long-term capital gain, is the net profit remaining in the sales price of
a capital asset held for more than 12 months, minus the remaining cost
basis and unrecaptured gain, and to the extent it is taxed is taxed at a
single rate of either 0%, 15% or 20% set by two thresholds applied to the
seller’s taxable income.5 [See Form 351 §5.4]
Further, when the resale price is less than the price paid to acquire the property
and make improvements (no capital gain is realized), the unrecaptured gain
taxed is limited to the net resale price minus the cost basis.

For example, a couple selling a rental property paid $300,000 for the property.
Their depreciation deductions total $100,000. The property is sold for $450,000,
a profit of $250,000 over their remaining cost basis of $200,000. Critically, the
couple’s taxable income for the year 2021 is between the $80,800 and $501,600
taxable income thresholds triggering the taxing of all capital gains in the
couple’s taxable income at the rate of 15%. [See Form 351 §4]

The couple’s profit of $250,000 is broken down — batched — into:

• unrecaptured gain, consisting of $100,000 in reported depreciation
deductions, taxed at remaining ordinary income tax rates up to a
ceiling 25% rate for a maximum tax liability of $25,000 [See Form 351
§5.3]; and
• long-term capital gain, limited to the remaining $150,000 of taxable
income, and based on taxable income thresholds taxed at the 15% rate
for a maximum tax liability of $22,500.
The taxable income thresholds which set the single rate used to tax all capital
gains are adjusted each year for inflation.6

In the order Here is presented a fuller picture of the effect on taxable income by including
in these examples the seller’s ordinary income and personal deductions
of descending which limit the amount of capital gains to be taxed.
rates to Typically the capital gain amount on a sale is greater than the portion of
reduce the seller’s taxable income allocated to capital gains and taxed. This result of
taxes on only a portion of the capital gains is due to the limitation on taxes
subsidies for the amount of the taxable income and priority treatment given to taxing
ordinary income and unrecaptured gains. When capital gain amounts are
greater than the amount of taxable income remaining after taxing ordinary
income and unrecaptured gains, the capital gain rate simply applies only to
the remainder of the taxable income.
4 IRC §1(h)(1)(E); see Form 351 §5.3
5 IRC §1(h)(1)(C)-(D)
6 IRC §1(j)(5)(B)
 Chapter 12: Taxable income taxed in descending order of rates 103

Also, when capital gains are reported personal deductions end up reducing
the amount of capital gains remaining to be taxed, but do not reduce ordinary
income or unrecaptured gains which are taxed at higher rates (up to 37%
and 25%) than capital gains (15% or 20%). Ordinary income in the AGI is
the first batch of taxable income to be accounted for and taxed. When sales
generate capital gains, any taxable income remaining untaxed after ordinary
income and unrecaptured gains are accounted for is taxed at the capital gains
rate. Capital gains exceeding the taxable income amount are ignored and
go untaxed due to offsets to the AGI for deductions to produce the taxable
income.

Other types of profit exist in taxable income which are batched and taxed
after accounting for ordinary income but before taxing unrecaptured gains.
Profit on the sale of coins and art is called a collectibles gain. Collectibles are
taxed up to a maximum rate of 28%, unless sold in a §1031 reinvestment plan
as exempt. Profit on the sale of small business stock, called a §1202 gain, is
also taxed up to a maximum rate of 28%.7

Recall that the total amount of all income, profits and allowable losses from
each income category is called adjusted gross income (AGI). Subtracting
Netting gains
personal and rental loss deductions from AGI produces the seller’s taxable and taxing
income.8
priorities
To determine the tax liability of the seller, taxable income is broken down
into two major components for sellers of real estate:
• net profit (unrecaptured and capital gains) [See Form 351 §5.1]; and
• ordinary income. [See Form 351 §5.2]
To accomplish this breakdown of the taxable income, the net profits – gains –
within each income category are added together to produce the AGI.

Further, ordinary income in the AGI is taxed at whichever produces the

greater amount of taxes:
• SIT rates ranging from 10% to a ceiling of 37%, or
• AMT rates of 26% and 28%.

To calculate the income tax on net profits from a sale, profits are broken down
and batched into unrecaptured gain and capital gain. Then after ordinary
Batching gains
income in the taxable income amount is taxed at rate brackets up to 37%, for taxable
profits are taxed by their type of gain in the order of descending rates, until
no amount of taxable income remains to be taxed: income
• first, any collectibles gain and business stock gain is, taxed at a 28% rate;
• next, any unrecaptured gain — depreciation taken, is, taxed at a
maximum rate of 25%; and

7 IRC §§1(h)(4), 1(h)(5), 1(h)(7)

8 IRC §§63(b), 63(d)
104 Tax Benefits of Ownership, Fourth Edition

• last, any taxable income remaining untaxed is long-term capital gain

taxed at either the 15% or 20% capital gain rate as set by thresholds
applied to the taxable income. [See IRS Form 1041, Schedule D Part IV]
Earnings on the sale of dealer property, also called inventory, are reported as
business income, not profit on the sale of assets. Recall that dealer property is
held primarily for sale to customers of a business, not for productive use in a
business or investment.9

The principal Profit remaining on the sale of a principal residence after taking the profit
exclusion is reported as a short- or long-term gain (held, respectively, less or
residence more than one year). [See Chapter 3]
profit For example, a homeowner and spouse paid $250,000 for their principal
exclusion residence which they are now offering for sale at a net sales price of $900,000.
The homeowners did not take any depreciation deductions on the residence
as a home office or as a rental, in whole or in part. Thus, their cost basis
remains unchanged as the price they originally paid for the residence and
additional improvements.

On the sale, they will take a profit of $650,000 since a principal residence
is classified as a capital asset. They qualify for a combined exclusion from
profit tax of $500,000. Thus, they have a reportable profit of $150,000 – a
portfolio income category profit which in combined into their AGI, and after
deductions, is part of the homeowner’s taxable income.

Further, the $150,000 in profit remaining (after taking their principal

residence profit exclusion) will be reported as a long-term capital gain and
taxed as remaining taxable income at the 15% rate after all other income is
taxed. Their maximum tax liability on the sale of the residence is $22,500. [See
Form 351 §5.4]

Conversely, a seller may not use a loss on the sale of the principal residence
to offset investment or business category income or profits — it is an
unsubsidized personal loss.

Profit allocated to any note carried back by a seller is reported each year as
Carryback payment is received. The profit allocated to the principal in the installment
sale profit payments is also batched and reported in the year received. The profit
allocated to the down payment and principal installments is taxed at the
reporting relevant rates.10

For example, real estate used to provide warehouse space for a seller’s
distribution business is sold for the net sales price of $1,000,000. Terms include
a $100,000 down payment, the buyer to assume or refinance a $400,000
mortgage and execute a $500,000 carryback note for the balance of the price.

9 IRC §1231(b)
10 IRC §453
 Chapter 12: Taxable income taxed in descending order of rates 105

The seller has taken depreciation deductions of $150,000, leaving an adjusted

cost basis of $500,000 at the time of sale. Thus, the profit on the sale is $500,000
(price minus basis equals profit).

As a result, the installment sale’s contract ratio of profit-to-equity

($500,000/$600,000) for the allocation of profit to principal is 83.3%.
Accordingly, the down payment of $100,000 is 83.3% profit ($83,333) and the
carryback note of $500,000 is 83.3% profit ($416,666), both amounts making
up the total profit on the sale. [See Chapter 15]

Further, by batching, $150,000 of the profits is unrecaptured gain

(depreciation), to be taxed before calculating the tax for any long-term gain
remaining in the taxable income. Thus, profit taxes are only paid when cash
is received from the down payment, and from installments of principal.

The entire profit of $83,333 in the down payment is reported as unrecaptured

gain and taxed up to the 25% ceiling rate. The remainder of the unrecaptured
gain is reported on 83.3% of the principal payments and taxed when received
on the carryback note, ending the year the unrecaptured gain is fully
reported. All remaining profit (83.3% of the note’s principal balance) is taxed
at the long-term capital gain rate as principal is received on the note. [See
Form 351 §§5.3 and 5.4]

For high-income earners, ordinary income tax needs to be calculated twice,

once under SIT rates and again under AMT rates.
The
alternative
This is not so for profits, as the rate on profits remain are the same for both SIT
and AMT reporting. minimum tax
Whichever SIT or AMT calculation sets the highest tax liability, that amount on other than
is the tax paid on the ordinary income portion of the taxable income.11 [See profits
Form 351 §§5.2(a) and 6]

The rates on ordinary AMT income (taxable income less profits) for all
taxpayers, except for married individuals filing separately, are (for 2021):
• 26% on amounts up to $199,900; and
• 28% on amounts over $199,900.12
When reporting AMT, depreciation taken on a property is reported as
unrecaptured gain taxed at remaining ordinary rate brackets up to a ceiling
of 25%, the same as SIT treatment of unrecaptured gain. Likewise, the long-
term capital gain rates and taxable income thresholds apply to both SIT and
AMT reporting.13

A NIIT tax of 3.8% is also imposed on the lesser of an owner’s: The net
• net investment income; or investment
11 IRC §55(a) income tax
(NIIT)
12 IRC §55(b)(1)(A)
13 IRC §55(b)(3)
106 Tax Benefits of Ownership, Fourth Edition

• AGI amounts greater than the $250,000 NIIT threshold amount for
joint filers ($200,000 for single filers).14
Net investment income (NII) for real estate investors is income, profits, and
losses from:
• operations and sales of rental property; and
• interest income on savings and trust deed notes, earnings on land held
for profit and rents received on management-free net-leased property.
The 3.8% surtax when imposed on AGI applies only to amounts of AGI
exceeding the NIIT threshold of $250,000 for joint filers ($200,000 for single
filers).

An owner’s AGI derived solely from salary or wages is not subject to the 3.8%
tax – zero NII exist. For example, when the owner has an AGI greater than
the NIIT threshold amount, but $0 in net investment income, the lesser of
the two amounts ($0) results in a $0 net investment income tax.

14 IRC §1411(a)(1)

Chapter 12 An agent’s tax knowledge passed on to clients becomes business goodwill.

This goodwill reflects positively on the agent’s brand and generates
Summary further employments. Encouraging a client to discuss the transaction
with other advisors available to the client – or the client authorizing the
agent to do so – results in increased coordination between the client and
the agent.

The sale of every parcel of real estate, except dealer property, produces
a profit (or loss as the flip side of that coin) for a seller when the price
exceeds the seller’s cost basis in the property.

By using an Individual Tax Analysis (INTAX) form for review with the
seller, the agent breaks down the profit taken on a sale into the two types
of gains, called batching. The agent is unable to develop an accurate
estimate of the seller’s tax liability generated closing a sale the agent
negotiated without first batching the gains.

The net profit on a sale is the difference between the net sales price (gross
price less transactional costs) and the seller’s remaining cost basis in the
property sold (price minus basis equals profit). Net profit consists of two
types of gain – unrecaptured gain and capital gain – each with different
sets of tax rates and priorities for computing taxes on taxable income.

Chapter 12 Individual Tax Analysis (INTAX)............................................ pg. 105

net profit........................................................................................ pg. 101
Key Terms
taxable income.............................................................................. pg. 99
 Chapter 13: The tax rates in application 107

Chapter
13
The tax rates in
application

After reading this chapter, you will be able to: Learning

• distinguish between unrecaptured gain and long-term capital
gain a couple takes as their profit on the sale of real estate;
Objectives
• advise clients on the rates applying to unrecaptured gains and
the taxable income thresholds setting the single tax rate for their
long-term capital gains; and
• counsel clients about arrangements which reduce the financial
consequences of income tax liabilities on their transactions.

all-inclusive trust deed note net sales proceeds Key Terms

(AITD) seller’s net sheet
net investment income tax
(NIIT)

Property owners considering the sale of a property are often averse to selling Tax rates
for fear of an unknown – tax consequences, a profit tax liability incurred
in the year of the sale. To neutralize this fear, an agent representing a seller
put to your
analyzes and advises on the approximate amount of profit taxes they will seller’s best
incur on the sale as part of the real estate services they render.
use
To discuss the tax aspects of a sale with anyone, real estate licensees need
sufficient expertise to understand and determine the likely profit tax
consequences of the transaction they are negotiating. Also, licensees have
good reason to develop their working knowledge about tax ramifications to
best manage the client’s contracting and financial aspects of a sale, whether
acting on behalf of a client or as a principal. The basis for this tax advisory
108 Tax Benefits of Ownership, Fourth Edition

approach with clients is that taxes are an inherent part of every real estate
sales transaction, may inform the client’s decisions, and that tax aspects as
accounting is taught as part of a real estate education for licensees.

On acquiring profit tax knowledge, many agents advertise they specialize in

advising investor clients on alternative structuring for generic cash-out sales
transactions. Based on their advice, sellers are enabled to consider prudent
steps they might take to avoid or defer profit tax, including:
• acquiring replacement property in a §1031 reinvestment transaction;
• carrying paper in a §453 deferred installment sale;
• timing the closing so gain is taxed at a lesser rate; or
• qualifying for the $250,000 per person principal residence profit
exclusion or 2020 Prop 19 replacement home assessment.
Recall that an agent uses the INTAX form to calculate the seller’s anticipated
federal tax liability on a sale. California’s state income tax liability on the sale
is additional, around one-third the amount of the federal tax liability.

When an owner sells a primary residence, each owner-occupant is entitled

to take up to $250,000 in capital gains profit on the sale tax-free due to the
principal residence profit exclusion. [See Chapter 3]

The mid- Consider an agent managing their employment under a listing agreement
with the owner of an income-producing property at a sales price of $900,000.
income The owner of the property acquired the property for $500,000 as shown in a
earner sells property profile title report.

property During discussions, the owner voices concern about any profit tax liability
a sale of the property might create since their depreciated cost basis in the
property is $270,000. On a review of documents in the property profile, the
owner comments on their recent refinancing of the property with a $400,000
mortgage originated to obtain cash to fund needs unrelated to the property.

Noting the mortgage balance is greater than the remaining cost basis, the
agent suggests the owner might consider avoiding taxes on any profit as
exempt by acquiring a replacement property in a §1031 reinvestment plan.
However, the owner only wants to liquidate their properties - they need the
sales proceeds for purposes other than real estate ownership.

Further, the agent mentions the owner’s ability to defer profit taxes in an
installment sale until principal is paid on the note received in a carryback
sale. Here too, the owner only wants cash.

On inquiry by the agent, the owner is aware profit taxes will reduce the
amount of cash sales proceeds but does not know by how much. The agent
offers to assist in a profit tax analysis and the owner agrees as the amount of
after-tax cash on the sale is a concern.
 Chapter 13: The tax rates in application 109

GOOD FAITH ESTIMATE OF SELLER’S NET SALES PROCEEDS

Figure 1
On Sale of Property

Form 310
Prepared by: Agent ____________________________ Phone _______________________
Broker ____________________________ Email _______________________
NOTE: This net sheet is prepared to assist the Seller by providing an estimate of the amount of net sales proceeds the
Seller is likely to receive on closing, based on the price set in the agreement, the estimated amount for expenses likely to be
incurred to market the property and close a sale, and any adjustments and pro rates necessitated by the sale.
The figures estimated in the net sheet may vary at the time each is incurred due to periodic changes in charges for
professional services, administration fees and work enforcement made necessary by later inspections, and thus

Good Faith
constitute an opinion, not a guarantee by the preparer.
If the property disposed of is IRC §1031 property and the seller plans to acquire replacement property, use a §1031 Profit
and Basis Recap Sheet to compute the tax consequences of the Seller’s §1031 Reinvestment Plan. [See ft Form 354]
DATE: _____________, 20______, at ______________________________________________________, California.

Estimate of
1. This is an estimate of the fix-up, marketing and transaction expenses Seller is likely to incur on a sale, and the
likely amount of net sales proceeds Seller may anticipate receiving on the close of a sale under the following
agreement:
Seller’s listing agreement Purchase agreement Counteroffer

Seller’s Net
Escrow instructions Exchange agreement Option to buy
1.1 dated _____________, 20______, at ______________________________________________, California,
1.2 entered into by _________________________________________________________, as the Seller, and
1.3 __________________________________________________________________________, as the Buyer,

Sales Proceeds
1.4 regarding real estate referred to as ________________________________________________________.
1.5 The day of the month anticipated for closing is _______________.
2. SALES PRICE: For a full-size, fillable copy of this or
any other form in this book that may
2.1 Price Received. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+)$_______________
3. ENCUMBRANCES:
3.1 First Trust Deed Note . . . . . . . . . . . . . . . . . . . . . . . $_______________
3.2 Second Trust Deed Note . . . . . . . . . . . . . . . . . . . . . $_______________
3.3 Other Liens/Bonds/UCC-1 . . . . . . . . . . . . . . . . . . . . . $_______________
0.00
3.4 TOTAL ENCUMBRANCES: [Lines 3.1 to 3.3] . . . . . . . . . . . . . . . . . . ($_______________
be legally used in your professional
4. SALES EXPENSES AND CHARGES:
4.1 Fix-up Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
practice, go to realtypublications.com/
forms
4.2 Structural Pest Control Report . . . . . . . . . . . . . . . . . . $_______________
4.3 Structural Pest Control Clearance . . . . . . . . . . . . . . . . $_______________
4.4 Property/Home Inspection Report . . . . . . . . . . . . . . . . . $_______________
4.5 Elimination of Property Defects . . . . . . . . . . . . . . . . . $_______________
4.6 Local Ordinance Compliance Report . . . . . . . . . . . . . . . $_______________
4.7 Compliance with Local Ordinances . . . . . . . . . . . . . . . . $_______________
4.8 Natural Hazard Disclosure Report . . . . . . . . . . . . . . . . $_______________
4.9 Smoke Detector/Water Heater Safety Compliance . . . . . . . $_______________
4.10 Homeowners’ (HOA) Association Document Charge . . . . . . $_______________
4.11 Mello-Roos Assessment Statement Charge . . . . . . . . . . . $_______________
4.12 Well Water Reports . . . . . . . . . . . . . . . . . . . . . . . . $_______________
4.13 Septic/Sewer Reports . . . . . . . . . . . . . . . . . . . . . . . $_______________
4.14 Lead-Based Paint Report . . . . . . . . . . . . . . . . . . . . $_______________
4.15 Marketing Budget. . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
4.16 Home Warranty Insurance. . . . . . . . . . . . . . . . . . . . . $_______________
4.17 Buyer’s Escrow Closing Costs . . . . . . . . . . . . . . . . . . $_______________
4.18 Loan Appraisal Fee . . . . . . . . . . . . . . . . . . . . . . . . $_______________
4.19 Buyer’s Loan Charges . . . . . . . . . . . . . . . . . . . . . . . $_______________
4.20 Escrow Fee. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
4.21 Document Preparation Fee . . . . . . . . . . . . . . . . . . . . $_______________
— — — — — — — — — — — — — — — — — — — PAGE ONE OF TWO — FORM 310 — — — — — — — — — — — — — — — — — — —

— — — — — — — — — — — — — — — — — — — PAGE TWO OF TWO — FORM 310 — — — — — — — — — — — — — — — — — — —

4.22 Notary Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________

4.23 Recording Fees/Documentary Transfer Tax . . . . . . . . . . . $_______________
4.24 Title Insurance Premium. . . . . . . . . . . . . . . . . . . . . . $_______________
4.25 Beneficiary Statement/Demand . . . . . . . . . . . . . . . . . . $_______________
4.26 Prepayment Penalty (first) . . . . . . . . . . . . . . . . . . . . . $_______________
4.27 Prepayment Penalty (second) . . . . . . . . . . . . . . . . . . . $_______________
4.28 Reconveyance Fees . . . . . . . . . . . . . . . . . . . . . . . . $_______________
4.29 Brokerage Fees . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
4.30 Transaction Coordinator Fee . . . . . . . . . . . . . . . . . . . $_______________
4.31 Attorney/Accountant Fees . . . . . . . . . . . . . . . . . . . . . $_______________
4.32 Other ___________________________________ . . . . . . . . $_______________
4.33 Other ___________________________________ . . . . . . . . $_______________
4.34 0.00
TOTAL EXPENSES AND CHARGES [Lines 4.1 to 4.33] . . . . . . . . . . . . . ($_______________
0.00
5. ESTIMATED NET EQUITY: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
6. PRO RATES DUE BUYER:
6.1 Unpaid Taxes/Assessments . . . . . . . . . . . . . . . . . . . . $_______________
6.2 Interest Accrued and Unpaid . . . . . . . . . . . . . . . . . . . $_______________
6.3 Unearned Rental Income . . . . . . . . . . . . . . . . . . . . . $_______________
6.4 Tenant Security Deposits . . . . . . . . . . . . . . . . . . . . . $_______________
6.5 TOTAL PRO RATES DUE BUYER [Lines 6.1 to 6.4] 0.00
. . . . . . . . . . . . . . . $_______________
7. PRO RATES DUE SELLER:
7.1 Prepaid Taxes/Assessments . . . . . . . . . . . . . . . . . . . . $_______________
7.2 Impound Account Balances . . . . . . . . . . . . . . . . . . . . $_______________
7.3 Prepaid Association Assessment . . . . . . . . . . . . . . . . . $_______________
7.4 Prepaid Ground Lease . . . . . . . . . . . . . . . . . . . . . . $_______________
7.5 Unpaid Rent Assigned to Buyer . . . . . . . . . . . . . . . . . $_______________
7.6 Other ___________________________________ . . . . . . . . $_______________
7.7 0.00
TOTAL PRO RATES DUE SELLER [Lines 7.1 to 7.6]. . . . . . . . . . . . . . . $_______________
0.00
8. ESTIMATED PROCEEDS OF SALE: . . . . . . . . . . . . . . . . . . . . . . . . . (=)$_______________
8.1 The estimated net proceeds at line 8 from the sale or exchange
analyzed in this net sheet will be received in the form of:
a. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
b. Note secured by a Trust Deed. . . . . . . . . . . . . . . . $_______________
c. Equity in Replacement Real Estate. . . . . . . . . . . . . . $_______________
d. Other ________________________ . . . . . . . . . . . . . $_______________
seller’s net sheet
I have prepared this estimate based on my knowledge I have read and received a copy of this estimate.
and readily available data.
Date: _____________, 20______ Date: _____________, 20______
A document prepared
Broker: _______________________________________
DRE #: ______________________________________
Seller’s Name: _________________________________ and used by a seller’s
Agent: ________________________________________
Signature: _____________________________________
agent to itemize
expenditures and
Signature: _____________________________________ Signature: _____________________________________ charges incurred on
FORM 310 08-11 2011 first tuesday, P.O. BOX 20069, RIVERSIDE, CA 92516 (800) 794-0494
a sale of a property,
disclosing the financial
consequences of a sales
price set in a listing
agreement or a buyer’s
Initially, the agent prepares a seller’s net sheet for review with the owner offer to purchase.
based on a cash-out sale of the property at the listed price. Using the net sheet
the agent determines the amount of net sales proceeds the owner can
anticipate receiving at the listed price — before payment of taxes on profits net sales proceeds
taken on the sale. [See Figure 1] The amount of a
seller’s receipts on
closing a sale of
Starting with the listing price of $900,000, the agent deducts the $400,000 their property after
mortgage financing and estimated closing costs of $70,000. The estimated deducting all costs of
the sale and mortgage
net sales price is $830,000 – $900,000 gross sales price minus $70,000 closing
assumptions/payoffs
costs. On review of the net sheet with the seller, the agent advises the owner from the gross price,
to anticipate receiving approximately $430,000 in net sales proceeds on the but before payment of
taxes on any profit on
close of escrow — in the form of cash. the sale.
110 Tax Benefits of Ownership, Fourth Edition

The gathering Further, the agent now requests personal tax information which the owner
provides, including:
of tax figures
• the owner’s ordinary income of $65,000;
known to the • accumulated depreciation deductions of $230,000 taken during
client ownership of the listed property;
• the couple’s remaining cost basis of $270,000 on the listed property; and
• the couple files a joint return taking the standard deduction of $25,100
(for 2021).
With tax information about the owner and the property, the agent calculates
the couple’s taxable profit on the sale (remember, price minus basis equals
profit):
• $830,000 net sales price; minus
• $270,000 remaining cost basis; equals
• $560,000 in reportable profit – gains.
However, the agent notes the profit of $560,000 on the sale is significantly
larger than the net sales proceeds of $430,000. This inversion is the result of
the mortgage-over-basis financing of their ownership.

When the owner refinanced the property with a mortgage encumbrance to

withdraw equity in cash (the ATM effect), they incurred no tax consequence
for the cash back they received as they are tax-free dollars. In contrast, profit
taken on a sale may or may not generate a tax liability depending on whether
the profit is exempt or its reporting deferred.

On the close of a sale, the mortgage is either satisfied using funds received
from the buyer or remains of record, assumed by the buyer. However, a
portion of the mortgage principal represents profit taken on the sale and is
reported and taxed (when not exempt or deferred). This tax result is partially
due to debt relief in a mortgage-over-basis situation on a cash-out sale.

Next, the agent fills out an INTAX form using the information provided by
the couple. The couple’s estimated taxable income is $600,000. [See Figure 2
§4 accompanying this chapter]

The taxable income consists of:

• the owner’s joint ordinary income of $65,000; [See Figure 2 §1.1]
• their total profits taken during the year of $560,000 profit - this income
property sale; [See Figure 2 §1.4]
• totaling their Adjusted Gross Income (AGI) of $625,000 [See Figure 2
§1.10] from which
• their $25,100 (for 2021) standard personal deduction is subtracted; and
[See Figure 2 §3.3, which is rounded]
• totaling taxable income of $600,000. [See Figure 2 §4]
 Chapter 13: The tax rates in application 111

Note that taxable income is less than the combined ordinary income and
profits on the sale which comprise the adjusted gross income (AGI). Further,
that ordinary income is taxed first leaving the remainder of taxable income
as gains taxed at lower rates. [See Figure 2 §5.1]

Calculating the approximate amount of taxes is straightforward using the Tax

Batching section 5 in figure 2. Initially, from the taxable income of $600,000
Taxing the
you subtract all the couple’s ordinary income in the AGI, here being $65,000 profits, batch
of professional income. The result is the amount of reported profit in their
taxable income. Since the couple’s net profit at line 5.1 is less than their total by batch,
profits in the AGI at line 1.4, the profits taxed in section 5 will be less than the in taxable
profits taken during the year. [See Figure 2 §5.1]
income
The $65,000 reportable ordinary income is the first batch of taxable income
to be taxed. The types of income and gains are taxed with priority based on
the highest tax rate batches taxed first before the next lowest, and so on. [See
Figure 2 §5.2]

Observe: The $65,000 in ordinary income

INDIVIDUAL exceeds(INTAX)
TAX ANALYSIS the 10% ordinary income
tax bracket ceiling ($19,900
Prepared by: Agent
in 2021 for married couples filing jointly), but not
Phone
the 12% ordinary income Brokertax bracket ceiling amount Email ($81,050 in 2021). Thus,
two tax brackets in tandem set the amount of tax on ordinary income. The
NOTE: This form is used by an agent when negotiating a sale or partial §1031 transaction for a client, to prepare an
estimate for review and provide advice on any income tax liability generated by the proposed transaction.
tax due
Date:on the ordinary
Client:
, 20 income is $7,400 ($2,000 + .12($65,000 -$19,900)). [See
Figure 2 §5.2(a)]
Prepared by:

Standard Income Alternative Minimum

Items
Tax (SIT) Tax (AMT)
The remaining taxable income is taxed at rates on gains for the profit taken
on the sale.
1. ADJUSTED GROSS INCOME (AGI):
65,000
1.1 Salary/professional fees/wages (+) $ (+) $
1.2 Trade or business income/loss (+/-) $ (+/-) $
Before proceeding with the profit tax analysis, you separate the profit of
1.3 Sale of business property profit/loss (+/-) $ (+/-) $
1.4 560,000
Rental operating income and profit (+) $ (+) $
$560,000 on the proposed sale into its component gains as their priority for
1.5 Business related rental operating loss (-) $ (-) $
taxing and the tax rates for each are different. Here, the gains which are the
1.6 Loss spillover of rental sales (-) $ (-) $
1.7 Investment category income and profits (+) $ (+) $
profit, in the order of priority they are taxed, include:
1.8 Investment category capital losses (up to $3,000) (-) $ (-) $
1.9 Retirement, pension and annuity plans (-) $ (-) $
625,000
• unrecaptured gain on real estate ($230,000),
1.10 ADJUSTED GROSS INCOME $ the result$ of depreciation
2. REAL ESTATE RELATED DEDUCTIONS:
deductions
2.1 taken by the couple
First/second home interest ($750,000 loan cap) [See
(-) $ Figure 2 §5.3];
(-) $ and
2.2 $25,000 rental loss deduction (-) $ 0 (-) $ NONE
• long-term
2.3 TOTAL REALcapital gains
ESTATE RELATED on the (-)sale
DEDUCTIONS $ ($330,000),
0 the
(-) $ portion of the net
3.sales price exceeding the price the couple paid for the property. [See
OTHER DEDUCTIONS AND EXEMPTIONS:
3.1 Medical and dental (-) $ (-) $ NONE
Figure
3.2 2 §5.4](charitable contributions, etc.) (-) $
Other deductions (-) $ NONE
3.3 Personal deduction (-) $ 25,000 NONE
3.4 AMT exemption (-) $
3.5 TOTAL OTHER DEDUCTIONS AND EXEMPTIONS (-) $ -25,000 (-) $
4. TAXABLE INCOME (line 1.10 minus lines 2.3 and 3.5) $ 600,000 $ Figure 2
5. TAX BATCHING:
5.1 Net profits and short term losses (+/-) $ 535,000 $
(line 4 minus income in line 1.10 not a gain) Excerpt from
5.2 Ordinary income
(line 4 minus line 5.1 but not less than zero) $ 65,000 $ Form 351
(a) Tax: Use SIT and AMT tax bracket rates $ 7,400 $
5.3 Unrecaptured depreciation gain $ 230,000
(b) Tax: Use further SIT and AMT tax rates up to 25% $ 53,060 $ Individual Tax
Analysis (INTAX)
5.4 Long-term capital gain (line 5.1 minus line 5.3) $ 305,000
(c) Tax: Use threshold tax rates when line 4 is >$87,500 $ 61,000 $
(2021 thresholds for couples: line 4 > $87,500 use 15%; >$496,600 use 20%)
121,460
6. INCOME TAX: The total of lines a, b, and c $ $
(Tax amount due is the larger of the SIT or AMT at line 6)
Additional taxes are due for state income taxes and possible NIIT.

FORM 351 04-21 ©2021 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517
112 Tax Benefits of Ownership, Fourth Edition

Because the couple’s ordinary income ($65,000) is $15,250 less than the $80,250
ceiling for the 12% tax bracket, $15,250 of the $230,000 unrecaptured gain on
the sale is taxed at the 12% rate ($1,830 in tax). The ordinary tax rate bracket
is used since its tax rate is lower than the ceiling rate of 25% for unrecaptured
gain.

The $214,750 balance of the unrecaptured depreciation gain ($230,000 minus

$15,250) is then taxed on the next $91,700 at the 22% tax bracket ($21,700
additional tax). This leaves $123,050 in unrecaptured gain to be taxed at the
24% ordinary income bracket rate ($29,530 additional tax). Thus, the total
tax on the unrecaptured depreciation gain portion of the taxable income is
$53,060 ($1,830 + $21,700 + $29,530). [See Figure 2 §5.3(b)]

The couple’s taxable income now remaining to be taxed is $305,000 (the

taxable profits of $535,000 at line 5.1 minus $230,000 at line 5.3). The remaining
taxable income being long-term capital gain is taxed at a single rate set based
on the amount of taxable income reported.

Note: While the reportable amount of capital gain on the sale was $330,000,
the taxable income remaining to be taxed at the capital gains rate is $305,000,
$25,000 less than the capital gains on the sale – the result of personal
deductions from AGI to set the taxable income.

To select the one tax rate applied to the couple’s capital gain portion of
the remaining taxable income, the agent applies threshold figures to their
taxable income (line 4).

For couples filing jointly in 2021, one of the following rates applies to all their
capital gains:
1. When the couple’s taxable income is below $80,800 ($40,400 for
individual filers) the tax rate is 0% for capital gains – no tax on it, but
this zero rate does not apply to this couple’s capital gain;
2. When the couple’s taxable income amount is between $80,800 and
$501,600 ($40,400 and $445,850 for individual filers) the tax rate on
all capital gains is set at 15% - but this 15% rate does not apply to the
couple’s capital gain;
3. When the couple’s taxable income is over $501,600 ($445,850 for
individual filers) the tax rate on all capital gains is set at 20%.1
Thus, the couple’s long-term capital gain rate for taxing the $305,000
remainder of the taxable income is 20%. Their taxable income of $501,600 (for
net investment 2021) exceeds the 20% threshold for couples filing jointly. Here, the capital
income tax (NIIT) gain tax on the remainder of the taxable income is $61,000. [See Figure 2
A surtax on income
from investment assets §5.4(c)]
such as income, profits
and losses from the Separately and in addition to the figures in the INTAX form, the couple’s
operations and sales
of rental property,
$605,000 profits exceed the $250,000 threshold for the 3.8% net investment
interest income, stocks, income tax (NIIT) by $355,000. This overage is subject to NIIT liability.
bonds, and land held
for profit on resale.

1 [Internal Revenue Code §1(j)(A)-(B)

 Chapter 13: The tax rates in application 113

When the total profit on the sale of investment properties is greater than the
NIIT threshold, the excess here of $355,000 is subject to an additional NIIT tax
of 3.8%, a further tax of $13,490 ($355,000 x 0.038). [See Chapter 12]

Thus, the couple’s total tax on the sale of the property is $127,550 ($53,060
unrecaptured gain tax + $61,000 long-term capital gain tax + $13,490 NIIT).
[See Figure 2 §§5.3(b); 5.4(c)]

Remember, the couple further owes approximately a third of these amounts

as additional tax of around $40,000 due the State of California on the sales
profit and other income.

Based on the agent’s estimation of the net sales proceeds (seller’s net sheet) After-tax net
and profit tax liability (INTAX form) at the listed price, the total amount of
after-tax net proceeds the couple can anticipate from the sale is approximately proceeds
$302,450 (net sales proceeds of $430,000 minus profit taxes of $127,550).

Thus, the payment of profit taxes to the IRS consumes approximately 40%
of the net sales proceeds on account of the mortgage-over-basis situation. all-inclusive trust
Critically, the profit tax due the IRS of $127,550 equals 23% of the $560,000 deed note (AITD)
A note entered into by
profit on the sale (state taxes being around an additional 8% of profit). a buyer in favor of the
seller to evidence the
Since the couple is liquidating some of their estate to obtain cash, the agent amount remaining
suggests ways the couple can reduce their taxes, including: due on the purchase
price after deducting
the down payment.
• considering the sale of different property with a lower loan-to-value This amount includes
(LTV) ratio and a higher basis-to-value ratio to generate more after-tax mortgage debts
sales proceeds; or remaining of record
which the seller
• carrying paper in the form of an all-inclusive trust deed (AITD) remains responsible
after a substantial cash down payment to minimize risk of loss and for paying. Also
called a wraparound
maximize tax benefits available by reporting as a carryback sale to mortgage or overriding
defer and reduce taxes in the year of sale. [See Chapter 15] mortgage. [See RPI
Form 421]
114 Tax Benefits of Ownership, Fourth Edition

Chapter 13 When selling a property, an agent alleviates their seller’s fear of

unknown tax consequences and profit tax liability by analyzing and
Summary giving advice on the estimated amount of taxes generated by their sale.

Licensees need to be sufficiently knowledgeable about tax ramifications

to best manage the contracting and financial aspects of a sale, whether
acting as a principal or on behalf of a client. Taxes are inherent in most
real estate education as they do affect ownership. Many agents advertise
specializing in advising investor clients on alternative structuring for
generic cash-out sales transactions. Based on their advice, sellers are
able to consider which steps they might take to avoid or defer profit tax.

An agent prepares an individual tax analysis (INTAX) form, to calculate

the seller’s anticipated federal tax liability on a sale. An agent prepares
a seller’s net sheet to determine the amount of net sales proceeds the
owner can anticipate receiving on a sale at the listed price – before
payment of taxes on profits taken on the sale.

all-inclusive trust deed.............................................................. pg. 113

Chapter 13 net investment income tax (NIIT).......................................... pg. 112
Key Terms net sales proceeds....................................................................... pg. 109
seller’s net sheet.......................................................................... pg. 109
 Chapter 14: Inflation, appreciation, and taxes 115

Chapter
14
Inflation, appreciation,
and taxes

After reading this chapter, you will be able to: Learning

• identify price inflation and appreciation as separate factors
contributing to tax revenues through upward property price
Objectives
movement;
• explain capital gain taxes as taking a percent of the value increase
a property experiences on resale over the price the seller paid to
acquire the property; and
• understand a rental property’s earning power and value as driven
by inflation and appreciation.

asset price inflation Consumer Price Index (CPI) Key Terms

consumer price inflation real profit
real rate

Consider an investor who decides to sell an improved parcel of real estate Uncle Sam
they bought 21 years ago for $440,000. The investor’s broker locates a buyer
willing to pay $1,000,000 for the property. The seller’s net sales price will be creates his
$900,000 ($1,000,000 minus $100,000 in transactional expenses).
share —
During their ownership of the property, the investor took $140,000 in mostly
depreciation deductions. Consequently, the investor’s adjusted basis in the
property is $300,000 ($440,000 original cost basis minus $140,000 depreciation).

The investor does not plan to reinvest the net sales proceeds by acquiring
replacement property in a §1031 reinvestment plan.
116 Tax Benefits of Ownership, Fourth Edition

The investor’s agent reviewing a seller’s net sheet with the investor informs
the investor their net profit on the sale will be $600,000 ($900,000 net sales
price minus $300,000 adjusted cost basis). The investor’s profit comprises:
• $140,000 in unrecaptured gains due to depreciation deductions, taxed
at ordinary income rates limited to a ceiling of 25%; and
• $460,000 in long-term capital gains due to an increase in the property’s
dollar value, taxed at capital gains bracket rates of 0%, 15% and 20%.
The broker’s analysis of the sales tax consequences does not consider the
monetary inflation that has taken place in the past 21 years and is reflected
in the property’s price increase — and thus the profit.

When consumer inflation of the dollar is taken into consideration, the

purchasing power of the investor’s property value and net operating income
has remained, in real terms, unchanged over the 21-year period of ownership.

A basket of Changes in the general price level are measured and indexed as a figure by
the Bureau of Labor Statistics. The Bureau reports the figures periodically for
goods and several metropolitan regions as the Consumer Price Index (CPI). The CPI
measures and tracks the rate of consumer inflation. CPI is simply an index of
services fluctuations in the general price of a huge selection of consumable products
— a “basket of goods and services.”

The CPI is published nationally and regionally; however, the most relevant
index is regional. There are three regional indexes for California: Los Angeles-
Consumer Price
Index (CPI) Long Beach, San Francisco-Oakland and San Diego. Regional indices reflect
An index of local economic pressures affecting retail pricing.
fluctuations in the
general price of a
wide selection of
The CPI doubled during the investor’s 21-year holding period. Thus, a dollar
consumable items held on the date they bought the property has only about half its purchasing
consisting of goods and power today. Put another way, over 21 years it takes twice as many dollars
services to measure
and track the rate of to purchase the same amount of land, labor, and materials to produce the
consumer inflation. property the investor is now selling.

The demographic and cultural conditions which affect the property’s value
may not have changed — but the dollar has.

The investor believes it is unfair to pay tax on their receipt of inflated dollars
from a sale — especially since the dollar’s value has decreased due to the
monetary policy of the very government doing the taxing.

The investor claims the taxes need to be based on real economic gain — the
nominal sales price today less the inflation-adjusted cost basis — to bring
the two figures into conformity with the worth of the dollar today. The
adjustment eliminates the effects of federally induced monetary inflation
over the period since the investor’s acquisition of the property.
 Chapter 14: Inflation, appreciation, and taxes 117

The property is located in Riverside County, so the investor calculates real profit
their real profit (adjusted for inflation) by using the same CPI figures for The price received on
Los Angeles the investor uses to adjust the rents they charge tenants. The the sale of property
less the owner’s capital
calculation is: investment in the
property as adjusted
• 212.9 (Current CPI) for consumer inflation
over the period of
• 106.45 (Original CPI at time of purchase 21 years ago) ownership.
• X $440,000 (Original purchase price)
• = $880,000 (Original purchase price in today’s dollars)
Thus, $440,000 of the current net sales price is created solely by price inflation.
Due to a lack of local demographic changes other than wages running parallel
with inflation, the appreciation factor has added nothing to the nominal
dollar value of the property while consumer inflation alone has altered its
dollar value.

On closing, the investor reports the profit on the sale — using inflation-
adjusted figures — as $300,000 ($900,000 resale price minus $600,000, the
remaining cost basis of $300,000 adjusted for inflation).

The IRS disagrees and claims the profit is $600,000 ($900,000 resale minus the
nominal $300,000 remaining cost basis).

Does the investor owe capital gain taxes on the $440,000 portion of the net
sales proceeds which consists solely of inflated dollars?
consumer price
Yes! Taxes are based on nominal profit, calculated as the actual dollars of inflation
capital invested in the property subtracted from the net sales price of actual An increase in the
general price level of
dollars received on the sale of the property. The real profit (after inflation all goods and services
adjustments) received by the investor on the original investment is of consumed in the
no concern to the government. However, the real profit is of concern to a economy. Contrast
with asset price
prudent investor and their broker when determining the time to sell during inflation.
an economic business cycle.1

Inflation is the rise in general price levels of everything people buy. Fluctuation
Inflation consists of two categories:
in the price
• consumer price inflation; and
• asset price inflation. level of goods
Although the two categories of inflation are intertwined with the dollar (and and services
California real estate is a US dollar denominated asset), their differences are
significant. asset price inflation
A rise in the value
Consumer price inflation is an increase in the general price level of all of assets, such as
stocks, bonds, and
consumable goods and services in the economy. Simply, the rate of consumer real estate. Contrast
price inflation is set by the rise in price of everything we buy to consume. with consumer price
inflation.
While the category of consumable goods includes rent movement in
housing, it does not include the price movement of the underlying asset —
1 Hellerman v. Commissioner (1981) 77 TC 1361
118 Tax Benefits of Ownership, Fourth Edition

the housing itself. Home improvements are not consumed, only used, while
remaining intact. Land and improvements are directly correlated to savings
— a store of wealth in the ownership of a home. A property’s resale value
is not associated with day-to-day expenditures for consumable goods or
services while the rental value of the property is.

The Consumer Price Index (CPI) does not measure asset inflation. Asset
prices behave quite differently and independently from factors driving
consumer price movement. Assets are investments, with pricing based on
the capitalization rate applied to the likelihood of a return on the investment.
These are an investor’s expectations, not a consumer’s. For investors, inflation
relates to the future price of the investment; for consumers, inflation is today’s
changes in the price of goods and the wages they earn to buy them.

The government’s need to raise revenue through a system for taxation of

Inflation and income and profits that does not respond well to inflation. When inflation
the taxes occurs and investors take profits, they need to pay taxes on any profit created
by the inflated dollars the investor accepts at the time of sale.
sellers pay on
sales Thus, investors pay taxes on the nominal dollar amount of inflation-
generated profit. Profit taxes are not calculated on the actual economic value
received which reflects the real profit.

There are two reasons the tax system largely ignores inflation.

First, the U.S. dollar’s primary function is to act as a uniform medium of

exchange, or the dollar’s “legal value.” The dollar is the unit of exchange
the U.S. has established to pay all public and private debts, including the
payment of taxes.2

As a medium of exchange, inflated dollars affect everybody, everywhere

who sets prices for goods in US dollars. Not only do we receive inflated
dollars for services, but we pay for services with inflated dollars. Therefore, an
investor who sells property and receives inflated dollars as their price pays
taxes with inflated dollars (from net sales proceeds). The adverse impact of
inflated values is diminished since the investor pays their taxes with inflated
dollars.

Also, during the time the investor holds the property, rents typically increase
to cover the landlord’s inflated cost of operations and earnings on increased
property value. Greater amounts of rent for the same property can only be
successfully demanded when wages and salaries increase.

In a loopback, consumer inflation is met by consumers demanding higher

wages and salaries, usually at or above the rate of consumer inflation, the
COLA pay raise. Recall that rent amounts paid for housing are part of the
calculation setting the rate of consumer inflation. Inflated rents in turn set
real rate the value of the rental property (based on the current capitalization rate for
The nominal interest like investments which always includes an inflation premium added to the
rate minus the rate of
inflation.
base real rate of return).
2 Norman v. Baltimore & O. R. Co. (1935) 294 US 240
 Chapter 14: Inflation, appreciation, and taxes 119

Second, when profit is calculated, the amount includes actual dollars received
on a sale. Profit does not factor in the effect of inflation on the quantity and
quality of consumables, i.e., goods and services.

For a capital gains profit to exist in a real estate transaction, more dollars are
received on a sale than dollars paid to acquire and improve the property. In
this sense, the capital gains tax takes a portion of only the increase in actual
dollars received. Yet, when the inherent value of the real estate declines due
to physical deterioration or obsolescence, the property’s value in current
dollars may fail to keep up with consumer inflation. In terms of real value,
the property’s dollar value has fallen when the dollar amount of inflation
since acquisition is backed out of the property’s current market value.

For example, an investor bought a property 20 years ago for $440,000. What
if the current resale price for the property is $500,000 — an 11% nominal
increase in dollars?

Here, the investor has a capital gain of $60,000 – the 11% increase in value.

However, under the real profit analysis, our investor has an inflation-
adjusted loss of $180,000 ($500,000 resale minus $580,000, the investor’s
inflation-adjusted price on acquisition).

Editor’s note — For the property to maintain its original purchasing power
of $440,000, the investor would have to net $880,000 on resale — after the
payment of their capital gain profit tax.

Can the investor report a loss on the sale?

No! The profit is again measured in actual dollars received, even though the
real estate’s price (and its basis) has not kept pace with inflation.3

This applies to both state and federal taxes. California definitions of income
and profit are the same as federal definitions.4

Losses due to inflation and cost basis reduction through depreciation

deductions are subject to the same rules — the use of actual dollars paid and
received, without any adjustment for inflation.

The government awards itself a share of an investor’s real estate value, Cutting its
payable on any resale of the property at a price greater than the investor’s
remaining cost basis — in the form of capital gain taxes. share
To understand how “government equity sharing” works, it is important to
recognize the economic fact that, everything else remaining constant (like
cap rates, which don’t), improved real estate tends to follow inflation trends
over time as rents tend to rise at the rate of inflation (as do salaries to pay
the rent). Thus, the earning power of improved, income-producing real
estate typically remains constant. Rents simply increase to meet (and create)
inflation. Increased demographics within the local population is a factor
3 Spurgeon v. Franchise Tax Board (1984) 160 CA3d 524
4 Calhoun v. Franchise Tax Board (1978) 20 C3d 881
120 Tax Benefits of Ownership, Fourth Edition

creating property appreciation, not asset inflation. Over time, appreciation

of the property’s location by the population adds to a property’s value. By
definition, appreciation drives the increase in a property’s value beyond the
rate of annual inflation.

When real estate values and the CPI increase at the same pace over time,
the real economic value of the real estate remains constant. Due to this
phenomenon, real estate is deemed a “hedge” against inflation, albeit a hedge
that is taxed if the property is disposed of in a cash-out sale.

Were profits not driven by inflation, the government would not receive as
much tax revenue as it now does.

For example, consider an investor who bought real estate for $500,000 20
years ago.

Today, the property’s value is $1,000,000. However, due to intervening

consumer price inflation, the property is worth the same as it was 20 years
ago in real terms.

When the investor sells the property for $1,000,000, they will have a $500,000
profit on property that has only maintained its original worth in dollar
purchasing power. The profit taken due to price increase is classified as net
long-term capital gain, currently taxed at 15% and 20%.

Thus, the government cuts itself a 7.5% to 10% share in the total current dollar
value of the property due solely to a reduction in the value of the dollar (not
to mention the transactional costs of a sale running in the range of 5% to 10%
of a property’s gross price).

The investor is economically worse off selling the property than retaining
it. This makes it difficult for agents to encourage owners to sell, unless the
owner acquires like-kind replacement real estate in a §1031 exchange to
exempt all profit from taxes.

Economic Investors need to keep a close eye on long-term inflation trends and business
cycle price fluctuations (from boom to bust) and maximize annual rent
consequences increases and thus property value, and on a sale, profits. It is said the three
most important words in real estate are “location,” “timing” and “price.”

The timing of any sale of a property up for consideration to be sold needs to

be influenced by an increase in its value through asset price inflation, which
exceeds the percentage change in the CPI since acquisition. When the value
increase exceeds the increase in the CPI figures, which usually occurs during
a business cycle’s boom but not a recession, the investor will experience a
real economic profit on the sale.

When an investor sells real estate that has not kept pace with inflation at
the time of sale, they will have lost real money, but they will still be taxed
on their inflation-created profit. The investor will be poorer going forward
for failure to sell at the right time — at the peak of the upward phase of a
business cycle.
 Chapter 14: Inflation, appreciation, and taxes 121

Inflation is the rise in general price levels of everything people buy. Chapter 14
Inflation consists of two categories: consumer price inflation and asset
price inflation. Consumer price inflation is an increase in the general Summary
price level of all goods and services consumed in the economy, while
asset price inflation is the rise in the value of assets, such as stocks, bonds
and real estate.

Simply, the rate of consumer price inflation is set by the rise in price of
everything we buy to consume. Asset prices behave quite differently
and independently from factors driving consumer price movement.
Assets are investments, with pricing based on the capitalization rate
applied to the likelihood of a return on the investment.

For investors, inflation relates to the future price of the investment; for
consumers, inflation is today’s changes in the price of goods and the
wages they earn to buy them.

asset price inflation.................................................................... pg. 117 Chapter 14

Consumer Price Index (CPI)...................................................... pg. 116
Key Terms
consumer price inflation.......................................................... pg. 117
real profit....................................................................................... pg. 117
Notes:
 Chapter 15: Short payoff on negative equity property 123

Chapter
15
Short payoff on
negative equity property

After reading this chapter, you will be able to: Learning

• understand that a discounted payoff on a short sale produces
income from debt relief; and
Objectives
• discuss the tax reporting with sellers for their discharge of
indebtedness income on a short sale.

deficiency judgment recourse debt Key Terms

discharge-of-indebtedness short sale
nonrecourse debt

Consider a homeowner who purchases their residence for the price of The short-
$450,000 with a down payment of $25,000. The residence was purchased at
the peak of a real estate pricing boom. sale discount:
The homeowner’s cost basis in the residence consists of the $450,000 price income,
paid, plus transactional/mortgage costs incurred to acquire the property and profit, or
any value-adding improvements made to the property. When the owner
resells the property, their cost basis will be subtracted from the net sales price. loss?
The difference between the cost basis and net sales price is the profit or loss
the owner takes whether they dispose of the property by a conventional sale,
short sale, foreclosure sale or a deed-in-lieu of foreclosure.

Due to the cyclical decline in real estate values following a speculator-

driven peak in prices, the owner’s residence is now worth $250,000. Also,
while the monthly mortgage payments on the FRM have remained the
124 Tax Benefits of Ownership, Fourth Edition

same, the owner’s combined household income has declined. Nearly all
of the homeowner’s disposable income and savings are now consumed by
mortgage payments.

The mortgage balance is $400,000, far greater than the current market value
of the property — a negative equity property.

The owner lists the residence for sale with a broker. The listing notes that the
closing of a sale is to be conditioned on the mortgage holder’s acceptance of
the seller’s net sales proceeds as the payoff amount and in full satisfaction
of the mortgage, called a short-sale contingency provision.1 [See Form 274
accompanying this chapter; see RPI Form 150-1]

The seller’s agent understands the fair market value (FMV) of the residence is
below the outstanding debt encumbering it. Further, they need to negotiate
with the mortgage holder for a discount on a payoff demand, called a short
pay. When the mortgage holder agrees to accept a discounted payoff in full
satisfaction of the mortgage, the transaction is processed by escrow as a short
short sale
A sale of mortgaged sale.2
property by the owner
when at closing the Editor’s note — Equity purchase (EP) investors who will not occupy a
mortgage holder
accepts the owner’s net property-in-foreclosure they purchase in a short sale need to use an equity
sales proceeds in full purchase agreement with a short sale provision. [See RPI Form 156-1]
satisfaction of a greater
amount of mortgage When reporting the sale of their principal residence to the IRS and the
debt.
California Franchise Tax Board (FTB), the income tax issue confronting the
seller is whether to report the amount of the discount as:
• a reduction in cost basis, which produces either a reduced capital loss
or an increase in home profit; or
• discharge-of-indebtedness income, taxable at ordinary income tax
rates unless excluded.
For the sale of all properties other than a principal residence, and for all
mortgages other than a purchase-assist, or the refinance of a purchase-assist
debt on a principal residence, the debt discharged — the discount — is subject
nonrecourse debt to ordinary income tax rates unless the mortgage has nonrecourse status.
A mortgage debt
recoverable on default
solely through the Through December 31, 2020, unless extended again, the discharge-of-
value of the security indebtedness income from the sale of a qualified principal residence in
interest held by
the lender in the
California is excluded from the seller’s gross income — and by extension,
mortgaged property. their taxable income — up to $500,000 when it is a nonrecourse mortgage.
Contrast with recourse In comparison, under federal law the qualified principal residence exclusion
debt.
does not set a limit.3

1 Holmes v. Summer (2010) 188 CA4th 1510

2 Calif. Civil Code § 2943
3 Internal Revenue Code §108(a)(1)(E), Calif. Revenue and Taxation Code §17144.5
 Chapter 15: Short payoff on negative equity property 125

Form 274
SHORTSALE ADDENDUM
Loan Discount Approval Shortsale
Prepared by: Agent ____________________________
Broker ____________________________
Phone _______________________
Email _______________________
Addendum
DATE: _____________, 20______, at ______________________________________________________, California.
Items left blank or unchecked are not applicable.
FACTS:
1. This is an addendum to the following agreement:
Purchase Agreement Counteroffer
Escrow Instructions ________________________________
1.1 of same date, or dated _____________, 20______, at ______________________________, California,
1.2 entered into by _________________________________________________________, as the Buyer, and
1.3 __________________________________________________________________________, as the Seller,
1.4 regarding real estate referred to as _________________________________________________________
_____________________________________________________________________________________.
AGREEMENT:
In addition to the terms of the above referenced agreement, Buyer and Seller agree to the following:
2. Close of escrow under this agreement is conditioned on Seller obtaining payoff demands at a discount from the
lienholders of record in full satisfaction of all amounts owed them.
2.1 The discounts are to be amounts which collectively allow Seller to fully perform on this agreement and
escrow instructions without the need for escrow to call for funds from Seller to close escrow.
2.2 Seller on opening escrow to promptly request payoff demands from the lienholders, directly or through
escrow, and diligently assist each lienholder in their analysis of their discount and processing of their
payoff demand by providing them with information and documentation on themselves and this transaction.
3. After _____________, 20______, this agreement may be terminated by either Buyer or Seller should
Seller be unable to obtain written payoff demands, or consent from the lienholders, to accept Seller’s proceeds
from this transaction which remain after disbursement of all costs incurred by Seller in the full performance of
this agreement and escrow instructions. [See ft Form 183]
4. Seller may accept backup offers contingent on the cancellation of this agreement.
4.1 If backup offers are received, they will be submitted to the lienholders for payoff demands which may be
accepted by the lienholders in lieu of a payoff demand on escrow complying with this agreement.
4.2 Should lienholders submit a written payoff demand in a backup offer acceptable to Seller, Seller may
terminate this agreement. [See ft Form 183]
5. The Seller understands a discount by a lienholder in full satisfaction of the debt owed will likely have
consequences on the Seller's creditworthiness and income tax reporting, and other unforseen difficulties,
including,
5.1 The delinquencies on payments due the lienholders and the discount allowing for payment of a lesser
amount then owed may be reported by the lienholder to credit reporting agencies and adversely affect
the Seller in the future.
5.2 The amount of the interest on the discount on the principal will be reported by the lienholder to the IRS as
a 1099 Form receipt of income, and depending on the recourse or nonrecourse nature of the debt
discounted, or whether secured by the Seller's principal residence, will be reported by the Seller as
discharge of indebtedness income, part of the price realized on the sale or a reduction in cost basis.
5.3 Seller may terminate this agreement within five days of acceptance, based on Seller's reasonable
disapproval or the disapproval of tax or legal advisors to the Seller, of the consequences of this discount
on Seller's credit or tax reporting, or on liability issues arising due to the discount. [See ft Form 183]
I agree to the terms stated above. I agree to the terms stated above.
Date: _____________, 20______ Date: _____________, 20______
Buyer: ________________________________________ Seller: ________________________________________

Signature: _____________________________________ Signature: _____________________________________

Buyer: ________________________________________ Seller: ________________________________________

Signature: _____________________________________ Signature: _____________________________________

FORM 274 10-11 ©2011 first tuesday, P.O. BOX 20069, RIVERSIDE, CA 92516 (800) 794-0494

A short sale is the sale of a property by the owner that:

The short
• generates net sales proceeds for the seller in an amount less than the
total amount(s) owed on the mortgage(s) encumbering the property;
sale and the
and resulting
• the mortgage holder by prior agreement accepts the net sales proceeds short pay as
as full satisfaction of the mortgage debt.
a discount
When the broker is unable to negotiate a discount with the mortgage holder
in these negative equity ownership situations, one of the owner’s alternatives
is to stop making payments. An owner by no longer making payments
is exercising the put option they hold under the trust deed securing the
mortgage debt. Thus, the negative equity owner forces the holder of a non-
126 Tax Benefits of Ownership, Fourth Edition

recourse mortgage to take the property by a foreclosure sale and terminate

both the ownership and the mortgage debt. The put option is a contract
right inherent in all trust deed mortgages in California due to the effect of
antideficiency laws.

When the mortgage holder does not agree to a short sale compromise before
their foreclosure sale, the seller’s default has forced the mortgage to complete
the foreclose sale.

Ironically, most mortgage holders require the seller to default on payments

for at least three months (so they pay the penalty of a ding to their FICO
score) before the mortgage holder will consider a discounted payoff to
accommodate a short sale.

The discount Again, consider the seller-in-foreclosure who owes $400,000 on the purchase-
assist trust deed mortgage encumbering their residence. The property’s FMV
reduces the is $250,000. The original purchase price, and thus the seller’s cost basis, is
homeowner’s $450,000 (plus closing costs).

cost basis The seller sees an advertisement which implies any discount taken by the
mortgage holder on the sale or foreclosure of the property, called discharge-
of-indebtedness income, is taxed at ordinary rates — meaning the seller
discharge-of- would owe taxes on the loss of their home.
indebtedness
Reportable income The ad claims the homeowner will avoid the tax liability resulting from
resulting for an owner
from a mortgage
income generated by the discount on a short sale when title to the property
holder’s discount on a is transferred to the person offering the service, calling themselves a
payoff of a mortgage “coordinator.”
debt. Also called a
short pay.
The coordinator offers to take title to the property in foreclosure, and either:
• complete or arrange a short sale of the property themselves; or
• allow the mortgage holder to foreclose, eliminating the coordinator’s
ownership interest in title for nonpayment of installments.
Does the advertisement correctly represent the homeowner’s tax reporting
and tax liability exposure from a short sale?

No! The short sale of an owner-occupied one-to-four unit residential property

encumbered by a purchase-assist mortgage or improvement mortgage –
nonrecourse mortgages – does not trigger IRS reporting of ordinary income
by the seller for the discounted portion of the mortgage.

The discount on purchase-assist and home improvement mortgages, in this

case $150,000, is deducted from the seller’s cost basis ($450,000) to establish
an adjusted cost basis of $300,000. Thus, the sale produces a capital loss of
$50,000 — the price realized ($250,000) minus the owner’s adjusted cost
basis ($300,000). Since the property was the owner’s principal residence, the
owner’s capital loss is a personal loss and may not be written off to reduce
taxable income. [IRC §108(h)(1)]
 Chapter 15: Short payoff on negative equity property 127

RECORDING REQUESTED BY
Form 406
AND WHEN RECORDED MAIL TO
Deed-in-Lieu of
Name
Foreclosure
Street
Address

City &
State

SPACE ABOVE THIS LINE FOR RECORDER'S USE

DEED-IN-LIEU OF FORECLOSURE

NOTE: This form is used by a mortgage holder when the owner of a mortgaged property defaults and faces loss of the
property by foreclosure, to transfer ownership of the property to the lender in exchange for the lender cancelling the trust
deed note.
DATE: , 20 , at , California.
1. I/We, ________________________________________________________________________________________,
hereby quitclaim to ______________________________________________________________________________
1.1 all of my rights, title and interest in the real property situated in _________________________County, California,
referred to as _____________________________________________________________________________
________________________________________________________________________________________
2. This deed is an absolute conveyance in consideration for ________________________________________________
__________________________________________________________________________________________ and
2.1 the cancellation and release of all rights and obligations arising from the document
2.2 entitled __________________________________________________________, dated __________________,
2.3 entered into by _______________________________________________, as the ___________________, and
2.4 _______________________________________________________________, as the ___________________.
3. Grantor declares that this conveyance was freely and fairly made upon the consideration listed above, and no agreements
exist, oral or written, except as contained in this deed, with respect to the described property.
� See attached Signature Page Addendum. [RPI Form 251]
Date: , 20
(Print name) (Signature)

Date: , 20
(Print name) (Signature)

A notary public or other officer completing this certificate verifies only the identity of the individual who signed the document to which this certificate is
attached, and not the truthfulness, accuracy, or validity of that document.
STATE OF CALIFORNIA
COUNTY OF ____________________________________________________________________________________________________________
On ____________________________ before me, ______________________________________________________________________________
(Name and title of officer)
personally appeared ________________________________________________________________________________________________________,
who proved to me on the basis of satisfactory evidence to be the person(s) whose name(s) is/are subscribed to the within instrument and acknowledged
to me that he/she/they executed the same in his/her/their authorized capacity(ies), and that by his/her/their signature(s) on the instrument the person(s),
or the entity upon behalf of which the person(s) acted, executed the instrument.
I certify under PENALTY OF PERJURY under the laws of the State of
California that the foregoing paragraph is true and correct.
WITNESS my hand and official seal.

(This area for official notarial seal)

Signature: _________________________________________________
(Signature of notary public)
recourse debt
A mortgage debt which
FORM 406 03-15 ©2016 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517
exposes a borrower
to personal liability
when a judicial
foreclosure sale of the
secured property does
not fully satisfy the
debt. Contrast with
nonrecourse debt.

Recourse mortgage discounts are reported to the IRS as gross income. Thus,
the owner is not entitled to apply capital gain tax rate to the amount of the
Recourse
discount. Any discharge-of-indebtedness is income, not profit. Instead, the mortgage
entire discount is taxed at ordinary income rates — even when a short sale
occurs. discounts
A nonrecourse debt discounted on a short sale does not create an extra tax
taxed as
liability for the seller when reporting to the IRS. However, the net sales price income
is set at the greater amount of the principal on the nonrecourse mortgage,
without concern for the discount or the property’s FMV. [Code of Federal
Regulations §1.1001-2(a)(4)(i)]
128 Tax Benefits of Ownership, Fourth Edition

Consider a property encumbered by a $400,000 mortgage. When the mortgage

is a recourse debt and the value of the property securing the debt is less
than the debt, the owner is exposed to a deficiency judgment on a judicial
foreclosure, but not when the completed foreclosure sale is by a trustee.

The real estate is now worth only $250,000, and the owner’s cost basis in the
real estate is $450,000.

The owner sells the real estate in a short sale. The net amount the buyer
pays for the real estate is $250,000. The mortgage holder accepts the net
proceeds from the sale as a short payoff in full satisfaction of the recourse
debt. The remaining unpaid balance of $150,000, the discount, is forgiven by
cancellation of the note. As a result, the mortgage holder does not judicially
foreclose as is required to pursue a deficiency judgment against the owner/
deficiency judgment borrower. Here, mortgage holders report the discount to the IRS as income to
A money award
obtained by the holder
the property owner.
of a recourse mortgage
debt to recover money The owner’s tax consequences on a recourse mortgage debt include:
losses experienced
when the value of the • a capital loss of $200,000 ($250,000 price received from the buyer minus
mortgaged property is
less than the mortgage
the owner’s cost basis of $450,000); and
debt at the time of their • a discharge-of-indebtedness income of $150,000 ($400,000 mortgage
judicial foreclosure
sale. amount minus the $250,000 price realized and paid to the mortgage
holder), reported as ordinary income.
A discount on the payoff of a recourse mortgage (refinancing) encumbering
a principal residence results in taxable discharge-of-indebtedness income.
Ironically, a capital loss produced by the principal residence on a short sale
is a personal loss and may not offset income produced by a short pay in the
same sale of the same principal residence.4

Discount For an investor, debt discharged by a discount of a mortgage paid off on a short
sale of property other than the investor’s principal residence is a recourse
reporting mortgage producing discharge-of-indebtedness income, unless the investor:
for investor- • assumed a nonrecourse mortgage;
owners • executed a carryback note secured solely by the property acquired by
the investor; or
• executed a note with an exculpatory clause releasing the investor from
any personal liability.
When the payoff discount is on a nonrecourse antideficiency mortgage, the
amount of debt discharged by the discount is added to the net sales price the
seller received for their for the negative equity property (and turned over to
the mortgage holder). Tax-wise, the price realized and reported by the seller
is the total principal amount due to the mortgage holder before the discount.
Further, any profit taken on the price realized (the mortgage amount) is taxed
at capital gains rates, not ordinary rates.5

4 Vukasovich v. Commissioner of Internal Revenue (9th Cir. 1986) 790 F2d 1409; IRC §165(c)
5 Rev. Reg. §1.1001-2(a)(2)
 Chapter 15: Short payoff on negative equity property 129

When faced with discharge-of-indebtedness income on a recourse mortgage, Foreclosure

a negative-equity property owner might decide to exercise their put option
by defaulting on payments thus forcing the mortgage holder to foreclose avoids the
and acquire the property. Mortgage holders nearly always foreclose by
trustee’s sale. When they do not and elect to foreclose judicially, the owner is
discount
confronted with recourse liability exposure by way of a deficiency judgment
amount.

Further, mortgage holders at a trustee’s sale usually bid on the property in the
amount of all monies owed them, regardless of the property’s present market
value. Thus, they have been fully satisfied by their bid without a discount or
uncollectible amount remaining due (but uncollectible) from the owner —
which means no discharge-of-indebtedness income.

A short sale is a sale of encumbered property when at closing the Chapter 15

mortgage holder accepts the seller’s net sales proceeds in full satisfaction
of a greater amount of mortgage debt. A short sale is the sale of a property Summary
that: generates net proceeds for the seller in an amount less than the
total amount(s) owed on the mortgage(s) encumbering the property and
fully satisfies the mortgage(s) on receipt of the net proceeds from the
sale.

When a homeowner sells a one-to-four unit residential property

encumbered by a first trust deed in a short sale, the discount is discharged
and the mortgage holder barred from collecting any deficiency.

For the sale of all properties other than a principal residence, and for
all mortgages other than a purchase-assist or refinance of the purchase-
assist debt on a principal residence, the debt discharged — the discount
— is subject to ordinary income tax rates unless the mortgage has
nonrecourse status.

Nonrecourse debt is a mortgage debt recoverable on default solely

through the value of the security interest held by the lender in the
mortgaged property.
130 Tax Benefits of Ownership, Fourth Edition

Chapter 15 deficiency judgment................................................................... pg. 128

discharge-of-indebtedness........................................................ pg. 126
Key Terms nonrecourse debt......................................................................... pg. 124
recourse debt................................................................................. pg. 127
short sale...................................................................................... pg. 124
 Chapter 16: Option money tax consequences 131

Chapter
16

Option money tax

consequences

After reading this chapter, you will be able to: Learning

• understand the nature of option money paid for an option to buy
property as an alternative to a buyer’s good faith deposit with a
Objectives
purchase agreement offer; and
• advise on the tax aspects of option money for an option to buy
any type of property.

capital gain option to buy Key Terms

Consider a buyer who submits a purchase agreement offer to acquire rental When
income property that initially appears suitable. The offer is accompanied by a
$10,000 good-faith deposit payable to escrow. Further-approval contingency exercised,
provisions in the purchase agreement condition the closing on the buyer’s
completion of a due diligence investigation and approval of the property’s:
expired or
• income and expenses;
assigned
• physical condition; and option to buy
A unilateral agreement
• title condition. [See RPI Form 159 §11] entered into by a
property owner
Due primarily to the contingencies in the buyer’s offer, the listing agent granting a prospective
recommends the seller counter with an offer to grant a four-month option buyer the right to buy
property by exercising
to buy for $10,000. [See RPI Form 160] the option within a
specified time period
Granting an option to buy, also referred to as a call option, presents the seller or on an event, at a
determinable price
with some advantages. and terms for payment.
[See RPI Form 161]
132 Tax Benefits of Ownership, Fourth Edition

Option money is the buyer’s payment of consideration for the seller granting
an irrevocable option to buy. The buyer buys an option, not the property as
occurs under a purchase agreement.

To distinguish, option money paid by the buyer is not a good faith deposit
toward payment of the purchase price. Thus, when a buyer holds an option
and fails to acquire the property, the seller retains the option money as earned
income. On a buyer’s failure to purchase by exercising the option, the seller’s
retention of option money does not expose the seller, as under a purchase
agreement, to a claim of wrongful forfeiture for failure to release a good faith
deposit to the buyer.

Options, by their nature, do not contain contingency provisions. With an

option, the buyer is forced to decide whether to exercise the option and buy
the property on the price and terms for payment stated. The buyer exercises
their option when they complete their due diligence investigation and
decide to buy the property – before the option expires.

In our example, the seller on considering their agent’s advice, makes a

counteroffer to grant an option to buy, which the buyer accepts. [See RPI
Form 160]

Within the first month of the option period, three months before it expires,
the buyer decides not to exercise the option based on their due diligence
investigation.

The buyer tells their agent they have a high-income year and will write
off the loss this year, the tax year in which they purchased and paid for the
option. Further, the option expires next year, not the year the option was
granted.

The agent advises the buyer there is no reportable tax consequence for a
buyer until the tax year in which the option:
• is exercised;
• expires; or
• is assigned to a substitute buyer.
Is the agent’s advice about the buyer’s timing of tax reporting for option
money correct?

Yes! The option money has no tax consequence to the buyer (or the seller)
when the option is granted.

In further counseling, the agent discusses the resale of the option by

assignment to another buyer as the ‘right to buy’ may have value to other
buyers. Also, when a substitute buyer is found, any loss is reported in the
year of the assignment.
 Chapter 16: Option money tax consequences 133

The buyer authorizes their agent to locate a substitute buyer and negotiate
the sale and assignment of the option rights based on disclosure of the buyer’s
due diligence findings. (Note: The agent’s fee is a provision in the option to
buy, just as it is in a purchase agreement.)

The agent locates a substitute buyer for the option. The agent’s buyer is
reimbursed for the costs incurred in the due diligence investigation as total
consideration for an assignment of the option. The sale of the option is
completed before the end of the current tax year. The buyer is not reimbursed
for the option money payment. Thus, the buyer realizes a capital loss on
assignment of their option rights.

The buyer properly reports the loss in the year of the assignment, which
offsets an equal amount of income from taxation as sought by the buyer of
the option.

The tax treatment of option money paid by buyers and received by sellers Option money
depends initially on the character of the real estate involved, which may be:
as a cost of
• a capital asset held for investment as either a passive or portfolio
income category property; acquisition
• a business-use asset held in connection with a trade or business;
• a personal residence which is a capital asset; or
• dealer property held as inventory for sale in a trade or business.1
Thus, whether the client is the buyer or seller, the tax treatment of option
money depends on their use or intended use of the property.

A capital asset is property purchased primarily for investment comprising

passive or portfolio income category assets.2
Buyer’s
option money
Recall that real estate used to house and operate the taxpayer’s business,
including hotels, inns, motels, and business-use property, is a trade or treatment
business asset. However, business category assets are treated the same as when exercised
capital assets but only after they have been held for more than one year.
or expired
An option to buy a capital asset or a business asset is a separate property right,
itself treated as a capital asset. Likewise, option money paid is reported in the
income category for the property as determined by the buyers intended use
of the property.

When a buyer exercises an option and acquires a capital or business-use

asset, the buyer adds the amount of option money paid to their cost basis
for the property acquired. Option money is part of the buyer’s transactional
costs incurred to acquire the real estate. It is not an expense since it was not
incurred in the operations or ongoing ownership of the optioned property.3

1 Internal Revenue Code §1234(a)(1)

2 IRC §1221
3 Revenue Regulations §1.1234-1(a); Realty Sales Co. v. Commissioner of Internal Revenue (1928) 10 BTA 1217
134 Tax Benefits of Ownership, Fourth Edition

In contrast, consider a buyer who holds an option to buy a capital asset as

an investment, such as an industrial or residential income property, and
allows the option to expire unexercised. Here, the buyer reports the amount
of option money they paid as a capital loss.

Depending on the length of the option period (less or more than one year),
the loss is classified as either a short- or long-term capital loss. The capital loss
is reported in the income category for the type of property optioned. In this
example the option money is reported in the passive income category as a
loss on a rental property investment.

Seller’s A seller granting an option in exchange for option money does not report the
option money when it is received.
option money
However, when the buyer closes escrow and acquires the property by
treatment as exercise of the option, the seller then accounts for their prior receipt of the
income or option money. The amount of the option money is added to the net proceeds
from the sale under the option, becoming part of the price received for the
gain property. The option money either increases the seller’s profit or decreases
their loss on the sale.

Consider a seller who grants an option to buy property held as dealer property.
On the buyer’s exercise of the option, the seller adds the amount of the option
money to the price received for the optioned property. Thus, the accounting
either increases ordinary income or reduces ordinary loss on the sale of their
dealer property.4

Conversely, consider a seller who grants an option to buy. The buyer does not
exercise the option. It expires and the seller retains ownership of the property.
Here, the seller reports the option money as ordinary income generated by the
property optioned in the year the option expires. For a seller, option money
on expiration of an option is always ordinary income, like rent, regardless of
the category of the optioned real estate.5

Assignment A buyer acquires an option to buy with the intent to immediately sell and
assign it on locating a substitute buyer. In lieu of an assignment, the buyer
of an option might exercise the option, take title, and concurrently resell the real estate
via a double escrow situation to the substitute buyer.
from buyer
to substitute Buyers who are flippers often employ the contractual arrangements of
options, sandwiching themselves between the owner who is selling and the
buyer ultimate buyer who will pay the agreed price. The flipper receives a fee for
the assignment of the options, or a higher price on a double escrow – either
way it is ordinary income in their business.

When an option is assigned to a substitute buyer, any profit or loss on the

sale of the purchase option is reported within the same income category as
the real estate which is the subject of the option. In this flipper example, the
4 Rev. Regs. §1.1234-1(d)
5 Rev. Regs. §1.1234-1(b)
 Chapter 16: Option money tax consequences 135

option money is reported as trade or business category income. The property

optioned is not a capital asset or a business-use asset. It is inventory for resale
in the business of flipping properties. No long-haul investment intent there.

Now consider a buyer who purchases an option for $10,000 to buy an income
property for their own account. The buyer later sells the option for $25,000
having himself located a more suitable property to acquire. The assignment
of the option produces a reportable $15,000 capital gain in the passive capital gain
Profits from the sale of
income category on the sale of the option, a capital asset. a capital or business-
use asset at a price
Had the option been sold for $7,500, the buyer would report a capital loss of exceeding the cost
of acquisition and
$2,500 in the passive income category. The property optioned was treated by further improvements.
the buyer as a capital asset — an investment property, not inventory which Contrast with
produces ordinary income or loss, as with a flipper. unrecaptured gain.

Consider a buyer who negotiates an option to buy a home for use as their Principal
residence. The buyer pays the owner option money for granting the option.
On exercise of the option, the buyer adds the amount of the option money to residences
the price they paid for the property, their cost basis.

Likewise, the seller, on closing the sale, adds the option money to their net
sales proceeds to determine their profit or loss, regardless of the seller’s use of
the property.

In contrast, had the homebuyer failed to exercise the option to purchase a

property intended for use as their principal residence, it would expire. Here,
the buyer may not write off the option money as a capital loss, even though
the home sought as a principal residence is a capital asset. Yes, the homebuyer
has a capital loss, but the loss is personal and thus disallowed. Had the buyer
intended to purchase the residence as an income property investment, the
buyer writes off the option money as a capital loss in the passive income
category.6

In a reversal of fortunes, a homebuyer holds an option to buy property they

intend to use as their principal residence. They sell and assign the option for
more than they paid, taking a profit. Since a principal residence is a capital
asset, the profit is reported as a capital gain and taxed – in the portfolio
income category as the capital asset was not a rental property.

Recall that dealer property – inventory – includes real estate bought and Dealer
held primarily with the intent to resell it to customers in the normal course
of an owner’s trade or business. property
The owner’s sale of dealer property produces ordinary income or loss for their
trade or business. Dealer property is not a capital or business-use asset and
thus generates business income, not profits on sale.

6 IRC §165(c)
136 Tax Benefits of Ownership, Fourth Edition

A buyer exercising an option and acquiring property for any intended use,
including its resale to business customers, will always add the option money
to the cost basis for the property as a cost of acquisition. For a business operator,
it is not an expense of doing business, but a cost of acquiring inventory.7

On expiration of a buyer’s unexercised option to acquire property to be held

as dealer property, such as land to subdivide, develop and resell as lots or
units, or an SFR/condo to be flipped, the buyer accounts for the option money
as an ordinary trade or business loss in the year the option expires.

7 Rev. Regs. §1.1234-1(c)

Capital assets are assets of a permanent nature which produce operating

Chapter 16 income or sales profits, such as land, buildings, machinery, equipment
Summary and IT software.

The portion of profits from the sale of a capital asset at a price exceeding
the cost of acquisition and further improvement is known as capital
gain.

Option money paid by the buyer is not a good faith deposit toward
payment of the purchase price. Rather, option money is the buyer’s
payment of consideration to the seller for granting an irrevocable option
to buy. Option money received by a property owner becomes income,
profit or loss depending on the character of the real estate as held by the
owner.

When a buyer exercises an option to buy a capital or business-use asset,

the buyer adds the amount of option money paid to their cost basis for
the property acquired. Option money is part of the buyer’s transactional
costs for acquiring real estate. Tax treatment of option money depends
on their use or intended use of the property.

Chapter 16 capital gain....................................................................................pg. 135

option to buy................................................................................ pg. 131
Key Terms
 Chapter 17: Seller financing shifts profit taxes to other years 137

Chapter
17

Seller financing shifts

profit taxes to other years

After reading this chapter, you will be able to: Learning

• explain how a seller’s profit reporting and taxation is deferred to
later years by a carryback sale;
Objectives
• apply the installment sale profit-to-proceeds ratio to set the profit
reported on a carryback sale; and
• advise a carryback seller on mortgage debt relief avoidance to
increase the portion of profits for deferred taxation.

balloon payment straight note Key Terms

pledge

Consider a seller who lists their rental property for sale by employing a Untaxed
real estate agent. The listing price for the property is $1,500,000 and it is
unencumbered by mortgage debt. The seller’s cost basis in the property profits
is $100,000 — the land value when purchased — as the price allocated to
improvements is fully depreciated.
increase
after-sale
The agent understands the seller wants to convert their net proceeds on
the sale of the property into a relatively management-free, interest-bearing earnings
investment. The seller is an experienced investor not inclined to turn their
real estate over to a managing trustee or exchange it for an unsecured annuity.

To meet this objective, the agent suggests the seller consider carrying back an
interest-bearing installment note to provide purchase-assist financing for a
creditworthy buyer who makes a substantial down payment. For the seller,
the property’s current net operating income (NOI) is replaced by receipt of
138 Tax Benefits of Ownership, Fourth Edition

monthly principal and interest payments on a carryback note. As security for

the carryback note, the property’s location and physical condition assure it
will retain its rental value for years.

After a period of marketing the property under a listing agreement, a buyer

submits a full-price offer consisting of:
• a 20% down payment; and
• a carryback mortgage in favor of the seller for the remaining 80% of the
purchase price.

Terms of the The buyer agrees to tender a $300,000 down payment in cash and sign and
deliver (i.e., execute) a promissory note for the balance of the price, payable
carryback on terms suitable for the buyer and seller, secured by a trust deed on the
sale property.

The terms of the carryback note include:

• $1,200,000 in principal;
• a 7% fixed interest rate;
• monthly payments of $7,983.63 on a 30-year amortization schedule;
and
balloon payment • a 10-year due date with a balloon payment of $1,037,732.25.
Any final payment
on a note which is Editor’s note – The balloon payment discussed in this example envisions a
greater than twice the
amount of any one carryback note and trust deed to finance a buyer’s business or investment
of the six regularly acquisition. In contrast, the inclusion of a balloon payment on a consumer
scheduled payments
immediately preceding
carryback mortgage (buyer occupant of a one-to-four unit residential
the date of the final property) is subject to restrictions set by Regulation Z (Reg Z) when the seller
payment. [See RPI carries back more than five consumer mortgages in a calendar year.
Form 418-3 and 419]
The agent prepares an estimate of the seller’s net proceeds from the sale of
the property and reviews it with the seller. After payment of around $100,000
in closing costs, the net sales price is approximately $1,400,000. Taking the
seller’s cost basis of $100,000 into account, the seller’s agent quickly figures
the profit of unrecaptured gain and capital gain on the sale is approximately
$1,300,000. [See RPI Form 310]

Further, the agent now considers the amount of taxes the seller incurs on a
$1,300,000 profit in a carryback sale.

Tax bite The seller reports the transaction as a carryback sale — also called an
installment sale — on their income tax return for the year escrow closes on
deferred by the sale.
installments The installment sale treatment for the carryback note defers reporting and
taxes on the portion of the profit allocated to the carryback note. To determine
the amount of profit allocated to principal in the note, you first calculate the
profit on the sale. Then calculate the profit-to-proceeds ratio unique to the
 Chapter 17: Seller financing shifts profit taxes to other years 139

carryback transaction. In turn, the ratio establishes the percentage of the

dollar amounts on closing of net cash proceeds and principal on the carryback
note that is profit. [Internal Revenue Code §453(c)]

Recall that the amount of the seller’s profit realized on a sale is the sum of
the net sales price minus the seller’s remaining cost basis in the property,
represented by the formula:

net price - basis = profit

Also recall that profit realized on a sale is reported and taxed — recognized —
in the year of sale, unless the profit is:
• excluded, as occurs when the sale of property qualifies for the $250,000
principal residence profit exclusion per individual homeowner;
• exempt, as occurs when the net sales proceeds from the sale of business
of investment property are used to acquire like-kind replacement
property in a §1031 reinvestment plan, or to replace property taken by
eminent domain; or
• deferred, as occurs in an installment sale for the profit allocated to a
note carried back on the sale.
Critical to understanding the treatment of profit is awareness of the different
situation-titles given to taking a profit on a sale versus taxing that profit,
specifically:
• profit is realized when the seller closes the sale of a capital or business-
use asset and takes a profit on the sales price; and
• profit is recognized when it is subject to taxation in the year of the sale
unless the profit is excluded or exempt from taxes, or its recognition for
taxation deferred to another tax year.
Again, the sale of dealer property, such as vacant lots or homes held out for
sale by a developer or flipper, generates ordinary income, not profit.1

To report the profit realized on an installment sale, first calculate the contract
ratio for the transaction — called the profit-to-proceeds ratio. The ratio sets
Setting and
the percentage of profit in the dollar amounts of net proceeds from the sale – applying
the cash and carryback note received by the seller.
the profit-
The percentage figure is applied to set the dollar amount of the cash and to-proceeds
principal in the carryback note which represents profit taken on the sale.
ratio
In our introductory example, the net sales proceeds are calculated as the
sales price ($1,500,000), minus any mortgage debt relief ($0), minus closing
costs ($100,000).

Here, the profit-to-proceeds ratio for the sale is based on profit of $1,300,000
realized on the sale and the $1,400,000 in net sales proceeds, a ratio of 93% as
profit.
1 IRC §1231(b)(1)(A-B)
140 Tax Benefits of Ownership, Fourth Edition

For reporting, 93% of the cash portion of the net sales proceeds ($200,000)
received on closing is recognized as profit ($186,000) taxed in the year of
the sale. Further, the 93% ratio is applied to each payment of principal as
it is received on the carryback note. The ratio determine the amount of the
principal recognized – reported – as profit taxed in the year principal amounts
are received.

The $14,000 of the cash proceeds from the down payment that is not profit
represents the seller’s recovery of a portion of their remaining cost basis in
the property. It is a return of invested capital from the sales price, not profit or
income earned on capital invested.

During the year following the year of sale, the 12 installments of $7,983.63
the seller receives on the carryback note includes $12,189.71 in principal plus
$83,613.85 in interest. The seller reports all interest received (i.e., unearned
income) as portfolio category income.

The profit- Carryback notes are portfolio category investments no matter how obtained.
Like stocks, bonds, and savings accounts they are management-free. While
to-proceeds the property sold for a profit was an asset with income and profits reported
ratio in the passive income category, interest income is earned on principal in the
note, not the real estate sold which now is security for a mortgage held by the
seller as a creditor.

Continuing on previous example, the carryback seller’s taxable profit in the

year following the year of sale is $11,336.43 — the result of $12,189.71 in
principal payments the seller receives multiplied by the profit-to-proceeds
ratio of 93%.

The 7% of the principal remaining in each principal payment ($853.28) is not

taxed. Again, it represents a partial return of the seller’s unrecovered cost
basis — original invested capital.

Ten years after closing, the seller receives the balloon payment. Again,
the final principal payment of $1,037,732.25 is multiplied by the profit-to-
proceeds ratio of 93% to determine the profit recognized and taxed. The result
is $965,090.99 in profit, reported by the carryback seller and taxed on receipt
of the balloon payment.

The seller acquired the improved property as a capital asset and annually
reported depreciation deductions, reducing the cost basis below the price
paid for the property. Recall that depreciation taken is taxed as recaptured
gain on a sale of the property. The profit taken by the seller and allocated pro
rata to the net proceeds of an installment sale consists of both unrecaptured
gain and long-term capital gain - profits.

Critically, as profits are received, they are first treated and taxed as
unrecaptured gains until no further unrecaptured gains remains. All profits
then remaining are capital gains.
 Chapter 17: Seller financing shifts profit taxes to other years 141

On a carryback sale of a capital or business-use asset, the seller achieves two The seller’s
financial objectives:
goals for an
• the highest sales price possible, achieved by extending credit to the
buyer in the form of purchase-assist financing; and installment
• the maximum annual income going forward, by earning interest on sale
the untaxed principal in the carryback note.
Now consider a seller who carries back a straight note calling for a single straight note
payment of principal in a year after the year of sale. Here, the sale is reported An instrument
as an installment sale. To qualify, at least one installment is scheduled for evidencing a debt
on which the entire
payment in a year after the year of the sale.2 amount of principal
together with accrued
Conversely, a straight note due in the year of the sale but on a default is paid interest is paid in a
single lump sum when
in the following year, does not qualify the transaction for installment sale the principal is due.
reporting. Thus, the seller incurs a tax liability on the profit allocated to the [See RPI Form 423]
note in the year of sale without first receiving the principal due on the note.

Further, the seller may structure payments on the carryback mortgage so

they receive all or most of their principal lumped in a designated later year
(or in any year when the carryback note is due and payable on demand). This
is advantageous when the seller anticipates taking a substantial loss in the
future.

Combining the separate profit and loss events allows the seller to offset
reportable profit allocated to the principal in their carryback mortgage on
incurring the loss. Buyers with cash reserves or who acquire a line of credit
for the payoff may be willing to accommodate these arrangements.

Consider a seller who lists their rental property for sale. The seller recently Mortgage-
refinanced the property, encumbering it with a $480,000 mortgage.
over-basis,
The seller is willing to accept the following terms for the sale of the property:
profit, and
• a purchase price of $800,000;
taxes
• a 20% down payment of $160,000;
• an assumption of the existing $480,000 mortgage by a buyer (or a new
purchase-assist mortgage); and
• a carryback mortgage for the balance of the seller’s proceeds of $160,000.
The agent inquiries the seller about the remaining cost basis in the property
which is $50,000. Improvements to the property are fully depreciated as the
seller purchased the property decades ago.

After deducting all transactional costs, the net sales price is approximately
$720,000.

2 IRC §453(b)(1)
142 Tax Benefits of Ownership, Fourth Edition

The net sales price, comprising mortgage debt and net sales proceeds,
represents a return of the remaining $50,000 of originally invested capital
and a $670,000 profit on the sale. The profit represents the sum of:
• accumulated depreciation deductions – taxed as unrecaptured gain at
ordinary income rates up to a 25% ceiling; and
• the increase in the property’s dollar value over the price paid to acquire
it – taxed as long-term gain at 15% and 20% capital gains tax bracket
rates.
Federal taxes and state taxes require the seller to pay up to 28% of the net
sales proceeds from the sale (unless exempt or excluded).

The agent advises the seller that an assumption or refinancing of their

existing mortgage by the buyer on a carryback sale produces an adverse tax
consequence the seller needs to consider avoiding.

Existing The calculation of profit on a sale is unaffected by the existence of mortgage

debt. Debt encumbering a property plays no role in calculating the profit on
mortgage a sale — debt is associated with proceeds from the property’s equity (price
debt versus minus debt equals proceeds), but not profit.

profit However, the assumption or refinancing of an existing debt by a buyer in a

carryback sale does play a significant financial role. Only net sales proceeds,
which do not include existing mortgage debt, and profits are considered by
the profit-to-proceeds ratio when setting the percentage of profit allocated
to the cash and carryback note in an installment sale. Thus, mortgage debt
affects the amount of profit reported in the year of sale in an installment sale.

As a goal, the seller in an installment sale seeks to structure the net sales
proceeds to produce the lowest possible profit-to-proceeds ratio on the
transaction, all other sales considerations being acceptable having priority.
The lowest ratio occurs when the net sales price and the net sales proceeds
are the same – when no mortgage exists.

Maximum Again, the seller receives the maximum benefits of installment sales tax
deferral when no debt relief occurs. To entirely avoid debt relief on the sale
tax deferral of a property encumbered by mortgage debt, the seller needs to remain
benefits responsible for payment of the mortgage installments after closing the sale.
An alternative for the seller is to pay off or reduce the mortgage debt with
their separate funds prior to the close of escrow.

With an existing mortgage at time of closing, debt relief is avoided in an

installment sale situation by use of either a carryback all-inclusive trust deed
(AITD) note or land sales contract. With an AITD carryback note, the buyer
does not assume responsibility for or refinance the seller’s existing mortgage
on the property. The buyer makes a down payment and executes an all-
inclusive trust deed and note, together their dollar amounts comprise the
purchase price. [See RPI Form 167 and 168]
 Chapter 17: Seller financing shifts profit taxes to other years 143

With an AITD, the principal amount of the carryback note is the balance of
the purchase price remaining to be paid after deducting the buyer’s down
payment.

However, the profit on the sale does not vary, regardless of how the price
is financed or structured for payment. Thus, the smaller the amount of the
carryback seller’s net sales proceeds in proportion to the sales price, the higher
the percentage of profit allocated to those net sales proceeds. Eventually,
the profit is 100% or more of the net sales proceeds, all due to the profit-to-
proceeds ratio driven up by greater amounts of mortgage debt.

The profit-to-proceeds distortion of 100% or more profit than the amount of

the net sales proceeds occurs when the amount of the mortgage debt assumed
or financed by the buyer exceeds the seller’s remaining cost basis. As a result,
the amount of the seller’s profit is greater in amount than the seller’s net sales
proceeds, a situation called mortgage-over-basis.

Thus, all cash and principal in the carryback note received on closing the
transaction is profit. Further, the profit-to-proceeds ratio tops out the note as
100% profit. The remaining unallocated profit spills over and is reported and
taxed in the year of the sale due to debt relief.3

In our mortgage assumption example, 100% of the net proceeds from the
down payment and the entire principal in the seller’s $160,000 carryback
Existing
note is profit, taxable when principal is received by the seller. Again, the tax mortgage
is deferred only on the portion of the $670,000 profit allocated to the principal
in the carryback note ($160,000).
assumption
by the buyer
However, $510,000 in profit remains that is not allocated to the carryback
note ($670,000 - $160,000). It is taxed in the year of sale. Thus, the profit taxes
of up to the 25% ceiling rate on the unrecaptured gain and at brackets of 15%-
20% on the capital gain are payable to the IRS in the year of sale – around
$105,000 (plus state taxes).

However, the seller’s cash sales proceeds are only $80,000, the $160,000 down
payment minus the $80,000 in closing costs.

When the carryback seller allows a buyer to assume or refinance the existing
mortgage in a mortgage-over-basis situation, the immediate financial result
is disastrous. In this instance, taxes greatly exceed the seller’s cash proceeds
on closing. The seller’s only relief on an assumption/refinance and carryback
sale comes from any losses incurred in their businesses or investments when
the losses are allowed to offset these profits and reduce the profit tax liability.

However, a more favorable approach exists for the seller to consider.

The prudent seller on the advice of their agent considers structuring any
carryback mortgage on the sale of encumbered property as an AITD mortgage.
Again, the AITD note amount is for the balance of the purchase price after
deducting only the down payment, the mortgage remaining the seller’s
3 Revenue Regulations §15a.453-1(b)(2)
144 Tax Benefits of Ownership, Fourth Edition

obligation under the AITD. Unlike a standard carryback note when the buyer
assumes or refinances the existing mortgage, the AITD principal amount is
not calculated based on the seller’s equity minus the down payment.

With an AITD, the amounts of the net cash from the down payment and the
carryback AITD note equal the net sales price. Here, the AITD principal is
a substantial 80% portion of the sales price. The resulting profit-to-proceeds
ratio is the lowest percentage figure available for setting the amount of
profit allocated to the cash proceeds and the carryback mortgage. Thus, the
seller ameliorates the profit tax consequences in the year of sale due to the
mortgage-over-basis financing.

The profit realized on the sale is $670,000 while the net sales proceeds are
$720,000 – the net cash and the AITD carryback. This results in a profit-to-
proceeds ratio of 93%, the lowest percentage possible on the transaction, the
tax objective in installment sales.

In the year of sale, the seller nets $80,000 in cash sales proceeds. 93% is profit
($74,400) realized on the sale. All other profit realized is allocated to the
principal amount of the all-inclusive note, the equivalent of 93% profit in the
AITD note principal. Thus, the profit allocated to the cash proceeds received
on closing is recognized and taxed. The profits allocated to the AITD note
while realized on the sale are not taxed until they are recognized – deferred
to later years when principal is received by payments on the AITD note.

The $74,400 profit allocated to the cash proceeds represents unrecaptured

gain. It is taxed before capital gains and at rates up to 25% — here around
$18,600. The use of the AITD avoids the $105,000 in taxes the seller otherwise
incurs in the year of sale had the buyer assumed or refinanced the seller’s
existing mortgage.

Structuring the carryback sale as an AITD allows the seller to receive after-
tax sales proceeds of $61,400 from the $80,000 net down payment.

Engineering An AITD carryback seller may incur a loss in future years and want to use it to
offset a portion of the profit allocated to the AITD. This may be accomplished
future tax in any year following the sale by future negotiations with the buyer to
reporting modify the AITD. The seller then arranges for a substantial portion of the
installment profit to be recognized and reported in that year by:
• shifting responsibility for payment of the wrapped mortgage to the
buyer by their assuming or refinancing it which then reduces the
principal balance due on the AITD note (and AITD payment amounts);
or
• pledging the all-inclusive note as collateral for a loan of an amount
greater than their losses. [See RPI Form 242]
Recall, the percentage of profit in the principal of the AITD note is set by the
profit-to-proceeds ratio. It is applied to the principal payments received on
the AITD note to determine the profit to be reported. The principal reduction
 Chapter 17: Seller financing shifts profit taxes to other years 145

on the AITD note due to mortgage debt relief is equal to the amount of the
mortgage assumed or refinanced by the buyer, or the amount the carryback
seller borrows on a pledge of the note.

Thus, on incurring debt relief by converting the AITD note into a regular note,
the carryback seller engineers the time for reporting a substantial amount of
the profit on their carryback. As a result, the seller avoids tax on the profit due
to the offsetting losses from business or rental category operations and sales
in the year the AITD note is modified.

A seller who pledges — hypothecates — their carryback note as collateral

for borrowed money from a lender triggers recognition and thus taxation of
Pledging
profit allocated to the carryback note. carrybacks
The borrowing and pledging may also be timed to occur in a tax year when a pledge
loss on a business or rental activity has occurred, thus offsetting the loss. To provide an asset,
such as an existing
carryback note, as
Critically, when a seller pledges a carryback note, the amount of loan collateral or security
proceeds received is considered equivalent to receipt of principal on the note. for repayment
Thus, profit allocated to principal equal to the loan amount is recognized – of a borrowing.
Also known as
reported and taxed in the year of the pledge.4 hypothecation. [See
RPI Form 242]
Essentially, the percentage determined by the profit-to-proceeds ratio sets the
amount of the loan proceeds – or debt relief – recognized as profit reported
and taxed on the carryback note in the year of the pledge.5

The principal received by a seller in full satisfaction of a carryback note Prepayment

includes profit. The profit is recognized and taxed in the year of the payoff.
avoidance
To ensure a seller retains the tax advantages of a carryback sale until the year
the balloon payment becomes due, the seller’s agent suggests their client preserves tax
include a prepayment penalty clause in the carryback note. benefits of a
Statutory limits exist for prepayment penalties on carryback mortgages carryback
secured by owner-occupied, one-to-four unit residential properties.
Additionally, all consumer carryback mortgages with a prepayment penalty
are required to meet qualified mortgage (QM) parameters under federal
ability-to-repay (ATR) rules.6

For business and investment property carryback financing, an enforceable

prepayment penalty clause in the carryback note is structured to compensate
the seller for the entire amount of the profit tax they anticipate they will
incur due to the prepayment of principal on the note.

The prepayment penalty needs to be reasonably related to the actual amount

of profit taxes likely to be incurred on a buyer’s early payoff, including:
• profit taxes, based on current or reasonably anticipated rates; and
4 IRC §453A(d)(1)
5 IRC §453A(d)(2)
6 Calif. Civil Code §2954.9
146 Tax Benefits of Ownership, Fourth Edition

• maintaining a portfolio yield during the lag time between early payoff
and the reinvestment of funds.

A carryback seller may elect out of installment sale reporting by voluntarily

Election out reporting the profit as taxable in the year of the sale.7

Reporting all the profit on a carryback sale as taxable in the year escrow
closes may be advantageous to a seller who has an equivalent offsetting loss
during the year of sale.

Possible offsetting losses include:

• trade or business losses on a real estate brokerage, speculator fix-and-
flip programs or a developer’s business;
• rental operating losses offset by the profit on a carryback sale of a
rental property;
• rental operating losses which reduce the seller’s adjusted gross income
(AGI) when they qualify as in a real estate-related business;
• capital losses on the sale of a rental or passive business investment; or
• capital losses carried forward or from the sale of investment/portfolio
category assets (stocks and bonds) when the installment sale involves
an investment/portfolio category property.

California Unlike the federal withholding scheme, California requires the buyer,
through escrow, to withhold 3.33% of the sales price from the seller’s proceeds
Franchise on property sales, unless the transaction is excluded from withholding.
Tax Board Excluded transactions include sales by:
carryback • all California-based entities; and
rules • any individual who certifies that the transaction qualifies for an
exclusion from withholding for the Franchise Tax Board (FTB).
For individual sellers entering into a carryback sale of their property, the
transaction is either:
• qualified to avoid withholding by the individual seller certifying they
are excluded; or
• not qualified and subject to the mandatory withholding of the entire
3.33% of the price from the down payment, unless the buyer agrees
to withhold the 3.33% from each installment of principal paid on the
price and forward to the FTB. [See Franchise Tax Board Form 593-I]
The seller’s transaction is excluded from FTB withholding on both the down
payment and the dollar amount of a carryback note when:
• the property is the seller’s principal residence;

7 IRC§453(d)(1)
 Chapter 17: Seller financing shifts profit taxes to other years 147

• the seller declares the sale is a §1031 transaction (with the carryback
note payable to the buyer’s trustee for ultimate assignment as
consideration for the purchase of a replacement property);
• the property is sold at a loss; or
• the property is sold for a price of $100,000 or less.
When the buyer refuses to withhold and forward 3.33% of the principal in
each periodic payment to the FTB or permit arrangements for a payment
service to do so, the carryback note may call for installments of interest-only
payments to avoid amortization of the principal and withholding.

Thus, only the final/balloon payment contains a payment of principal. In this

fashion, the buyer’s agreement to withhold principal is limited to the final
payoff, which is handled through an escrow for payoff and reconveyance of
the carryback trust deed.

A carryback note needs to qualify for installment sale reporting at the time Miscellaneous
the sales escrow closes.
installment
Consider a carryback note with a due date in the year of the sale, signed
and delivered to the seller on close of escrow. Here, the seller may not later rules
restructure the carryback transaction after escrow closes in an attempt to
qualify the sale as an installment sale by extending the due date on the
carryback note to beyond the year of the sale.8

However, the seller may later modify the terms of a carryback note they have
reported as an installment sale by:
• extending its due date to further defer profit taxes;
• subordinating the carryback mortgage to a new mortgage; or
• accepting substitute security from the buyer.
Installment sale reporting is not available for builders, developers and
speculators who sell their dealer property on a credit sale. Their earnings from
the sale of inventory are classified as trade or business income, not profits
taken on the sale of a capital asset or property used to house and conduct an
ongoing trade or business operation.9

However, the exclusion of dealer property from installment sale reporting of

income does not apply to the carryback sale of farms, vacant residential lots,
and short-term timeshares when classified as dealer property.10

8 Rev. Regs. §15a.453-1(b)(1)

9 IRC §§453(b)(2)(A), (l)
10 IRC §453(l)(2)
148 Tax Benefits of Ownership, Fourth Edition

Chapter 17 A balloon payment is as any final payment on a note which is greater

than twice the amount of any one of the six regularly scheduled
Summary payments immediately preceding the date of the final payment.

Installment sale treatment defers profit reporting on the portion of the

profit taken on a sale and allocated to the carryback principal until the
seller receives principal installments on the carryback mortgage. For a
seller of real estate, profit is the portion of the net sales price remaining
after deducting the seller’s remaining cost basis in the property.

When reporting the profit realized on a sale, the profit is first allocated
pro rata to the net cash proceeds and the principal of the carryback note
received from the sale.

To allocate the profit between the cash and carryback components of the
net sales proceeds, a percentage figure called the contract ratio or profit-
to-proceeds ratio is calculated as: the percent the amount of profit on
the sale represents of the net sale proceeds the seller receives on closing
(cash and a carryback note).

Chapter 17 balloon payment ......................................................................... pg. 138

pledge.............................................................................................pg. 145
Key Terms straight note.................................................................................. pg. 141
 Chapter 18: Profit on modification of a trust deed note 149

Chapter
18

Profit on modification
of a trust deed note

After reading this chapter, you will be able to: Learning

• distinguish the tax treatment of notes held by a carryback seller
from those held by a trust deed lender; and
Objectives
• identify when the modification of a note is treated as a disposition,
triggering the reporting and taxing of profit.

disposition Key Term

Consider a seller who carries back a note and trust deed in an installment sale No taxation on
to facilitate the buyer’s need for medium-term financing to pay part of the
purchase price, sometimes called a “bridge loan.” modification
The note contains a five-year due date calling for a balloon payment at the of a carryback
end of the fifth year after the close of escrow. note
The net sales price received for the property is greater than the seller’s
remaining cost basis in the property. Thus, a profit is realized on the sale.
Taxwise, a portion of the seller’s profit on the sale is:
• a percentage of the principal amount of the carryback note (and the net
cash proceeds) under the profit-to-equity ratio (IRS contract ratio); and
• reported and taxed in the year the owner receives principal payments
on the carryback note.1 [See Chapter 17]

1 Internal Revenue Code §453(c)

150 Tax Benefits of Ownership, Fourth Edition

As the due date approaches for payoff of the note, the seller wants to further
defer reporting the profit. When the balloon payment of principal is paid, the
profit in the principal is taxed. The carryback seller enters negotiations with
the buyer to extend the due date, modifying the terms of the note. [See RPI
Form 425 accompanying this chapter]

To induce the buyer to agree to the modification, the seller offers to lower
the interest rate (but not lower than the applicable federal rate for imputing
interest) and reduce monthly payments to interest only.

The seller and buyer memorialize their agreement in a note modification

agreement. [See RPI Form 426]

With the due date for payment of principal extended, may the seller further
defer the reporting of profit allocated to the principal in the carryback note
to a later year?

Yes! Initially, a carryback seller automatically defers reporting and payment

of taxes on the part of their profit allocated to the principal amount of the
carryback note. Sellers may elect out and pay profit taxes in the year of the
sale.2

During ownership of the note, the carryback seller may extend the due date
and alter the interest rate and payment schedule on their note without
triggering taxes on the profit due to the modification. Modifying a carryback
note does not bring about the reporting or taxation of:
• profits in principal balance of the carryback note; or
• income on any increase in the note’s current market value due to the
modification.3
While the payment of taxes on the profit apportioned to the note principal
continues to be deferred, any increase in the current value of the note due
to the modification is exempt from reporting until received as increased
disposition
The act of transferring
principal or interest paid on the note.4
or otherwise giving
up an asset, such as In contrast, modification of a note held by an institutional mortgage holder
property or a trust deed or trust deed dealer/investor triggers a recharacterization of the modification
note, which triggers
the reporting and as a disposition of the note. Thus, reporting and taxing of income results
taxing of profit. from a modification of a money mortgage, but not on a carryback note held
by a seller.5

Institutional and private trust deed lenders, and subdividers or builders who
The carry back a mortgage on the sale of parcels in their projects, are classified
installment for taxation as dealers in notes. Taxwise, trust deed notes held by dealers are
categorized as either:
sale
• portfolio assets, when held by a mortgage lender or trust deed investor
exemption for income (or profit on a resale); or
2 IRC §1001(d)
3 Revenue Ruling 68-419
4 Rev. Rul. 82-122
5 IRC §1001(b)-(c)
 Chapter 18: Profit on modification of a trust deed note 151

• trade or business inventory, when held by a developer or subdivider

from a sale of inventory.
The modification of a note held for investment by a trust deed investor or
mortgage holder or carried back on the sale of a builder’s business inventory,
is a reportable disposition of the note and taxed. The existing note is treated
as exchanged for a new one or sold for cash.

On a modification of a mortgage, the dealer is charged with constructive

receipt of the principal in the note — whether the modified note represents
the receipt of cash, a new note or a “rollover” obligation represented by the
modified note.

In contrast, a carryback seller of property used in the operation of their trade or

business (not held as inventory), or of rental or investment category property,
is exempt from profit reporting on modification of the carryback note.

The sale or exchange of a carryback note is considered a disposition of the

note and any remaining profit allotted to the note principal is taxed. Also, a
carryback note collaterally assigned to provide security for a loan causes the
carryback seller to report and pay taxes on profit in the note principal equal
to the amount of the loan proceeds.

On a subdivider’s modification of a note carried back on the sale of improved

dealer property, the income on the sale assigned to the carryback note or any
value increase in the note due to the modification is income and not reported
under installment sale rules. Exceptions exist for the sale of unimproved lots,
short-term time shares, and farms.6

A seller holding a note they carried back on the sale of a capital asset is
allowed to:
Modifying the
• modify payment schedules;7
carryback
• alter the interest rate;8
• accept substitute security;9
• bifurcate the note into separate obligations when the secured property
is subdivided;10 and
• accept new or additional obligors, such as an assuming buyer of the
secured real estate, whether or not the existing owner is released of
liability.11
However, consider the resale of real estate encumbered by a carryback note
held by a prior seller. To help facilitate the owner’s resale of the property,
the prior seller agrees to cancel their note and reconvey the trust deed in
exchange for the resale buyer executing a new note and trust deed in their
favor on entirely different terms for payment of the remaining principal.
6 IRC §453(l)
7 Rev. Rul. 68-419
8 Rev. Rul. 82-122
9 Rev. Rul. 55-5
10 Rev. Rul. 74-157
11 Rev. Rul. 82-122
152 Tax Benefits of Ownership, Fourth Edition

Form 425
MODIFICATION OF THE PROMISSORY NOTE
Modification of
the Promissory Prepared by: Agent
Broker
Phone
Email
Note NOTE: This form is used by a holder of a mortgage, their servicing agent or broker when a modification of the debt has
been negotiated, to evidence the modification of the original note and state the change in terms of the note.

DATE: , 20 , at , California.
Items left blank or unchecked are not applicable.
FACTS:
1. This is a modification of a promissory note
1.1 executed by , as the Payor,
1.2 in which , as the Payee,
1.3 dated , at , California,
1.4 in the original amount of $ .
2. The promissory note is secured by a deed of trust of the same date
2.1 executed by , as the Trustor,
2.2 in which is the Beneficiary,
2.3 recorded on , as Instrument No. ,
in the records of County, California.
3. regarding real estate referred to as
.
AGREEMENT:
4. The above mentioned promissory note is modified as follows:

I agree to the terms stated above. I agree to the terms stated above.
� See attached Signature Page Addendum. [RPI Form 251] � See attached Signature Page Addendum. [RPI Form 251]
Date: , 20 Date: , 20
Payee's Name: Payor's Name:

Signature: Signature:

Signature: Signature:

FORM 425 03-11 ©2016 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517

Here, the carryback seller disposed of their original carryback note in

exchange for an entirely new and different note and trust deed from a
different person. Only the amount of principal and security for its repayment
remain the same.

As a disposition of the note, the carryback seller reports and pays taxes on
profit allocated to the remaining carryback principal.12

Instead of canceling and reconveying the original note and trust deed,
the carryback seller needed to retain the original note and trust deed and
enter into an assumption and modification agreement to set the terms of
12 Burrell Groves, Inc. v. Commissioner (1955) 223 F2d 526
 Chapter 18: Profit on modification of a trust deed note 153

the carryback note with the new buyer. Here, the carryback seller achieves
the same economic result without a disposition of the note and premature
taxation of their profits.

Consider an investor who purchases a carryback note secured by a second

trust deed on the property sold. The note has a face amount of $250,000 with
Modification
10% interest and monthly payments of $3,276, fully amortizing over a ten- rules for trust
year period.
deed dealers
The note now has a principal balance of $199,000 with seven years remaining
until paid in full. The investor pays $180,000 to purchase the note, producing
a yield rate of 13.4% interest on the investor’s funds.

Later, the value of the secured property declines, reducing the note’s market
value to $120,000. The investor wants to sell the note and take their loss. The
principal owed is a nonrecourse debt collectible only from the remaining
value of the property. The loss will be reported and used to offset income
from other sources.

The investor seeks a stable — though reduced — stream of income on

disposition of the now risky and devalued note. The investor knows a more
aggressive trust deed buyer who holds a well-secured note valued at $120,000.
They exchange notes by assignment.

The investor writes off their loss on the exchange of the notes against income
from other notes. They claim their exchange of the devalued note for another
note, secured by different real estate and executed by a different borrower,
is a disposition of the carryback note as though it had been sold for cash,
triggering profit/loss reporting.

The IRS claims the exchange of the trust deed note for a similarly valued
trust deed note is not a material alteration of the investor’s rights under the
carryback note they disposed of. The IRS views the transaction as merely an
acceptance of an economic substitute other than cash for the original note,
the same as modifying the note by accepting substitute security and new
obligors.

Is the trust deed investor allowed to report their lost value on the exchange
of the notes?

Yes! The exchange of notes secured by different properties with different

borrowers is a material alteration of the debt evidenced by the note and
trust deed the investor assigned. Thus, the exchange is a disposition of a note
triggering profit/loss reporting.13

IRS regulations control whether modifications to dealer-held trust deed

notes trigger profit reporting.14
IRS dealer
paper
13 Cottage Savings Association v. Commissioner of Internal Revenue (1991) 499 US 554 regulations
14 Revenue Regulations. §1.1001-3(b)
154 Tax Benefits of Ownership, Fourth Edition

The modification of a dealer note triggers profit reporting when:

• the fixed interest yield is altered by more than 1/4th of 1% per annum or
5% of the note rate, whichever is greater;
• payments are deferred or payment amounts altered such that payment
of principal is deferred;
• the due date is extended for more than five years or 1/2 of the original
term of the note, whichever is less;
• a buyer assumes a recourse note and the original borrower is released
from liability, called a novation;
• the security pledged on a nonrecourse note is materially altered;
• substitute security is given on a nonrecourse note;
• a fixed rate note is changed to a variable rate or contingent interest note
(e.g., a shared appreciation mortgage), or vice versa, unless the change
has been agreed to in the original note; or
• a note is otherwise altered from a recourse to a nonrecourse obligation,
or vice versa.15

Disposition Insignificant modifications of dealer paper that do not trigger disposition

and profit reporting include:
and profit
• altering the interest yield 1/4th of one percent or less per annum;
reporting not • altering payment terms in a way that does not defer payments on
triggered principal and does not increase the interest yield (i.e., changing to
quarterly payments from monthly payments, provided the quarterly
payments are the same as three monthly payments);
• a due date extension that does not exceed five years or 1/2 the term of
the note, whichever is less;
• prepayment of any portion of the note, or imposition of a penalty on
the prepayment;
• assumption of a nonrecourse note;
• addition of a co-obligor;
• improvements to the secured property;
• a substitution of security for a recourse note; or
• subordination of the trust deed securing the note.16

15 Rev. Regs. §1.1001-3(e)

16 Rev. Regs. §1.1001-3(f)
 Chapter 18: Profit on modification of a trust deed note 155

Disposition is the act of transferring or otherwise giving up an asset Chapter 18

such as property or a trust deed note which triggers the reporting and
taxing of any profit. Summary
When a note originated or acquired by an institutional mortgage
holder or trust deed dealer/investor is later modified, the modification is
recharacterized as a disposition of the note.

The modification of a note held for investment by a trust deed dealer or

mortgage holder or a note carried back on the sale of a builder’s business
inventory is a reportable disposition of the note. On a modification,
a mortgage holder is treated as having constructively received the
proceeds of the original note — whether it is the receipt of cash, a new
note or a “rollover” obligation represented by the modified note.

Unlike a modification, when a seller sells or exchanges a carryback

note, it is considered a disposition of the note and tax is due on
remaining untaxed profit allocated to the note. Any benefit received
when a carryback note is collaterally assigned as security for a loan
triggers reporting of an amount of profit equal to the amount of the loan
proceeds.

disposition .................................................................................... pg. 150 Chapter 18

Key Term
Notes:
 Chapter 19: Lease-option sale triggers profit reporting — it’s a carryback 157

Chapter
19
Lease-option sale
triggers profit reporting
— it’s a carryback

After reading this chapter, you will be able to: Learning

• identify when a lease-option agreement masks a reportable
carryback sale; and
Objectives
• advise clients on the tax implications of a lease-option sale.

Applicable Federal Rate (AFR) homeowners’ association Key Terms

common interest (HOA)
development (CID) land sales contract
equitable ownership recharacterization

During the recovery phase of a real estate sales cycle, while mortgage Ownership
financing is tight and tenants need incentive to become an owner, sellers for
various reasons use lease-option forms designed as intended for leasing to deductions
document a carryback sale.
for the buyer
The tax reporting advantages available to sellers granting an option to buy
include:
• larger sales profits through a premium sales price;
• tax-deferred profit or income from option monies;
• no interest stated as accruing on the amount owed on the price;
• rental income in lieu of interest;
158 Tax Benefits of Ownership, Fourth Edition

• rental operating expense deductions; and

• depreciation and mortgage interest deductions.
A lease-option agreement used to sell property typically couples the
normally separate documents used for a tenant to lease real estate and the
landlord to grant the tenant an option to buy the leased property. However,
the combining of these documents, with slight modification, creates a hybrid
form real estate transaction intended to “mask” a sale more conventionally
entered into as a purchase agreement and escrow conveying title or,
occasionally, a land sales contract. [See RPI Form 163]

Granted concurrently with the transfer of a leasehold interest in the real

estate, the conventional features of an option to buy real estate include:
• the price to be paid, almost always stated as the property’s market value
on the date of exercise, rarely a fixed dollar amount as in a purchase;
• the right to possession and use of the property by the tenant for the
lease term, a tenant’s primary financial objective;
• no payment of option money, the consideration for the grant of the
option always being the lease agreement entered into by the tenant
which incorporates the option; and
• No financial compulsion to exercise the option, such as periodic dollar
credits applied toward the price from either rent or ongoing option
money payments.

He who wears Coupling the lease and option to buy in a lease-option sale masks from
local government agencies and the public what is actually a sale. The
a mask combination, together with provisions adjusting the economic function of a
lease agreement to fit a purchase, commingles the separate financial aspects
of each, a hybridization producing a reportable sale of the property.

The legal function of the hybrid lease-option sale documentation is that of a

note and security device – a trust deed. The resulting agreements collectively
contain evidence of both the principal amount remaining due on a fixed
purchase price and the creditor status of the seller retaining title as security
until fully paid. Thus, the hybrid documentation for a lease-option sale is just
another form of seller carryback financing.

land sales contract In application, a purported lease-option sale is either:

A security device used
for the sale of real • a land sales contract under California law (when the term for
estate when the seller payments exceeds one year);
retains title to the
property as security • a two-party mortgage or wraparound mortgage for a term less than one
until all or a prescribed year; or
part of the purchase
price has been paid. • a trust deed or all-inclusive trust deed (AITD) when the documentation
contains a power-of-sale provision.
When a “lease-option” agreement calls for part or all of the periodic payments
(rent) to apply to the purchase price and a conveyance of title to occur more
 Chapter 19: Lease-option sale triggers profit reporting — it’s a carryback 159

than one year after entering into the agreement, the agreement is a land
sales contract. Thus, the title given the documentation does not conform to
the economic function of the agreed-to financial arrangements.1

The title of “lease-option” is an incorrect recharacterization of the transaction.

The owner credits the buyer with a buildup of equity in the property produced
by the agreed-to principal reductions on the price received in each monthly
payment. This economic function is more akin to a buyer owning property
subject to a mortgage securing a debt owed to the seller, called equitable equitable ownership
Held by a person who
ownership since the seller retains vested title. purchases a property
and has possession but
Buyers might intentionally structure a sale as a lease-option on the mistaken has not yet received
belief the arrangement for the seller to retain title avoids reassessment for legal ownership with
title vested in their
local property tax purposes. However, lease-option documentation used name, such as occurs
to mask a sale results in the same property tax consequences as a grant under an unexecuted
purchase agreement,
deed conveyance, recorded or not. The lease-option sales transaction is land sales contract
characterized as a change of ownership triggering reassessment. When the or lease-option sales
lease-option documents are recorded to perfect the buyer’s interest in the agreement.
property, the assessor’s office reassess the property on review.2

The lease-option sale format does not state the rate of return the seller receives Seller’s
on the principal remaining unpaid on the price. No provision exists stating
either an annual percentage yield or an interest rate the buyer is paying on erroneous tax
the balance owed to the seller. However, the annual yield – interest rate – is
easy to calculate under lease-option sale figures.
expectations
Typically, the periodic payments received by the seller are labeled “rent.”
Unlike rent, however, some or all of the payments are credited toward the
purchase price — a reduction of principal labeled as both rent and payment
on the purchase price, an irreconcilable conflict in terminology. [See RPI
Form 163 §17.3]

In spite of the credit on the price, the seller intends to report all payments on
the lease as rental income, not as interest and principal (which includes a
return of capital and profit) as reported on a carryback sale.

Alternatively, the monthly payment is broken into two separate amounts:

one for rent and the other for option money. The provision for monthly
option money payments is structured to extend the option an additional
month on receipt of the option money.
homeowners’
The seller defers reporting of the option money payments until the option association (HOA)
is exercised or expires. Thus, the rent income is reduced and the profit on An organization made
up of owners of units
exercise of the option increased, a shift of interest income earnings into gains within a common
from profit. The result is a lower tax rate and reduced taxes. interest development
(CID) which manages
The payment of rent in gross leases implicitly includes ownership expenses and operates the
project through
disbursed by the seller for property taxes, insurance premiums and enforcement of
homeowners’ association (HOA) assessment when the property is located conditions, covenants,
and restrictions
1 McCollough v. Home Ins. Co. of New York (1909) 155 C 659 (CC&Rs).
2 State Board of Equalization Letter to Assessor No. 80/147
160 Tax Benefits of Ownership, Fourth Edition

common interest in a common interest development (CID). The rent remaining after the
development (CID) seller’s payment of expenses is offset by interest paid on the existing loan and
Condominium projects, depreciation deductions allowed on residential rental property and reported
cooperatives, or single-
family residences by the seller.
in a planned unit
development. [See RPI However, the typical lease-option agreement shifts all care and maintenance
Form 135]
of the property to the buyer, a net lease set of conditions. Thus, the risks of
ownership are the burden of the buyer, as is the risk of loss when the property
value drops below the option price.

The lease- Consider a seller who relocates to another community and is unable to sell
their vacate residence at an asking price of $385,000.
option in
The residence is encumbered by a loan with a balance of $275,000. The
application monthly loan payment is $2,000, plus property taxes and insurance premium
impounds. However, the market rental value of the residence is just $1,500.
The seller needs to sell the property and get out from under its negative cash
flow, which is a debilitating drain on earnings.

The seller refuses to deed out their property and carry back a note and trust
deed based on the understanding they are not to help finance a sale unless
the buyer has at least a 10% cash down payment net to the seller.

However, to attain the desired sales price, the seller needs to offer buyers
some incentives, though they still have no cash downpayment.

A creditworthy but cash-poor prospective buyer with a high paying job is

located. The buyer qualifies to make monthly payments of $3,000, which is
double the current market rental value, but sufficient to cover the seller’s
carrying costs of the property.

The buyer suggests a lease with an option to purchase the property. However,
the buyer wants all monthly rent and option money payments to apply to
the fixed purchase price. Mathematically, this will build up a deferred down
payment (and equity in the property) as the buyer makes monthly payments.

Ultimately, the buyer and the seller agree to lease-option terms calling for a
$3,000 monthly payment — $1,500 allocated to rent due under the lease and
$1,500 as option money for monthly extension of lease and the option.

The agreement also calls for a $6,000 advance payment at the time of
occupancy — $3,000 prepaid for the first and last months’ rent and $3,000
as option money. The lease and option have a two-year term, at the end of
which the buyer may exercise their option by paying the balance due on the
price, decreased by credit for all payments of rent and option money.

The lease terminates if the buyer does not pay either the monthly rent or
the option money. Any default in monthly payments triggers a forfeiture
provision that either converts all payments to rent or declares a loss of the
right to credit payments to the price.
 Chapter 19: Lease-option sale triggers profit reporting — it’s a carryback 161

Tax-wise, the seller expects to report the lease-option transaction as:

• $36,000 in rental income over the two-year term of the lease — $19,500
the first year and $16,500 the second;
• $37,500 in option money received over the term of the lease, to be
reported only in the year the option is exercised or expires, as profit or
income, respectively;
• $311,500 in gross sales price remaining to be paid through a sales escrow
in the form of cash and loan assumption or new financing, which price
equals the portion of the lease-option remaining unpaid when the
option is exercised at the end of the term (the balloon payment);
• $8,500 in annual depreciation deductions based on a cost basis for the
property of $310,000 (75% depreciable on a 27.5-year schedule);
• $30,000 in annual mortgage interest deductions against rental income;
and
• a $250,000 principal residence profit exclusion for each seller on
exercise of the option.
The seller’s anticipated tax reporting includes an annual gross rental income
of $18,000 offset by insurance and property tax expenses along with interest
and depreciation deductions taken as owner of the property, netting a rental
operating loss of about $46,000 over the two-year term of the lease.

Two years of depreciation deductions will reduce their cost basis in the
property to $293,000.

The seller will report $349,000 on the sale, the amount of the price due on the
exercise of the option plus the option money they have received ($311,500
plus $37,500). Escrow will not reference the lease-option, and no purchase
agreement other than the escrow instructions will be prepared.

Thus, the seller figures their profit on the sale will be $56,000.

All payments will be reported as profit and excluded from income since it
is profit on the sale of property that qualifies as a principal residence of the
seller.3

On an audit, the Internal Revenue Service (IRS) looks beyond the form
used by a seller and a buyer in a lease-option transaction, ferreting out its
IRS
underlying economic function and legal substance. recharacterization
The IRS looks into a number of factors to determine whether a purported
lease-option is really a sale, including:
• whether the buyer has built up an equity in the property without
regard to forfeiture provisions [See RPI Form 163 §17.3];
• who bears the risk of loss for property damage and reduced property
value [See Form 163 §§11, 12];
• who pays property taxes [See Form 163 §5(c)];
3 IRC §121
162 Tax Benefits of Ownership, Fourth Edition

• the relationship of payments to market value rent; and

• the price paid on the option’s exercise compared to the property’s value
when the option is exercised.
When the IRS finds a lease-option is actually a sale, the seller’s tax reporting
will be disallowed and recalculated as a carryback sale, triggering:
• the recharacterization of rent as interest income;
• the imputing and reporting of interest at the agreement’s Applicable
Applicable Federal Federal Rate (AFR), reported as investment/portfolio category
Rate (AFR)
Rates set by the income;
Internal Revenue
Service and used by
• a reduction of the sales price due to re-allocation based on imputed
carryback sellers to interest;
impute and report
minimum interest • option money reported as interest income at the AFR, with any
income when the note remainder credited to the price;
rate on their carryback
debt is a lesser rate. • profit reporting of principal payments applied to the price, based on
the carryback sale contract/profit-to-proceeds ratio;
• disallowance of rental operating losses;
• allowance of a deduction from interest income for interest paid on the
underlying loan;
• disallowance of depreciation deductions; and
• allowance of the $250,000 profit exclusion on sale of the principal
residence when the two-of-five year ownership-occupancy rule is met.
[See Chapter 3]

recharacterization The recharacterization of the lease-option as a sale is based on the seller’s

The depiction of transfer of equitable ownership to the buyer by the terms of the lease-option
a lease-option
agreement as the
agreement functioning as a carryback note and trust deed. An equity buildup
economic equivalent in the property results from the credit of some or all of each payment to the
of a sale and financing price paid for the property.4
arrangement rather
than by the function
of a landlord/tenant When a buyer in possession of property is building equity over a period
transaction. exceeding one year, their lease-option is a land sales contract in everything
but name. It is not a trust deed as no provision for a trustee’s foreclosure
on default is written into the lease-option documents. The option money
realistically is a payment on the price as it reduces the amount owed, and
the rent is interest and principal (and possibly impounds for property taxes
and insurance premiums) under what is a disguised mortgage.5

Editor’s note — No legislation exists that recharacterizes a bogus lease-option

as a masked land sales contract. However, rules relating to equivalent lease-
back and option arrangements involving equity purchasers are codified.6

When a lease-option agreement masks what is a land sales contract, the

tenant becomes a buyer with equitable ownership of the property — because
they are in possession of the property, have agreed to responsible for all

4 Petersen v. Hartell (1985) 40 C3d 102; see Form 163 §17.3

5 Oesterreich v. Commissioner (1955) 226 F2d 798
6 Calif. Civil Code §1695.12
 Chapter 19: Lease-option sale triggers profit reporting — it’s a carryback 163

property repairs and maintenance and make payments that apply to a fixed
purchase price. None of the terms of a sale or carryback note are missing or
cannot be calculated.7

The landlord-in-fact as agreed in the lease-option becomes a carryback seller-

at-law on a land sales contract. They are a secured creditor with different
rights than those of an owner or landlord, even though they retain title –
security for payment.8

Tax-wise, the lease-option sale is an extension of credit by the seller and

subject to carryback sale reporting. Thus, the seller needs to report a minimum
Charge
amount of interest income at the carryback sale’s AFR. interest or
A lease-option sale contract is a form used to document seller financing, as impute it
are also:
• a land sales contract;
• a carryback note with or without a trust deed; and
• some unescrowed (unexecuted) purchase agreements with long-term
interim occupancy.
Each device for the credit sale of real estate has its own AFR. These seller
carryback security devices evidence the debt owed to the seller for the
remaining unpaid amount due on the purchase price.

Tax-wise, all payments received by the lease-option seller in excess of

impounds for property taxes and insurance, regardless of how they are
characterized, apply first to interest at the AFR on the entire amount owed to
the seller. Any amount remaining is principal and is applied to the purchase
price.

The seller’s tax reporting requirements have no effect on the buyer’s

financial obligations to the seller. However, on entering into a lease-option
purchase and taking possession, the buyer has acquired sufficient incidence
of ownership as a result of applying payments to the purchase price,
maintenance provisions and a set amount for the purchase price that they
are treated as the owner for tax purposes.

The seller reports the interest income portion included in each payment
based on the AFR as investment/portfolio category income. The principal
portion is allocated between basis and profit on the sale based on the seller’s
profit-to-equity ratio for the installment sale and is subject to the $250,000
residential profit exclusion.

7 McClellan v. Lewis (1917) 35 CA 64

8 Los Angeles Investment Co. v. Wilson (1919) 181 C 616
164 Tax Benefits of Ownership, Fourth Edition

Chapter 19 For various reasons, sellers use lease-option forms designed as intended
for leasing to document a carryback sale. A lease-option agreement
Summary typically couples the normally separate documentation used for a
tenant to lease real estate and the landlord to grant the tenant an option
to buy the leased property.

With slight modification, combining these documents creates a hybrid

form real estate transaction intended to “mask” a sale more conventionally
entered into as a purchase agreement and escrow conveying titles. The
legal function of this hybrid lease-option documentation is that of a
note and security device—a trust deed.

The resulting agreements collectively contain evidence of both the

principal amount remaining due on the fixed purchase price and the
creditor status of the seller retaining title as security until fully paid.
However, recorded or not, lease-option documentation used to mask
a sale results in the same property tax consequences as a grant deed
conveyance.

However, the typical lease-option agreement shifts all care and

maintenance of the property to the buyer, a net lease set of conditions.
Thus, the risks of ownerships are the burden of the buyer, as is the risk
of loss when the property value drops below the option price. On an
audit, the Internal Revenue Service (IRS) looks beyond the form used
by a seller and a buyer in a lease-option transaction, ferreting out its
underlying economic function and legal substance.

Applicable Federal Rate (AFR)................................................. pg. 162

Chapter 19 common interest development (CID).................................... pg. 160
Key Terms equitable ownership.................................................................. pg. 159
homeowners’ association (HOA)............................................. pg. 159
land sales contract....................................................................... pg. 158
recharacterization....................................................................... pg. 162
 Chapter 20: The foreclosing mortgage holder’s profits and losses 165

Chapter
20

The foreclosing
mortgage holder’s
profits and losses

After reading this chapter, you will be able to: Learning

• advise on the strategies mortgage holders use to avoid reporting
income or profit on the acquisition of property at a trustee’s sale;
Objectives
• discuss the IRS’s presumption that a mortgage holder’s successful
credit bid at a trustee’s sale is equal to the fair market value (FMV)
of a property; and
• distinguish the tax treatment of a seller’s foreclosure on a carryback
mortgage from that of a mortgage lender.

bid-equals-value presumption fair market value (FMV)

Key Terms
deed-in-lieu of foreclosure

Consider a property owner who defaults on a mortgage with a remaining Planning the
balance of $500,000. The mortgage holder calls the note due and commences
a trustee’s foreclosure to enforce collection of the amounts due under the tax-free, note-
mortgage note and trust deed.
for-property
At the trustee’s sale, the mortgage holder submits an opening credit bid of exchange
$400,000. No other bidders appear. The mortgage holder as the high bidder
acquires title to the property in exchange for partial satisfaction of the debt
owed. Based on the amount of bid and the debt owed, the mortgage holder
suffers a loss of $100,000.
166 Tax Benefits of Ownership, Fourth Edition

On analysis, note that the maximum amount of any mortgage holder’s credit
bid equals the total debt owed to the mortgage holder under the note and
trust deed, including:
• the principal remaining due on the note;
• any cash advances made under the trust deed;
• foreclosure costs and attorney fees for any litigation;
• interest accrued and unpaid;
• late charges; and
• prepayment penalties.

fair market value

Contrary to the amount of the credit bid, the fair market value (FMV) of
(FMV) the property received in exchange for satisfaction of debt was $550,000 on the
The price a reasonable, date of the trustee’s sale. Thus, a $150,000 profit is realized on the exchange.
unpressured buyer
and seller would agree
to for property on the May the mortgage holder write off the unpaid, uncollectible balance
open market, both remaining on the note as a loss on their mortgage investment based on the
possessing symmetric
knowledge of material
amount of their underbid and acquisition of the property?
facts.
Yes, with a flipside. Here, the remaining debt owed on the note has become
uncollectible. Anti-deficiency laws bar the mortgage holder from collecting
the $100,000 balance remaining unpaid on the note. The lender foreclosed by
completing a trustee’s sale, not a judicial sale of the property.1

Here, at the option of the mortgage holder, the $100,000 underbid loss taken
at the foreclosure sale is fully deductible.

Not exempt Financially, however, the mortgage holder received a profit on the exchange
at the trustee’s sale. This profit too is taxed if not offset by losses. The exchange
from taxation transaction of a foreclosure and acquisition of real estate is not exempt from
taxation.

The economic function of a foreclosure sale in an exchange by the mortgage

holder:
• satisfaction of all or a portion of the mortgage debt as consideration
given in exchange for
• acquiring ownership of real estate which was security for the debt.
In our example, the exchange of principal remaining due on the note, even
a portion of that principal, for ownership of the secured property is a taxable
transaction.2

Thus, the mortgage holder receives a profit on their credit bid acquisition of
the property. The FMV of the property ($550,000) was the value received in
exchange for satisfaction of a $400,000 portion of the mortgage debt.

1 Calif. Code of Civil Procedure §580d

2 Internal Revenue Code §1001(c)
 Chapter 20: The foreclosing mortgage holder’s profits and losses 167

As a result, the foreclosing mortgage holder realizes a $150,000 profit on the

note-for-property exchange transaction, taxable in the year of the foreclosure
transaction.

The mortgage holder concurrently suffered a $100,000 loss on the note due to
the underbid and bar against collection and enjoyed a $150,000 profit on their
exchange — a net profit of $50,000 on the entire exchange-by-foreclosure
transaction.3

Now the flipside. The mortgage holder may avoid reporting the profit taken
due to the greater value received in the foreclosed property by applying the
Internal Revenue Service (IRS) bid-equals-value presumption.

A mortgage holder acts as a creditor at a foreclosure sale by limiting its bid Mortgage holder
to include only the amount of the remaining principal, advances and costs.
Classified as a creditor, the IRS presumes the amount of the credit bid is equal forecloses and
to the property’s FMV. Thus, the mortgage holder receives no reportable buys – a forced
income in the form of interest and penalties added to the bid. Importantly,
the profit on the greater value in the property acquired at the foreclosure sale purchase
is not reported — the result of the bid-equals-value presumption.4
bid-equals-value
The mortgage holder properly opens bidding at or below the amount of presumption
The IRS’s presumption
the remaining principal balance plus advances and foreclosure costs. And a mortgage holder’s
when cash bidders overbid, it is prudent for the mortgage holder to consider successful bid at
a foreclosure sale,
increasing their credit bid, limited to the amount that covers the accrued limited in amount
interest, earned late charges and any prepayment penalty due and unpaid. to the remaining
principal, costs and
A mortgage holder will rarely bid an amount in excess of the total amount advances, is equal
to the FMV of the
owed on the debt unless competitive bidding drives up the bid amount and interest acquired in the
the mortgage holder is willing to add cash in an exchange to become the property leaving no
owner of the property. reportable income in
the exchange.

Consider a mortgage holder who forecloses on a mortgage with an outstanding

balance of $400,000. The mortgage holder’s successful bid at the trustee’s sale
“Bidding in”
is $350,000, but the property’s FMV is only $320,000. is buying
The mortgage holder takes a $50,000 loss on their mortgage. Further, the property
mortgage holder has an additional $30,000 reportable loss. They received only
$320,000 in FMV on their exchange of the portion of the mortgage debt they
canceled for property ownership at the foreclosure sale. Thus, the mortgage
holder’s total losses amount to $80,000.5

To substantiate the loss on the exchange, the mortgage holder presents

evidence to the IRS, such as an opinion of value or appraisal, demonstrating
the property’s FMV is below their successful bid.

3 Helvering v. Midland Mut. Life Ins. Co. (1937) 300 US 216

4 Revenue Regulations §1.166-6(b)(2)
5 Nichols v. Commissioner (6th Cir. 1944) 141 F2d 870
168 Tax Benefits of Ownership, Fourth Edition

IRS The bid-equals-value presumption for reporting the exchange is rebuttal by

the IRS. Thus, the IRS may independently establish the property’s value at
presumptions the time of the trustee’s sale when a loss is reported by the mortgage holder.
and When the IRS demonstrates through appraisals that the property’s FMV was
higher than the bid price at the foreclosure sale, the mortgage holder either
appraisals reduces the reported loss or reports income for the difference between the
property’s FMV and the mortgage holder’s basis in the mortgage.

For example, consider a mortgage holder who forecloses by trustee’s sale on

several mortgages. Losses are declared based on the difference between their
underbidding and their cost basis in the mortgages.

Reporting their losses triggers an audit. The IRS appraises the properties to
determine their values at the time of the foreclosure sales. The IRS discovers
the FMV of the properties was much higher than the bid prices and disallows
the losses and assesses taxes on the profits.

The mortgage holder claims:

• the bid prices set the FMV of the properties under state law, as all the
trustee’s sales were publicly advertised auctions properly conducted
under California foreclosure law;6
• a trustee’s foreclosure sale bars any deficiency judgment and collection
of remaining debt in California;7 and
• the IRS presumes the underbid price at a properly conducted trustee’s
sale to be the FMV.
Is the IRS bound by the California limitations on foreclosures or any other
borrower defenses?

No! The state anti-deficiency laws are designed with the purposes of
protecting borrowers after foreclosure, not mortgage holders. Federal tax law,
on the other hand, is designed to measure a mortgage holder’s income, profits
deed-in-lieu of or losses on a foreclosure since a foreclosure sale concluding with the lender
foreclosure
A grant deed from the
taking title to the property is a taxable exchange.8
owner of mortgaged
real estate conveying Here, the IRS may independently appraise the property to calculate the
it to the mortgage mortgage holder’s profit on the note-for-property exchange that occurred.
holder in exchange
for cancelling the When establishing a higher value for the property than the price bid, the IRS
mortgage debt and rebuts their own bid-to-value presumption. Moral: do not do loss reporting
avoiding foreclosure. that will trigger an audit if you are foreclosing at a profit.

Deed-in-lieu By taking a deed-in-lieu of foreclosure, a mortgage holder acquires the

property immediately, rather than waiting for a foreclosure sale to be noticed
of foreclosure and processed. Thus, they reduce one risk of further loss.
as an When the value of a property conveyed to the mortgage lender by a deed-in-
exchange lieu is greater than the remaining balance, costs and advances, the mortgage

6 Calif. Civil Code §§2924 et seq.

7 CCP §580d
8 Community Bank v. Commissioner (9th Cir. 1987) 819 F2d 940
 Chapter 20: The foreclosing mortgage holder’s profits and losses 169

holder will have interest income, and possibly profit, to report. Unpaid
interest when received constitutes a creditor’s income, while excess value in
the real estate acquired (as the seller exchanging a mortgage) produces profit.

On the other hand, when the property’s value is less than the unpaid mortgage
balance, the mortgage holder has a reportable loss on the cancellation of
mortgage debt in exchange for ownership of the property.

For a deed-in-lieu to be insurable by a title company, the deed needs to state

the conveyance is freely and fairly made as granted in full satisfaction of the
debt. [See RPI Form 406]

Some title companies further require an estoppel affidavit or additional

statement in the deed that confirms the mortgage holder’s consideration for
the deed equals the value of the interest conveyed in the property. However,
the mortgage holder needs to avoid reporting a loss when they accept a full
satisfaction declaration in a deed-in-lieu.

A prudent foreclosing mortgage holder appraises the property before the

foreclosure sale to:
Foreclosure
• ascertain whether the property’s FMV exceeds the debt owed; and
guidelines
• plan a bidding strategy to avoid reportable income or profit on the
foreclosure.
Ordinarily, mortgage holders do not want to acquire secured property at a
foreclosure sale. However, a foreclosing mortgage holder making a full credit
bid is usually the successful bidder at a trustee’s sale (the owner-in-foreclosure
had no equity to sell). Typically, trustee’s sales are not competitive bidding
events, except during transitions after a recession when the recovery has
been acknowledged.

When the amount of remaining mortgage debt is greater than the property’s
FMV, the mortgage holder’s opening bid at a foreclosure sale is often set at
Debt-over-
or below the property’s FMV, called an underbid. Thus, the mortgage holder value
does not create reportable income on acquiring of the property.

Here, the mortgage holder acquiring over-encumbered (underwater)

property on an underbid declares:
• no income on the unpaid accrued interest;
• no profit on the note-for-property exchange; and
• a reportable capital loss on the note.
The mortgage holder receives no income or profit on the note-for-property
exchange because:
• accrued interest income is not included in the bid; and
• the FMV roughly equals the price set for the underbid.
170 Tax Benefits of Ownership, Fourth Edition

The loss reported on the note is proper, as the total unpaid principal due on
the note exceeded the property’s substantiated FMV.

Value- When the property’s FMV exceeds the debt owed (and no waste or insured
casualty loss has occurred which are recoverable when a loss results from the
over-debt trustee’s sale bid), the mortgage holder’s opening bid will not be greater than
foreclosure the amount of principal and cash advances due under the note and trust
deed, including foreclosure costs and attorney fees.
bidding
Having acquiring title to the property on a bid equal to the funds invested in
principal and cash advances plus the costs of enforcing collection of the debt
by foreclosure and preserving the security, the mortgage holder:
• reports no capital loss on the note;
• reports no ordinary income on the interest accrued (since it remains
unpaid); and
• delays until resale the reporting of profit taken on acquiring a property
of greater value than the amount of the debt canceled.
Mortgage holders need to avoid overreaching to create a short-term loss by
deliberately underbidding when the property FMV measurably exceeds the
bid and they face no competitive bidding.

The IRS bid-equals-value presumption works to the mortgage holder’s

advantage unless the holder appears to be overreaching with losses. When a
foreclosure is profitable a mortgage holder who abuses the presumption by
declaring a loss on an underbid runs the risk of triggering an audit resulting
in disallowed losses and taxes assessed on the unreported profit taken at the
time of the foreclosure sale when acquiring the property.

Carryback sellers who foreclose on their buyer and bid in the full amount of
Carryback the debt are exempt from the income and profit tax inflicted on foreclosing
seller’s mortgage lenders who do the same.

foreclosure Occasionally, a seller who carries back a note and trust deed is later forced
by the buyer’s default to foreclose and retake ownership of the property. This
exemption recovery objective may be met by negotiating a deed-in-lieu of foreclosure
conveyance from the buyer. Like a foreclosing mortgage holder, the foreclosing
carryback seller reacquires the property in exchange for cancellation of the
note and reconveyance of the trust deed.

Unlike mortgage holders, carryback sellers who reacquire property on a deed

in lieu or a full credit bid for all sums owed them, including interest, late
charges and prepayment penalties, are exempt from reporting income or
profit on the exchange.
 Chapter 20: The foreclosing mortgage holder’s profits and losses 171

Accordingly, the reacquisition of property sold in a carryback sale triggers

no reportable income or profit on the foreclosure activity. The value of the
seller’s security interest in the property may be higher or lower than the
entire debt owed the seller with no change in the tax consequence.

Likewise, the carryback seller has no loss when the FMV of the property has
decreased below the principal amount of debt remaining unpaid, which is
typically the reason for default. They have recovered the property they sold
and are whole again as though they never sold – except for current market
and pricing conditions. [IRC §1038]

However, the foreclosing carryback seller’s reporting of the original

installment sale is reconstructed. Any net cash proceeds on the sale or
principal in installment payments not taxed (it was a return of capital) are
now taxed as income – the seller has ownership of the property back and
holds untaxed earnings generated by the property due the installment sale.

The economic function of a foreclosure sale in an exchange by the Chapter 20

mortgage holder is satisfaction of all or a portion of the mortgage debt as
consideration given in exchange for acquiring ownership of real estate Summary
which was security for the debt.

When a mortgage holder limits its bid to the amount of the remaining
principal, advances and costs, the IRS presumes the amount is equal
to the property’s FMV. A mortgage holder will rarely bid an amount in
excess of the total amount owed on the debt unless competitive bidding
drives up the bid amount and the mortgage holder is willing to add cash
to become the owner of the property.

When the IRS demonstrates through appraisals that the property’s

FMV was higher than the bid price at the foreclosure sale, the mortgage
holder either has to reduce the reported loss or report income as the
difference between the property’s FMV and the mortgage holder’s basis
in the mortgage.

By taking a deed-in-lieu of foreclosure, a mortgage holder acquires the

property immediately, rather than waiting for a foreclosure sale to be
noticed and processed. Thus, they reduce their risk of potential loss.

bid-equals-value presumption................................................ pg. 167

deed-in-lieu of foreclosure........................................................ pg. 168
Chapter 20
fair market value (FMV)............................................................. pg. 166 Key Terms
Notes:
 Chapter 21: The §1031 reinvestment plan – educating real estate investors 173

Chapter
21

The §1031 reinvestment

plan – educating real
estate investors

After reading this chapter, you will be able to:

Learning
• grasp the tax objectives a seller of investment real estate needs to Objectives
consider to replace property in a §1031 reinvestment plan.

§1031 cooperation provision nonrecognition of gain Key Terms

A workable §1031 reinvestment environment exists when a property owner Determining

wants to sell a property and avoid diminishing their net sales proceeds by
paying taxes on the profit they realize on the sale. Here, the owner’s listing what an
agent is in a position to:
investment
• negotiate the sale of the owner’s property to a buyer who agreed to
cooperate with the owner at the time of closing to instruct escrow to
property
transfer funds into a §1031 reinvestment plan; and owner wants
• coordinate the owner’s use of the net proceeds from the sale of their
property to purchase like-kind replacement property.
An agent working with a property owner who wants to sell and is considering
the use of the net proceeds from the sale to purchase replacement property,
called a §1031 reinvestment plan, needs to prepare a client profile sheet in a
counseling session with the owner.
174 Tax Benefits of Ownership, Fourth Edition

The client profile sheet documents the owner’s needs and expectations for
a replacement property the owner is willing to acquire with the net proceeds
from a sale, also called §1031 money. With this information, the agent is best
prepared to find property suitable for the owner to acquire as a replacement
using the equity in the property for sale. [See RPI Form 350]

When located, the buyer of the owner’s property needs to cooperate, allowing
§1031 transfer of the owner’s net proceeds on the sale at the close of escrow into a
cooperation purchase escrow set up by the owner or to a §1031 trustee for holding the funds
until the replacement property is located. To bargain for this cooperation, the
provision purchase agreement contains a §1031 cooperation provision. [See RPI
Form 150 sec 11.6]

Buyers typically agree to cooperate in the transfer of the seller’s net proceeds
of the sale as part of negotiations to set the price and terms of payment. Most
buyers, as investors or business owners, appreciate the benefits of avoiding
the tax on profit, which the owner plans to do on the sale.

The financial benefits available to a real estate owner when entering into
§1031 a §1031 reinvestment plan on the sale of 1031 property and acquiring
reinvestment replacement property, include:
benefits, as • the exemption from reporting all or a portion of the profit on the sale;
planned • an increase in income yield achievable by replacing the property sold
with a more efficient and more productive property, usually one of
higher value,;
§1031 cooperation • an increase in the amount of depreciation deductions on acquiring
provision a higher-priced replacement property by assuming (or originating) a
A condition in greater amount of debt, or adding cash or other property;
purchase agreements
advising participants • an inflation and appreciation hedge by selling at the end of a recession
about §1031
reinvestment planning
and acquiring a more highly leveraged property to take maximum
and providing for advantage during the recovery period of an anticipated rapid increase
mutual cooperation in cyclical rents and property values;
prior to closing for the
disbursement of net • the voluntary buyout of a partner in a co-ownership of property by
sales proceeds when a
participant decides to
acquiring multiple replacement properties for an “in-kind” distribution
purchase or sell other to the partner during the following year to end the partnership;
property in §1031
reinvestment plan. • a consolidation of equities held in several properties (owned by one
[See RPI form 159 sec or each by different owners to form a group acquisition) into a single,
11.6] more efficient property for ownership and management;
• the acquisition of several lesser-valued replacement properties to
diversify the investment and reduce the risk of loss inherent in the
ownership of one high-value property, or, alternatively, for the purpose
of facilitating an orderly liquidation of a single, high-value property
over a period of years;
• the receipt of tax-free cash from sales proceeds by negotiating a
carryback note as part of the terms for payment of the price to acquire
the replacement property;
 Chapter 21: The §1031 reinvestment plan – educating real estate investors 175

• the replacement of a management-intense property under gross leases

with a more manage-free property;
• the avoidance of profit taxes on foreclosure of a property which has
little-to-no equity by adding cash or other property in an exchange for
replacement property taking on equal or greater debt;
• the relocation of wealth, undiminished by taxes, by selling or
exchanging the equity in property to acquire property in a different
geographic location when the owner relocates;
• the creation of a job for the owner who desires to undertake the
management or rehabilitation of replacement property;
• the coupling of an assignment of a trust deed note carried back in a
prior sale of other property with the equity in the property to be sold
or exchanged as consideration to acquire a replacement property; and
• the $250,000 profit exclusion on the sale of a qualifying principal
residence converted to a rental property coupled with the §1031 profit
exemption on reinvestment of the net sales proceeds remaining after
first withdrawing principal from the sale in the amount of profit
excluded from taxes as a residence.

The primary tax advantage for an owner participating in a §1031 reinvestment The cost
plan is the ability to “transfer” the cost basis remaining in the property
sold to the replacement property purchased. The cost basis is adjusted for basis carried
contributions or withdrawal of cash and the difference in mortgage balances forward
due to debt relief on the property sold and mortgages on the property acquired.

The carry forward treatment of the cost basis to the replacement property nonrecognition of
is a result of the nonrecognition of gain in a 1031 transaction. Thus, the gain
The exemption from
profit or loss realized on the sale, which amount is not reported, is implicitly taxes on profits
carried forward to the replacement property without a taxable consequence. or losses realized
on disposition
Of course, when the replacement property is disposed of – transferred – in a
of investment or
taxable sale, the profit taken on that sale is taxed. Only on a taxable sale is the business-use property
amount of profit determined and taxed at rates applicable in the year of sale. when the net equity
in the property is
replaced by acquiring
other investment or
business-use property
in a continuing
ownership of property.
176 Tax Benefits of Ownership, Fourth Edition

Chapter 21 When a property owner wants to sell a property to avoid diminishing

their net sales proceeds by paying taxes on the profit they realize
Summary on the sale, a workable §1031 reinvestment environment exists. An
agent working with a property owner who wants to make a §1031
reinvestment plan, uses a client profile sheet to document that owner’s
needs and expectations for a replacement property.

Once a buyer is located, their cooperation is bargained for in the purchase

agreement under a §1031 cooperation provision.

Many financial benefits are available to a real estate owner when

entering into a §1031 reinvestment plan on the sale of §1031 property
and acquisition of replacement property. The primary tax advantage for
an investor participating in a §1031 reinvestment plan is the ability to
“transfer” the cost basis remaining in the property sold to the replacement
property purchased, adjusted for contributions or withdrawal of cash or
mortgage boot.

When the investor’s acquisition of the replacement property is delayed

until after escrow closes on their sale, the net sales proceeds are rerouted
and received by a person other than the investor.

Chapter 21 §1031 cooperation provision.................................................... pg. 174

nonrecognition of gain.............................................................. pg. 175
Key Terms
 Chapter 22: Tax aspects advice as a potent aid 177

Chapter
22
Tax aspects advice as
a potent aid

After reading this chapter, you will be able to: Learning

• turn tax knowledge to your competitive advantage by offering
advice to clients on the tax consequences of their real estate
Objectives
transaction you are negotiating;
• develop a higher level of clientele due to your willingness to
advise on the tax aspects of transactions which involve your
services; and
• understand when a client needs third-party tax counsel, and
their transaction documents need a tax-related further-approval
contingency provision.

agency duty Agency Law Disclosure Key Terms

Consider the owner of an income-producing parcel of improved real estate

who intends to retain a brokerage office to market the property for sale. The
Analyzing a
owner interviews a few brokers and sales agents to determine who they will transaction’s
employ.
tax aspects
The owner’s primary concern is to hire a broker whose agents are most likely
to produce a prospective buyer to purchase the property. Thus, the interviews
with agents include an inquiry into:
• the contents of the listing package the agent prepares to market income
property;
• the scope of the advertising the agent undertakes to locate prospective
buyers and any costs to the seller;
178 Tax Benefits of Ownership, Fourth Edition

• the agent’s accessibility and responsiveness to inquiries into listings

the agent publicizes; and
• the professional relationship the agent has with brokers and agents
who represent buyers.
One agent interviewed asks about the owner’s intended use of the proceeds
from the sale. The owner indicates they want to reinvest the funds in
developable land, to hold for profit on a later resale to a subdivider or builder.
Minimal management is the owner’s objective.

On request, the owner provides the agent with data on:

• the price they paid for the income property;
• the principal balance and terms of the mortgage on the property; and
• the depreciated cost basis remaining in the property.
These three key pieces of data are needed for an agent to assist the owner in
tax planning for a sale.

The agent does some quick math to approximate the amount of profit the
Initial opinion owner will take — realize — on a sale. The agent immediately determines the
of tax liability owner profits on a sale, they amount owed for profit taxes on unrecaptured
gains (rates up to 25%) and long-term capital gains (rates from zero to15%-
20% brackets) which equal a fifth of the net proceeds from a sale (plus 1/3rd
more for state taxes).

The agent expands the discussion with the owner into how they can avoid
reporting the profit and paying taxes on the sale by locating and buying
land suitable for the owner to acquire – a §1031 reinvestment plan which
starts with the property to be sold.

The agent also informs the owner that listing and purchase agreements
entered into for the sale of the income property and the purchase of the
like-kind replacement property will contain a contingency provision
conditioning the closing of the sale on the owner’s purchase of other property.

Disclosure To properly relay the extent of the agent’s experience, the agent informs
the owner they have not personally negotiated a sale that concluded with
of known replacement property in a §1031 transaction. However, the agent has taken
courses on §1031 transactions and discussed §1031 funding procedures with
consequences brokers and escrow officers who have relevant experience.

The agent explains that they are fully able to properly market the property
and locate suitable land for the owner’s reinvestment, as well as follow up on
the steps needed for §1031 tax avoidance if the owner lists the property with
the agent’s broker.

The owner interviews a second agent concerning the sale of the property.
However, on inquiry the agent is reluctant to become involved in a review
of the income tax aspects of selling property and asks for no tax information.
 Chapter 22: Tax aspects advice as a potent aid 179

The second agent hands the owner a written statement attached to a proposed
listing agreement advising the owner that the agent:
• has disclosed the extent of their knowledge of the tax consequences on
the sale of real estate;
• is unable to give further tax advice on the rules and procedures
involved in a §1031 reinvestment plan; and
• recommends the owner seek the advice of their accountant or tax
attorney on how to properly avoid the tax on profit from the sale and
purchase of real estate.
Did both agents comply with their agency duty to make proper disclosures
agency duty
to the owner about their knowledge and willingness to provide tax advice? The fiduciary duty a
broker and their agents
Yes! Both agents met the agency duty undertaken when soliciting owe a client to use
diligence in attaining
employment for services in a commercial transaction since each agent: the client’s real estate
objectives. [See RPI
• considered the tax consequences of the owner’s sales transaction, thus Form 305]
implicitly treating profit taxes as a material fact;
• disclosed the extent of their knowledge regarding the possible tax
consequences of the sale; and
• advised on any need for another professional to further review and
advise on the §1031 tax aspects.
One necessary question remains for agents to sort out: does an agent employed
by a seller of real estate owe their seller a duty to consider the need for tax
advice as an included service to their seller?

The answer lies in a review of:

• the type of real estate involved; and
• the client’s intended use of the sales proceeds.

Consider a seller’s agent who determines that information about the tax An affirmative
aspects of a sale is material to a sales transaction under consideration by
their client. Tax information when known to the client in any type of sales duty to
transaction may alter their handling of the transaction. Due to an awareness disclose as
of taxable events affecting a client, the agent owes their client a duty to
disclose the extent of the agent’s knowledge on the transaction’s tax aspects. advise on
Further, a concerned seller’s agent goes beyond a discussion of tax information material facts
and assists their client to structure the sales arrangement so they achieve the
tax consequences most consistent with the client’s financial and investment
objectives.

In conflict with these general rules about disclosures of material facts is a

specific rule that in a one-to-four unit residential dwelling transaction
a seller’s agent has no duty to disclose their knowledge of possible tax
consequences. Even when the agent understands that the tax consequences
180 Tax Benefits of Ownership, Fourth Edition

when discussed might affect their client’s handling of a one-to-four unit sales
transaction, the seller’s agent has no duty to disclose their tax knowledge,
unless transaction-related taxes is the subject of the client’s inquiry.1

Advice Consider the seller of a one-to-four unit residential property who employs a
broker (and in turn the broker’s agent) to sell the property by entering into a
disclosure listing agreement.
disclaimer The listing agreement form used by the agent’s broker contains a boilerplate
without an clause stating a real estate licensee is qualified to advise on real estate.
This statement is a general statement consistent with the purpose of state
explanation licensing standards. However, further provisions state that when the seller
desires legal or tax advice, the seller is to consult an appropriate professional.
Nothing is said about the qualifications of the listing broker or their agent
to advise on the transaction they are negotiating or whether they know the
client need tax advice on the consequences they will experience.

Agency Law The agent also hands the seller a statutorily mandated Agency Law
Disclosure Disclosure form that states: “A real estate agent is a person qualified to advise
Restatement of agency
codes and cases about real estate. When legal or tax advice is desired, consult a competent
summarizing the professional.” Here, the competent professional consulted may just be the
agency conduct of real listing broker and agent involved — who on request are obligated to give
estate licensees. It is
delivered to all parties their best advice.
in consumer sales and
leasing transactions. Neither tax-aspects disclaimer calls for the broker or their agents to provide
[See RPI Form 305]
tax advice, much less obligate the seller as a threshold condition to employ
another professional to advise on the tax aspects of their one-to-four unit
residential transaction before closing escrow. These tax-aspects disclaimers
reek with the implication that taxes in a transaction are material. If not, then
no need exists for making the disclaimer of a duty. Left without advice, the
client may be unclear on the tax consequences of a transaction, the terms of
which their agent negotiated.

The agent markets the property and locates a buyer who enters into a
purchase agreement with the seller. The purchase agreement, like the listing
agreement, again states the seller is to consult their attorney or accountant
for tax advice. The disclaimer, as is their nature, does not require the client
to do anything, nor is a contingency provision required for a third-party
professional approval before closing.

Prior to closing the sale, the agent also negotiates for the seller to purchase
another one-to-four unit residential property, for which the agent prepares a
purchase agreement offer that is accepted.

Before escrow closes on either transaction, the seller asks the agent about the
number of days they have after the sale closes to purchase the replacement
property and avoid paying profit tax on the sale. The seller has never been
involved in a §1031 reinvestment plan.

1 Cali f. Civil Code §2079.16

 Chapter 22: Tax aspects advice as a potent aid 181

The agent is unsure and orally advises the seller to consult a tax accountant.
The seller does not do so. The agent now knows the seller knows and is
concerned about tax consequences. Critically, the agent does not include a
contingency provision for the further approval of the tax consequences in
the purchase agreement or escrow instructions to protect the client.

Ultimately, the seller is taxed on the profit from the sale, but not because of the
time constraints on the closing of escrow on the purchase of the replacement
property. The profit is taxed because the seller failed to avoid receipt of
the net sales proceeds. Escrow instructions dictated by the agent using the
purchase agreement called for the net sales proceeds to be disbursed directly
to the seller. To avoid receipt of the net sales proceeds as required by a §1031
reinvestment plan, the seller needed to direct escrow to either:
• directly transfer the sales proceeds from the sales escrow to the
purchase escrow; or
• impound the sales proceeds with a third-party trustee until the
proceeds are needed to fund the purchase escrow for the replacement
property.

After being taxed on the profit from the sale, due to the mishandling of the
net sales proceeds used to purchase the replacement property, the seller seeks
Tax advice
to recover losses from the agent due to adverse tax consequences incurred liability
on the sale of §1031 property. The seller claims the agent breached their
agency duty by failing to disclose the structure of the seller’s transfer of net
exception
sales proceeds, as arranged by the agent, might (it will) result in adverse tax
consequences due to the seller’s receipt of the reinvestment funds.

The agent claims they have no duty to advise the seller on the tax consequences
of the sale since the listing agreement, the Agency Law Disclosure and the
purchase agreement all clearly stated:
• the agent does not advise on tax matters; and
• the seller is to look to other professionals for tax advice.
Did the seller’s agent have a duty to advise the seller on the tax consequences
of the sale as known to the agent?

No, but not because of these unworkable disclaimers. On the sale of one-
to-four unit residential property, sellers and buyers as consumers are
expected as a matter of public policy to obtain tax advice from competent
professionals other than the residential real estate brokerage office handling
the transaction.

A broker and their agent have no duty to be forthcoming and voluntarily

disclose any tax aspects surrounding the sale of a one-to-four unit residential
property. This legislated rule applies even when the information on how to
avoid the adverse tax consequences is known to the broker or the sales agent.
In contrast, on a direct inquiry from the buyer or seller, the agent is duty
bound to respond honestly and to the full extent of their knowledge.2
2 Carleton v. Tortosa (1993) 14 CA4th 745
182 Tax Benefits of Ownership, Fourth Edition

The Agency Law Disclosure addendum attached to listing agreements and

purchase agreements restates the law that eliminates the duty of a broker
and their agents to disclose their knowledge about the tax aspects of a sale
when a one-to-four unit residential property is involved.

The tax consequences of sales transactions involving the use of sales proceeds
The irony of to purchase replacement property are as material to a seller as the structuring
mandated of carryback financing. Carryback arrangements require an agent to make
extensive mandated disclosures regarding documentation and rights of
disclosures the carryback seller. However, carryback arrangements are less frequently
encountered than §1031 reinvestment plans.

Further, the financial damage of profit taxes avoidable in a §1031 transaction

often exceeds the risk of loss on an improperly structured carryback note and
trust deed transaction. Unlike the agency duty of a broker and their agents in
§1031 transactions, the agency duty an agent owes to their carryback seller
includes full disclosure of information necessary for the seller to make an
informed decision about the financial suitability of a carryback sale before
the seller enters into the transaction.3

Avoid The boilerplate statement included in some listing agreements and purchase
agreements, used by unionized real estate brokers and their agents, incorrectly
misleading implies they are not qualified (or worse, not authorized) to give tax advice.
clients When a broker or agent is not qualified to handle a §1031 transaction, they
by using most likely are at least aware tax advantages are available through a §1031
reinvestment plan. Further, real estate brokers and their agents with tax
disclaimers knowledge are duty-bound to advise their client about the material facts in
a real estate transaction their client is about to enter — unless a one-to-four
unit residential property is involved.

However, a savvy agent capitalizes on the tax knowledge they have by

advising clients on the tax results of their real estate transactions, regardless
of the type of property involved. As always, the agent who advises a client
on a transaction’s tax consequences as part of their services has a duty to not
mislead the client by intentional or negligent misapplication of the tax rules.4

To avoid misleading the client- negligence - the agent needs to disclose to the
client:
• the full extent of their tax knowledge regarding the transaction;
• how they acquired this knowledge; and
• whether the client needs further advice from other professionals.

Shifting Brokers and agents who provide tax advice are best served by involving
the client’s other advisors in the final decision, such as their attorney or tax
reliance for
tax advice 3 Timmsen v. Forest E. Olson, Inc. (1970) 6 CA3d 860
4 Ziswasser v. Cole & Cowan, Inc. (1985) 164 CA3d 417

given a client
 Chapter 22: Tax aspects advice as a potent aid 183

accountant. Input from others who know the client helps the agent eliminate
future claims arising from adverse tax consequences ostensibly due to the
client’s reliance on the agent’s silence or erroneous statement of opinion.

The most practical (and effective) method for shifting reliance to the client or
others when the agent has discussions with the client about a transaction’s
tax consequences is to insert a further-approval contingency provision in
the purchase offer or counteroffer signed by the client.

The contingency provision imposes a duty on the client to initiate the

investigation and obtain additional tax advice and a decision about the
further approval of the transaction’s tax consequences from an attorney or
accountant before allowing escrow to close.

An oral or written warning — or general advice to further investigate — is

insufficient. Further, advisory statements do not require the client to act
like a contingency provision does. Worse, advisories do not explain why the
broker or agent providing the advisory statements does or does not believe
the client needs to act on one or more of the statements to protect themselves.
A further-approval contingency provision avoids all this noise, making the
agent’s advice an opinion to be confirmed by the client before closing. Here,
risk mitigation is the goal.5

In a purchase agreement (or exchange agreement) involving implementation

of a §1031 reinvestment plan, a further-approval contingency provision
Tax advisor’s
regarding the transaction’s tax consequences calls for the client to confirm, further
prior to closing, that the transaction qualifies for §1031 tax-exempt status, as
represented by the agent. When the client is unable to confirm the tax status approval
as represented, they may terminate the transaction by delivery of a notice of
cancellation. [See RPI Form 171 §5.2j]

Essentially, the client is not relying on the agent’s opinion when they decide
to enter into a purchase or exchange agreement with the intent to close
escrow only after further confirmation of the tax consequences opined by
the agent.

Further, a purchase agreement or exchange agreement containing a written

contingency provision also contains an unwritten implied covenant
provision. Under the implied covenant, before a client may cancel a
transaction based on third-party approval, they are required to “act in good
faith and with fairness” in their effort to obtain third-party approval, such
as submitting data on the transaction for confirmation by an attorney or
accountant they retain.

Here, the client’s agent usually steps into the chain of events by getting
authority from the client to contact the third party and providing the
paperwork needed to review the transaction for its §1031 tax-exempt status.
On review, the agent makes procedural changes needed to meet the client’s
objectives and satisfy the concerns of the third party advisor.

5 Field v. Century 21 Klowden-Forness Realty (1998) 63 CA4th 18

184 Tax Benefits of Ownership, Fourth Edition

Since fair dealing and reason are implied in every agreement and applied to
the conduct of all parties, a termination of the exchange agreement due to the
disapproval of an activity or occurrence subject to a contingency provision
must be based on a justifiable reason.

On a potential disapproval and possible termination due to reasons expressed

by the client or their third party advisor, the agent might be able to cure
the defect that gave rise to the reason for disapproval, or demonstrate that
the third party’s concern is unfounded, i.e., when the third-party advisor’s
concern is an erroneous conclusion.6

An agent who is not knowledgeable about the handling required for a

§1031 reinvestment initially avoids a discussion of tax aspects by including
the §1031 cooperation provision in the purchase agreement. The provision
brings to the seller’s attention the availability of activities that go to the tax
consequences of the sale and provide for tax handling to be addressed and
implemented before closing.

An agent’s A client’s technical questions which go beyond their agent’s knowledge or

expertise require a forthcoming and meaningful response from the agent,
knowledge including:
of basic tax • disclosing the extent of their knowledge to the seller and advising the
aspects in seller to seek further advice from another qualified source;
• involving a more knowledgeable broker, tax attorney or accountant
transactions who provides the seller with advice; or
• learning how to handle §1031 reinvestments and giving the advice
themselves.
Escrow officers are of great assistance to an agent who has a potential §1031
transaction on their hands. Many escrow officers, transaction agents and
persons holding themselves out as qualified intermediaries advertise their
expertise in handling §1031 reinvestments.

Ideally, agents handling the sale of like-kind §1031 real estate do, as a matter
of basic competency, possess an understanding of several fundamental tax
concepts, such as:
• the $250,000 principal residence profit exclusion on a sale [See Chapter
3];
• the separate income and profit categories for different types of real
estate ownership [See Chapter 6];
• the §1031 profit reporting exemption;
• the mortgage interest deduction (MID) [See Chapter 1];
• depreciation schedules and cost recovery deductions;
• the $25,000 deduction and real-estate-related business adjustments for
rental property losses;
• the tracking of rental income/losses separately for each property;
6 Brown v. Critchfield (1980) 100 CA3d 858
 Chapter 22: Tax aspects advice as a potent aid 185

• profit and loss spillover on the sale of a rental property;

• standard and alternative tax bracket rates [See Chapter 1]; and
• carryback sales with deferred profit reporting.
These tax aspects are basic to the sale or ownership of real estate commonly
listed and sold by agents. One or more always apply. When they apply they
have significant financial impact on sellers and buyers of real estate. Any
agent with working knowledge of the tax aspects of real estate may offer
a wider range of services — including tax advice — when competing to
represent buyers and sellers in their real estate transactions.

Additionally, a seller receiving tax advice concerning a §1031 reinvestment

plan who follows the advice always leads to a second fee. It is earned for
negotiating the purchase of the replacement property and coordinating
the transfer of funds. Add in the goodwill created with the client and you
generate referrals of like-type clients.

The primary concern of owner of an income-producing parcel of Chapter 22

improved real estate who intends to retain a brokerage office to market
the property for sale is to hire a broker who is most likely to produce a Summary
prospective buyer to purchase the property.

The owner’s chosen broker or broker’s agent assists the owner in tax
planning for a sale. A concerned seller’s agent goes beyond disclosure
of mere tax information and assists their client in structuring the sales
arrangement to achieve the tax consequences most consistent with the
client’s financial and investment objectives.

The tax consequences of sales transactions involving the use of sales

proceeds to purchase replacement property are as material to a seller as
the structuring of carryback financing.

Real estate brokers and their agents with tax knowledge are duty-bound
to advise their client about the real estate transaction into which their
client is about to enter. When a broker or agent is not qualified to handle
a §1031 transaction, they most likely are at least aware tax advantages
are available through a 1031 reinvestment plan. A savvy broker or
agent capitalizes on the tax knowledge they have by advising clients on
the tax results of their real estate transactions, regardless of the type of
property involved.

agency duty .................................................................................. pg. 179 Chapter 22

Agency Law Disclosure.............................................................. pg. 180
Key Terms
Notes:
 Chapter 23: A formal exchange of properties 187

Chapter
23

A formal exchange of
properties

After reading this chapter, you will be able to: Learning

• represent an owner of real estate who exchanges their property
for another;
Objectives
• identify the distinctions and similarities between exchanges and
cash-out sales of real estate; and
• effectively locate suitable properties for exchange.

equity exchange Key Terms

An exchange of properties is a multi-property transaction structured as a Structuring a

barter agreement — a swap — entered into by the separate owners of two or
more parcels of real estate. By agreement, they transfer to one another the comprehensible
ownership of their properties, conveying them through concurrent closings
in consideration for the value of the equity in the property they receive
transaction
from the other.
exchange
The exchange transaction, often called a trade, is in fact two separate sales A means of trading the
of properties, owned by different persons, which are purchased by the other equity in a property,
owned for the equity
person. Exchanges occur most frequently during the recessionary phase of a in another, treated as
business cycle. During recessions, property owners frequently are unable or a single transaction
involving two
unwilling to part with cash and the supply of properties whose owner need
properties conveyed
to sell are plentiful. through tandem
escrows. Also called
barter.
188 Tax Benefits of Ownership, Fourth Edition

equity Financial adjustments are arranged for the difference in the dollar amount
The value of an of equity in each property based on the values given each in the exchange
owner’s capital interest agreement. The values given do not affect income tax reporting, while the
in real estate exceeding
the mortgages mortgages are part of the tax reporting on the transaction.
encumbering it.
Thus, the owners of separate real estate, on entering into a written exchange
agreement, agree to sell and convey their property to the other owner who
agrees to purchase and acquire it — take it in trade. However, unlike a sale
under a purchase agreement, the down payment is not in the form of cash.
Rather, the down payment is the equity in the property the owner wants to
dispose of.

In an exchange of properties, as in the sale of property with a cash down

payment, the balance of the price remaining unpaid, after deducting the
value of the equity used as the down payment, is paid in some form of
consideration.

Equity Unlike a sale calling for a cash down payment and assumption of an existing
mortgage or new financing, any balance of the price remaining to be paid in
adjustments an exchange is often deferred, evidenced by a carryback note and trust deed.
common to Exchanges frequently have little to no cash involved beyond transactional
costs, a side effect of the times when exchanges are most prevalent.
concurrent
Adjustments made in a sale to pay the difference between the cash down
exchanges payment and the mortgage amount, such as a carryback note, are the same
for payment of the difference between the equities in an exchange situation,
called balancing of equities. The equity adjustment in an exchange occurs
when the equity in one property is larger than the equity in the other
property. Here, the owner of the larger equity receives the consideration
given for the adjustment, such as a carryback note, other property or just cash.

Also, unlike a cash sale which “frees up” the capital invested in real estate
by converting a seller’s equity to cash on closing, an exchange continues the
owner’s investment in real estate, moving wealth in one property to another.
In an exchange, the owner disposes of a property they have and no longer
want and acquires one they want. Further, whatever other factors may
motivate an owner to participate in a §1031 reinvestment plan, the §1031
profit tax exemption is always one of them.

The owner might use their equity to move up into property of greater value
for increased leverage to expand their wealth by mortgage amortization and
property value appreciation. Or the owner consolidates several properties
they own in an exchange for a single, more efficiently operated property.

A contrast in The hallmarks of an exchange transaction, in contrast to the common features

of a sales transaction, include:
thought and
• the exchange of equities in real estate in lieu of a cash down payment,
style though some cash might be involved, casually referred to as sweetener;
 Chapter 23: A formal exchange of properties 189

• no good-faith deposit since cash is infrequently used in an exchange of

equities. Rather than a cash deposit, the consideration for entering into
the exchange agreement is the signature of each owner binding them
to perform as promised in the exchange agreement;
• a takeover of existing financing with or without a formal assumption
of the mortgages, rather than refinancing and incurring expenses that
greatly increase the cost of reinvesting in real estate;
• adjustments brought about by the difference in the value of the
equities exchanged, a balancing that requires the owner with the
lesser-valued equity to cover the difference, typically by a note calling
for cash installments;
• joint or tandem escrows, interconnected for the concurrent conveyance
of properties, is similar in effect to the purchase of property for cash when
the closing is contingent on the buyer’s sale of other property for funds
needed to close escrow. This contingency occurs in §1031 reinvestment
plans when agreeing to buy a property as the replacement property
before selling the property to be disposed of;
• two sets of broker fees, one for each property involved in the exchange,
rather than the receipt of a single fee as occurs in a cash-out sale of
property; and
• one owner simultaneously involved in selling and buying, a coupling
of two properties, consisting of the sale of one and purchase of the other.

Common features in an acquisition of real estate, by either a cash purchase or

an exchange of properties, include:
Commonality
• disclosures by the owner and their agent of the conditions known to
with a sale
them about the property improvements, title, operation, and natural
hazards of the location which adversely affect the property’s market
value or the buyer’s intended use of the property; and
• a due diligence investigation by the person acquiring title concerning
their future ownership, use and operation of the property.
As in all real estate transactions, a form is used to prepare the offer and
commence written negotiations. The objective of a written agreement is to
provide a comprehensive checklist of boilerplate provisions the client is to
consider in their offer, acceptance, and counteroffer negotiations.

Once the owner’s agent locates a suitable like-kind replacement property,

owned by a person whose agent indicates is willing to consider an exchange
of properties, the agent prepares an exchange agreement. The agent reviews
the terms of the exchange agreement with the owner, they both sign it, and
the agreement is submitted to the owner of the replacement property for
acceptance, counteroffer, or rejection. [See RPI Form 171]

As presented in this chapter, an agent only uses the exchange agreement

format when an owner’s equity in a property is offered as a down payment
in exchange for another owner’s property. Conversely, for an owner who has
already entered into a purchase agreement to sell their property to a cash
190 Tax Benefits of Ownership, Fourth Edition

buyer and now (after tax counseling) wants to include the sale in a §1031
reinvestment plan, their agent prepares and submits a separate purchase
agreement offer to buy a replacement property. No exchange agreement is
entered into as no exchange exists – just a sale and a purchase of separate
properties, coupled solely by a transfer of sales proceeds as part of a §1031
investment plan. [See RPI Form 159].

A client considering an exchange of real estate usually intends to complete a

Tax aspects §1031 reinvestment plan. With tax avoidance properly in mind, the real estate
of an acquired needs to have equal or greater debt and equal or greater equity than
exists in the property they now own. A tax free trade-up environment exists
exchange when taking on greater debt and greater equity in a wealth building effort.
transaction Again, when the exchange is a fully qualified §1031 transaction, none of the
profit realized on the transfer of the property sold or exchanged is recognized.
Thus, the profit is not taxed.

Profit, when exempt from taxes on the sale of the property, is implicitly
transferred to the replacement property. Whatever the profit may eventually
become is determined and taxed when the replacement property is disposed
of in a taxable sale. The bookkeeping for the replacement property does
not have a book entry for profit, only an account for the cost basis carried
forward and reallocated between land and improvements for depreciation
deductions.

Locating When searching for replacement properties, the owner’s agent first locates
suitable properties owned by someone interested in acquiring the client’s
properties for property.
exchange The most productive environment for locating owners of suitable properties
who have an interest in acquiring the client’s property exists at marketing
sessions attended by licensed brokers and agents, called exchange or
investment groups. At these meetings, they “pitch” their listings and advise
attendees about the types and locations of property their clients are willing
to exchange. With technology like Zoom, the attendance greatly expanded
in 2020. Also, loopnet.com is a major player in MLS type distribution of
information.

Multiple listing service (MLS) printouts, websites and large brokerage

firms with income property sales sections also provide an opportunity for
brokers and agents to locate suitable properties. The agent locating properties
available for exchange need to contact agents who have listed suitable
property to determine whether their client is interested in acquiring property
in exchange. If so, they must be willing to acquire the type of property owned
by the agent’s client.

A prudent agent will not prepare or submit an offer to exchange before getting
a reading on the other owner’s (or their agent’s) willingness to consider an
exchange of properties.
 Chapter 23: A formal exchange of properties 191

To look into the possibility of an exchange and document the inquiry for
later follow up, a broker or agent will often prepare a preliminary proposal
form and deliver it to the other agent to encourage discussions. The proposal
form notes the type of properties involved, the amount of equity and debt
and arranges for the exchange of information for a discussion between the
agents before preparing an exchange agreement. The agent retains a copy of
the prepared form in the client file as evidence of the agent’s diligence duty
to locate property. [See RPI Form 170]

The preliminary proposal is not an offer. As a proposal, it does not contain

intent-to-contract wording. The clients are not directly involved in
the proposal, only the agents who are looking for a possible match. On
determining the probability, the other owner will consider entering into an
exchange, the agent then prepares an exchange agreement, has it signed and
submits it for consideration.

As always, cash buyer are the preferred takers of your client’s property.
Cash leaves the seller and their agent free to make offers on other property
as replacement using cash, without the difficulties of culling for owners to
locate one who will take your client’s property in exchange.

Once an agent locates like-kind replacement property and its owner indicates Equity
a willingness to consider an exchange, the market value of the properties
needs to be established. Valuation then becomes the single most important adjustments
task for negotiating an exchange agreement. The equity in each property is
dependent on the value of each property.
to balance
the equities
Until a consensus exists between the owners about the approximate amount
of equity in the properties, negotiations tend not to go forward. With a
consensus on property valuations, the amount of the adjustment for the
difference between the equities in each property can be set. A due diligence
investigation cannot begin in earnest until a consensus about the equity in
each property is reached.

At some point, the agent prepares an exchange agreement offer. The offer is
based on the owner’s and the agent’s analysis of valuations, including:
• the fair market value (FMV) of each property to be exchanged [See RPI
Form 171 §1.3 and 2.3];
• the mortgage amounts encumbering each owner’s property, and
whether they are to remain of record; and
• the equity valuations calculated as the FMV of each property, minus
the principal amount of existing mortgages.
On determining the present value of the equity in each property, the agent
proposes adjustments to cover the difference between the equity valuations
in each property.
192 Tax Benefits of Ownership, Fourth Edition

Negotiating Since the equities in properties exchanged are rarely the same dollar amount,
adjustments nearly always need to be negotiated. Thus, a contribution of
adjustments money, carryback promissory note or personal property, collectively called
cash boot – and possibly additional real estate – needs to be contributed. It is
the owner of the property with the lesser amount of equity value who adds
cash or other consideration to adjust for the dollar difference in equities.

When existing financing encumbers the properties being exchanged,

negotiations may call for the mortgages to remain of record or be paid off and
reconveyed. Refinancing of the replacement property may be necessary to
generate cash funds to pay off and reconvey the existing mortgages and pay
transactional costs. When additional cash is required for these purposes, a
contingency provision for new financing needs to be activated.

Cultivating Consider an agent with a working knowledge of income property transactions

in the region served by their office. The agent regularly attends marketing
an exchange sessions and visits brokers and agents whose clients have properties they
want to convert to cash or directly exchange for other property that meets
environment their needs.

The agent is working with an investor who wants to get out from under the
management burdens of a smaller residential rental property they own. The
investor prefers to own a single-user property requiring little of their time
to oversee maintenance and repairs, a net lease agreement situation. The
investor has owned the property for some time and their remaining cost
basis in the property is low compared to the property’s present FMV.

The agent and the investor discuss selling the units and locating a more
suitable property to meet the investor’s ownership objectives. A property
listing is entered into, employing the agent’s broker.

A reinvestment provision in the listing calls for the location and acquisition
of like-kind replacement property. Thus, the owner’s agent is employed to
maintain the client’s continuing investment in replacement real estate, as
required to qualify the profit taken on a sale for the §1031 exemption. [See
RPI Form 102 §9]

The agent locates an industrial property owned by an entrepreneur. Their

company occupies the entire building. The entrepreneur’s agent explains
their client wants to lease back the property from the buyer rather than
move. The entrepreneur’s objective is to reduce debt so they can enlarge the
credit line for their business.

The agent asks the entrepreneur if they might be a “taker” of the residential
income units (with a much smaller mortgage) in exchange for their property.
The agent gets a positive response. The entrepreneur already owns residential
rental properties, so property management does not pose a challenge.
 Chapter 23: A formal exchange of properties 193

Information on the properties is exchanged. The investor’s units are priced at Preliminary
$1,500,000 with a debt of $500,000 and equity of $1,000,000. The entrepreneur’s
industrial building is listed at $3,000,000 subject to a mortgage of $1,750,000 due diligence
with equity of $1,250,000.
investigation
When the investor analyzes the information on the industrial property as a
probable replacement property under a net lease with the owner-occupant,
the investor finds its just what they are looking for. They will be acquiring
a property with a higher value to add to their investment portfolio and the
demands on management will be minimal. The flow of rental income will
cover payments on the mortgage, generate spendable income and provide
an acceptable rate of return on the investment.

The agent then conducts a preliminary investigation into the property, the
mortgage encumbering it, and refinancing.

The agent prepares an exchange offer. Besides the routine due diligence
investigation into each property, typical contingencies and closing
provisions, the agent needs to negotiate:
• the adjustment for the $250,000 difference between the equities in the
two properties; and
• the terms of a lease for the entrepreneur’s continued occupancy of the
industrial building.

The terms offered in the investor’s exchange agreement for payment of the
$3,000,000 price for the industrial property, include: Analyzing
• the $1,000,000 equity in their residential units to be transferred — the the flow of
down payment consideration; considerations
• an assumption of the $1,750,000 mortgage on the industrial building to
be acquired — the primary mortgage financing; and
• execution of a $250,000 note and trust deed in favor of the entrepreneur
— the amount of the adjustment needed to balance the equities
between the two properties in the exchange.
On the flip side of this exchange, the consideration the investor asks of the
entrepreneur, in exchange for the investor’s mortgaged residential units and
the investor’s execution of a carryback note, includes:
• the $1,250,000 equity in the industrial property; and
• an assumption or refinance of the $500,000 mortgage on the residential
units.
Thus, with the entrepreneur’s receipt of a $250,000 carryback note secured by
the industrial building the total consideration the entrepreneur is to pay for
the residential units is $1,000,000 on acceptance of this offer.
194 Tax Benefits of Ownership, Fourth Edition

Closing the The leaseback arrangement the investor offers is based on the FMV of the
industrial property and rents recently agreed to for comparable properties.
deal The terms of the lease are set in an addendum attached to the exchange
agreement offer (which may well be a proposed lease agreement).

On receiving and reviewing the offer, the entrepreneur’s agent submits a

counteroffer to the investor including the terms of the exchange agreement,
modified as follows:
• the carryback note provision is deleted; and
• the amount of $250,000 to be paid in cash to adjust the equities.
Ultimately, escrow is opened based on a downward adjustment of $25,000
in the price of the industrial building. The adjustment for the difference in
equities becomes $225,000, payable by a $125,000 note and $100,000 in cash.

Talented Californian real estate agents can be clever when pushed to be

creative by owners who want each other’s property. Initially, an agent’s
motivation is in the transaction fees they receive — but innovation generates
goodwill, which generates future business by referral and awareness of the
transaction by other professionals.

Chapter 23 A multi-property transaction structured as a barter agreement — a swap

— entered into by the separate owners of two or more parcels of real
Summary estate is called an exchange of properties. By agreement, they transfer
to one another the ownership of their properties, conveying them
concurrently in consideration for the value of the equity in the property
they receive from the other.

The exchange transaction, often called a trade, is in fact two separate

sales of properties, owned by different persons, which are purchased by
the other person. Financial adjustments are arranged for the difference
in the dollar amount of equity in each property based on the values
given each in the exchange agreement. Exchanges frequently have
little to no cash involved beyond transactional costs.

A client considering an exchange of real estate usually intends to

complete a §1031 reinvestment plan. With tax avoidance properly in
mind, the real estate acquired needs to have equal or greater debt and
equal or greater equity than exists in the property they now own.

With a consensus on property valuations, the amount of the adjustment

for the difference between the equities in each property can be set. A
due diligence investigation cannot begin in earnest until a consensus
about the equity in each property is reached.

Chapter 23 equity.............................................................................................. pg. 188

exchange........................................................................................ pg. 187
Key Terms
 Chapter 24: §1031 like-kind property by intended use 195

Chapter
24

§1031 like-kind property

by intended use

After reading this chapter, you will be able to: Learning

• determine whether the property owned or acquired is like-kind
property; and
Objectives
• identify intent and conditions which disqualify a property as like-
kind property.

dealer property disposition property Key Terms

Properties owned either for productive use in a trade or business, or for rental Qualified to
or other investment purposes, are referred to as like-kind property sold and
acquired in a §1031 reinvestment plan.1 sell or buy as
The profit taken by an investor on the sale of real estate is exempt from §1031 like-
taxation only when both the real estate sold or transferred in an exchange, kind property
and the real estate purchased or acquired in exchange, qualify as Internal
Revenue Code (IRC) like-kind property in the hands of the investor.
dealer property
Property which does not qualify as like-kind property includes: Real estate held for
sale to customers in
• dealer property, such as inventory items and real estate bought for the ordinary course
resale other than for business use, rental income, or for increase in of an owner’s trade
or business, where
value due to inflation and appreciation; the earnings on the
sales of the properties
• a principal residence; and are taxed as business
• foreign real estate.2 inventory at ordinary
income rates.
1 Internal Revenue Code §1031(a)(1)
2 IRC §§1031(a)(2), (h)
196 Tax Benefits of Ownership, Fourth Edition

Further, properties acquired in an exchange between related persons need

to be held for two years after acquisition to qualify as like-kind property.
When during the two year related-persons holding period for ownership the
property acquired is sold or further exchanged, the §1031 exemption is lost
and the profit on the property sold in the failed §1031 investment plan is
taxed. The property acquired from the related person has not yet qualified as
like-kind property. [IRC (f)(1)]

When a resale of a property acquired in an exchange between related persons

occurs within two years of closing, the property acquired is considered
disposition property held by the person acquiring it. Disposition property
is not like-kind property due the intent to use it to cash out of the real estate
investment. Thus, the property received fails to qualify as like-kind property.
In turn, the profit realized on the property exchanged is taxed in the year the
exchange closed.

Investment Like-kind property consists of two classifications of property:

vs. trade or • investment property; and

• trade or business property.
business
• Investment property includes:
property • rental properties, both residential and commercial, held as passive
income category property;
• vacation homes held for profit on resale [See Chapter 27]; and
• real estate held as portfolio income category property.3
The business-use and investment property criteria for like-kind property
does not include dealer property. Dealer property is held primarily for sale to
customers of the owner’s trade or business.

Recall that inventory such as subdivided lots, land held as inventory by

builders, or properties purchased at auction for the purpose of renovation
and resale are held for immediate sale in the ordinary course of the owner’s
trade or business. Thus, dealer property is not business-use property held by
a trade or business, even though it is owned by the trade or business. It is
inventory held for resale.4

Like investment property, real estate used as the premises to operate the
owner’s trade or business, or in the operation of a hotel or motel, is like-kind
property.

However, trade or business use property needs to be owned for a one-year

holding period before it qualifies as like-kind property for sale or exchange
in a §1031 reinvestment plan.5

3 IRC §1221
4 IRC §1231(b)(1)(B)
5 IRC §1231(b)(1)
 Chapter 24: §1031 like-kind property by intended use 197

Investment property may be sold and replaced by trade or business use

property or other investment property in a §1031 reinvestment plan.
Likewise, in the reverse situation of a business-use property sold it may be
replaced by purchasing investment property .

Many novice investors who own one-to-four unit properties and small
business entrepreneurs who own property the business occupies mistakenly
Small
believe §1031 benefits are available exclusively to wealthy investors investors may
who own large income projects. However, no investment or business-use
property is too small, or too big, to qualify for §1031 tax-exempt treatment.
exchange too
The property’s dollar value is not relevant.

By coupling their sales and acquisitions, an investor further builds their

personal net worth by avoiding the diminution of wealth wrought by
profit taxes when unwanted property is sold so other preferred property can
be acquired. The investor organizes a §1031 reinvestment plan to sell the
property they no longer want, avoid receipt of some or all of the net sales
proceeds, and timely identifies and purchases replacement property with
some or all of the sales proceeds.

Also, a leasehold interest in real estate qualifies as §1031 property when the
remaining term of the lease period exceeds 30 years, including options to
extend or renew, when sold or acquired by assignment. [Revenue Regulations
§1.1031(a)-1(c)]

No limitations are placed on size, value or location of the property involved

in a §1031 reinvestment plan, so long as the properties are located within the
United States. An owner may reside in California, sell Texas real estate and
purchase Hawaiian replacement property.

A §1031 reinvestment plan may involve the sale of one or more parcels of
undeveloped real estate and the purchase of one or more parcels of improved
real estate for use in a business or operated as rentals.

Two or more investors may be brought together in a syndicated transaction,

called a consolidation exchange. Each investor sells their solely owned
like-kind property and combines the net sales proceeds with those of other
investors, each owner acquiring a pro rata fractional tenant-in-common
(TIC) interest in one replacement like-kind property.

For example, a $300,000 equity in one parcel of real estate plus a $700,000
equity in another parcel of real estate may be sold and replaced by acquiring
a single parcel of real estate with an equity of $1,000,000 or more.

§1031 tax-free reinvestment of sales proceeds encourages net worth

enhancement by acquiring bigger, more efficient, and more suitable
investment property. An investor, who takes a profit exempt from taxes
under §1031, retains a dollar amount of property value equal to the tax they
avoided. The adverse financial consequences of a sale and acquisition are
limited to the transactional costs incurred and any negative variation in the
risk of loss in the property acquired compared to the property sold.
198 Tax Benefits of Ownership, Fourth Edition

Thus, the investor increases their after-tax dollars capital interests when
they participate in a §1031 reinvestment plan. Conversely, they cash out,
report profits, pay unrecaptured and capital gains taxes and later reinvest
the diminished after-tax funds when the timing for pricing is right. These
cash-out sales take place during boom years with the sales proceeds held in
reserve for their option value, then used to acquire investment opportunities
during recessionary and initial recovery years.

Adaptation Based on intended use, an owner holds real estate for one of four economic
purposes:
for §1031 • immediate resale for business income, as with dealer property;
treatment • business use, as with real estate used to operate the owner’s trade or
business;
• investment, as with rental property for income from operations or
land held for long-term profit on resale; or
• personal use, as with an owner’s principal residence.
Dealer property generates ordinary income on resale, not profit. Profit occurs
on the resale of a property held and productively used by the business for
more than 12 months. Thus, the sale of dealer property is not entitled to
§1031 tax-exempt benefits or profit tax treatment.6 [See Chapter 7]

Property used in a business or held for investment, such as unimproved land,

may become reclassified as dealer property and no longer qualify as like-kind
property. This transformation may occur at any time during ownership.

The owner alters the tax status of their ownership by simply modifying their
intent and conduct in the use of the property. For example, an owner shifts
their objective in holding a parcel of unimproved property from investment
to retail sales purposes by taking steps to subdivide and market the resulting
lots for sale. Same situation for an apartment building conversion to condo
units, renovation, and resale of units.

Property Capital assets make up the investment classification of §1031 property, except
for a principal residence. Capital assets do not include:
held for
• dealer property;
investment • property used to house a trade or business (however, it also qualify as
§1031 like-kind property when held for more than one year);
• copyrighted material and literary, musical or artistic compositions held
by the creator of the material or the person for whom it was produced;
• accounts receivable, such as unpaid rent; and
• government debt obligations, such as treasury bills, notes, and bonds.7

6 IRC §§1031(a)(2), 1231(b)

7 IRC §1221(a)
 Chapter 24: §1031 like-kind property by intended use 199

Capital assets include real estate, furnishings, stamps/coins, gems, paintings,

antiques, precious metals, manuscripts, and other valuables held for
long-term appreciation. Again, when these assets are held or acquired for
immediate resale, they are inventory in a trade or business, not capital assets.

Consider an owner with several individual residential rental properties held

for investment and one residence held for personal use. All are capital assets.

The rental residences held for investment purposes may be sold and purchased
in a §1031 reinvestment plan. However, an owner’s personal residence does
not qualify as §1031 property since it is not owned and operated as either a
rental or to house their business.

Yet, a personal residence is a capital asset. The sale of a personal residence

reports profits as portfolio category capital gains, not ordinary income as
with inventory. Further, profits on the sale of a personal residence are not
taxed when owners qualify for the personal residence profit exclusion up to
$250,000 per qualifying owner. While profits on a personal residence sale are
reported as excluded or taxed, any loss on the sale of a personal residence is
disallowed and cannot offset any income or profits.

Investment properties include leasehold estates in property with a remaining

period on the lease term of over 30 years at the time of assignment (including
extension or renewal periods), fee or equitable ownership of residential and
commercial rental properties, vacation homes and land held for long-term
profit. Thus, these assets qualify as like-kind properties.

Trade or business property includes real estate used primarily by the owner
to house and operate their trade or business. These business-use properties
Property used
are not strictly classified as capital assets. Recall that for §1031 treatment, in a trade or
business-use property is subject to a holding period of more than one year.
After one year of ownership, it is “treated” as a capital asset for profit tax
business
reporting and the §1031 exemption.

Examples of business-use property include land and its improvements,

parking lots, timberland, hotels, motels, inns, and vacation rentals not
personally used by the owner.

Property owned by the business, but not used to house and operate the
business, includes:
• inventory property, such as lots or homes in a subdivision created by
the owner;
• dealer property, bought to be immediately resold, or held to be
improved and sold such as the business of a property flipper;
• copyrights;
• timber, coal, or domestic iron ore held for less than one year;
• cattle and horses held for less than two years;
• other livestock held for less than one year; and
200 Tax Benefits of Ownership, Fourth Edition

• unharvested crops on land used for trade or business — unless the land
is held for more than one year and the crop and the land are sold or
exchanged at the same time and to the same person.8

Disposition Replacement properties acquired in a §1031 exchange, when intended to be

immediately resold in a cash-out sale or conveyed to another individual or
property taxable entity, are called disposition property.
nullifies use Disposition property does not qualify as like-kind property. The attributes of
of §1031 ownership regarding the intended use and operation of disposition property
by the owner are identical to dealer property.
exemption
When replacement property is acquired on the sale or exchange of other
property and put to some dealer activity, such as cashing out, subdividing,
restoring, renovating, building or improving the property and then
disposition property immediately reselling it in a cash-out sale, the disposition disqualifies the
Replacement property
acquired in a §1031 replacement property as like-kind property.
reinvestment plan and
immediately resold Without the replacement property being like-kind property, the profit in
in a cash-out sale or
conveyed to another
the like-kind property sold or exchanged is taxed. Both properties in a §1031
individual or taxable reinvestment plan must be like-kind property or the exemption does not
entity, disqualifying it apply.
as like-kind property
when received.
Properties acquired to be cashed out on a resale are tainted with the intention
to manage them as dealer property, often by spending time and effort to
prepare (and upgrade) them for resale. Simply put, the properties are acquired
to be upgraded and “flipped” for a profit in a cash-out sale as inventory of a
trade or occupation.9

Property acquired by an individual as replacement property for property

sold and promptly conveyed to a corporation under IRC §351 (in a §351 tax-
free exchange for stock) is classified as disposition property. When the owner
immediately conveys property they acquired in a §1031 transaction to a
corporation, the profit realized in the transaction is taxed as the exemption
does not apply.10

Conversely, when an owner acquires replacement property and then deeds

it to a partnership or LLC – disregarded passthrough entities – for the same
percentage of ownership they held in the replacement property, such as in
a syndicated or consolidation exchange, the further conveyance does not
make it disposition property.

Further conveyance to a partnership or LLC entity does not alter the tax
reporting by the owner. After acquiring the property, the owner’s income tax
reporting produces the same tax result, whether they retain title or further
conveyed the property to a partnership or LLC.

8 IRC §§1231(b), 631

9 Little v. Commissioner of Internal Revenue (9th Cir. 1997) 106 F3d 1445
10 Revenue Ruling 75-292
 Chapter 24: §1031 like-kind property by intended use 201

However, this is not so for further conveyances to a corporation on completion

of a §1031 reinvestment plan.11

11 Magneson v. Commissioner (1985) 753 F2d 1490

Properties owned either for productive use in a trade or business, or for Chapter 24
rental or other investment purposes, are referred to as like-kind property
in a §1031 reinvestment plan. Summary
Property which does not qualify as §1031 like-kind property includes:
• dealer property, such as inventory items and real estate bought
for resale rather than for business use, (rental) operating income
or for increase in value due to appreciation or inflation;
• a principal residence; and
• foreign real estate.
Disposition property is not like-kind property due to the intent to use it
to cash out of the real estate investment.

Like-kind property consists of two classifications of property: investment

property and trade or business property. Investment property includes:
• rental properties (both residential and commercial) held as passive
income category property;
• vacation homes held for profit on resale; and
• real estate held as portfolio income category property.
Dealer property is not included as it is held primarily for sale to customers
of the owner’s trade or business.

A taxpayer’s principal residence does not qualify as §1031 like-kind

property (even though it is a capital asset) since it is not used in a
business or held for investment purposes.

The profit taken on the sale of real estate is exempt from income tax
when both the real estate sold and the real estate purchased qualify as
Internal Revenue Code (IRC) §1031 like-kind property in the hands of
the owner seeking the profit tax exemption.

dealer property............................................................................. pg. 195 Chapter 24

disposition property................................................................... pg. 200
Key Terms
Notes:
 Chapter 25: The delayed purchase of replacement property 203

Chapter
25
The delayed purchase
of replacement
property

After reading this chapter, you will be able to: Learning

• implement the control an investor may assert over the acquisition
and improvement of like-kind replacement property purchased
Objectives
in a §1031 reinvestment plan; and
• understand the limited involvement of a third-party trustee used
to avoid an investor’s actual or constructive receipt of proceeds on
the sale of property in a §1031 reinvestment plan.

§1031 trustee trust account Key Terms

§1031 reinvestment plans are structured from the outset for an investor to: Replacement
• sell or exchange one property; and property
• acquire another property by purchase or exchange.
purchased
The investor uses one of two procedures for closing these §1031 transactions:
as a §1031
• a concurrent exchange of one property for another in a two-way, equity-
for-equity transfer of property between two owners, or alternatively, reinvestment
coordinate the concurrent closing of a sales escrow to directly fund the
closing on a purchase escrow to acquire the replacement property; or
• a delayed exchange comprising two independent transactions closing
at different times, one for the sale of the investor’s property, and one
for the investor’s purchase of replacement property. The nexus is the
204 Tax Benefits of Ownership, Fourth Edition

arrangement with a trustee or intermediary to receive, hold, and

disburse the net proceeds from the property sold to fund the purchase
of the property acquired to complete the §1031 reinvestment plan.
Handling of the net sales proceeds from the sale of a property in a delayed
exchange is critical to qualifying profits for §1031 exemption. When the
investor is in escrow to sell property in a delayed exchange and has not yet
opened a purchase escrow to acquire replacement property, a third party
must receive the investor’s net sales proceeds at the time of closing, directly
from the sales escrow for the property sold.

The investor may not receive the funds on closing. Nor can they constructively
receive the funds through putting them to their beneficial use following the
closing of the sale, like as collateral for a loan. Thus, the funds must be placed
at risk with a third-party trustee under one of two sets of at-risk rules:
§1031 trustee • the general rule calls for placing the sales proceeds at risk until the sales
A third party who, in proceeds fund the purchase escrow to acquire replacement property.
lieu of the seller in a
§1031 reinvestment This approach allows the investor to appoint a §1031 trustee to
plan, receives and receive, hold and disburse sales proceeds on the investor’s instructions
holds the net sales to fund their purchase of replacement property to close out their §1031
proceeds from the sale
of property, and on reinvestment plan; and
demand from the seller
deposits the funds in
• safe harbor rules, established by regulations, allow the alternative use
a purchase escrow the of a “qualified intermediary” to facilitate the risk by their receipt of the
seller opens to acquire sales proceeds on closing the sales escrow and hold them for their later
replacement property.
disbursement to fund the closing of the investor’s purchase escrow for
the replacement property.

Conduct The sale of an investor’s business or investment property is typically the

first step taken in a §1031 reinvestment plan. The second step is locating and
connected acquiring replacement property to complete the plan. Thus, the investor will:
to direct • transfer title to the property sold by a grant deed conveyance directly
to the buyer acquiring the property; and
deeding
• take title to the property purchased by grant deed directly from the
seller of the replacement property.
Consider a different staging, the reversal of the sale and purchase events.
Here, the investor first locates a replacement property, contracts to buy
it, and acquires the replacement property via a parking transaction title-
holding arrangement using personal funds. On closing the purchase escrow
for the replacement property, title and ownership will be parked with a third
party operator while the investor sells the property they no longer want. On
closing the sales escrow on the property to be sold, the net sales proceeds
are transferred to a purchase escrow for the investor to acquire title to the
“parked” replacement property, completing the §1031 reinvestment. [See
Chapter 28]

More typically, an investor’s acquisition of replacement property is delayed

until after the investor closes the sales escrow for the property sold. Here,
 Chapter 25: The delayed purchase of replacement property 205

prior to closing the sales escrow, the investor appoints a §1031 trustee to hold trust account
the net proceeds from the sale. The funds held by the trustee are placed in an An account in the
interest-bearing trust account as instructed. name of the trustee in
which funds held for
a client are deposited,
Thus, the funds remain available on demand (and protected in any separate and apart
bankruptcy) to fund the investor’s purchase of replacement property and the from the trustee’s
personal funds.
cost of any construction or renovation to be completed prior to taking title.

Neither the buyer of the investor’s property nor the §1031 trustee are
involved in the investor’s location, selection, due diligence approval, title-
holding (except in the event of a parking transaction) or construction of
improvements on the replacement property.

The trustee’s sole task, under the general rules for §1031 reinvestment plans,
is to disburse funds for the investor’s purchase and any construction of
improvements on the replacement property from the sales proceeds held by
the trustee.1

An investor uses any type of agreement to control and purchase the Use of any
replacement property, including:
• a purchase option;
type of
• a purchase agreement; agreement to
• a purchase escrow, with or without an underlying purchase agreement buy
or option; or
• an exchange agreement.

When purchasing replacement property, the investor, as the buyer in a Full

typical purchase transaction, may personally:
involvement
• negotiate the price and terms for payment directly with the sellers, as
well as all conditions and contingencies; purchasing
• make a good-faith deposit with the purchase offer, payable to escrow the
for the account of the investor, using their own funds or the sales
proceeds held by the §1031 trustee; replacement
• enter into the acquisition agreements and escrow instructions as the property
named buyer;
• handle the due diligence investigations and personally satisfy or
waive conditions and contingencies;
• oversee and direct renovation or construction on the property prior
to closing and assume liability for any funding such as by co-signing
or guaranteeing a construction loan. The investor may not undertake
personal liability for renovation or construction of improvements.
However, they may sign the note as a co-signer or guarantor obligated
to pay borrowings which fund the renovation or improvements but
may not be a vested owner of the property until closing;2
1 Biggs v. Commissioner (5th Cir. 1980) 632 F2d 1171
2 Coastal Terminals, Inc. v. United States (4th Cir. 1963) 320 F2d 333
206 Tax Benefits of Ownership, Fourth Edition

• originate purchase-assist financing, or assume loans encumbering the

replacement property on taking title to the replacement property;
• advance at any time any additional funds or properties necessary to
fund the closing of the purchase escrow on the replacement property;
• execute any notes and trust deeds which finance the purchase of the
replacement property;
• assign an interim owner in a parking transaction the investor’s rights
to purchase and possess the replacement property prior to the sale of
the investor’s property, together with the simultaneous entry into a
purchase agreement/escrow to acquire the property from the interim
owner on close of the sales escrow for the property sold; and
• receive all interest earned on the net sales proceeds held by the §1031
trustee, minus trustee fees, the right to receive the interest always
deferred until replacement property is acquired.3

§1031 To assure the investor is able to avoid receipt of net sales proceeds when they
close escrow on the sale of their property, purchase agreement provisions
provisions need to include the buyer’s consent:
included in • to perform under a mutual §1031 cooperation clause [See RPI Form
agreements 159 §10.6]; and
• to enter into supplemental escrow closing instructions to cooperate
to redirect receipt of the seller’s net sales proceeds to a third party
on closing. [See RPI Form 172-2 and Form 173-2 accompanying this
chapter]
For tax reporting, the sale of the investor’s property and the purchase of
replacement property are treated as one complete transaction comprising
two steps, occurring concurrently or over a 180-day period. On completion of
the reinvestment, the tax consequences are calculated based on withdrawal
of any net mortgage boot or cash boot from the property sold and whether
the withdrawals are timed to be offset by the price and terms of payment for
the replacement property. [See Chapter 23]

However, limitations exist on the structure of a §1031 reinvestment plan,

including:
• the investor may not refinance the property they sell as part of a
financing arrangement to implement the §1031 reinvestment plan;
• the investor may have actual and constructive receipt of some, but not
all of the net proceeds from the sale of the property;4
• the investor may not receive interest accruing to their account on the
net sales proceeds held by the §1031 trustee or intermediary until on or
after acquisition of all replacement property;
• the investor must identify the replacement property within 45 days
after close of escrow on the property sold [See Chapter 30];5
3 Starker v. United States (9th Cir. 1979) 602 F2d 1341
4 Carlton v. United States (5th Cir. 1967) 385 F2d 238
5 Internal Revenue Code §1031(a)(3)(A)
 Chapter 25: The delayed purchase of replacement property 207

Form 173-2
SUPPLEMENTAL ESCROW INSTRUCTIONS
§1031 Reinvestment In Lieu of a Cash-Out Sale — Part cash, Part Paper Supplemental
Prepared by: Agent ____________________________ Phone _______________________ Escrow
Broker ____________________________ Email _______________________

NOTE: For use to comply with the general rules for avoidance of actual or constructive receipt of sales proceeds. [IRS
Instructions
Regs. §1.1031 (k)-1(a)]
DATE: _____________, 20______, at ______________________________________________________, California.
To ___________________________________________________________________________________________
______________________________________________________________________________________________
Attention ______________________________________________________________________________________
Escrow No. ____________________________________________________________________________________
Seller ________________________________________________________________________________________
Buyer ________________________________________________________________________________________
§1031 Trustee _________________________________________________________________________________
1. All prior instructions in this escrow and underlying agreements between the parties are amended as follows:
1.1 Seller shall at no time receive cash or paper as consideration for the conveyance of the subject property,
except the sum of $_______________; cash through escrow.
1.2 You are authorized to close this escrow when you cause or confirm that the §1031 Trustee named below,
as Trustee for the Trust entitled: The ____________________________________________________Trust,
holds the following:
a. cash sum of $_______________; and
b. a promissory note in the face amount of $_______________ executed by the Buyer in favor of
the Trustee and secured by a deed of trust on the subject property.
1.3 You are to prepare Seller’s closing statement showing the agreed-to charges and credits to include
“Exchange Valuation Credits” due Seller in the amount of $_______________, in lieu of the disbursements
of items originally provided for in your instructions.
1.4 You are instructed to draft the promissory note and trust deed, which your present instructions call for
the Buyer to execute, to reflect the payee of the note and beneficiary of the trust deed to be:
“ _________________________________________________________________________, as the Trustee,
for The ___________________________________________________________________________Trust.”
Address _______________________________________________________________________________.
a. You are instructed to deliver these documents or cause them to be delivered to the trustee on the close of
escrow.
2. The following are conditions with which escrow need not be concerned:
2.1 Seller intends the sale to qualify as an Internal Revenue Code §1031 transaction, exempt from profit
reporting. The ultimate tax status of the sale provides no consideration for the agreement between
the parties, and failure to qualify under Internal Revenue Code §1031 provides no grounds for rescission.
2.2 Buyer and §1031 Trustee, concurrent with the signing of these instructions, shall execute a declaration of
trust creating a trust to receive and hold as the trust estate the amounts and items delivered to the Trustee
by escrow on the close of this escrow.

See attached Signature Page Addendum. [ft Form 251] See attached Signature Page Addendum. [ft Form 251]
Date: _____________, 20______ Date: _____________, 20______

Seller: ______________________________________ Buyer: ______________________________________

Seller: ______________________________________ Buyer: ______________________________________

Date: _____________ 20______

Trustee: _____________________________________

FORM 173-2 03-11 ©2011 first tuesday, P.O. BOX 20069, RIVERSIDE, CA 92516 (800) 794-0494

• the investor must acquire ownership to the replacement property

within 180 days after close of escrow for the property sold [See Chapter
30];6 and
• the owner may not own both properties concurrently, thus, the title-
parking arrangements.7
The receipt of excess proceeds from any refinancing or equity financing of the
property the investor is selling, or receipt of a portion of the net sales proceeds
prior to acquiring the replacement property is cash boot. Cash prematurely

6 IRC §1031(a)(3)(B)
7 Bezdjian v. Commissioner (9th Cir. 1988) 845 F2d 217
208 Tax Benefits of Ownership, Fourth Edition

withdrawn from the property sold prior to acquiring the replacement

property is treated as profit and cannot be offset on acquiring replacement
property.8

Consider an investor who opens an escrow to purchase a replacement

Escrowing the property.
replacement As the named buyer, the investor approves or disapproves all buyer
property contingencies in the purchase escrow. Contingencies include preliminary
title reports, zoning, new loan commitments, leases and rental operating data,
inventories, termite reports/clearances, structural condition and property
inspections.

The investor fulfill all performance of the purchase agreement and escrow
instructions for acquisition of the replacement property. The §1031 trustee
holding the net sales proceeds from the property sold is instructed by the
investor to deposit the funds in escrow when escrow calls for a wire of funds
to close. The funds are deposited directly into the purchase escrow for the
account of the investor as buyer.

Here, the investor never receives the net sales proceeds used to purchase
the replacement property. Purchase escrow instructions do not permit the
release of funds once deposited into escrow without the signed authorization
from both the seller and the buyer. Thus, the funds deposited directly in the
purchase escrow from the investor’s sales escrow or from the §1031 trustee
avoid constructive receipt of the funds by the investor.

When the §1031 trustee holds the investor’s net sales proceeds, the purchase
price and the cost of any improvements for the replacement property are
funded by the trustee using the proceeds.

Any additional funds required from the investor beyond the amount held
by the trustee may be advanced by the investor. Again, all funds go through
the purchase escrow the investor opened to buy the replacement property,
including any funds remaining that are not needed to close the purchase
escrow.

The investor takes title to the replacement property directly from the seller
of the replacement property. The §1031 trustee, or a facilitator, never need to
hold title or any interest in the replacement property. 9

The policy of title insurance on the replacement property is issued in the

name of the investor, as the buyer and new owner of the property.

Occasionally, funds held by the trustee remain undisbursed on completion of

Unused sales the §1031 transaction. Here, the trustee, after deducting their fee, may deliver
proceeds the remaining funds as well as any interest accrued directly to the investor.

8 Revenue Regulations §1.1031(k)-1(f)]

9 Alderson v. Commissioner (9th Cir. 1963) 317 F2d 790; Revenue Ruling 90-34
 Chapter 25: The delayed purchase of replacement property 209

Receipt of unused funds from the sales proceeds on or after acquiring

replacement property is reported as a cash item received in the §1031
transaction.10

The interest accrued on the sales proceeds held by the §1031 trustee is
separately reported as portfolio category income for the year the interest
accrued.11

10 Rev. Regs. §1.1031(k)-1(f)

11 Rev. Regs. §1.1031(k)-1(h)

§1031 reinvestment plans are structured from the outset for an investor Chapter 25
to sell or exchange one property and acquire another by either purchase
or exchange. For closing these transactions, an investor has a choice Summary
between a concurrent exchange or delayed exchange.

A concurrent exchange is the exchange of one property for another in a

two-way, equity-for-equity transfer of property between two owners. A
delayed exchange is comprised of two independent transactions closing
at different times, one for the sale of the investor’s property and one for
the investor’s purchase of replacement property.

A trustee or intermediary is needed to receive, hold and disburse the net

proceeds in a delayed exchange. The funds must be placed at risk with a
third-party trustee under one of two sets of at-risk rules: general rule and
safe harbor rules. General rule calls for placing the sales proceeds at risk
until the sales proceeds fund the purchase escrow to acquire replacement
property. This approach allows the investor to appoint a §1031 trustee to
receive, hold, and disburse sales proceeds on the investor’s instructions
to fund their purchase of replacement property to close out their §1031
reinvestment plan.

Safe harbor rules, established by regulations, allow the alternative use

of a “qualified intermediary” to facilitate the risk by their receipt of
sales proceeds on closing the sales escrow and hold them for their later
disbursement to fund the closing of the investor’s purchase escrow for
the replacement property.
210 Tax Benefits of Ownership, Fourth Edition

Understanding the limited involvement of a third-party trustee used to

avoid an investor’s actual or constructive receipt of proceeds on the sale
of property in a §1031 reinvestment plan, optimizes the control they
may assert of the acquisition and improvement of like-kind replacement
property.

Chapter 25 §1031 trustee................................................................................. pg. 204

trust account................................................................................. pg. 205
Key Terms
 Chapter 26: Tax deferred installment sale coupled with a §1031 exemption 211

Chapter
26
Tax deferred installment
sale coupled with a
§1031 exemption

After reading this chapter, you will be able to: Learning

• advise clients about the tandem use of exempt and deferred profit
reporting when an installment sale is coupled with a partial §1031
Objectives
reinvestment; and
• discuss the structuring of a carryback note as a regular note to
maximize the amount of profit exempt under §1031 when a
mortgage exists on the property sold.

partial §1031 reinvestment Key Term

Consider an investor who owns and operates an income-producing parcel of Profit tax
improved real estate. Taxwise, the property is classified as both:
deferred and
• like-kind property, qualifying profit on a sale for exemption from taxes
on reinvestment;1 and tax-exempt
• rental property, with income, profit, and losses reported in the passive profit as the
income category.
plan
The investor’s property is encumbered with a mortgage principal balance
greater than the remaining cost basis in the property. Here, the financial
situation is called mortgage-over-basis, the result of refinancing unrelated
to selling the property. On a sale, the amount of the mortgage exceeding the

1 Internal Revenue Code §1031

212 Tax Benefits of Ownership, Fourth Edition

cost basis represents profit. Conceptually, on a cash-out sale, the more the
mortgage balance exceeds the basis the greater the percentage of net sales
proceeds consumed to pay profit taxes.

In a partial §1031 reinvestment plan such as an installment sale or the

withdrawal of cash on closing the sale, part of the profit is not exempt from
taxes. However, taxation of the profit allocated to principal in the carryback
is deferred until principal is received.

Counseling In this scenario, the investor’s objective is to sell the property and invest the
cash proceeds in management-free interest-bearing investments to maintain
your seller a constant flow of monthly income. Alternatively, the investor will take
on listing a income-producing commercial real estate that generates a net spendable
income — but only if the property requires considerably less time and effort
cash-out sale to manage than the residential property being sold.

The investor’s agent in a counseling session determines the investor will

sell on terms that include an appropriate down payment from a buyer and a
carryback note for the balance of the investor’s equity as an acceptable source
of future income.

To meet the investor’s income objectives, the terms of any carryback note
will include monthly installments, ending with a final payoff due date. A
prepayment penalty provision will be included in the note to fund payment
of the profit tax liability the investor will incur on a premature payoff of the
carryback note.

Although the investor does not need to withdraw cash from a sale, a
significant down payment is necessary to shift most of the risk of loss to the
buyer in the event of a default on the carryback note.

Mortgage- Occasionally, due to refinancing, the mortgage encumbering a property

listed for sale exceeds the investor’s cost basis in the property, as in the above
over-basis scenario. Thus, both the net equity in the property and a portion of the
unpaid mortgage balance represent an amount equal to the profit taken on
profit tax the sale. The portion of the mortgage balance not reported as profit represents
reduction the investor’s adjusted cost basis in the property — an untaxed recovery of
invested capital.

The investor who withdraws all the net sales proceeds for their equity on
closing a sale is also relieved of the mortgage debt, whether assumed or
refinanced by the buyer. Further, on a carryback sale with a mortgage-over-
basis situation, the entire amount of a standard carryback note (not an AITD)
is profit, taxed in the year principal payments are received.

The deferred tax result is the same when the cash proceeds from an installment
sale are used to purchase §1031 replacement property – but the allocation of
profit to the carryback is handled differently. [See RPI Form 354.5 §2]
 Chapter 26: Tax deferred installment sale coupled with a §1031 exemption 213

Again, the payment of taxes on the profit allocated to the note is automatically
deferred, shifted for calculation and payment of profit taxes from the year of
the sale to later years when principal is paid on the note.2

The agent advises the investor that an installment sale of their property does Combining
not trigger profit reporting on the sale when:
a carryback
• all the net proceeds from the sale (both the cash and the carryback note)
are used to purchase replacement real estate in a §1031 reinvestment with a §1031
plan; and
• the replacement property is encumbered by debt equal or greater in
amount than the remaining mortgage principal on the property sold.3
A question arises. May an investor, on an installment sale structured as a
tandem IRS §453-§1031 tax avoidance combination, do the following:
• receive, hold, and report the carryback note as an installment sale to
defer taxes on the profit allocated to the note; and
• use some or all of the cash proceeds from the down payment to purchase
replacement property in a §1031 reinvestment plan to exempt profit
not allocated to the carryback note.
The answer? Yes to both! When some or all the cash proceeds from the
carryback sale of property fund the purchase of §1031 property and the
investor retains the carryback note created by the sale, the profit as allocated
is either §453 deferred for later recognition or §1031 exempt from taxes. Thus,
the investor pays no taxes in the year of the sale, except for principal received
in note payments. Here, the tax treatment for the cash and carryback sale
includes:
• installment sale reporting — automatic deferral of taxation — on the
profit allocated to principal in the note; and
• §1031 reporting for all remaining profit as exempt in a §1031 partial §1031
reinvestment.4 reinvestment
A sales transaction
triggering reporting
When an investor receives a carryback note in an installment sale and and taxes of a portion
some or all of the proceeds from the cash down payment are used to acquire of the profit realized on
replacement property, the §1031 reinvestment plan is reported as a partial the sale of property in
an Internal Revenue
§1031 reinvestment. The note carried back and retained by the investor in Code (IRC) §1031
the partial §1031 reinvestment is classified as cash boot. It is not mortgage reinvestment plan
boot since it is an extension of credit, not the lending of money. when less than all
the sales proceeds
are reinvested in
Again, the profit allocated to a carryback note the investor receives on closing replacement property.
is treated as a tax-deferred installment sale.5

2 IRC §453
3 Revenue Regulations §1.1031(d)-2
4 IRC §453(f)(6)
5 IRC §1031(b)
214 Tax Benefits of Ownership, Fourth Edition

Profit In an installment sale, when some or all of the net cash proceeds are used to
purchase property in a §1031 reinvestment plan, all the profit not allocated
allocated to to the carryback note is exempt from taxes under §1031. When cash proceeds
the carryback from a carryback sale are reinvested in a §1031 replacement property, the
profit realized on the sale is allocated as follows:
in a partial • First, calculate the profit taken on the property sold or exchanged
§1031 (remember, price minus basis equals profit) [See RPI Form 354 §3.13];
• Second, allocate profit to the cash reinvested in the property acquired
in the amount of cash reinvested;
• Third, allocate profit to the principal in the carryback note, limited to
the amount of the carryback note;6
• Next, any unallocated profit is tax exempt and automatically reflected
in the value of the property acquired as the remaining cost basis is
carried forward to the property acquired; and
• Finally, adjust the cost basis carried forward to the replacement
property to net out by offsets the debt relief and cash items (carryback
note) withdrawn on the sale.
However, a combined installment sale and partial §1031 reinvestment plan
raises related profit allocation aspects:
• How is the carryback note best structured to minimize the allocation of
profit to the carryback note?
• Is the carryback note best structured as an all-inclusive trust deed
(AITD) note or a regular note to maximize the amount of exempt profit
on the sale?

No AITD in Consider a property sold in a carryback sale with a mortgage-over-basis

situation as in the opening scenario above. The net sales proceeds are not
a mortgage- reinvested in a replacement property. No §1031 aspects exist in this example.
over-basis Here the use of an AITD note to wrap the existing mortgage(s) instead of a
§1031 regular carryback note reduces profit taxes in the year of sale. The profit taxed
in the year of sale is limited to the amount of the cash received on closing
transaction and any principal paid on the AITD note that year.7

And again, in an installment sale, the use of an AITD note maximizes the
allocation of profit to the AITD note while minimizing the profit allocated to
the cash proceeds from the sale.

However, when property sold in a partial §1031 reinvestment plan has a

mortgage-over-basis situation, use of an AITD note becomes a profit tax
disaster — the use of an AITD increases the amount of profit allocated to the
carryback note and that is not a §1031 objective. The AITD automatically
works to reduce the amount of tax-exempt profit in a §1031 reinvestment
plan.

6 IRC §453(f)(6)(A); Rev. Regs. §15a.453-1(b)(2)(iii)

7 Professional Equities, Inc. v. Commissioner (1987) 89 TC 165
 Chapter 26: Tax deferred installment sale coupled with a §1031 exemption 215

Property Owner’s Owner’s Terms Tax Figure 1

sold equity profit of sale aspects
$1M
Tax analysis
on the
Tax
Down property sold
$900K Exempt
Payment
Profit
1 in a combined
§453/§1031
$800K
Basis exceeds
mortgage
$700K Profit
Equity
Profit in
$600K Carryback 2
Carryback Note
Note
$500K

$400K
Capital
in note 3
$300K

$200K Basis Basis

Loan 4
Loan Carried
Assumed
Forward
$100K

1. § 1031 equity used to purchase replacement property.

2. §453 tax deferred profit which is 80% of the principal in the carryback note.
3. Tax free return of capital which is 20% of principal in carryback note.
4. Basis carried forward to the replacement property.

Each column represents a separate set of facts, each column having the $1 ,000,000
sales price as its common factor. The tax exempt profit in Column 4 is tax exempt only
if the loan assumed by the buyer in Column 3 (debt relief) is offset by the owner’s
assumption of equal or greater debt or the contribution of cash items to purchase the
replacement property.

For example, consider a real estate investor who agrees to sell property with
a mortgage-over-basis situation on terms that include:
• a cash down payment;
• the buyer’s assumption/refinance of the existing mortgage; and
• a regular carryback note for the balance of their equity.
216 Tax Benefits of Ownership, Fourth Edition

Figure 2 Property Owner’s Owner’s Terms Tax

sold equity profit of sale aspects
Tax analysis
$1M
on the
property sold Tax
Down
$900K Exempt
in a combined Payment
Profit
1
§453/§1031
$800K Equity
Mortgage
exceeds basis Profit in
Carryback
$700K Profit Carryback 2
Note
Note

$600K
Tax Exempt
Profit to
$500K Replacement 3
Property

$400K

Loan
$300K Loan
Assumed
Basis
$200K Basis Carried 4
Forward

$100K

1. § 1031 equity used to purchase replacement property.

2. §453 tax deferred profit which is 100% of the principal in the carryback note.
3. §1031 rules control, when combined with §453 rules to allow debt relief and the
profit in it to be offset and exempt.
4. Basis carried forward to the replacement property.

Each column represents a separate set of facts, each column having the $1 ,000,000
sales price as its common factor. The tax exempt profit in Column 4 is tax exempt only
if the loan assumed by the buyer in Column 3 (debt relief) is offset by the owner’s
assumption of equal or greater debt or the contribution of cash items to purchase the
replacement property.

Here, the profit the investor realizes on the sale is greater than the investor’s
net equity in the property sold — due to the property’s mortgage-over-basis
situation. On closing the sale, the profit is greater than the investor’s net sales
proceeds (cash and carryback note).

The use of a regular carryback note in a mortgage-over-basis situation

allocates a smaller amount of profit to the regular note than occurs with the
 Chapter 26: Tax deferred installment sale coupled with a §1031 exemption 217

use of an AITD note. While an AITD produces a beneficial tax result in a sale
without a §1031 reinvestment, an AITD produces an adverse tax result in a
§1031 transaction.

In contrast, with use of an AITD note instead of a regular note for the balance
of the equity after the down payment, all profit not allocated to the cash used
to purchase the replacement property is allocated to the AITD note.

Consider an investor who sells real estate for $1,000,000. The property’s
adjusted cost basis is $400,000; the profit $600,000. The existing encumbrance
Calculating
is $300,000; the equity $700,000. profit in
The terms of the buyer’s purchase include: a §1031
• a cash down payment of $200,000; carryback
• assumption or refinance of the existing $300,000 mortgage; and sale
• execution of a $500,000 carryback note payable to the investor.
The investor uses the cash proceeds from the installment sale to purchase
replacement property in a §1031 reinvestment plan. The amount of profit
exempt under §1031 and the amount of profit deferred as allocated to the
carryback note are calculated as follows:
• The profit is $600,000;
• First, allocate profit of $200,000 to the $200,000 cash down payment as
tax exempt, as it is used to purchase the replacement property;
• Next, allocate the remaining $400,000 in profit to the $500,000 carryback
note (Rule: not to exceed the amount of the note).
As you note, $400,000 profit allocated to the $500,000 carryback note sets
a profit ratio of 80%. Thus, 80% of each principal payment received on the
carryback note is reported annually as profit recognized – taxed. The other
20% of all principal payments on the note represents a tax-free return of
invested capital. [See Figure 1]

Now consider the same $1,000,000 property with its $400,000 basis, but due
to refinancing in the past is encumbered with a larger mortgage amount of
$600,000 — the mortgage-over-basis situation.

At the $1,000,000 selling price with a $200,000 cash down payment, the
investor carries back a note in the principal amount of $200,000 to evidence
the balance remaining due for payment of the investor’s $400,000 equity.

Again, to determine exempt profit and allocation of profit to the carryback

note:
• First, deduct the $200,000 cash down payment reinvested in §1031
replacement property from the $600,000 profit on the sale;
• Next, allocate the remaining $400,000 in profit to the principal in the
$200,000 carryback note (but not to exceed the amount of the note);
218 Tax Benefits of Ownership, Fourth Edition

• Thus, the remaining $200,000 of profit unallocated is exempt under

§1031 and not taxed – it is implicitly carried forward to the replacement
property.
100% of each payment of principal on the carryback note is reported as profit,
taxed annually as received. [See Figure 2]

In this mortgage-over-basis situation, had an $800,000 AITD note been carried

back to evidence the balance of the purchase price remaining after the cash
down payment, the amount of profit allocated to the AITD after deducting
the cash used to purchase the replacement property would be less than the
amount of the AITD note. Thus the entire remaining profit is allocated to the
AITD note. No further profit remains to be implicitly carried forward with
the cost basis to the replacement property. Not what an investor wants.

Chapter 26 An investor who owns and operates an income-producing parcel of

improved real estate, taxwise, classifies the property as both like-kind
Summary property and rental property. Like-kind property qualifies profit on
a sale for exemption from taxes on reinvestment and rental property
reports income, profit and losses in the passive income category.

When the investor’s property is encumbered with a mortgage principal

balance greater than the remaining cost basis in the property, this
financial situation is called mortgage-over-basis. Mortgage-over-basis is
the result of refinancing unrelated to selling the property.

On a sale, the amount of the mortgage exceeding the cost basis represents
profit. The portion of the mortgage balance not reported as profit
represents the investor’s adjust cost basis in the property – an untaxed
recovery of invested capital.

The investor who withdraws all the net sales proceeds for their equity
on closing a sale is also relieved of the mortgage debt, whether assumed
or refinanced by the buyer.

Further, on a carryback sale with a mortgage-over-basis situation, the

entire amount of a standard carryback note (not an AITD) is profit, taxed
in the year principal payments are received.

The use of a regular carryback note in a mortgage-over-basis situation

allocates a smaller amount of profit to the regular note than occurs with
the use of an AITD note. While an AITD produces a beneficial tax result
in a sale without a §1031 reinvestment, an AITD produces an adverse
tax results in a §1031 transaction.

Chapter 26 partial §1031 reinvestment ...................................................... pg. 213

Key Term
 Chapter 27: Vacation home sales — talk taxes 219

Chapter
27

Vacation home sales

— talk taxes

After reading this chapter, you will be able to: Learning

• identify allowable deductions for property taxes, mortgage
interest, operating expenses, and depreciation the owner of a
Objectives
vacation home may take to subsidize ownership;
• explain what constitutes personal use of a vacation home and
whether a vacation home qualifies as a passive, portfolio, or trade
or business income category property; and
• advise clients selling a vacation home whether it qualifies as like-
kind property in a §1031 reinvestment plan.

vacation home
Key Term

A vacation home, also known as a second home, is a dwelling unit, such Held for
as a house, apartment, condominium, mobile home, recreational vehicle, or
boat, personally used by the owner or co-owners and their families or friends investment
as a residence other than the owner’s principal residence. The vacation home
may be used by guests who pay rent, also called transient occupants, and
and personal
retain its status as a vacation home. use
Property taxes and interest, accrued and paid on purchase-assist mortgages
secured by a vacation home, are itemized and deducted from the owner’s
adjusted gross income. Property taxes, when combined with other state and
local taxes, are collectively limited to the amount of the standard personal
deduction.
220 Tax Benefits of Ownership, Fourth Edition

vacation home The use of the property and the length of occupancy by the owner or paying
Any dwelling guests does not affect the itemized deduction for mortgage interest.1
unit, such as a
house, apartment, However, the deduction of expenses incurred for repair and maintenance
condominium, mobile
home, recreational of a vacation home is not permitted unless the property is rented to guests
vehicle, or boat, and the amount of expenses deductible is prorated based on the total days of
personally used by the
owner or co-owners
all types of occupancies.
and their families or
friends as a residence Further, depreciation deductions are permitted when the vacation home is
other than the owner’s occupied by paying guests during the year and the owner occupies the unit
principal residence.
for not more than 14 days during the year.

Finally, the owner reports the vacation home income, expenses, and
depreciation in one of the three income categories —passive, portfolio or
trade or business — depending on the nature of occupancies during the year.

Interest Recall that the owner of a first or second home deducts interest accrued and
paid on mortgages, secured by either home, under the mortgage interest
deductions deduction (MID) rules. The MID has a ceiling limiting interest accrued and
for second paid on a combined $750,000 in principal on mortgages used to fund the
purchase or improvement of the home securing the mortgage.2
homes
Interest paid on mortgage balances exceeding $750,000 in principal is not
deductible. [See Chapter 1]

The deduction allowed for interest paid on the first and second home
mortgages is subtracted from the owner’s adjusted gross income. Thus, the
owner reduces their taxable income under both the standard income tax
(SIT) and alternative minimum tax (AMT) reporting rules.

In contrast, the real estate property tax deduction on the first and second
homes only reduces the owner’s taxable income for SIT, not AMT tax liability.
The owner of a vacation home may deduct the full amount of property taxes
they paid from their SIT income, without reduction for having rented the
property for any period. Again property and state tax write offs are limited
by the personal deduction ceiling which is separate from the ceiling for the
MID.3

Deductibility The owner’s deductibility of expenses incurred to repair and maintain the
vacation home is determined by whether:
of expenses • the vacation home is used exclusively by the owner and their
family or friends and is not rented – here, the expenses for repair and
maintenance are not deductible against any income;4

1 Internal Revenue Code §§163(h)(4)(A)(iii), 280A(e)(2)

2 IRC §163(h); IRS News Release 2018-32
3 IRC §164
4 IRC §280A(a)
 Chapter 27: Vacation home sales — talk taxes 221

• the vacation home is rented for not more than 14 days during the
taxable year – here, no expenses may be written off (and the owner
reports no rental income);5 or
• the vacation home is rented for more than 14 days – here, a pro rata
amount of the expenses incurred to operate the vacation home is
deductible, determined as a percentage of the number of days rented
over the number of days occupied for personal use, family or friends
(other than days occupied for property repairs and maintenance). [IRC
§280A(e)]

The days of personal use for setting the percentage of expenses and depreciation
which may be deductible, excludes days during which the owner conducts a
Exception for
full-time schedule of repair and maintenance of the property.6 repairs and
Consider the owner of a vacation home who arrives at the property with maintenance
their family on a Saturday afternoon to stay until the following Saturday.
The primary purpose for the stay is relaxation and the performance of annual
repairs and maintenance to prepare the property for the vacation rental
season. They do no maintenance work on Saturday, the day of arrival. The
owner and their spouse relax the entire week, fishing, walking and visiting
neighbors. They occasionally assist other family members in the maintenance
of the property.

However, some members of the family work on the property full-time each
day, except for the days of arrival and departure. They all leave the following
Saturday.

Here, the mixed use of the vacation home is not treated as personal use — it is
primarily for repairs and maintenance of the property. Tax-wise, none of the
days spent at the property are personal use days.

The owner of a vacation home may take depreciation deductions to recover

the cost of the improvements, unless the owner, their family, or friends
Depreciation
occupy the vacation home during the year for periods totaling more than 14 deductions
days or 10% of the days the property is rented, whichever is greater.7
based on use
Consider the owner of a vacation home who rents it during the year at a fair
rental rate for a total of 140 days or less. The owner, and people who pay less
than fair rent, occupy the property for no more than 14 days. Here, the owner
may take the full amount of the scheduled depreciation deduction.8

However, should the property be rented out for more than 140 days during
the year, the total number of days the owner may personally use the vacation
home without losing the right to depreciation deductions may exceed 14 days,
limited to 10% of the days rented. For example, the owner of a vacation home

5 IRC §280A(g)
6 IRC §280A(d)(2)
7 IRC §280A(d)(1)
8 280A(d)(1)
222 Tax Benefits of Ownership, Fourth Edition

who rents the property 200 days during the year is allowed up to 20 days
of personal use of the vacation home. Owners who exceed their occupancy
limit may not take depreciation deductions on the vacation home.9

For income tax reporting, the owner of a vacation home uses two depreciation
schedules:
• 27.5 years straight-line depreciation for SIT reporting; and
• 40 years straight-line depreciation for AMT reporting.

Vacation The ownership of a vacation home is reported, depending on the owner’s

personal use of the home and the average length of the occupancies of
home paying guests and tenants, as an asset in one of the three income reporting
reporting, categories:

but in which • trade or business;

• passive/rental; or
income
• portfolio/investment.
category?
A vacation rental property is reported as a trade or business income category
asset when the owner, their family or friends do not occupy it at any time
but manage the property as a vacation rental. Here, the owner or their agent
takes reservations from guests under occupancy agreements with an average
period of occupancy 30 days or less. As a trade or business asset, the owner
reports the income, expenses, interest, and depreciation for the vacation
rental property as they would for a motel, inn, or hotel operation.

Conversely, a vacation home personally used for any period during the
year is not classified as a trade or business category asset, even when guests
renting the property are transient occupants with an average occupancy of
30 days or less.10

When the vacation home is sometimes used by the owner, family, friends,
and at other times rented to tenants or guests, the ownership of the home is
reported as either:
• a rental property in the passive income category; or
• an investment property in the portfolio income category.
To be a rental property, the vacation home income needs to be occupied by
tenants for periods more than 30 days on average. Typically, a residential
month-to-month rental agreement is used to document the tenant’s
agreement to pay rent. When the average figure for different occupancies
during the year is 30 days or less, the vacation home is not a passive income
category property.

Thus, vacation homes occupied by transient occupants for periods of several

days to a week or two, under a guest occupancy agreement, disqualify the
property for passive income category treatment as it is a trade or business
asset due to average occupancy (if family and friends never occupy).
9 IRC §§163(h)(4)(A)(i)(II)
10 Revenue Regulations §1.469-1T(e)(3)(ii)(B)
 Chapter 27: Vacation home sales — talk taxes 223

However, when a capital asset is held for investment, such as a vacation

home personally used by the owner, their family and friends, and at other
times used to generate income under reservation agreements with transient
occupants, its income and expenses are reported in the portfolio income
category.

Consider the buyer of a vacation home who purchases the property for the
personal use of family and friends. The owner’s intent is to own and enjoy
A vacation
the property until it is no longer of use as a vacation home. home as
Having acquired ownership of the vacation home, the owner is now working §1031
with an agent to buy another, more expensive vacation home in a different property
recreational area of more interest to their family members. The owner informs
the agent they are in escrow on the sale of their current vacation home. They
are taking a profit and are unsure of the tax consequences of selling and
buying these properties.

The owner is aware they may avoid profit taxes under:

• the $250,000 principal residence profit exclusion for each owner or
occupant;11 and
• the §1031 profit tax exemption for the sale of property held for
investment, when sold as part of a §1031 reinvestment plan.
However, the owner is unaware of any method of tax avoidance for profits
from the sale of a vacation home that the owner and their family enjoyed
intermittently for personal use and rented on occasion. The owner asks their
agent what they know about the profit tax situation on a vacation home.

The broker points out that the personal use of a vacation home by the family
and friends to enjoy is not a factor in the property’s tax status. Rather, the
intention to hold the vacation home for eventual resale at a profit establishes
the vacation home as an investment in a capital asset held for profit in the
portfolio income category — and thus it is §1031 like-kind property.

The owner erroneously believed their personal use of the vacation home did
not qualify the property as like kind for a §1031 reinvestment plan.

Here, the vacation home was never intended to be retained in the family as
property held in trust, such as a retreat estate made available for the personal
use of succeeding generations. Thus, a vacation home used exclusively or
primarily for personal use and held as an investment for eventual resale
may be sold as part of a §1031 reinvestment plan to acquire a replacement
vacation home or any other §1031 like-kind property.12

11 IRC §121
12 IRC §1031(a); IRS Private Letter Ruling 8103117]
224 Tax Benefits of Ownership, Fourth Edition

Chapter 27 A vacation home, also known as a second home, is a dwelling unit,

such as a house, apartment, condominium, mobile home, recreational
Summary vehicle, or boat, personally used by the owner or co-owners and their
families or friends as a residence other than the owner’s principal
residence.

To retain its status as a vacation home, it may be used by guests who

pay rent, also called transient occupants. Property taxes and interest,
accrued and paid on purchase-assist mortgages secured by a vacation
home, are deductible from the owner’s adjusted gross income.

The use of the property and the length of occupancy by the owner or
paying guests does not affect the amount the deductions for property
taxes or interest. The deduction of expenses incurred for repair and
maintenance of a vacation home is not permitted unless the property
is rented to guests and the amount of expenses deductible is prorated
based on the total days of all occupancies.

Depreciation deductions are permitted when the vacation home has

been occupied by paying guests during the year and the owner occupies
the unit for less than 15 days.

The ownership of a vacation home is reported, depending on the owner’s

personal use of the home and the average length of the occupancies
of paying guests and tenants, as an asset in one of the three income
reporting categories – passive, portfolio or trade or business.

Chapter 27 vacation home.............................................................................. pg. 220

Key Term
 Chapter 28: A delay in the §1031 reinvestment 225

Chapter
28
A delay in the §1031
reinvestment

After reading this chapter, you will be able to: Learning

• advise clients regarding the concurrent running of time periods
and the notices to be prepared for identifying and acquiring
Objectives
replacement property in a delayed §1031 reinvestment.

incidental property tenants in common (TIC) Key Terms

reverse §1031 transaction

Consider an investor who enters into a purchase agreement to sell business- Identification
use or investment real estate they no longer want. The agreement negotiated
by the investor’s agent provides for a 90-day escrow period. The purchase and
agreement contains boilerplate provisions which are activated calling for:
acquisition
• the buyer’s cooperation with the funding of the investor’s §1031
reinvestment plan; and
periods run
• the investor’s location of replacement property as a condition for from closing
closing escrow.
The agent confirms they are to coordinate the sale of exchange of the
investor’s with the investor’s purchase of replacement property to achieve tenants in common
(TIC)
the investor’s tax objective — the exemption of profit on the sale from taxes. Co-ownership of real
estate by two or more
The agent locates replacement property and the investor enters into a persons, who each
purchase agreement with the property’s co-owners, a tenants in common hold equal or unequal
undivided interest,
(TIC) investment group. The separate escrows for the property sold and the without the right of
survivorship.
226 Tax Benefits of Ownership, Fourth Edition

replacement property are scheduled to close concurrently. The investor’s sales

proceeds will be transferred directly from the sales escrow to the purchase
escrow, funding the down payment on the replacement property.

However, one of the TIC co-owners dies before signing the deed to transfer
the replacement property to the investor. Title to the deceased co-owner’s
interest has not yet been cleared for conveyance to the investor.

The investor does not want to waive the condition for closing requiring
replacement property to be located until title to the replacement property
can be conveyed and a title insurance policy issued for conveyance of fee
simple by all co-owners.

No As the deadline for closing both escrows draws near, it is evident title to the
replacement property cannot be cleared in time for the purchase escrow for
concurrent the replacement property to close as scheduled. Thus, a concurrent closing
closing of of the sales escrow and the purchase escrow will not be possible without an
extension of closing dates. The investor considers waiving the purchase-of-
the sales and other-property contingency and closing escrow on the sale of their property
before the escrow for the replacement property can close.
purchase
escrow Here, the risk of losing the 1031 exemption arises when the investor closes
escrow on the property sold before the purchase escrow for the replacement
property can close. When title to the replacement property is not delivered
within 180 days after the close of the investor’s sales escrow, the profit on the
sale will not qualify for the §1031 exemption.

The investor’s real estate attorney on investigating the conveyancing advises

that the delay in clearing title is temporary and no other foreseeable obstacles
exist to prevent the transfer of title and the issuance of title insurance in the
next few weeks.

To waive the condition regarding the location of other property and close
escrow on the property sold, the investor is now involved in a delayed §1031
reinvestment. The result is the investor closes escrow on the sale of one
property and later acquires ownership of the replacement property.

The investor is still engaged in two mutually exclusive transactions, they

just are not closing concurrently. The delayed closing of the purchase escrow
does not prudently allow for the direct transfer of the investor’s funds from
one escrow to another in the belief the purchase escrow will close. Funds
ought not be deposited for closing in a purchase escrow until escrow calls for
closing funds.

So, what happens to the investor’s sales proceeds?

To qualify the investor’s profit for the §1031 exemption when the purchase
escrow for the replacement property cannot be closed concurrent with the
investor’s sales escrow, the investor needs to:
• prepare mutual closing instructions directing the sales escrow to
hand the investor’s net proceeds to a 1031 trustee, commonly called a
facilitator [See Chapters 25 and 26];
 Chapter 28: A delay in the §1031 reinvestment 227

• prepare mutual closing instructions directing the sales escrow to

credit the investor in the closing settlement statement with Exchange
Valuation Credits (EVCs) in lieu of a check from escrow for the net sales
proceeds;
• select an entity or individual the investor knows and trusts to be
appointed as the trustee under a 1031 trust agreement the buyer is to
execute for receiving and holding the investor’s net proceeds from the
sale for funding the investor’s purchase of replacement property;
• identify the replacement property plus two alternative replacement
properties within 45 days after closing the sales escrow [See Form 174
accompanying this chapter]; and
• close escrow on the purchase of a replacement property within 180
days after the sales escrow closes.
The investor decides the risk for failure to timely close the purchase escrow
is sufficiently minimal to justify waiving their purchase-of-other-property
contingency.

Again, the 180-day reinvestment period includes the 45-day identification

period. Both commence on the day escrow closes for the property sold and
run concurrently but for different lengths of time.1

When an investor fails to comply with either the identification or

reinvestment deadlines, any property acquired outside these parameters
will not qualify as replacement property under §1031. Thus, some or all the
profit in the property sold will not be exempt from taxes under §1031.2

Further, when an investor sells two or more properties and consolidates

their net sales proceeds into one replacement property, the identification
and acquisition periods run from the closing date of the first property sold.3

An investor processing a delayed §1031 reinvestment plan identifies the Replacement

replacement property to be acquired, in writing, by midnight on the 45th day
after the date the sales escrow closes on the property sold. Day one is the day property
after the date escrow closes.4 identification
Replacement property when ownership is acquired within the 45-day period
identification period is treated as identified without further documentation
on a §1031 property identification form.5

Thus, an investor may avoid the identification process entirely by closing the
purchase escrow(s) on all replacement property within the 45-day period.

1 Internal Revenue Code §1031(a)(3)

2 Revenue Regulations §1.1031(k)-1(a)
3 Rev. Regs. §1.1031(k)-1(b)(2)(iii)
4 Rev. Regs. §1.1031(k)-1(b)(2)(i)
5 Rev. Regs. §1.1031(k)-1(c)(1)
228 Tax Benefits of Ownership, Fourth Edition

Form 174
§1031 PROPERTY IDENTIFICATION STATEMENT

§1031 Property
For Delayed §1031 Transactions

Prepared by: Agent

Identification
Phone
Broker Email

Statement NOTE: This form is used by a seller's agent when a seller in a delayed §1031 reinvestment plan locates suitable
replacement property(ies) within 45 days after closing a sale of property, to prepare the notice needed to identify suitable
replacement property(ies) to be acquired within 180 days of closing the sale.
DATE: , 20 , at , California.
FACTS:
This is an addendum to the following agreement:
� Sales escrow instrustions
�
dated , 20 , at , California.
with escrow company,
entered into by , as the Seller/Taxpayer,
and , as the Buyer or Buyer's Trustee,
regarding replacement of real estate referred to as
.
TO ESCROW: This addendum is intended to comply with Internal Revenue Code §1031(a)(3)(A) within 45 days after
closing the sale by identifying property to be received to complete a §1031 reinvestment plan.
DECLARATION:
One or more of the following properties will be purchased to complete the terms of the above-referenced agreement.
1. ($ )
2. ($ )
3. ($ )

4. ($ )
5. ($ )
6. ($ )
7. ($ )

NOTE: If four or more properties are identified within the 45-day identification period, the fair market value of each
property identified or previously contracted for or received must be listed and comply with the 200% aggregate-value rule
or the 95%-of-value acquisition rule. [Rev. Regs. §§1.1031(c)-3(c)(4)(i), (ii)]
Escrow Officer: Seller/Taxpayer:
Receipt is hereby acknowledged. I hereby submit the above.
Date: , 20 Date: , 20
Name: Name:

Signature: Signature:
Address: Name:

Phone: Cell:
Email:
Signature:
Address:

Phone: Cell:
Email:

FORM 174 03-11 ©2015 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517

The failure to acquire ownership of multiple replacement property within

the 45-day identification period compels the investor to prepare, sign, and
deliver a written §1031 property identification statement within the 45-day
period to either:
• the owner who is conveying the replacement property to the investor;
or
• any entity or individual involved in the §1031 transaction, except the
investor or disqualified persons.6 [See RPI Form 174]

6 Rev. Regs. §1.1031(k)-1(c)(2)

 Chapter 28: A delay in the §1031 reinvestment 229

Although the sales escrow has already closed, the identification statement
may be delivered to the escrow agent or title company involved in the sale
of the investor’s property.

Consider a real estate agent who lists investment real estate for sale. When Persons to be
listing the property, the investor advises the agent they intend for the sale of
the property to be the first leg of a §1031 reinvestment plan. notified of the
During the previous 12 months, the agent has acted as the investor’s agent identification
in real estate transactions. All sales and purchases handled by the agent on
behalf of the investor relate to §1031 transactions.

Is the agent qualified to receive the property identification statement?

Yes! Persons disqualified (DQed) for receipt of the property identification notice
include only those real estate agents, attorneys, employees, accountants and
investment bankers who, within two years prior to the closing of escrow
on the property sold, performed any professional services on behalf of the
investor that were not part of a §1031 transaction.

Since the agent’s activities as the investor’s agent only consisted of

§1031-related transactions, the agent is qualified to receive an identification
statement.7

Financial institutions, title insurance companies or escrow companies that

perform routine financial, title insurance, escrow or trust services for the
investor are also qualified to receive an identification statement, even when
those services are unrelated to §1031 transactions.8

Persons disqualified to receive the property identification notice include:

• close family members, including half-siblings, spouses, ancestors, and
lineal descendants; and
• a corporation or partnership in which the investor or the investor’s
agents own more than 10% of outstanding stock, capital interest or
profit-sharing interest.9
To avoid qualification issues, the investor delivers the identification form to
the escrow office or title company that handled the closing on the property
sold, not the escrow or title company they intend to use for the replacement
property (although it is proper to do so). A cover letter advising them where
to file the identification form is appropriate, so the notice is not misplaced on
receipt.

The identification form need not be delivered to the buyer’s §1031 trustee.
While the trustee may be an unrelated person, they may well be a disqualified
person such as the investor’s personal attorney, CPA or investment banker
who rendered services unrelated to the investor’s §1031 transactions.

7 Rev. Regs. §1.1031(k)-1(k)(2)

8 Rev. Regs. §1.1031(k)-1(k)(2)(ii)
9 Rev. Regs. §1.1031(k)-1(k)(3)
230 Tax Benefits of Ownership, Fourth Edition

Location and Written identification of the selected replacement properties includes the
legal description and street address, or assessor’s number of each property
quantity of identified.10
properties The investor may identify more than one replacement property. However,
identified the number of potential replacement properties identified places different
limitations on which identified properties the investor may or must acquire,
such as:
• when identifying three or fewer properties, regardless of their value,
any one or more may be purchased;
• when identifying four or more properties and the total of the combined
values of all properties identified does not exceed twice the price
received for the property sold, any one or more may be purchased; or
• when identifying four or more properties, and the combined value of
all properties exceeds twice the price received for the property sold, the
investor is required to purchase 95% of the total value of all replacement
properties identified to qualify for the §1031 profit tax exemption (an
absurdity).
The investor who identifies four or more properties when their combined
values exceed the 200% value ceiling and then does not purchase 95% of the
total value of all replacement properties identified, no properties identified
and purchased qualify as a replacement property. The 95% acquisition
requirement renders the use of this condition unlikely as highly improbable
to be attained, unless all identified properties have one owner and the status
of title is not an issue – such as a group of SFRs, fourplexes or small industrial
buildings.11

Included automatically to determine the number of properties identified are

any replacement properties the investor acquires ownership to during the
45-day identification period.

For example, consider an investor who closes escrow on their purchase of a

replacement property within the 45-day identification period. The price paid
for it is less than the price the investor received for the real estate they sold.
Thus, the amount of mortgage debt or equity in the property purchased, or
both does not fully offset the debt and equity in the property sold to exempt
all profit on the sale from taxes.

To complete a fully exempt profit under §1031, the investor needs to purchase
an additional replacement property using the funds remaining from their
sale.

10 Rev. Regs. §1.1031(k)-1(c)(3)

11 Rev. Regs. §1.1031(k)-1(c)(4)(ii)
 Chapter 28: A delay in the §1031 reinvestment 231

Here, the replacement property acquired during the identification period is

automatically included as one of the properties identified. Thus, the investor
who acquires property within 45 days of closing escrow on the property sold
is limited after the 45 days to either:
• identifying two additional replacement properties (for a total of three
as the acquired property is automatically included) of any combined
fair market value (FMV) and purchase one, both or neither additionally
identified properties; or
• identifying three or more additional properties whose total values
(including the value of the replacement property already purchased)
do not collectively exceed twice the price the investor received for
the property sold and purchase any or none of the newly identified
properties.12
The investor who is in escrow to purchase a replacement property before
the running of the 45-day period, but not scheduled to close until after
the identification period expires includes it as one of the three properties
identified.

Replacement property with improvements to be constructed prior to closing Identification

under a purchase agreement, option, or escrow instructions qualifies as §1031
property. in the case of
Further, the property identification form while including a legal description construction
or parcel number for the real estate needs to include an adequate reference
to existing plans and specifications for the improvements to be constructed
on the identified parcel.13

When substantial changes in construction deviate from the plans and

specifications in the identification notice and those changes produce a
structure for an entirely different use than the one identified (an apartment
versus a mini-storage facility, for example), the replacement property with
improperly identified construction will not be considered substantially the
same property.14

Consider an investor who purchases an apartment building as replacement

property in a §1031 reinvestment plan. The purchase price includes personal
The 15%
property transferred by bill of sale such as furnishings, washing machines incidental
and maintenance equipment located on the property. The fair market value
of the personal property does not exceed 15% of the portion of the price personal
allocated to the real estate. property rule
Is the investor required to list the personal property as part of the replacement
property on the 45-day §1031 property identification form?

12 Rev. Regs. §1.1031(k)-1(c)(4)(iii)

13 Rev. Regs. §1.1031(k)-1(e)(2)
14 Rev. Regs. §1.1031(k)-1(e)(3)(i)
232 Tax Benefits of Ownership, Fourth Edition

incidental property No! Personal property used in the operations of real estate — called
Personal property used incidental property — is considered included with the legal description of
in the operation and the replacement property on the identification form unless the market value
management of real
estate. of the personal property exceeds 15% of the separate value of the real estate.
This rule typically applies to hotels, motels, transient housing, and fully
furnished apartments.15

Also, when personal property valued at a figure within the 15% incidental
property rule is acquired as part of the purchase of a replacement property,
the value of the personal property is not reported as cash boot received in the
§1031 reinvestment plan.

Consider an investor who locates three suitable replacement properties for

Revoking an purchase to complete a §1031 reinvestment. The investor prepares a property
identification identification notice listing the three properties and sends it to the §1031
trustee.
statement on
modification Before the end of the 45-day identification period, the investor locates further
potential replacement properties that are more suitable. The investor sends
another, entirely new identification form to the §1031 trustee, listing three
of the newly located properties substituting these to replace the properties
originally identified.

To accomplish the substitution, the new identification form contains a

provision revoking the prior notice which identified replacement properties.

Does the investor need to comply with the 200% value rule since a total of six
properties have now been identified?

No! The investor revokes the first identification of replacement properties

by including a provision revoking the prior identification statement in the
statement identifying the newly located replacement properties. Critically,
the new statement and revocation is delivered to the same person who
received the initial property identification statement. Oral revocation or
merely identifying more properties does not revoke prior identifications.16

The investor may revoke a notice of identification of replacement property

and identify different properties at any time before the 45-day identification
period runs.

When identifying replacement property, ownership of the replacement

The 180-day property needs to be acquired within the 180-day §1031 reinvestment period
acquisition — also called the delayed exchange period. The period for acquiring the
replacement property by closing the purchase escrow ends on the earlier of:
period after
• 180 days after the date escrow closed on the sale of the property the
closing the investor originally sold;
sale • the date the taxpayer files their return for the year of the sale for the
property sold; or
15 Rev. Regs. §1.1031(k)-1(c)(5)
16 Rev. Regs. §1.1031(k)-1(c)(6)
 Chapter 28: A delay in the §1031 reinvestment 233

• the scheduled due date for filing the investor’s tax return for the year of
the sale, including any extensions.
For example, consider the sale of real estate with a profit the investor intends
to exempt in a §1031 reinvestment plan. Escrow closes on December 22. The
investor’s federal income tax return for the year in which the property was
sold is due the following April 15 — less than 180 days after closing on the
property sold.

The investor files their return on April 15, before acquiring ownership of
the replacement property. The investor takes ownership of the replacement
property within the 180-day reinvestment period following the close of the
escrow on the property sold. As a result, the investor’s tax return is amended
to report the acquisition and closing out of their §1031 reinvestment plan.

The IRS claims the profit on the sale of the property does not qualify for the
§1031 tax exemption. The investor failed to acquire the real estate prior to
filing their tax return for the year of the sale. Thus, the reinvestment period
expired before the investor acquired the replacement property.

The investor claims the reinvestment period ended on June 20, not April 15,
since they were entitled to an automatic six-month extension for filing of
their tax return for the year of the sale, whether or not they filed a return on
April 15.

Does the transaction qualify for the exemption?

No! The investor needed to extend their tax return filing date to take
advantage of the entire 180-day reinvestment period.

The investor closed out their tax year (and their §1031 reinvestment plan)
simply by filing their return. When filing, they were unable to couple the sale
of their property, which was reported on their tax return, with the transfer
of its basis to the replacement property, which was not reported. They had
not yet acquired the replacement property and improperly filed their return
without the linkage needed to carry forward the basis from the property sold
to the replacement property.

To avoid profit reporting, the investor needed to file for the automatic six-
month extension (and pay any taxes due), not their tax return. Thus, by the
filing for the extension the reinvestment period ends midnight of June 20,
180 days after the sale of the investor’s property, before the extended due date
for filing their return.17

After the 45-day period during which property is identified (but not acquired), Basic
and before the 180-day reinvestment period expires, the investor needs to
acquire ownership to substantially the same property as the property character
identified in the 45-day notice.18 of property
acquired
17 Rev. Regs. §1.1031(k)-1(b)(3)
18 Rev. Regs. §1.1031(k)-1(d)(1)(ii)
234 Tax Benefits of Ownership, Fourth Edition

For example, consider an investor who identifies an unimproved parcel of

real estate in their 45-day notice as replacement property. Before expiration
of the reinvestment period — and before they close escrow on the purchase of
the replacement property — the investor constructs a fence on the periphery
of the property.

On closing, the investor receives substantially the same property as the

property identified, even though they made minor improvements before
closing escrow and acquiring title. The fence does not change the basic
character of the parcel of real estate identified as the replacement property.19

Now consider an investor who identifies 20 acres of unimproved real estate

with a fair market value of $2,500,000 as the replacement property. The
investor ultimately purchases only 15 acres of the real estate for $1,875,000.

Here, the property acquired is substantially the same property they identified.
As in the previous example, the character of the property does not change by
acquiring only a portion of the property identified. The investor purchased
75% of the property identified at 75% of the fair market value of the whole.20

For a further example, consider an investor who identifies a parcel of real

estate including a description of improvements to be constructed before
acquiring ownership. However, construction will not be finished when
the 180-day reinvestment period expires. The investor closes escrow within
the 180 period and takes ownership of the property before construction is
complete.

Here, the real estate is still substantially the same real estate as the property
identified. The improvements, to the extent they exist, are the same
improvements the investor identified in the 45-day notice — just not all of
them.21

However, the value of improvements constructed after the investor closes

escrow is not part of the price paid (or debt assumed) for §1031 purposes. Thus,
the value of the portion of the construction not yet completed is not part of
the debt or equity in the replacement property. The value of the portion of
the improvements not yet completed does not exist at the time of closing.
Thus, they are not part of the value received in the replacement property on
closing.22

An extension exists for meeting §1031 reinvestment deadlines interrupted

120-day by a disaster.
extensions
The disaster may have been a tsunami, earthquake, wildfire, drought, flood,
for disaster or be brought about by a terrorist or military action. The President of the
relief United States needs to declare the area affected a disaster area.

19 Rev. Regs. §1.1031(k)-1(d)(2), Example 2

20 Rev. Regs. §1.1031(k)-1(d)(2), Example 4
21 Rev. Regs. §1.1031(k)-1(e)(3)(iii)
22 Rev. Regs. §1.1031(k)-1(e)(5)(iii)
 Chapter 28: A delay in the §1031 reinvestment 235

When declared, the IRS publishes a Notice or News Release extending the
45-day identification and §1031 reinvestment deadlines, stating the duration
of the extension (called a postponement by the IRS) and the location of the
disaster area.

To qualify for the 120-day disaster extension, an investor involved in a §1031

reinvestment plan needs to be affected by one of the following situations:
Qualifying for
• the investor’s principal residence or their place of business is located
an extension
within the area covered by the IRS Notice or News Release; or
• the investor has difficulty meeting their §1031 deadlines due to the
disaster for one of the following reasons:
° either an identified replacement property or, in a reverse
exchange under safe harbor rules, the property to be sold, is
located within the disaster area;
° the principal place of business of any individual or person
connected to the §1031 transaction, such as an intermediary,
buyer, seller, attorney, mortgage holder, escrow, or title
company is located within the disaster area;
° any individual or employer connected to the §1031 transaction
was killed, injured, or went missing as a result of the disaster;
° a document prepared in connection with the §1031 transactions
or a relevant title record was destroyed, damaged, or lost as a
result of the disaster;
° a mortgage holder decides not to fund a closing, permanently
or temporarily, due to the disaster or a disaster-related
unavailability of hazard insurance; or
° a title insurance company refuses to issue a policy due to the
disaster.
The 120-day postponement in transactions affected by the disaster applies to
§1031 deadlines running on or after the disaster’s occurrence, and to 45-day
identification periods which ran before the disaster.

The 120-day disaster extension does not apply to the investor’s tax return for
the year of the sale. But to qualify for the §1031 extension the investor needs
to obtain extensions and file their tax return only after replacement property
is acquired.

When the investor is in a reverse §1031 transaction — also known as a reverse §1031
parking transaction — and a disaster occurs after acquisition of replacement transaction
An Internal Revenue
property, but before closing a sale on the property identified to be sold, the Code (IRC) §1031
investor may apply the 120-day disaster extension to these deadlines: transaction in which
an investor controls
• the five-business day period expiration date for entry into an interim title to replacement
property before
title-holding agreement with a qualified intermediary;
disposing of the
• the 45-day identification period expiration date for the property to be property to be sold.
Also called a parking
sold; transaction.
236 Tax Benefits of Ownership, Fourth Edition

• the 180-day period expiration date for the sale of the property identified;
and
• the 180-day combined time period expiration date for the qualified
intermediary to release the replacement property and property to be
sold.
Now consider a disaster which occurs after the expiration of a 45-day
identification period. A property identified was substantially damaged. The
property needs reconstruction or repair, or another property needs to be
substituted for it in a new notice of property identification.

Here, the investor may use the 120-day disaster extension to identify other
properties by:
1. revoking the original notice of property identification (which listed
the substantially damaged property); and
2. preparing a new identification notice.
The investor needs to deliver the new notice and revocation to the appropriate
person prior to expiration of the additional 120 days.23

23 Revenue Procedure 2004-13 as modified by IRS Notice 2005-3

Chapter 28 When a concurrent closing of the sales escrow and the purchase escrow
will not be possible without an extension of closing dates, an investor
Summary finds themselves in a delayed §1031 transaction. In a delayed §1031
transaction, the investor closes escrow on the sale of one property and
later acquires ownership of the replacement property.

The investor is still engaged in two mutually exclusive transactions, they

just are not closing concurrently. However, the 180-day reinvestment
period and the 45-day identification period deadlines run concurrently
from the close of sale.

Failure to comply with either the identification or reinvestment

deadlines, any property acquired outside these parameters will not
qualify as replacement property under §1031. Replacement property
when ownership is acquired within the 45-day identification period is
treated as identified without further documentation on a §1031 property
identification form.
 Chapter 28: A delay in the §1031 reinvestment 237

When ownership of any replacement property is to be acquired after

the 45-day identification period, the investor needs to sign and deliver
a written §1031 property identification statement within the 45-day
period

incidental property ................................................................... pg. 232 Chapter 28

reverse §1031 transaction......................................................... pg. 235
Key Term
tenants in common (TIC)........................................................... pg. 225
Notes:
 Chapter 29: The §1031 trustee in a delayed reinvestment 239

Chapter
29
The §1031 trustee in a
delayed reinvestment

After reading this chapter, you will be able to: Learning

• understand the use of a §1031 trustee to receive, hold, and disburse
proceeds from the sale of a property under the general rules for the
Objectives
seller to avoid receipt of sales proceeds in a §1031 reinvestment
plan; and
• identify persons who qualify to act as a §1031 trustee.

deferred exchange corporation Key Term

Recall that an investor orchestrates a concurrent closing of a sales escrow for Control
the property sold and a purchase escrow for the replacement property in a
§1031 transaction when the investor: over the
• is in escrow for their sale of a property; disbursement
• locates and opens a purchase escrow to acquire replacement property; of funds
• coordinates the closing of both the sales escrow and the purchase
escrow on or about the same date; and
• authorizes by mutual escrow instruction the transfer by escrow of the
sales proceeds from the property sold directly to the purchase escrow
for the account of the investor.
Thus, due to the relatively concurrent closing of both the sales and purchase
escrows and the transfer of funds between escrows, the sales proceeds remain
contractually beyond receipt by the investor on demand. Thus, a 1031 trustee
is not needed to hold the sales proceeds.
240 Tax Benefits of Ownership, Fourth Edition

Because of this direct transfer between escrow accounts, the investor avoids
actual or constructive receipt of the proceeds from the property sold. At all
times, the funds are held in one or another bilateral escrow. Accordingly, all
participants are required to enter into any release of funds to the investor.

Typically, concurrent closings are not often possible. The closing date for a
sales escrow frequently arrives before the investor locates a replacement
property, contracts to purchase it, eliminate contingencies, and has a
purchase escrow ready to close on replacement property.

Without concurrent closings, the sales escrow is instructed to deposit the

investor’s sales proceeds with a §1031 trustee. The trustee will hold and
disburse the funds under the terms of a trust agreement entered into by the
buyer of the investor’s property. The trustee receives and holds the sales
proceeds until the investor is able to close on the purchase of the replacement
property and complete the reinvestment. [See RPI Form 172-4]

Further, the settlement closing statement for the sales escrow will credit the
investor with Exchange Valuation Credits (EVCs) in lieu of a “check herewith”
for the sales proceeds. [See RPI Form 172-2 §1.3]

After the sales escrow closes, the buyer of the investor’s property is no longer
involved in the investor’s reinvestment plan. On receipt of the sales proceeds,
the §1031 trustee carries out the buyer’s duty under the §1031 cooperation
provision in the purchase agreement to fund the purchase escrow for the
replacement property.

The investor’s control and access to the funds held by the trustee is limited to
directing the trustee to disburse the sales proceeds to the investor’s account in
the purchase escrow opened to fund the closing for the replacement property
selected by the investor. [See RPI Form 172-3]

Consider a buyer of §1031 property who does not agree to a contingency

A §1031 provision in the purchase agreement conditioning closing on the purchase
trustee of other property. Such a contingency provision allows the investor to first
locate a suitable replacement property for acquisition. When a replacement
acts as a property is not located by the scheduled date for closing, the investor has the
facilitator right to either cancel the sale or extend the closing date until replacement
property is located.

However, the buyer does agree to a boilerplate §1031 cooperation clause for
the disbursement of funds to meet the investor’s objective of accomplishing
a §1031 reinvestment, whether by a concurrent or delayed closing.

The investor advises escrow the sale will be the first leg of a delayed §1031
reinvestment plan. Thus, mutual closing instructions need to accommodate
the transfer of their sales proceeds to a §1031 trustee.
 Chapter 29: The §1031 trustee in a delayed reinvestment 241

The escrow officer informs the investor about the escrow company’s deferred exchange
affiliated deferred exchange corporation. It acts under safe harbor rules corporation
as a facilitator in delayed acquisitions of replacement property to ensure the A corporate facilitator
retained to act as a
seller avoids receipt of the sales proceeds. trustee in a delayed
§1031 transaction
The escrow officer then explains the sale, the impounding of funds and the to receive, hold and
disburse proceeds from
purchase of the replacement property can all be handled out of the same the sale of a property
escrow office to ensure compliance with §1031 rules for avoiding the receipt under safe harbor rules
of the sales proceeds. for the seller to avoid
receipt of their sales
proceeds.
Does the investor need to use a deferred exchange corporation, whether or
not it is affiliated with the escrow company, to avoid actual or constructive
receipt of the net sales proceeds?

No, but they may! Under the general rules for avoidance of receipt of sales
proceeds, the investor is free to select their §1031 trustee, as well as a different
escrow company to handle documents and instruments for the purchase of
replacement property.

However, the investor may not use an entity controlled by the investor or
any person – individual or entity – considered to be related to the investor as
the §1031 trustee.1

The investor’s attorney, accountant or broker may act as the trustee when
the buyer, not the investor, establishes the trust. Thus, the trustee holds the
sales proceeds as the agent of the buyer, not the investor, with authorization
limited to funding a purchase escrow on instructions from the investor.2

Deferred exchange corporations claiming to be facilitators often present The risk with
themselves as “§1031 specialists” with expert analysis and creative handling.
unregulated
However, these corporations are separate from the licensed activity of the
escrow company that might recommend their use. California licensees who facilitators
operate an affiliated “facilitator business” do not act in the capacity of a
licensed real estate broker or independent escrow agent.

Despite a deferred exchange corporation’s “affiliation” with an escrow or

brokerage office, they are not part of an escrow transaction covered for losses
by the Escrow Agents’ Fidelity Corporation (EAFC).

In fact, when they do not act under an agreement that establishes a trust
for their holding of the funds as a trustee, facilitators may commingle §1031
funds in their general accounts.

A prudent investor will use a regulated, bonded, or insured entity, such as a

title company, bank or thrift, or select an individual the investor knows to be
trustworthy to act as a §1031 trustee. Otherwise, the investor risks losing their
funds to an incompetent individual or entity.

1 Internal Revenue Code §§267(b), 707(b)

2 Revenue Regulations §1.1031(k)-1(k)(2)
242 Tax Benefits of Ownership, Fourth Edition

Form 172-2
SUPPLEMENTAL ESCROW INSTRUCTIONS
Supplemental §1031 Reinvestment In Lieu of a Cash-Out Sale

Escrow
NOTE: This form is used by a seller's agent or escrow officer when handling the seller's cash sale of property in a delayed
Instructions §1031 reinvestment plan, to authorize escrow to disburse the cash sales proceeds to a trustee for funding the seller's
future acquisition of replacement property.

DATE: , 20 , at ,California.
To

Attention Escrow No.

Seller
Buyer
§1031 Trustee
1. All prior instructions in this escrow and underlying agreements between the parties are amended as follows:
1.1 Seller will at no time receive cash or paper as consideration for the conveyance of the subject property, except
the sum of $_______________ cash through escrow.
1.2 You are authorized to close this escrow when you cause or confirm that Trustee holds for Buyer the sum of
$_______________ under the Trust entitled
.
1.3 You are to prepare Seller’s closing statement showing the agreed-to charges and credits to include “Exchange
Valuation Credits” due Seller in the amount of $_______________, in lieu of the net proceeds originally provided
for in your instructions.
2. The following are conditions with which escrow need not be concerned:
2.1 Seller intends the sale to qualify as an Internal Revenue Code §1031 transaction, exempt from profit reporting.
The ultimate tax status of the sale provides no consideration for the agreement between the parties, and failure
to qualify under Internal Revenue Code §1031 provides no grounds for rescission.
2.2 Buyer and §1031 Trustee, concurrent with the signing of these instructions, will execute a trust agreement creating
a trust to receive and hold as the trust estate the proceeds of this sale.

� See attached Signature Page Addendum. [RPI Form 251] � See attached Signature Page Addendum. [RPI Form 251]

Date: , 20 Date: , 20

Seller: Buyer:

Seller: Buyer:

Date: , 20

§1031 Trustee:

By:

FORM 172-2 03-11 ©2016 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517

Further, any bankruptcy petition filed by or involuntarily imposed on a

§1031 trustee will not jeopardize the availability of the trust funds under the
§1031 trust agreement.3

A listing agent begins the §1031 reinvestment process at the time the
The buyer investor enters into a purchase agreement to sell the listed property. The
cooperates as purchase agreement entered into includes a boilerplate §1031 cooperation
provision calling for the buyer to accommodate, through mutual closing
agreed

3 In re Sale Guaranty Corporation (9th Cir. BAP 1998) 220 BR 660

 Chapter 29: The §1031 trustee in a delayed reinvestment 243

instructions, the investor’s need to re-route disbursement of the investor’s

net sales proceeds from the sales escrow directly to a trustee for later funding
the purchase of a replacement property.

Before closing the sales escrow, the investor determines they will reinvest the
proceeds in replacement property. The investor decides to exercise the right
granted to them by the §1031 cooperation provision in purchase agreement
with the buyer to reroute the net sales proceed to a §1031 trustee the investor
selects.

Two documents are prepared and handed to the buyer to sign and return as
the paperwork needed to perform under the cooperation provision, including:
• supplemental closing instructions calling for escrow to disburse the
net sales proceeds on closing to the trustee selected by the seller and
identified in the instructions, and not disburse the funds to the investor
as called for in the original instructions [See Form 172-2]; and
• a declaration of trust executed by the buyer to establish a trust and
appoint the trustee selected by the investor to hold the net sales proceeds
until the trustee is further instructed by the investor to disburse the
money to the purchase escrow handling the investor’s acquisition of a
replacement property. [See Form 172-4]
The inclusion of the cooperation provision in the purchase agreement
eliminates any need for the investor to later resort to the riskier election to
use the safe harbor rules to avoid receipt of their sales proceeds, unless the
buyer refuses to cooperate as agreed.

Prior to preparing closing instructions for the sales escrow and the trust
agreement, the investor needs to select the person who will be appointed by
the buyer as the §1031 trustee. Any person may be selected by the investor
to be the §1031 trustee, except for a family member and any business entity
controlled by the investor, called related persons.4

The cooperation needed from the buyer is limited solely to establishing

a facilitator — a §1031 trustee or “buyer’s trustee.” Thus, the buyer fulfills
their promise to cooperate in the disbursement of funds for the purchase of
replacement property yet to be acquired by the investor.

After the sales escrow closes, the buyer is no longer involved in arrangements
for the investor’s §1031 reinvestment. The trustee carries on in place of the
buyer and escrow, holding the net sales proceeds until disbursed to fund the
investor’s purchase of a replacement property.

Prior to closing the sales escrow, the agent dictates supplemental escrow
closing instructions to be prepared for signatures from the investor, buyer
§1031
and §1031 trustee. [See Form 172-2] instructions
The supplemental escrow instructions in no way alter the buyer’s rights and for escrow
obligations under the purchase agreement or original escrow instructions.
4 IRC §267(b); Rev. Regs. §1.1031(k)-1(k)
244 Tax Benefits of Ownership, Fourth Edition

Form 174-2
DECLARATION OF TRUST FOR §1031 PROCEEDS
Declaration of Cash-Out Sale

Trust for §1031

NOTE: This form is used by a seller's agent when closing escrow on the cash sale of property in the seller's §1031
Proceeds reinvestment plan and the escrow for the seller's acquisition of the replacement property cannot be closed concurrently,
to set up a trust to hold the net sales proceeds until needed to fund acquisition of replacement property.

Page 1 of 2 DATE:
FACTS:
, 20 , at , California,

1. This declaration of trust is entered into between

1.1 , as the Trustor and Beneficiary,
1.2 and , as the Trustee,
1.3 to create a trust entitled "The Trust."
2. This Trust is to perform Trustor’s obligations under the terms of a §1031 provision in a purchase agreement
dated , 20 , and escrow instruction No. with ,
between , as the Buyer,
and , as the Seller.
DECLARATION:
3. Trustor hereby transfers and delivers to Trustee all of the property described hereunder to constitute, together with any
other property that may become subject to this Declaration, the Trust Estate of an express trust to be held, administered
and distributed by the Trustee as provided herein.
4. Trust Estate:
4.1 The Trust Estate will consist of cash in the amount of $ , caused to be delivered to Trustee
by Trustor.
5. Responsibility for Costs:
5.1 Trustee’s fee for establishing the Trust and its management fee thereafter of $_____________ per month will be
payable out of funds received and held by Trustee.
5.2 In the event Trustee becomes involved in any litigation arising out of this Trust or the transaction between Trustor
and Seller, reasonable attorney fees incurred by the Trustee are recoverable from the Trust Estate.
6. Powers of the Trustee:
6.1 General powers of the Trustee: In addition to all other powers and discretions granted to or vested in the Trustee
by law or by this Declaration, the Trustee has power with respect to the Trust Estate, or any part of the Trust
Estate, to:
a. Retain in the Trust any property received by it.
b. Fund the purchase of §1031 replacement property to perform Trustor’s obligations under the
supplemental escrow instructions for the §1031 treatment dated _____________, 20_____,
escrow no. with .
6.2 Special powers of the Trustee:
a. Trustee is instructed and directed to use the Trust Estate to fund Seller’s acquisition of §1031 replacement
property(ies) selected by Seller. Seller’s selection and request for funding will be in writing directed to the
Trustee.
b. Any remaining money in the Trust Estate after payment of expenses and funding of Seller’s acquisition of
replacement property(ies) to be delivered to Seller in complete and full performance of Trustor’s obligations
under the §1031 provision between Trustor and Seller.
c. During the existence of the Trust, and prior to the funding by the Trust of the purchase of §1031 property,
the Trustee will have the authority, in their sole discretion, to invest prudently in the name of the Trust, any
sums constituting part or all of the Trust Estate into federally insured savings accounts or certificates of
deposit or other like quality interest earning investments.
7. Termination of the Trust:
7.1 When the Trust Estate is disbursed by the Trustee to fund acquisition of §1031 property, the Trust will terminate.
On termination, the Trustee will deliver to Seller any remaining assets and money held in the Trust Estate.
8. Income of the Trust:
8.1 The Trustee will pay or apply all of the Trust Estate, including any interest earned thereon, toward the performance
of powers of the Trustee.

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - PAGE 1 OF 2 — FORM 172-4 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

The mutual supplemental escrow instructions direct the escrow officer to

disburse funds that accrue to the account of the investor to the §1031 trustee
on close of escrow, except for prorations and any portion of the net sales
proceeds withdrawn by the investor.

The supplemental closing instructions authorize the sales escrow to:

• disburse the investor’s net sales proceeds, less any withdrawals made
by the seller, by issuing a check on the close of escrow made payable
to the §1031 trustee for the amount of the investor’s net proceeds; and
 Chapter 29: The §1031 trustee in a delayed reinvestment 245

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - PAGE 2 OF 2 — FORM 172-4 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

Form 172-4
9. Trust is Irrevocable:
9.1 This Trust is irrevocable pursuant to California Probate Code §15400 and may not be amended or modified in
any way.
Declaration of
10. Spendthrift Provisions:
10.1 No Beneficiary of this Trust will have any right, power or authority to alienate, encumber or hypothecate their
Trust for §1031
interest in the principal or income of this Trust in any manner, nor will such interest of any Beneficiary be subject
to claims of their creditors or liable to attachment, execution or other process of law.
Proceeds
11. Successor Trustee:
11.1 If the Original Trustee becomes unable or unwilling to act as Trustee, then _____________________________
___________________________ is to become Trustee of this Trust, will succeed to all title of the Trustee to the
Page 2 of 2
Trust Estate and to all powers, rights, discretion, obligations, and immunities of the Trustee under this Declaration.
12. Law for construction of the Trust:
12.1 The Trust provided for in this Declaration will be governed by the laws of the State of California.

EXECUTED ON , at , California.

Trustor: Trustee:

Trustor: Trustee:

FORM 172-4 03-11 ©2016 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517

• issue a closing statement to the investor noting the investor received

Exchange Valuation Credits (EVCs) in lieu of a “check herewith,”
in an amount equal to the amount of the cash proceeds disbursed by
escrow to the §1031 trustee. [See Form 172-2]
The dollar amount of the EVCs in the closing statement represents the amount
of funds disbursed to the §1031 trustee and available to fund the investor’s
purchase of replacement property.

Even though disbursement of the net sales proceeds is, as a condition of

closing escrow, diverted away from the investor to the §1031 trustee, the
investor retains control over the funds for their use as a down payment on
the purchase price of replacement property selected and contracted for by the
investor.

The §1031 trustee is instructed, by the terms of the trust agreement, to hold Investor’s
the trust funds on deposit in government-insured, interest-bearing accounts.
receipt of
The interest earned and credited to the account first pays the costs of
maintaining the savings account and payment of any trustee’s fee. Interest
accrued
remaining after payment of the trustee’s costs and fees belongs to the investor interest
(and is taxed as the investor’s portfolio income). The investor may, but need
not, apply the remaining interest toward the purchase of the replacement
property.

The investor is entitled to the interest earned on the funds impounded with
the trustee since interest is the economic product of the investor’s net sales
proceeds while they are held in trust.
246 Tax Benefits of Ownership, Fourth Edition

Form 172-3
INSTRUCTION TO TRUSTEE TO FUND ACQUISITION
Instruction to Cash Only

Trustee to Fund
NOTE: This form is used by a seller's agent when a §1031 trustee holds proceeds from the seller's cash sale of property
Acquisition in a delayed §1031 reinvestment plan, to instruct the trustee to forward funds to a purchase escrow for acquisition of
replacement property.
(Cash Only)
To Trustee:
Name of Trust
1. You are hereby advised of my selection and intended acquisition of real estate referred to as

.
2. Further, you are hereby requested, on a demand by escrow on you for funds, to disburse cash from the
Trust Estate, for credit toward the purchase price to be paid for the property, in the amount of $ ,
payable to (Escrow Company) ________________________________________ Escrow #
Address

Dated: , 20

Seller:
(As named in declaration of trust)

Seller:
(As named in declaration of trust)

FORM 172-3 03-11 ©2015 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517

Critically, the interest may not be disbursed to the investor before they
acquire ownership of all the replacement property to be received in their
reinvestment plan. When interest earned on the §1031 money is prematurely
disbursed to the investor (to an escrow is fine) before completing the purchase
of all replacement property to be acquired, the investor loses the entire §1031
exemption.5

The investor reports the interest income as portfolio earnings of the investor.
Interest is not part of the net sales proceeds, but merely taxable earnings
generated by the net proceeds of the sale.6

5 Rev. Regs. §§1.1031(k)-1(g)(5), 1.1031(k)-1(g)(6)(iii)(A)

6 Starker v. United States (9th Cir. 1979) 602 F2d 1341
 Chapter 29: The §1031 trustee in a delayed reinvestment 247

The final stage of a delayed §1031 reinvestment plan begins when the Funding the
investor enters into a purchase agreement to acquire replacement property.
On opening an escrow to purchase the replacement property, the investor purchase of
instructs the §1031 trustee to forward funds to the purchase escrow when
escrow calls for funds. The call occurs at the time escrow is able to close. [See
replacement
Form 172-3 accompanying this chapter] property
When no further property is to be acquired by the investor to close out
the reinvestment plan, the call for funds by escrow demands all funds
held by the trustee. This transfer of funds from the trustee to the investor’s
purchase escrow removes the trustee from any further disbursement or any
withholding of funds for the Franchise Tax Board (FTB).7

On the purchase escrow’s receipt of funds from the trustee, the funds are
credited to the account of the investor as the buyer. The investor takes title
to the replacement property by a grant deed conveyance directly from the
owner of the property to the investor. With the conveyance, the reinvestment
plan is complete.

Any funds unused by escrow to pay the investor’s down payment and
transactional costs are disbursed to the investor. Funds disbursed to the
investor on or after acquiring the replacement property will be taxed as profit
unless they are interest earned during the delay or offset by the amount of
any purchase-assist mortgage or carryback note executed by the investor to
purchase the replacement property. [See Chapter 23]

7 Calif. Revenue and Taxation Code §18662(e)(3)(D)

248 Tax Benefits of Ownership, Fourth Edition

Chapter 29 In a §1031 transaction, due to the relatively concurrent closing of both

the sales and purchase escrows and the transfer of funds between
Summary escrows, the sales proceeds remain contractually beyond receipt by the
investor on demand. Thus, a §1031 trustee is not needed to hold the sales
proceeds.

The investor avoids actual or constructive receipt of the proceeds from

the property sold because of the direct transfer between escrow accounts.
The funds are held in one or another bilateral escrow, so accordingly,
all participants are required to enter into any release of funds to the
investor.

Without concurrent closings, the sales escrow is instructed to deposit the

investor’s sales proceeds with a §1031 trustee. The trustee will hold and
disburse the funds under the terms of a trust agreement entered into by
the buyer of the investor’s property.

The trustee receives and holds the sales proceeds until the investor is able
to close on the purchase of the replacement property and complete the
reinvestment. After closing the sales escrow, the buyer of the investor’s
property is no longer involved in the investor’s reinvestment plan.

On receipt of the sales proceeds, the §1031 trustee carries out the buyer’s
duty under the §1031 cooperation provision in the purchase agreement
to fund the purchase escrow for the replacement property.

The investor’s control and access to the funds held by the trustee is
limited to directing the trustee to disburse the sales proceeds to fund the
investor’s purchase of the selected replacement property.
Chapter 29
Key Term
Deferred Exchange Corporation ............................................. pg. 241
 Chapter 30: The §1031 Profit and Basis Recap Sheet 249

Chapter
30
The §1031 Profit and
Basis Recap Sheet

After reading this chapter, you will be able to: Learning

• explain the §1031 concepts of cost basis, capital offsets and taxable
profit experienced in a reinvestment plan based on use of a §1031
Objectives
profit and basis recap sheet.

cash boot net debt relief Key Terms

mortgage boot offsets
net cash items recapitalization

The tax objective sought by an investor when selling an investment or

business-use property is to eliminate, or at least minimize taxes on the
Offsets on
profit realized on the sale. To meet this tax objective, an investor reinvests reinvestment
their capital interest in the property sold – its market value comprised of
mortgage principal and equity value – in a replacement property.
eliminate
profit taxes
The reinvestment maintains their continued investment in real estate
without the payment of profit taxes on the sale, the foundational premise for on sale
the §1031 profit exemption.

What is “exchanged” in a §1031 transaction is the investor’s equity in one

property for the equity in another property. The transfer of equity to a
replacement property is accomplished either directly in a two-way exchange
or indirectly using the net proceeds from the property sold.

The nexus between the property sold and the property purchased is the net
sales proceeds generated by the sale of a like-kind property – §1031 money.
250 Tax Benefits of Ownership, Fourth Edition

The perfect tax-free match for a property sold and a property purchased
is an unencumbered property sold or exchanged to purchase another
unencumbered property of the same value. This is an exchange of same-
price property, but not likely to occur. Here, no adjustments are required as
mortgage amounts do not exist and no cash items are involved. Just equity
for equity.

Usually, properties in §1031 reinvestment plans are differently capitalized

with various amounts of capital values. Most properties are encumbered
with differing mortgage amounts and have unequal amounts of equity.
These variables of mortgage debt and equity – the investor’s capital – trigger
tax consequences for the profit realized on a sale or exchange of property
unless a replacement property of equal or greater market value is purchased.

Remember: cost basis and profit are the opposite sides of one coin and
mortgage debt and equity are the opposite sides of a another.. The only link
between them is the fair market value of the property sold. Again, the cost
basis in a property is never the same amount as the debt on the property.
The same is true of profit and equity. These distinctions are at work in every
paragraph in this chapter.

Capital A tax analysis of a sale of §1031 property goes beyond the mechanics
of avoiding receipt of the net sales proceeds from the property sold and
interest as complying with time limitations and procedures for identifying and
mortgage and acquiring replacement property.

equity For example, consider the three capital events, one or more manifesting
when a property is sold. Each, when present, triggers some level of profit
reporting on the sale, unless offset by capital events built into the terms of
purchase for the replacement property. The capital events on the sale of a
property include:
• mortgage relief on the sale or exchange of a property, consisting of
the principal amount of existing mortgages whether assumed, taken
over or paid off by the buyer of the property sold;
• equity sold for cash and carryback notes on the sale of property; and
• equity exchanged for unqualified property, also called other
property.

To trade No profit reporting occurs when an investor uses all the net proceeds from
their sale (or exchange of their equity) to purchase replacement property
up or trade which has equal-or-greater mortgage and equal-or-greater equity than the
mortgage and equity existing in the property sold. The investor has continued
down alters their investment in real estate without withdrawing capital. Further, they
the effect of have avoided reporting taxable profit on the sale, the product of offsetting.
offsets
 Chapter 30: The §1031 Profit and Basis Recap Sheet 251

Conversely, when an investor “trades down” by acquiring property for a

lesser price than the property sold, some amount of profit is reported on the cash boot
property sold. Profit reporting results from withdrawing capital, such as the Items of value received
on a sale of property
receipt of cash, a carryback note or unqualified property on a sale. Further, the or contributed to
replacement property, being of lesser value than the property sold, has either purchase replacement
lesser mortgage principal, lesser equity value or both, than the property sold. property in a §1031
reinvestment plan
Thus, the offsets available are insufficient to avoid profit reporting. which include
money, carryback
The investor, on acquiring a lesser-valued replacement property, withdraws notes, purchase-assist
financing for the
capital from the property sold or exchanged in the form of: replacement property,
and equity in property
• mortgage reduction, also called net debt relief by the Internal Revenue not qualified as §1031
Service (IRS) and more commonly called mortgage boot; or like kind property.
Also called money and
• cash, a carryback note or unqualified property, collectively called cash other properties.
items and other property and commonly called cash boot.

A §1031 Basis and Profit Recap Sheet is a checklist of all the §1031 issues to An agent’s
be considered. An agent uses the Recap Sheet to prepare a tax analysis of a
proposed purchase of replacement property for review with the client – an spreadsheet
investor or business owner. The Recap Sheet is used to approximate the
tax consequences of a potential §1031 transaction on locating a potential
for a client’s
replacement property. [See Form 354 accompanying this chapter] reinvestment
On the agent’s review of a filled-out Recap Sheet with the investor, the
investor visually grasps the tax impact of acquiring a specific property as a
continuing capital investment in real estate.

The Recap Sheet is also used to display the different tax consequences of
acquiring one suitable property as opposed to another. A client’s selection
of one replacement property among other suitable properties might be
influenced by disclosure of the tax consequences of acquiring it.

When an investor has entered into an agreement to sell a property,

enterprising agents use the Recap Sheet to inform the investor about the tax
benefits of converting the sales transaction into a §1031 reinvestment
plan prior to closing. [See Chapter 26]

Most agents tend to know what type of real estate is referred to as §1031
property or like-kind property. Also, agents usually know how to develop
§1031
an opinion of a property’s value, its equity and how to balance equities in expertise
an exchange. They certainly know how to control the sale or purchase of a
property using written agreements and escrow instructions. and a little
However, when an agent discusses the tax consequences of a §1031
knowledge of
reinvestment with their investors, they usually fear uncertainty for lack basic math
of sufficient training or personal experience: How do you anticipate and
calculate the capital investment variables that generate profit reporting and
taxes – the math underpinning §1031 tax results?
252 Tax Benefits of Ownership, Fourth Edition

The agent who decides to discuss the tax aspects of purchasing replacement
property with an investor needs to:
• know the accounting variables common to §1031 transactions; and
• understand their application to transactions.
Investment variables comprise capital created or transferred on the sale/
exchange of one property or the purchase of another. The investment
variables include:
• the equities in both properties;
• existing mortgages;
• cash;
• purchase-assist mortgage;
• carryback notes;
• unqualified property; and
• the remaining cost basis from investments in the property sold.
While this chapter presents the knowledge and understanding of §1031
issues and math, the next chapter puts this knowledge to work in practice
through case examples.

An agent uses the Recap Sheet to analyze the flow of capital invested,
The Recap withdrawn or contributed by an investor when selling and buying properties
Sheet in a §1031 reinvestment plan.

The Recap Sheet contains five sections.

Section One nets out the capital withdrawn from existing mortgage
and cash items on the sale or exchange of the property sold and capital
contributed to purchase of the replacement property.

Section Two analyzes any unqualified properties an investor contributes

to purchase the replacement property, such as personal property or dealer
property held by a developer. The contribution of unqualified property
produces a taxable profit or loss as though sold for cash.

Section Three calculates the profit realized on the sale. Here, the amount of
profit taken by the investor on the property sold in their §1031 reinvestment
plan is determined.

Section Four calculates the profit recognized and thus reported and taxed
on the §1031 reinvestment.

Section Five establishes the cost basis for the replacement property. The
cost basis is allocated to land and improvements based on their respective
percentages of the property’s value. The cost basis allocated to improvements
is a requisite to calculating the annual depreciation deduction allowed the
investor acquiring replacement property.
 Chapter 30: The §1031 Profit and Basis Recap Sheet 253

Form 354
§1031 PROFIT AND BASIS RECAP SHEET
§1031 Profit
Prepared by: Agent ____________________________
Broker ____________________________
Phone _______________________
Email _______________________ and Basis Recap
NOTE: To be prepared to estimate reportable profit (§ 4.5) and basis (§ 5.5) in a proposed §1031 reinvestment plan.
This form provides for a complete accounting for IRS 8824 off-form reporting.
Sheet
DATE: _______________, 20______.
PREPARED BY ________________________________________________________________________________ Page 1 of 2
OWNER’S NAME ______________________________________________________________________________
PROPERTY SOLD/EXCHANGED _________________________________________________________________
______________________________________________________________________________________________
COMMENTS ___________________________________________________________________________________
______________________________________________________________________________________________
REPLACEMENT PROPERTY ____________________________________________________________________
COMMENTS ___________________________________________________________________________________
______________________________________________________________________________________________
1. NET DEBT RELIEF AND CASH ITEMS:
Net existing debt:
1.1 Balance of debt(s) owner is relieved of on
all property sold/exchanged. . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________
1.2 Balance of debt(s) owner assumed on
§1031 property acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (–) $_______________
1.3 Total net existing debt: Enter the sum of 1.1 & 1.2 as either:
(a) Net debt relief (amount by which 1.1 exceeds 1.2) . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________ 0.00
(b) Net debt assumed (amount by which 1.2 exceeds 1.1) . . . . . . . . . . . . . . . . . . . . (–) $_______________ 0.00
Cash items received on close of the property sold:
1.4 Amount of cash received on sale (excluding prorations). . . . . . . $_______________
1.5 Amount of carryback note received on sale . . . . . . . . . . . . . . . . $_______________
1.6 Equity value in unqualified property received on sale . . . . . . . . . . $_______________
1.7 Total of cash items received on closing the property sold
0.00
(The sum of 1.4, 1.5 & 1.6). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________
Net cash items received or transferred on close of the
replacement property:
1.8 Amount of cash items received with replacement property
(excluding prorations). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________
1.9 Amount of cash owner contributed (excluding prorations) . . . . . . $_______________
1.10 Transactional costs disbursed at any time on either property
(excluding prorations and loan payoffs) . . . . . . . . . . . . . . . . . . . . . $_______________
1.11 Amount of purchase-money notes owner executed in
part payment for the replacement property . . . . . . . . . . . . . . . . . . . $_______________
1.12 Equity value of any unqualified property owner exchanged . . . . . $_______________
1.13 Subtotal of cash items owner transferred (1.9 through 1.12) . . . . . . . . . . . . . . . . . . . . (–) $_______________ 0.00
1.14 Total net cash items: Enter the sum of 1.8 & 1.13 as either:
(a) Net cash items owner received:
(amount by which 1.8 exceeds 1.13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________ 0.00
(b) Net cash items owner transferred:
(amount by which 1.13 exceeds 1.8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (–) $_______________ 0.00
Netting all debt relief and cash items:
1.15 Enter net debt relief from 1.3(a) . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________ 0.00
1.16 Enter net cash items
(a) owner received from 1.14(a) . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________ 0.00
(b) owner transferred from 1.14(b) . . . . . . . . . . . . . . . . . . . . (–) $_______________ 0.00
1.17 Net debt relief and cash items (1.15 & 1.16, but not less than zero) . . . . . . . . . . . . . . (+) $_______________ 0.00
1.18 Cash items received on sale from 1.7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________ 0.00
1.19 TOTAL net money and other properties owner received
(The sum of 1.17 & 1.18) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________0.00
— — — — — — — — — — — — — — — — — — — PAGE ONE OF TWO — FORM 354 — — — — — — — — — — — — — — — — — — —

Once the annual depreciation allowance is determined, the agent and

investor can review the replacement property’s annual reportable income
or loss from operations and ownership. The analysis of a property’s year-end
income, expenses and deductions is accomplished by preparing an Annual
Property Operating Data sheet (the APOD form). [See Chapter 28]

While the Recap Sheet estimates the amount of profit reported and taxed on
the sale in the §1031 reinvestment, the Recap Sheet does not determine the
amount of taxes an investor might pay.
254 Tax Benefits of Ownership, Fourth Edition

Form 354 — — — — — — — — — — — — — — — — — — — PAGE TWO OF TWO — FORM 354 — — — — — — — — — — — — — — — — — — —

2. PROFIT/LOSS ON TRANSFER OF UNQUALIFIED PROPERTY:

§1031 Profit
2.1 Market value of unqualified property owner transferred. . . . . . (+) $_______________
2.2 Remaining cost basis in unqualified property owner
transferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (–) $_______________
and Basis Recap 2.3 Total profit/loss on unqualified property owner transferred . . . . . . . . . . . . . . . (+ or –) $______________ 0.00

Sheet 3. PROFIT REALIZED ON THE §1031 PROPERTY SOLD OR EXCHANGED:

(before applying the §1031 exemption)
Consideration owner received:
3.1 Debt relief: Enter amount from 1.1 . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________ 0.00

Page 2 of 2 3.2 Market value of §1031 replacement property owner acquired . . . . $_______________
3.3 Total cash items received from property sold
Enter amount from 1.7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________ 0.00
3.4 Total cash items received with replacement property
Enter amount from 1.8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________ 0.00
3.5 Total consideration owner received (3.1 through 3.4) . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________ 0.00
Consideration owner transferred:
3.6 Debt owner assumed: Enter amount from 1.2 . . . . . . . . . . . . . . . . $_______________ 0.00
3.7 Enter remaining cost basis in all §1031 properties
owner transferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
3.8 Cash owner contributed: Enter amount from 1.9 . . . . . . . . . . . . . . $_______________ 0.00
3.9 Transactional costs disbursed: Enter amount from 1.10 . . . . . . . . $_______________ 0.00
3.10 Purchase notes owner executed: Enter amount from 1.11 . . . . . . $_______________ 0.00
3.11 Remaining cost basis in unqualified property owner transferred:
Enter amount from 2.2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________ 0.00
3.12 Total consideration owner transferred (3.6 through 3.11) . . . . . . . . . . . . . . . . . . . . . . . (–) $_______________ 0.00
3.13 Total profits realized in §1031 property sold or exchanged
0.00
(3.5 less 3.12). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+ or –) $_______________
4. REPORTABLE PROFIT/LOSS ON THE §1031 TRANSACTION:
4.1 Total net debt relief and cash items owner receives:
Enter amount from 1.19, but not less than zero . . . . . . . . . . . . (+) $_______________ 0.00
(a) Carryback basis allocation: Amount by which 3.7
exceeds 1.1, but not more than the amount at 1.5 . . . . . . (–) $_______________ 0.00
4.2 Total profit/loss on unqualified property owner transferred:
Enter amount from 2.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+ or –) $_______________ 0.00
4.3 Subtotal: The amount of equity withdrawn:
0.00
(the sum of 4.1(a) & 4.2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+ or –) $_______________
4.4 Total profits realized in §1031 property sold/exchanged:
Enter amount from 3.13 (but not less than zero). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________ 0.00
4.5 Total reportable profit/loss: (Enter lesser of 4.3 or 4.4). . . . . . . . . . . . . . . . . . . . . . (+ or –) $_______________ 0.00

5. BASIS OF ALL PROPERTY(IES) RECEIVED:

5.1 Debt relief. Enter amounts from:
0.00
(a) 1.3(a) Net debt relief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (–) $_______________
(b) 1.3(b) Net debt assumed . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________ 0.00
5.2 Cash items. Enter amounts from:
(a) 1.7 Cash items received on the sale . . . . . . . . . . . . . . . (–) $_______________ 0.00
(b) 1.8 Cash items received on purchase . . . . . . . . . . . . . . (–) $_______________ 0.00
(c) 1.9 0.00
Cash contributed . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________
(d) 1.10 Transactional costs disbursed . . . . . . . . . . . . . . . . . (+) $_______________ 0.00
(e) 1.11 Purchase-money notes executed . . . . . . . . . . . . . . . . (+) $_______________ 0.00

5.3 Remaining cost basis in all property transferred.

Enter amounts from:
(a) 3.7 0.00
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________
0.00
(b) 3.11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (+) $_______________
5.4 Reportable profit/loss. Enter amount from 4.5. . . . . . . . . . (+ or –) $_______________ 0.00
5.5 Basis of replacement property(ies) and cash items:
0.00
(The sum of 5.1 through 5.4). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
(See ft Form 355 for allocation to cash items, multiple replacement properties and improvements.)
FORM 354 03-11 ©2011 first tuesday, P.O. BOX 20069, RIVERSIDE, CA 92516 (800) 794-0494

The amount of taxes paid on the recognized profit depends on the investor’s
adjusted gross income, itemized deductions and tax credits available to them.
Further, the types of gains comprising the profit taken on the sale of improved
property have their own tax bracket rates. [See RPI Form 351; see Chapter 10]

To report a completed §1031 reinvestment plan when filing annual tax

Off-form returns, use IRS Form 8824. The form’s checklist does not provide for the line-
calculations by-line offsetting of the various capital events flowing from the purchase
of replacement property, comprising mortgage amounts, cash items and
for offsets unqualified property.
 Chapter 30: The §1031 Profit and Basis Recap Sheet 255

To properly report a §1031 reinvestment on IRS Form 8824, an investor’s

accountant separates:
• the existing mortgages the investor assumed on acquiring the
replacement property; and
• cash items the investor contributes, including any notes they execute
as carrybacks or to mortgage lenders to fund the purchase of the
replacement property.
Then, they net the capital withdrawals and contributions. To file the tax
return, they go off form to use a form such as the Recap Sheet to complete
the netting process. The Recap Sheet is attached to the IRS Form 8824 [See
Form 354]

Cash boot, called money and other properties by the IRS, comprises Mortgage
carryback notes, purchase-assist mortgages, the investor’s principal residence,
dealer status properties, assumed and personal unsecured debt and real estate relief and
unqualified for §1031 treatment. These cash boot items are either withdrawn cash items
on the sale of the property sold or contributed to purchase the replacement
property. Cash boot items include every capital item contributed or received
mortgage boot
that is not an existing mortgage or equity in like-kind property sold, The amount by
exchanged, or purchased. which the mortgage
balances existing on
Mortgages existing on the property sold by the investor are part of their the property sold,
whether assumed or
capital investment made as owner of the property. On a sale or exchange, paid off by the buyer,
the mortgage amounts existing on the property sold/exchanged always exceeds the sum of
the mortgage balances
constitutes debt relief, called mortgage boot. When the property sold is taken over on the
encumbered, the investor has been relieved of their commitment to repay replacement property
the mortgage principal amount. It is assumed or prepaid by funds from the purchased in a §1031
reinvestment plan and
buyer using their cash reserves or new financing. the net value of cash
items contributed in
Thus, mortgage relief is a withdrawal of capital by the investor. Mortgage the plan. Also called
relief triggers reporting – recognition – of some or all the profit on the sale/ net debt relief. Contrast
with cash boot.
exchange of a property unless the mortgage amounts are offset on acquiring
a replacement property. Offsets include the investor’s assumption of
mortgages and contributions of cash, unqualified property or the execution offsets
of carryback note and lender-funded mortgages used to pay the purchase A reduction, typically
reducing an amount
price of the replacement property.1 received by an amount
contributed by an
Cash boot received by the investor at the time of the sale/exchange of their individual in a §1031
reinvestment plan.
property cannot be later offset by any method. An investor’s later assumption
of mortgages, addition of cash (from reserves or mortgage lender financing)
or execution of a carryback note to purchase the replacement property, does
not offset any amount of prior withdrawals of cash items and unqualified
property.

Conversely, mortgage relief on a sale is later offset by the terms of a purchase

of replacement property when the price is greater than the price of the
property sold.

1 Revenue Regulations §1.1031(b)-1(c)

256 Tax Benefits of Ownership, Fourth Edition

Two An investor purchases replacement property by reinvesting the proceeds

from their sale of a property or by the exchange of the equity in their property.
categories of All other forms of capital withdrawn or contributed by an investor in a
boot §1031 reinvestment plan is inevitably classified for tax analysis as either:
• existing debt, called mortgage boot; or
• cash items and other property, called cash boot.
When analyzing the two categories of boot, existing mortgages are accounted
for separate from cash items (such as origination of purchase-assist mortgage
financing) and other property. Only as separate items does the netting of
withdrawals and contributions occur.

This separation determines whether the investor has taken a taxable profit
within each of the two categories of capital withdrawals – mortgage boot and
cash boot. Critically, mortgage boot does not offset cash boot, but cash boot
offsets mortgage boot.

For instance, the investor’s debt relief on the property sold is a reduction in
their capital invested in the form of debt relief income. Critically, debt relief
is later offset when the investor either:
• assumes or takes over mortgages of an equal or greater amount
which encumber the replacement property; or
• contributes cash items to purchase the replacement property, such
as advancing cash, executing a carryback note, originating purchase-
assist mortgages to fund the purchase and exchanging other real estate
or personal property not qualified as or incidental to §1031 property.
Thus, the dollar amount of equity value in other property (a cash item) an
investor contributes to purchase replacement property is additional capital
invested. The contributions offset an equal amount of mortgage relief on the
sale of the property sold.

Conversely, the investor cannot later offset the capital withdrawal of cash
items they receive on the sale of their property. They received cash items before
they acquired ownership of the replacement property. While the investor’s
assumption of an existing mortgage increases their capital investment in the
replacement property, the assumption does not offset any cash withdrawn at
any time, just mortgage debt relief on the property sold.

For example, on the purchase of replacement property, the mortgage assumed

by the investor often has a greater balance than the mortgage balance on
the property the investor sold. While taking on greater existing mortgage
debt fully offsets the debt relief on the property sold, the greater amount
of mortgage principal assumed on the replacement property does not spill
over to offset cash received by the investor before or on closing out the §1031
reinvestment plan.2 [Example 2]

2 Rev. Regs. §1.1031(d)-2

 Chapter 30: The §1031 Profit and Basis Recap Sheet 257

Only cash items contributed or executed (carryback note, new mortgage) by

the investor offset cash items received by the investor. Again, the cash offset
only applies to cash items received on or after the closing of the purchase
escrow to acquire the replacement property. [See Form 354 §1.7]

Essentially, the existing debt section of the Recap Sheet demonstrates how
profit reporting for the sale of the property sold is avoided by offsets to the
Netting
investor’s mortgage relief, when: existing
• the investor assumes mortgages on their purchase of replacement mortgage
property with principal balances greater than the mortgage balances
on the property they sold; or
separately
• they contribute cash items toward their purchase of the replacement from cash
property sufficient to offset the mortgage relief on the property sold. items
When mortgages on the property sold are greater in amount than the
mortgages assumed on the replacement property, the result is net debt net debt relief
The amount of the
relief. The investor has decreased their capital contribution to the §1031 existing mortgage
reinvestment plan in the form of reduced mortgage debt. Critically, net balance encumbering
debt relief is offset by the terms for payment of a greater purchase price for the property sold
not offset by the
replacement property. [See Form 354 §§1.3(a), 1.14(b) and 3.13] assumption of
mortgage balances
Offsetting mortgage relief is accomplished by contributing cash, equity in or contribution
of cash items on
unqualified property, originating purchase-assist financing or executing a acquiring replacement
carryback note to purchase replacement property with a greater purchase property in a §1031
price. [See Form 354 §§1.8, 1.9 and 1.10] reinvestment plan.
Also called mortgage
boot.
The netting process for existing mortgages includes:
• debt relief – mortgages taken over or paid off by the buyer of any type
of real or personal property the investor sells or exchanges in the §1031
reinvestment plan [See Form 354 §1.1]; and
• debt assumed – mortgages encumbering the replacement property
taken over by the investor and any unsecured debt the investor
formally assumes. [See Form 354 §1.2]
For example, an investor sells property encumbered by a mortgage. The buyer
takes over the mortgage (subject to or by assumption) or funds the payoff of
the mortgage. Thus, debt relief occurs for the investor.

However, the mortgage relief on a sale/exchange is later offset by:

1. equal or greater mortgage amounts taken over by the investor on their
purchase of the replacement property, or
2. cash items contributed to purchase replacement property of equal or
greater market value.
As a result, there is no net debt relief and no part of the profit on the sale/
exchange is reported and taxable.

When unsecured debt is taken over on the purchase of replacement

property, it is formally assumed to qualify and offset debt relief on the sale.
258 Tax Benefits of Ownership, Fourth Edition

A formal assumption is accomplished by a written agreement with either

the lender or the seller of the replacement property. The writing imposes an
enforceable legal duty on the investor for payment of the unsecured debt.
[See Form 431 accompanying this chapter; see RPI Form 432]

Netting Cash items include:

cash items • cash withdrawn or contributed by the investor;

• notes carried back by the investor on the property sold or executed by
separately the investor to purchase the replacement property;
from existing • money advanced by a lender originating a purchase-assist mortgage to
mortgages fund the investor’s purchase of replacement property; and
• unqualified properties, also called other property, received on
the sale or exchange of the property sold or contributed to purchase
replacement property.
The reasons cash items are withdrawn or contributed by an investor when
selling and buying real estate include:
• to cover the difference between the equity in the property sold and the
equity in the replacement property;
• to generate cashback on purchase of the replacement property; or
• a substitute for using cash, such as the execution of a carryback note or
a purchase-assist mortgage to fund part of the purchase price paid for
the replacement property.
Cash items, like existing mortgages, are not §1031 property. Cash, carryback
notes, unqualified property, purchase-assist mortgage funding, and existing
mortgage do not represent an equity in a §1031 property, which is the sole
like-kind capital interest held by the investor property.

Critically, cash items withdrawn by the investor prior to acquiring any

replacement property cannot be offset. The premature receipt of cash items
by the investor triggers the reporting of profit realized on the property sold
up to the face amount or the equity value in the cash items withdrawn. [See
Form 354 §§1.4, 1.7, 1.18]

The terms for payment of the purchase price of the replacement property
set the stage for a cash withdrawal without profit being allocated to the
cash and taxed. On the purchase the replacement property, payment of the
purchase price needs to include the investors execution of a carryback note or
purchase-assist mortgage for amounts equal to or greater than the cashback
recapitalization they receive on closing their purchase escrow.
The restructuring of
an owner’s capital The investor’s continuing capital investment in the replacement property
interest in a property
between equity and remains the equal or greater amount. They have merely restructured the
mortgage debt or vice form of their continued capital investment from equity to debt, called
versa, often achieved recapitalization.
by refinancing or
further financing of
the property.
 Chapter 30: The §1031 Profit and Basis Recap Sheet 259

A carryback note executed to pay part of the purchase of replacement property

is a cash item, as is a lender originated purchase-assist mortgage. These cash
items also offset mortgage relief incurred on the sale of the property sold that
is not offset by any mortgages assumed on the purchase of the replacement
property. [See Form 354 §1.17]

Critically, cash withdrawn from interest accrued on the impounded net

sales proceeds held by a §1031 trustee before acquiring replacement property
disallows any §1031 exemption. All profits are then taxed.

On occasion, a rental property sold in a §1031 reinvestment plan has

previously been occupied by the seller as their principal residence and is
First account
now occupied by a tenant, called the sequential use of property. for §121
Alternatively, the property might be currently occupied by the seller as profits, then
their principal residence with part of the premises used and depreciated as the §1031
either their home office space or a unit rented to a tenant, called a mixed-
use property. Mixed-use situations occur for an owner-occupant of a one-to- profits
four unit residential property or a single-family residence with a granny flat,
casita unit, etc. which are in part rented to others for a fair rental value.

In sequential-use and mixed-use situations, the homeowner exchanging

their principal residence is entitled to an Internal Revenue Code (IRC) §121
homeowner’s profit tax exclusion of $250,000. A homeowner qualifies
when they have owned and occupied the premises as their principal
residence for two years within the five-year period prior to the close of the
sale or exchange of the home. [See Chapter 3]

A homeowner entitled to the §121 exclusion on the sale or exchange may

withdraw cash from the sales escrow up to the total amount of the profit
exclusion. The cash withdrawal has no effect on their reinvestment of the
balance of the sales proceeds in a like-kind replacement property.

A seller exchanging their personal residence may want to withdraw only

a portion of their §121 exclusion in cash. Here, the entire amount of the
profit exclusion is deducted before accounting for profits in the §1031
transaction.3

Thus, §121 money excluded from profit taxes represents after-tax dollars.

Further, the profit attributable to the §1031 portion of the residence used as
a rental or for business purposes includes all the unrecaptured depreciation
gains and any long-term capital gains remaining after the exclusion of §121
monies. The withdrawal of any §121 money is not reflected on a §1031 Recap
Sheet.

Conversely, when all or a portion of the §121 money is reinvested in the

§1031 replacement property the seller acquires, the contribution of the §121
money, being after-tax dollars, is accounted for in the §1031 Recap Sheet as a
cash contribution. [See Form 354 §1.9]
3 Revenue Procedure 2005-14
260 Tax Benefits of Ownership, Fourth Edition

Form 431
ASSUMPTION AGREEMENT
Assumption Unsecured and Subrogated

Agreement NOTE: This form is used by a seller's agent or escrow officer when the sale of a property calls for the transfer of title with
the buyer taking over an existing mortgage, to document the buyer's unsecured promise to the seller to fully perform all
terms of the mortgage.
DATE: , 20 , at , California.
Items left blank or unchecked are not applicable.
FACTS:
1.
1. This assumption agreement is entered into by
1.1 , as the Buyer,
1.2 and , as the Seller,
1.3 regarding Buyer’s acquisition of real estate referred to as
.
2. FIRST TRUST DEED NOTE:
2.1 Buyer is acquiring title to the real estate subject to a first trust deed dated ,
2.2 executed by , as The Trustor,
2.3 in which is the Beneficiary,
2.4 recorded on , as Instrument No. , in the Offical Records
of County, California, and
2.5 given to secure a promissory note of the same date for the principal sum of $ .
3. SECOND TRUST DEED NOTE:
3.1 Buyer is acquiring title to the real estate subject to a second trust deed dated ,
3.2 executed by , as the Trustor,
3.3 in which is the Beneficiary,
3.4 recorded on , as Instrument No. , in the Official Records
of County, California, and
3.5 given to secure a promissory note of the same date for the principal sum of $ .
AGREEMENT:
4. Seller hereby assigns and delegates to Buyer all rights and obligations in the above note(s) and trust deed(s).
5. Buyer hereby assumes and agrees to timely pay the debt evidenced by the above promissory note(s) and to perform all
of Trustor’s obligations under the trust deed(s) securing the note(s).
6. This agreement is made for the benefit of the Beneficiary(ies) of the trust deed(s) securing the note(s).
7. If Buyer or Buyer’s successors default in the performance of this agreement, the whole sum of the principal and interest
on the assumed indebtedness(es) will become immediately due at the option of the holder of this assumption agreement.
7.1 On default, Seller is to become subrogated to the interest of Beneficiary under the defaulted note and trust deed.
8. In any action to enforce this agreement, the prevailing party is to receive attorney fees.

I agree to the terms stated above. I agree to the terms stated above.
Date: , 20 Date: , 20

Seller: Buyer:

Seller: Buyer:

FORM 431 03-11 ©2016 RPI — Realty Publications, Inc., P.O. BOX 5707, RIVERSIDE, CA 92517

Cash Cash advanced by an investor to sell or purchase properties offsets cash items
(unqualified properties) only when the investor receives them on or after
contributions they acquire ownership to the replacement property. [See Form 354 §1.13]
in a §1031 Cash invested includes all cash advanced by the investor in the §1031
plan as an reinvestment plan, excluding prorations paid or received on either closing.
[See Form 354 §§1.9 and 1.10]
offset
Examples of cash invested by the investor include:
• cash advanced by the investor toward the price paid to purchase the
replacement property [See Form 354 §1.9]; or
 Chapter 30: The §1031 Profit and Basis Recap Sheet 261

• cash advanced or accruing to the account of the investor used to pay

escrow closing costs on both the sale (or exchange) of their property
and their purchase of replacement property, called transactional costs.
[See Form 354 §1.10]
Cash does not include cash paid by the buyer to purchase the property sold
(or funded by the buyer’s lender) that is disbursed by escrow to pay off or
reduce mortgages encumbering the property sold by the investor.

Here, the use of cash funds the buyer of the buyer’s lender deposits in escrow
which pay off a mortgage on the property sold does not constitute the receipt
of cash by the investor. The funds were never available for disbursement
to the investor on demand. The buyer’s funds used for mortgage payoff
are neither actually nor constructively received by the investor. Thus, the
investor does not account for mortgage payoff funds deposited by the buyer
or the buyer’s lender.4

Again, mortgages whether paid off with the buyer’s funds or taken over by
the buyer are listed as debt relief. Any amount of mortgage relief not offset
on the reinvestment is a withdrawal of capital, typical in a price trade-down
situation. The withdrawal is taxed as profit recognized on the sale, limited as
always to the total profit realized on the sale.5

An investor on the sale of the property sold carries back a trust deed note. The
investor retains the note on closing rather than including it in the cash net
Carryback
proceeds sequestered with the §1031 trustee for reinvestment. Retaining the notes and
carryback note made payable to the investor triggers reporting and taxing of
profit.
purchase-assist
mortgages
However, the amount of profit allocated to principal in a regular
carryback note is not calculated on the profit-to-equity ratio for installment
sale reporting. Allocation of profit to the carryback retained in a §1031 plan
depends on whether the cost basis in the property sold is more or less than
the principal balance on mortgages encumbering it.

Two profit allocation situations exist for an investor who withdraws capital
by receiving a carryback note on the sale of the property sold in a §1031 plan:
1. The mortgage principal encumbering the property sold is greater than
the amount of the property’s cost basis, the mortgage-over-basis
situation due to past refinancing of the property. Here, the entire
amount of the carryback note is profit; or
2. The cost basis in the property sold is greater than the amount of the
mortgage principal encumbering the property, the basis-over-
mortgage situation. Here, the amount of cost basis exceeding the
mortgage balance is first allocated to the note. Only then is profit
allocated to the note for the portion of the principal not receiving the
excess cost basis allocation [See Form 354 §5; see Chapter 28]

4 Garcia v. Commissioner (1983) 80 TC 491

5 Barker v. Commissioner (1980) 74 TC 555
262 Tax Benefits of Ownership, Fourth Edition

The investor avoids receipt of the carryback note and the reporting of profit
by causing the note (and trust deed) to be made payable to and delivered to
the §1031 trustee as part of the investor’s net proceeds from the sale. All part
of the mutual closing instructions given to escrow.

Carryback notes include all notes:

• received by the investor, secured or unsecured, in payment of the
price received on their sale of a property [See Form 354 §1.5]; or
• executed by the investor, secured or unsecured, in part payment of
the purchase price paid for the replacement property. [See Form 354
§1.11]
Critically, a carryback note executed by the investor to purchase replacement
property offsets an equal amount of cash received by the investor on or after
the date they close the purchase escrow. [See Form 354 §§1.8 and 1.11]

Managing the Unqualified properties, called other property by the IRS and commonly
called cash boot, are properties exchanged which do not qualify as §1031
unqualified property. For example, an investor may:
property’s • receive unqualified property on the sale of their property; or
basis and • contribute unqualified property in part payment of the purchase price
for the replacement property. [See Form 354 §§1.6 and 1.12]
profit
Unqualified properties can be either real estate or personal property.
Examples of unqualified properties include:
• the investor’s personal residence, whether acquired in exchange
for the property sold or exchanged to acquire replacement property.
Here, they first deduct their $250,000 per individual §121 homeowner’s
exclusion for the profit in the home. Any profit remaining is subject to
taxes depending on their §1031 withdrawals and contributions;
• stocks, bonds and certificates for group investments such as an
existing co-ownership interest in a real estate investment group. Co-
ownership includes fractional interests held in group investments
vested in pass-through entities (LLC or partnerships) or as tenants in
common (TIC) that, by vote, eliminate the unanimous approval of the
right to buy or sell it;
• personal property exchanged or received in exchange, unless it
qualifies for the 15%-of-value incidental property rule or as §1031
personal property exchanged for like-type personal property, such as
trucks used in a business or furnishings in an apartment complex [See
Chapter 24]; and
• inventory and other dealer status property, real or personal. [See
Chapter 5]
Unlike other cash items such as cash, purchase-assist mortgages and
carryback notes, unqualified property does not have a face value. Thus,
the fair market value of unqualified properties needs to be set to determine
the profit or loss reported on transferring or receiving it.
 Chapter 30: The §1031 Profit and Basis Recap Sheet 263

The investor’s exchange of their unqualified property to purchase replacement

property is treated as a sale of the unqualified property. The transfer is treated
as though the investor sold the unqualified property for a cash price. The
dollar amount set as the value of the equity in the unqualified property is
additional capital contributed to purchase replacement property. [See Form
354 §2]

Occasionally, the unqualified property an investor contributes to purchase

replacement property is encumbered by a mortgage. On transfer, the investor
has debt relief in the amount of the existing mortgage. The debt relief is
tracked in the reinvestment plan recap. [See Form 354 Instructions §§1.1
through 1.3]

An investor contributes their equity in an unqualified property to pay

part of the purchase price of replacement property. The equity is additional
Profit or
capital invested and is analyzed twice: loss on
• first, the equity value offsets net debt relief from the property sold and contribution
any cash withdrawn on completion of the §1031 reinvestment plan
[See Form 354 §§1.12 and 1.17]; and
of unqualified
• second, the transfer of unqualified property is treated as a “cash sale” property
and the profit or loss on its transfer is separately reported and taxed.
[See Form 354 §2]
While the entire profit on the investor’s sale of §1031 property might be
exempt, the investor’s contribution of unqualified properties toward the
purchase of replacement property is separately reported as a sale since its
transfer generates a taxable profit or loss.

The profit or loss on the investor’s contribution of unqualified property is

set as:
• the price of the unqualified property, when stated in the exchange or
purchase agreement; less
• the investor’s remaining cost basis in the unqualified property. [See
Form 354 §§2.1 through 2.3]
Conversely, acceptance of unqualified property in exchange for the property
sold triggers reporting of profits on the property sold. The profit reported on the
property sold is equal to the value of the equity in the unqualified property
received. No offset, then or later, can avoid profit reporting, unless the
investor advanced cash when they sold their property, such as transactional
costs. [See Form 354 §§1.6 and 1.18]

The value of the equity in the unqualified property the investor receives is
included in the total profits realized on all aspects of the §1031 reinvestment
plan. [See Form 354 §3.3]
264 Tax Benefits of Ownership, Fourth Edition

Also, the profit or loss taken on the investor’s contribution of unqualified

property to purchase replacement property is entered in the Recap Sheet
solely to set the overall profit or loss reported on all aspects of the §1031
reinvestment plan. [See Form 354 §4.2]

Unqualified The market values of all property exchanged between parties are arguably
uncertain in amount. Without the involvement of any unqualified properties,
property the prices placed on the §1031 properties have no tax consequence.
market value: However, when an equity in unqualified property is received or contributed
priced or by an investor, the investor needs to consider structuring the pricing of the
§1031 properties to report taxable profit based on the lowest justifiable value
unpriced they can place on the unqualified property.

Typically, prices set during negotiations for an exchange that includes

unqualified property are all too often raised way out of proportion to cash
values.

As a result, the purchase or exchange agreement ends up stating the negotiated

price as the value of the unqualified property. These written agreements
control the value of the unqualified property for tax purposes. Critically, the
price in the exchange might justifiably be much lower, resulting in a lower
reportable profit.

Alternatively, for negotiating agreements, the value of unqualified property

received on a sale or contributed to purchase a replacement property is
left unpriced. When the value of the unqualified property is unstated in
exchange or purchase agreements, the transaction is called an unpriced
exchange. The true price is left for determination on later reflection when
reporting. Also, all properties in the exchange are left unpriced.

Hindsight, rather than negotiated prices, provides a better perspective for

establishing values set to report profits or losses.

Both sides in an exchange transaction involving the transfer of any

unqualified property want the lowest justifiable price. Both sides will report
some profit (or loss) on its exchange due to the unqualified property.

All the Without an exemption or exclusion of profit from taxes, the profit realized
on all sales or exchanges of any property is reported and taxed, called a
profits on the recognized gain.6
property sold As tax policy, IRC §1031 either fully or partially exempts the profit on the sale
or exchanged or exchange of like-kind properties from being reported and taxed.

6 Internal Revenue Code §1001

 Chapter 30: The §1031 Profit and Basis Recap Sheet 265

In a partial §1031 reinvestment, the investor reports a portion of the profit

they realize on the sale. To experience a partial exemption, the purchase price
for the replacement property is less than the price the investor receives for
the property they sold, called a price trade-down situation.7

For example, the price received for property the investor sold is greater than
the price paid for the replacement property. The difference between property
prices in this trade-down situation is the amount the investor reports as profit
— limited of course to the total profit realized on the sale. [See Form 354 §3.13]

The Recap Sheet sets the amount of all profits taken on the sale or exchange of Reportable
property, called realized gain by the IRS. The realized gain is the maximum
amount of profit reportable and taxed, as though the profit exemption did profit limited
not exist. Realized gain always includes the profit exempt from taxation in a
§1031 reinvestment.
to the total
profit, of
However, the portion of the realized profit taxed in a §1031 reinvestment
plan, called recognized gain by the IRS, is the lesser of: course
• the profit the investor realizes (price minus basis) on the sale or
exchange of the property sold [See Form 354 §3.13]; or
• the total of the net existing mortgages and net cash items the investor
receives in a §1031 reinvestment plan (but not less than zero), plus the
profit or loss on any unqualified property the investor contributes to
purchase the replacement property. [See Form 354 §§ 1.19 and 2.3]

The profit reporting analysis for the property sold in a reinvestment plan is
concluded in the last section of the Recap Sheet. Further calculated is the
Profit reported
reportable profit on the entire §1031 reinvestment plan. on the §1031
No loss is reported on a §1031 transaction. Any loss in an exchange is implicitly transaction
carried forward with the cost basis as is the exempt profit. However, in an
exchange where the investor contributes unqualified property with a value
less than its remaining cost basis, the transfer of the unqualified property is
separately reported as a cash sale. Here, the loss generated on its contribution
is reported, separate from the §1031 transaction report.

The total taxable profit on a §1031 reinvestment is the lesser of: net cash items
The sum of the amount
• the total of the amounts of mortgage relief and cash items received by of cash items from the
the investor which remains after offsets [See Form 354 §4.3]; or sale of the property
sold received prior to
• the total profits realized on all property sold or contributed by the acquiring replacement
investor (in which case a reinvestment plan and the §1031 exemption property, plus the
amount of cash
are unnecessary). [See Form 354 §4.4] items received on or
after the purchase of
In §1031 transactions where the investor withdraws no capital by way of replacement property
net debt relief or net cash items, no profit or loss is reported on the §1031 which exceed the
contribution of
property sold or exchanged by the investor. cash items toward
acquisition of the
replacement property.
7 IRC §1031(b)
266 Tax Benefits of Ownership, Fourth Edition

Consider a loss incurred on the sale of a like-kind property with a basis of

$1,000,000 that has fallen in value to a current market price of $750,000.
When the net proceeds from the sale are reinvested in replacement property,
this loss is implicitly carried forward with the cost basis to the replacement
property. The reporting of the loss is not allowed. In the opposite situation,
however, a cash-out sale of the property with no further nexus to a purchase
of replacement property produces a reportable loss of $250,000.8

8 Redwing Carriers, Inc. v. Tomlinson (5th Cir. 1968) 399 F2d 652

Chapter 30 When selling an investor or business-use property, an investor has a tax

objective of eliminating or at least minimizing taxes on the profit realized
Summary on the sale. The investor reinvests the capital interest they had in the
property sold in a replacement property (its market value comprised of
mortgage principal and equity value) to meet this tax objective.

This reinvestment maintains the foundational premise of the §1031

profit exemption —continued investment in real estate without the
payment of profit taxes on the sale. The investor essentially “exchanges”
equity in one property for the equity in another property.

Cost basis and profit are the opposite sides of one coin and mortgage debt
and equity are the opposite sides of another — the only link between
them is the fair market value of the property sold. The cost basis in a
property is never the same amount as the debt on the property and the
same is true of profit and equity.

A tax analysis of a sale of §1031 property goes beyond the mechanics

of avoiding receipt of the net sales proceeds from the property sold
and complying with time limitations and procedures for identifying
and acquiring replacement property. A §1031 Basis and Profit Recap
Sheet, called the Recap Sheet is a checklist of all the §1031 issues to be
considered.

The Recap Sheet is used to approximate the tax consequences of

a potential §1031 transaction on locating a potential replacement
property. An agent also uses the Recap Sheet to analyze the flow
of capital invested, contributed or withdrawn by an investor may
experience when selling and buying properties in a §1031 reinvestment
plan. The Recap Sheet contains five sections.

The broker and investor must complete all the sections to fully appreciate
the contrasting tax consequences of a reportable profit versus a §1031
reinvestment. While the Recap Sheet determines how much of the
profit on the sale will be reported due to the §1031 reinvestment, the
Recap Sheet does not determine the amount of taxes an investor might
pay.
 Chapter 30: The §1031 Profit and Basis Recap Sheet 267

cash boot ........................................................................................pg. 251 Chapter 30

mortgage boot...............................................................................pg. 255
net cash items............................................................................... pg. 265
Key Terms
net debt relief................................................................................ pg. 257
offsets..............................................................................................pg. 255
recapitalization............................................................................ pg. 258
Notes:
 Chapter 31: The cost basis for the replacement property 269

Chapter
31
The cost basis for the
replacement property

After reading this chapter, you will be able to: Learning

• estimate the cost basis for a replacement property to be acquired
so you can estimate the depreciation deductions and tax benefits
Objectives
of its ownership for your investor; and
• allocate the cost basis as a priority to set the basis and profit in
any carryback note received by the investor and any unqualified
property taken in exchange for the property sold.

cash boot net debt relief Key Terms

Again, consider an investor who enters into an agreement to sell real estate. The annual
Closing the sale is contingent on the investor’s purchase of another property
as part of a §1031 reinvestment plan. depreciation
When a replacement property suitable for the investor to buy is located, its deduction
operating data is gathered to prepare an Annual Property Operating Data offsets
Sheet (APOD form) as an aid to initially determine the economic feasibility
of the property. [See RPI Form 352] income
Tax-wise, you use the APOD form to estimate the investor’s yearly reportable
income or loss from annual operations and ownership. The estimate is based
on the replacement property’s current operating income and expenses as
disclosed by the seller’s agent and updated for new ownership – 12 months of
interest in any mortgage payments, and the annual depreciation deduction.
270 Tax Benefits of Ownership, Fourth Edition

However, the depreciation deduction to be entered on the APOD is derived

from the investor’s cost basis in the proposed replacement property. The
deduction is computed differently for a replacement property in a §1031
reinvestment plan than for a stand-alone purchase.

To estimate the depreciation deductions in a §1031 reinvestment to reflect

ownership of the replacement property, you first prepares a §1031 Profit and
Basis Recap Sheet. The Recap Sheet, in addition to identifying any reportable
profits or losses on the property sold, sets the adjusted cost basis for a proposed
replacement property. [See RPI Form 354; see Chapter 21]

After the cost basis is set by a workup of the Recap Sheet, you allocate a portion
of the cost basis to the property’s depreciable improvements. The allocation of
cost basis to improvements is worked up on a separate §1031 Basis Allocation
Worksheet and entering the cost basis amount. The allocation of basis to
improvements is based on the percentage of the replacement property’s fair
market value (FMV) represented by the value of the improvements, exclusive
of the value in the land. [See Form 355 accompanying this chapter]

You then calculate the depreciation deduction allowed for 12 months of

ownership on the allocation worksheet and enter it on the APOD form.
The applicable depreciation schedule (either 27.5, 39 or 40 years) provides
for the annual recovery of a portion of the investor’s capital invested in the
property’s improvements as an untaxed offset from rental income.1

The annual amount of the depreciation deduction is then entered on the

APOD form to finish the annual reportable operating income or loss estimated
for the proposed replacement property to be reviewed with the investor.

As a point of confidentiality, the investor’s cost basis in their property and the
amount of their profit is uninvolved in negotiations between the investor
and the buyer of the property sold. Likewise, the investor’s basis and profit
when considering a replacement property are of no legal, financial or tax
concern to the seller of the replacement property.

Editor’s note —Section 5 of RPI Form 354 brings together the cost basis
adjustments discussed above to establish the cost basis allocated to the
replacement property. Allocations of the cost basis to cash items withdrawn
by an investor or allocations between two or more replacement properties
are calculated on a separate allocation worksheet form as discussed below.
[See Form 355]

Establishing A separate cost basis and depreciation schedule is established for each
replacement property an investor acquires in a §1031 reinvestment plan.
the cost An investor’s agent anticipates the need for the cost basis to set the annual
basis for depreciation deduction by preparing approximations before the acquisition
is fully negotiated and under contract.
replacement
property
1 Internal Revenue Code §168(c), 168(g)
 Chapter 31: The cost basis for the replacement property 271

The agent calculates the investor’s likely basis in all proposed replacement
property using the §1031 Recap Sheet, as follows:
• carry forward the remaining cost basis from all types of properties the
investor sells or exchanges in the reinvestment plan [See Form 354
§5.3];
• adjust the cost basis carried forward to net out differences in existing
debt on the property sold and the property purchased, and in the dollar
amounts of cash boot contributed or withdrawn [See Form 354 §5.1 cash boot
Items of value received
and 5.2]; on a sale of property
• adjust the basis for profit or loss the investor reports for any contribution or contributed to
purchase replacement
of personal property to acquire the replacement property [See Form 354 property in a §1031
§5.4]; and reinvestment plan
which include
• total the above to set the new cost basis to be allocated between all money, carryback
types of properties received on completion of the reinvestment plan.2 notes, purchase-assist
financing for the
[See Form 354 §5.5] replacement property,
and equity in property
The calculations for each of these adjustments and allocations is reviewed in not qualified as §1031
the following subsections of this chapter. like kind property.
Also called money and
other properties by the
After determining the amount of the new cost basis, you establish the cost IRS.
basis for each replacement property individually. The new cost basis is
allocated between all properties and cash items received in the following
order of priority:
• for any carryback note received by the investor, enter the dollar amount
by which the basis carried forward exceeds the mortgage amount on
the property sold, limited to the amount of the carryback note [See
Form 355 §2];
• for any unqualified properties, real or personal, received by the
investor in exchange for their property, enter the dollar amount of the
equity in the unqualified properties [See Form 355 §3];
• the remaining basis is entered as the cost basis for the §1031 replacement
property; and
• allocate the cost basis entered for the replacement property between its
land and improvements. [Rev. Regs. §1.1031(d)-1(c); see Form 355 §4.1]
The portion of a replacement property’s cost basis allocated to its improvements
represents the amount of invested capital the investor recovers during
ownership as an untaxed offset from rents.3 [See Form 355 §5]

The agent then calculates the annual depreciation deduction taken annually
as a pro rata amount of the cost basis allocated to improvements over the
number of years set by IRS schedules (27.5, 39 or 40 years). [See Form 355 §6] ,

Generally, an investor’s cost basis in a property is the price paid to acquire it

plus capitalized transactional costs and further improvements. However, in
a §1031 transaction, the cost basis for the replacement property is not based
on the price paid for the replacement property.
2 Revenue Regulations §1.1031(d)-1
3 Rev. Regs. §1.1031(d)-1(c)
272 Tax Benefits of Ownership, Fourth Edition

The price paid for a replacement property comprises the sales proceeds
reinvested (or equity exchanged) and mortgages assumed. The investor’s
capital interest in the replacement property contains unreported profits
implicitly carried forward from the sale (or exchange) of the property sold.

Again, the unreported profit carried forward from the property sold, called
unrecognized gain by the IRS, is the difference between the price paid for the
replacement property and its cost basis on acquisition. [See Form 354 §3.13]

The following subsections lay out the calculations for adjustments to the cost
basis carried forward to establish the adjusted cost basis to be allocated to one
or more replacement properties received in a §1031 reinvestment plan.

Adjustments All property sold or exchanged by an investor has a cost basis of some amount,
whether the property is §1031 property or unqualified property. Again, the
made to the cost basis in each property sold is carried forward, subject to adjustments, to
cost basis establish the cost basis for the replacement property. [See Form 354 §5.3]

carried Adjustments are made to the cost basis carried forward for the following
capital items:
forward
• existing debt: adjust the basis for the net increase or decrease between
the amount of the existing mortgages on the property sold or
exchanged and the amount of the existing mortgages taken over on
the replacement property. [See Form 354 §1.3 and 5.1]
• cash items: adjust the basis by a decrease for the amount of any cash,
carryback notes and equity in unqualified property the investor
withdraws or receives at any time, and further adjust the basis by an
increase for the amount of cash the investor contributes, transactional
costs paid on both the sale and purchase, any carryback notes the
investor executes to buy the replacement property, and the value of
the equity in any unqualified property contributed to purchase the
replacement property. [See Form 354 § 1.7 to 1.12 and 5.2]
• profits reported: adjust the basis by an increase or decrease for the
amount of any profits or losses reported on the sale of the property sold
and in any unqualified property the investor contributes to acquire
the replacement property. [See Form 354 §4 and 5.4]
The old basis carried forward, coupled with these adjustments, sets the new
cost basis to be allocated among all personal and real property the investor
purchases or acquires as part of a §1031 reinvestment plan. [See Form 354
§5.5]

Handling When the dollar amount of net debt relief on the property sold is not offset
on acquisition of the replacement property. the investor reports and is taxed
adjustments on profit they realize on the property sold in a §1031 reinvestment plan.
for existing Debt relief is offset by the investor’s assumption of mortgages, execution of
purchase-assist financing or contribution of cash items on the purchase of
mortgages and replacement property. [See Form 354 §1.3 and 4.1]
cash items
 Chapter 31: The cost basis for the replacement property 273

The lack of offsets produces net debt relief which is deducted from the basis net debt relief
carried forward. This adjustment reflects the investor’s reduction of their The amount of the
continuing capital investment – debt is borrowed capital. As a result of profit existing mortgage
balance encumbering
taxed due to net debt relief, the profit reported is added to the basis carried the property sold
forward. [IRC §1031(d); Rev. Regs. §1.1031(d)-1(c); See Form 354 §1.3 and 5.1] not offset by the
assumption of
mortgage balances
Separate from debt relief but will offset debt relief, cash items include cash, or contribution
carryback notes and unqualified properties, called money and other property of cash items on
by the IRS and commonly just called cash boot. acquiring replacement
property in a §1031
reinvestment plan.
To net out cash items for adjustment to the cost basis carried forward, cash Also called mortgage
items are first grouped as either withdrawals or contributions by the investor boot.
in the reinvestment plan. Here, the dollar value of each cash item – the
equity value in unqualified property – the investor withdraws or receives
on either the sale of their property or their purchase of replacement property
is deducted to decrease the cost basis carried forward. These represent a
withdrawal of capital from the investment. [See Form 354 §5.2(a) and 5.2(b)]

Conversely, the amount of cash items the investor contributes – cash,

carryback notes they execute, and the equity in unqualified property – to
purchase replacement property is added to increase the cost basis carried
forward. These additions to basis represent additional capital investment.4

Property, including real estate not qualified as §1031 property, contributed by

the investor in exchange for replacement property constitute the additional
Contributing
investment of a cash item. However, accounting for the contribution of non- unqualified
§1031 property is handled differently from accounting for cash contributions,
such as cash or the execution of a carryback note to acquire replacement
property
property. to acquire
Critically, unqualified property the investor owns and contributes to the §1031
purchase of replacement property has a cost basis (and possibly a taxable
profit) in their hands.
property
The fair market value (FMV) of the unqualified property the investor
contributes, less the remaining cost basis in that property, sets the profit or loss
taken when it is contributed to acquire replacement property. Remember:
price minus basis equals profit. [See Form 354 §2]

Adjustments to the cost basis carried forward to the replacement property due
to the investor’s contribution of unqualified, non-§1031 property include:
• any existing debt encumbering the unqualified property contributed
is entered as further debt relief by an adjustment to decrease the cost
basis, equivalent to a withdrawal of invested capital whether the buyer
assumes or refinances the mortgage [See Form 354 §1.1, 1.3 and 5.1];5
• the cost basis remaining in the unqualified property is added to
increase the basis carried forward to the replacement property [See
Form 354 §5.3(b)]; and
4 Rev. Regs. §1.1031(d)-2; see Form 354 §5.2(c), 5.2(d) and 5.2(e)
5 Rev. Regs. §1.1031(d)-2
274 Tax Benefits of Ownership, Fourth Edition

Form 355
§1031 BASIS ALLOCATION WORKSHEET
§1031 Basis Replacement Property Depreciation Analysis
(Supplement to §1031 Recapitulation Worksheet Form 354)

Allocation Prepared by: Agent ____________________________

Broker ____________________________
Phone _______________________
Email _______________________
Worksheet NOTE: This form is used to determine the annual depreciation deduction to be entered on APOD ft Form 352 to set the after-tax
return on property to be acquired.

DATE: _____________, 20______, at _____________________________________________________, California.

Items left blank or unchecked are not applicable. References to forms includes their equivalent.
Prepared by: ______________________________________________________
Property sold or exchanged: __________________________________________
Replacement property: ______________________________________________
1. Cost basis allocable between replacement property and cash items received:
1.1 Enter the cost basis for all replacement properties as
calculated on ft Form 354 at line 5.5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
(If no unqualified property or carryback note was received
for the property sold, go to line 4.1)
2. Priority allocation of basis to installment note carried back on
the property sold:
2.1 Enter the cost basis carried forward from the property sold
(as shown on ft Form 354 at line 3.7) . . . . . . . . . . . . . . . . . . $_______________
2.2 Enter the debt relief on the property sold. . . . . . . . . . . . . . (-)$_______________
2.3 Cost basis of note: If the amount of line 2.1 exceeds
the amount of line 2.2, enter the difference, limited to
the amount of the note (as shown on ft Form 354 at line 1.5) . . . . . . . . . . . . . . . . (-)$_______________
3. Priority allocation of basis to unqualified property received:
3.1 Enter the amount of the equity in the unqualified property
received (as shown on ft Form 354 at line 1.6). . . . . . . . . . . . . . . . . . . . . . . . . . . . (-)$_______________
3.2 Enter the amount of any debt which encumbers
the unqualified property received. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
3.3 Cost basis for unqualified property: Enter the total of line
3.1 plus 3.2 to set the cost basis in the unqualified property
0.00
received in exchange for the property sold . . . . . . . . . . . . . . . $_______________
4. Allocation of the remaining cost basis to §1031 Replacement
Property:
4.1 Enter the sum of line 1.1 minus lines 2.3 and 3.1 as the cost
0.00
basis of all §1031 Replacement Property received . . . . . . . . . . . . . . . . . . . . . . . . (=)$_______________
4.2 Allocation of basis between two or more §1031
Replacement Properties: Property 1 Property 2
a. Identification: _______________ _______________
(Enter an identification for each §1031 property received)
b. Allocation for debt: $_______________ 0.00
$_______________ . . . . . . . . (-)$_______________
(Enter the amount of debt assumed on each property 1 and 2.)
(Enter the total of the debts assumed on both properties.)
c. Basis to be allocated: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
0.00
(Enter the amount at line 4.1 minus the total from line
4.2 b.)
d. Equity valuation: $_______________ $_______________ . . . . . . . (=)$_______________0.00

(Enter the equity value given each property 1 and 2.)

(Enter the total value of the equities in both properties.)
e. Equity ratios: _____% _____% = _______________
100%
(Enter the percentage of each property's pro rata share
of the total value of all equities from line 4.2 d.)
0.00
f. Allocation for equity: $_______________ 0.00
$_______________
(Enter the amount of each property's pro rata share
of line 4.2 c. based on line 4.2 e. percentages.)
g. New cost basis: 0.00
$_______________ $_______________
0.00
(Enter the total of the amounts allocated to each
property at line 4.2 b. and 4.2 f.)
— — — — — — — — — — — — — — — — — — — PAGE ONE OF TWO — FORM 355 — — — — — — — — — — — — — — — — — — —

• the amount of profit reported as taxable triggered by the contribution

of unqualified property is added to increase the cost basis carried
forward.6 [See Form 354 §2.3, 4.2 and 5.4]
For example, consider an investor who exchanges a $100,000 value in an
airplane as partial payment toward the price paid for replacement property.

The transfer of the airplane is reported as a separate sales transaction. Any

profit on the sale of the airplane does not qualify as like-kind property for
the §1031 profit tax exemption. Any profit or loss included in the price of the
airplane is separately reported and taxed. [See Form 354 §2.3 and 4.2]

6 Rev. Regs. §1.1031(d)-1(e)

 Chapter 31: The cost basis for the replacement property 275

Form 355
— — — — — — — — — — — — — — — — — — — PAGE TWO OF TWO — FORM 355 — — — — — — — — — — — — — — — — — — —

5. Depreciable cost basis for a single replacement property:

5.1 Enter the percent of the replacement property's market value
§1031 Basis
represented by the market value of its improvements . . . . . . . . . . . . . . . . . . . . . . . . . . _____%
5.2 Depreciable Cost Basis: Enter that portion of the basis at
Allocation
line 4.1 (or 4.2 g.) which represents the percentage of value
0.00
attributable to improvements at line 5.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $_______________
Worksheet
6. Depreciation deduction from income for each year of ownership:
6.1 Depreciation Schedule: Enter the number of years for
recovery of the cost of improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  ______ years
page 2
(27.5 years for residential; 39 or 40 years for nonresidential)
6.2 Annual Depreciation Deduction: Enter the result of
dividing the depreciable cost basis at line 5.2 by the number
of years at line 6.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . = $_______________
(Enter this amount on APOD ft Form 352 as
the annual depreciation deduction for the replacement property)
6.3 The estimated annual depreciation deduction at line 6.2 is probably understated.
From the property sold, the amount of the annual depreciation deduction and the
years remaining on the recovery period at the time of sale are carried forward (as
is the cost basis) and reported as the depreciable exchange basis for the
replacement property (or reported as extended 11.5 years if the property sold was
residential property and the replacement property is nonresidential). Any upward
adjustment in the depreciable basis in the replacement property over the
remaining depreciable exchange basis from the property sold (due to a trade up
into the replacement property) is separately set up as the replacement property’s
excess depreciable basis, and is deductible over the 27½- or 39-year depreciation
schedule applicable to the replacement property.

FORM 355 03-11 ©2011 first tuesday, P.O. BOX 20069, RIVERSIDE, CA 92516 (800) 794-0494

Since the airplane as unqualified property is capital contributed to acquire

replacement property, both the basis and the profit reported as a sale of the
airplane are added to increase the basis carried forward – an amount equal
to its value it represents in the replacement property. [See Form 354 §5.3(b)
and 5.4]

Further, the amount of any mortgage encumbering the airplane is a reduction

in the basis – it is debt relief by assumption or refinance on its transfer by the
buyer. [See Form 354 §1.1 and 5.1]

When the investor does not receive a carryback note or unqualified property Priority
on the sale of their property, the cost basis carried forward, adjusted for net
debt and net cash items, is allocated in its entirety to the §1031 replacement allocation of
properties. [See Form 355 §4.1] the adjusted
The adjusted cost basis, estimated using the §1031 Profit and Basis Recap cost basis
Sheet, is allocated among all types of properties the investor acquires in a
§1031 transaction - §1031 property, cash, carryback notes or unqualified real
or personal property.

When the investor receives a carryback note or unqualified property on the

sale or exchange of their property, the adjusted cost basis is first allocated to
any carryback note, then to unqualified property the investor receives. The
remaining cost basis is allocated to the 1031 replacement property.7

7 IRC §1031(d); Rev. Regs. §1.1031(d)-1(c)

276 Tax Benefits of Ownership, Fourth Edition

Further, the priority allocation of basis to the carryback note only occurs when
the amount of the cost basis in the property sold is greater than the mortgage
amounts that encumber it, the typical basis-over-mortgage situation.

Again, when the basis in a property sold is $300,000 and the debt on the
property is $200,000, the $100,000 difference is the amount of basis-over-
mortgage. This difference in overriding basis is first allocated to the carryback
note received by the investor. The allocation is limited to the amount of the
note. [See Form 355 §2]

The basis-over-mortgage condition results in a return of capital (which is not

taxed) due to installment sales reporting of a carryback note on the property
sold in a partial §1031 reinvestment plan. After the priority allocation of
the excess basis, the remaining portion of the principal in the note is profit,
taxable on a pro rata basis each year as principal is received on the note.

An investor occasionally receives unqualified property such as a boat, car,

plane, equipment, furnishings or a personal residence “in trade” on the sale
of their real estate. Any unqualified property the investor acquires is given
a priority allocation from the adjusted cost basis for the dollar value of its
equity. [See Form 355 §3]

Thus, when the unqualified property the investor receives is encumbered,

the amount of the adjusted cost basis allocated to it is equal to its equity
value. Then added together, the debt on the unqualified property and the
basis allocated to its equity become the cost basis in the unqualified property
the investor receives — like when a cash price is paid to buy the unqualified
property.

The basis remaining after all priority allocations becomes the basis for the
§1031 replacement properties. [See Form 355 §4]

Occasionally, an investor acquires two or more §1031 replacement properties

Basis to complete a §1031 reinvestment. The new cost basis is allocated between
allocated the replacement properties based on the price paid for each — but only when
the replacement properties are free of any mortgages.8
among two
When the investor acquires two or more replacement properties, one of two
or more situations arise:
replacement • the multiple replacement properties are unencumbered, with no debt
properties taken over by the investor, as mentioned above; or
• one or more of the multiple replacement properties is encumbered by
debt taken over by the investor, as covered below.9
Allocation of the cost basis among multiple replacement properties has
no relationship to the allocation of each replacement property’s cost
basis between its land and improvements. Critically, future depreciation
deductions are based solely on the basis allocated to improvements.

8 Revenue Ruling 68-36

9 Rev. Rul. 68-36
 Chapter 31: The cost basis for the replacement property 277

Consider an investor who acquires two replacement properties to complete Basis allocated
their §1031 reinvestment plan. The combined price paid is the same as the
price received for the property sold. among
All properties sold or exchanged and bought are free of debt. Thus, the investor debt free
receives no debt relief and no debt is acquired. Also, no cash boot is involved. replacement
Here, the basis carried forward needs no adjustment before it is allocated properties
between the two replacement properties. The cost basis to be allocated is the
same amount as the basis in the property sold. No debt relief or cash items
exist for adjustments.

The remaining basis in the property the investor sells is $600,000. Its sales
price is $1,200,000. Both the property sold and the replacement properties are
free and clear.

The price the investor pays for each of the replacement properties is $500,000
and $750,000, respectively, a total of $1,250,000. This is approximately the
same total amount as the price received for the property sold.

To allocate the cost basis between the two replacement properties, the investor
needs to first determine the percentage of each replacement property’s pro
rata share of the total value of all §1031 replacement properties received in
the reinvestment plan:
• $500,000 of $1,250,000 total for the first property received — a 40%
allocation of the cost basis; and
• $750,000 of $1,250,000 total for the second property received — a 60%
allocation of the cost basis.
Of the $600,000 cost basis to be allocated, $240,000 (40%) goes to the first
property, and $360,000 (60%) goes to the second. [See Form 355 §4.2]

Finally, the basis allocated to each replacement property is further broken

down and allocated between its land and improvements. The allocation to
improvements for each replacement property is based on the ratio of the
value of the improvements on each property as a percentage of the total price
paid for each property. [See Form 355 §5]

Usually, multiple replacement properties are encumbered with different

loan-to-value (LTV) ratios. However, IRS regulations do not address basis
Basis
allocation among multiple encumbered replacement properties, except that allocated
the allocation is to occur. Existing regulations only discuss allocating basis
when the replacement properties are free and clear of mortgage debt – a rare among
reinvestment situation easily understood as noted above. encumbered
To allocate basis among encumbered properties you set a ratio based on the replacement
value of equity in each property, not the price of each. You first allocate basis
to each §1031 replacement property in the amount of the debt assumed on
properties
each property – the “debt basis.” [See Form 355 §4.2(b) and 4.1]
278 Tax Benefits of Ownership, Fourth Edition

The cost basis remaining after the priority allocation for debt is the “equity
basis.” This remaining “equity basis” is allocated to each property based on
the ratio of the equity in each property. [See Form 355 §4.2(c), 4.2(d) and 4.2(f)]

Finally, total the basis allocated to each property for mortgage debt amounts
and equity valuations to set the new cost basis in each of the replacement
properties. [See Form 355 §4.2(b), 4.2(f) and 4.2(g)]

Thus, the mortgage-to-value disparity between two or more replacement

properties does not cause a highly leveraged property to end up with a
disproportionately low basis compared to its mortgage amount. This distortion
occurs when the allocation is based on the value of each replacement
property, rather than on the amounts of their debts and equities.10

10 Rev. Rul. 68-36

Chapter 31 As part of a §1031 reinvestment plan, once a suitable replacement

property is located, its operating data is gathered to prepare an Annual
Summary Property Operating Data Sheet (APOD form). The APOD form is an aid to
initially determine the economic feasibility of the property.

Taxwise, the APOD form is used to estimate the investor’s yearly

reportable income or loss from annual operations and ownership. The
estimate is based on 12 months interest in any mortgage payments and
the annual depreciation deduction.

The depreciation deduction is derived from the investor’s cost basis in

the proposed replacement property and is to be entered on the APOD
form. The portion of a replacement property’s cost basis allocated to its
improvements represents the amount of invested capital the investor
recovers during ownership as an untaxed offset from rents.

To estimate the depreciation deductions, the investor prepares a §1031

Profit and Basis Recap Sheet. The Recap Sheet, in addition to identifying
any reportable profits or losses on the property sold, sets the cost basis to
be allocated to the replacement property.

After the cost basis has been set on the Recap Sheet, the broker enters
the basis on the separate §1031 Basis Allocation Worksheet to allocate
a portion of the cost basis to the property’s depreciable improvements.
The allocation of basis to improvements is based on the percentage of
the replacement property’s fair market value (FMV), represented by the
value of the improvements.
 Chapter 31: The cost basis for the replacement property 279

Property sold or exchanged by an investor has a cost basis (even when it

is zero), whether the property is §1031 property or unqualified property
such as dealer property, the investor’s principal residence or personal
property. The cost basis remaining in each property sold or exchanged by
an investor in a §1031 reinvestment plan is carried forward to establish
the cost basis for the replacement property.

cash boot........................................................................................ pg. 271

Chapter 31
net debt relief................................................................................ pg. 273
Key Terms
Notes:
 Chapter 32: Change of ownership and assessment of replacement home 281

Chapter
32
Change of ownership
and assessment of
replacement home

After reading this chapter, you will be able to: Learning

• determine how the County Assessor sets a property’s base year
value assessment and taxable value on a change in ownership;
Objectives
• recognize the exemptions and exclusions as claims by a new owner
which lower a property’s taxable value below the property’s FMV;
• advise on the exclusions from taxable value on transfer of
factored base year value to a replacement primary residence or
on conveyance of the family home and farm between parent and
child.

assessed taxable value exclusions Key Terms

base year value exemptions
change of ownership factored base year value

Property taxes beginning in 1978 are limited in dollar amount to 1% of a Property

property’s assessed taxable value. To implement this change, each time
a property has a change of ownership the County Assessor determines its taxes geared
fair market value (FMV) and maintains the FMV as the property’s base year
value assessment. The property’s taxable value used to calculate property
to base
taxes is set annually as the amount of the factored base year value as year value
adjusted annually for consumer inflation, minus any exemptions the owner
qualifies to claim.
assessment
282 Tax Benefits of Ownership, Fourth Edition

exclusions
When the taxable value reflects a family exclusion (not an exemption), the
Types of property-tax taxable value is separately adjusted for inflation from the adjustment to the
avoidance claims base year value. Transfers on the sale and replacement of a primary residence
arising when a
primary residence of the factored base year value are not exclusions or exemptions, as
is replaced resulting presented later in this chapter.
in a base year value
reassessment less
than FMV and on
Before setting the amount of each year’s assessed taxable value during
transfers of the family ownership, the Assessor applies a rate of consumer inflation to the prior year’s
home or family farm base year value assessment. This calculation sets the increased amount of the
between parents and
children eliminating current year’s factored base year value which the Assessor uses to determine
up to $1,000,000 from the property’s assessed taxable value for the Tax Collector to levy property
assessed taxable value. taxes due from the owner.

The inflation adjustment rate is the lesser of California’s consumer price index
(CPI) figure for the prior year or 2%. This annual adjustment is a compounding
of the rate of inflation.
base year value
The assessment set by For property acquired or constructed prior to February 1975, the property’s
the County Assessor base year value assessment is set as its FMV in 1975 (a recession year of low
for the first year
following a change of values). All change of ownerships after February 1975 have a base year
ownership as the fair value set as the property’s FMV on the date of acquisition or completion of
market value (FMV)
of a property on the
construction.1
date the new owner
acquired it. Before 1975, real estate was subject to reassessment every year. A property’s
assessed taxable value changed annually (or less periodically as a practical
change of
matter) to reflect annual changes in property values brought about by asset
ownership inflation or deflation and any appreciation due to the demographics of the
A conveyance of local real estate market.
title to real estate
resulting in transfer
of the beneficial use Today, assessed taxable values for setting property taxes result from the
of the property which annual inflation adjustments rising from the base year value assessment
triggers reassessment initially set at FMV on a change of ownership, not a change in the property’s
of the property by the
County Assessor to FMV from year to year. Increases of a property’s FMV in future years no
set the property’s new longer controls the amount of a property’s assessed taxable value. Thus, a rise
base year value.
in FMV during ownership does not influence the amount of property tax the
owner will pay.

Conversely, in forward years when the FMV of a property drops below its
factored base year value assessment (or the taxable value if less), the property’s
assessed taxable value becomes temporarily unanchored from the base year
value assessment. During the years a property’s FMV is less than the factored
base year value, the Assessor sets the property’s taxable value at the current
fair market value (FMV).

Meanwhile, the calculation of the annual factored base year value assessment
continues to set the ceiling for the property’s assessed taxable value. When
in future years the property’s FMV rises above its factored base year value
assessment, the taxable value returns to be set by the factored base year value
and the greater FMV no longer controlling.

1 California Constitution, Article 13A

 Chapter 32: Change of ownership and assessment of replacement home 283

March 1st of each year is the lien date on which property taxes, based on the
amount set as the assessed taxable value for the year, are imposed as a lien on
the property for the upcoming fiscal year (July 1 through June 30).

Consider a parcel of real estate purchased this year in a conventional sale for
the price of $1,000,000. Its base year value assessment is $1,000,000 on March The annual
1, the lien date for the first year of the buyer’s ownership. Since the buyer work of the
claims no exemptions or exclusions the assessed taxable value used for
property tax purposes is set at $1,000,000 – the base year value assessment. property tax
Here, the property taxes for the first fiscal year — July 1 to June 30 — are
creep
limited to 1% of the assessed taxable value, a tax due to the Tax Collector of
$10,000. assessed taxable
value
The annual valuation
Each year the base year value assessment is increased at the rate of consumer of property set by the
inflation, limited to 2%. The adjusted assessment amount for ownership after County Assessor as
the first year is labeled the factored base year value assessment. Accordingly, the sum of the base
year value, factored
the assessed taxable value of the property for the second fiscal year of for inflation, minus
ownership is increased to $1,020,000 – the factored base year value for the exemptions and
exclusions, for use
year. Thus, the property tax due for the second fiscal year of ownership is by the County Tax
$10,200, 1% of $1,020,000. Collector to levy
annual property taxes,
Since the annual inflation increase is compounded, the 2% inflation commonly referred to
as the assessed taxable
adjustment for the base year value increase in the third fiscal year of the value or current
buyer’s ownership is calculated on the prior year’s factored base year value taxable value for a
of $1,020,000, not the initial base year value at FMV for the year of purchase. property.

Here, the property’s assessed taxable value for the third fiscal year is
$1,040,400, with a 1% property tax of $10,404.2

Avoiding FMV reassessment is financially significant when you have family,

have longevity of ownership, and great timing. Since 1980 (but not during
The inequities
the prior period back to WWII), California asset price inflation for the FMV of of California’s
real estate has averaged around 3.5% annually, far exceeding the consumer
inflation adjustment a property’s assessed taxable value for setting property
evolving
taxes is tied to. property tax
The assessed taxable value over the years a property is held by a long-term experiment
owner comprises a constantly declining percentage of the property’s inflated
and appreciated asset value in California’s real estate market. This market
price movement was driven primarily by declining long-term interest rates
during the past half-cycle of mortgage rates beginning in 1980. Interest rates,
whether ascending or declining directly influence the capitalization rate for
return on cash invested. This cap rate, in turn, sets asset values in all types of
markets – the lower the cap rate the higher the price of assets, or conversely
as in the reciprocal P/E ratio for stockholders as they like all things to rise
higher.

2 Armstrong v. County of San Mateo (1983) 146 CA3d 597

284 Tax Benefits of Ownership, Fourth Edition

As the ratio of assessed-value to asset-value increased after 1980 through

2020, say from 1:1 to 1:4 as with a four-fold price increase, the tax-to-FMV
percentage for real estate ownership decreased from 1% to 0.25% of FMV. The
same financials occur for income property operations where the percentage
of rental income expended to pay property taxes drops in tandem.

These distortions between assessment figures and current FMV are in part the
result of the annual base year value adjustment being restricted to consumer
inflation, not asset inflation. Okay for the fixed income homeowner; a
windfall for investors yet to be corrected.

As interest rates rise cyclically in the coming decades following 2020, annual
market value increases will more closely align with the annual maximum
2% consumer inflation adjustments reflected in assessed taxable values.

Also of note: Because turnover of ownership - other than a family home and
farm from parents to children - generates additional property tax revenue
for local governmental agencies, the Prop 13 change-of-ownership property
tax law is often referred to as the “Welcome Stranger” law. Said another way,
“our community needs services the extra revenue will fund.”

Single-family California homeowners who occupy a dwelling they own as a principal

residence are entitled to claim a $7,000 exemption from the property’s
residence, annual assessed taxable value. This exemption translates into a property tax
owner- reduction of $70. California’s housing policy uses the tax codes to encourage
ownership of a residence rather than renting a residence. [Calif. Const. Art. 13
occupant, §3(k)]
$7k For example, consider a homeowner whose principal residence has a factored
exemption base year value of $400,000. Due to the $7,000 exemption, the assessed taxable
value is set at $393,000. The maximum property tax rate of 1% is applied only
to $393,000 – the lesser assessed taxable value due to the exemption. Thus, the
exemptions owner pays $3,930 annually in property taxes instead of $4,000 — a $70 tax
Types of property-tax reduction for each year of owner-occupancy. Small money, but sufficient to
avoidance claims
made by the owner
supply beer, not wine, for a small party.
for setting the annual
taxable value at zero or The $7,000 exemption is a fixed recurring amount. It does not vary annually
by subtracting a fixed like the assessed taxable value which is inflation adjusted each year. For
dollar amount from
the property’s base example, when the $400,000 assessed taxable value of a homeowner’s
year value. residence is increased by the annual upward adjustment of the 2% maximum
inflation rate to $408,000, the exemption remains at $7,000. Thus, the assessed
taxable value for property taxes lowered to $401,000. The owner’s resulting
property taxes are $4,010, again representing an annual savings of $70 for the
owner-occupant of the single-family residential property.

Properties qualifying as a “dwelling” for the owner-occupant’s exemption

include:
• a condominium or planned-unit development;
• a multiple unit property occupied by the owner;
 Chapter 32: Change of ownership and assessment of replacement home 285

• a single-family dwelling;
• shares in a co-op housing corporation; and
• a mobilehome and any ownership interest in the space occupied by
the mobilehome. [Revenue & Taxation Code §218(c)(2)(B)]
A single-family residence which is rented or vacant does not qualify for the
exemption. Neither does a residence still under construction on March 1st,
with exceptions for reconstruction due to some disasters. Also, second homes
and residences with a disabled veteran’s $100,000 exemption do not qualify
for the $7,000 exemption from property assessment.3

The homeowner’s exemption applies to a homeowner’s residence whether

or not it is encumbered by a mortgage. Thus, a residence qualifies that is
purchased and financed by the buyer entering into a land sales contract or
lease-option sales agreement to finance their acquisition and possession as
an equity owner of the property.

Editor’s Note – Prop 19 legislation is now law. But this copy was posted prior Aged 55,
to the legislature enacting codes to implement Prop 19 procedures. When
enacted the codes may alter some of the minor details presented below. assessment
Consider a retired couple, one or both aged 55 or more. They have long owned transfers to
and occupied a single-family residence (SFR) but it no longer accommodates replacement
their needs for desirable shelter and card games. They intend to buy a
replacement SFR. home
A real estate agent they know is contacted for advice and assistance on the
sale of their residence. Their need to purchase a more commodious residence
in an urban area with greater cultural and social amenities than they now
have will be addressed.

While discussing listing arrangements for the sale and the separate costs
incurred to sell their residence and buy another, the agent brings up the topic
of annual property taxes they will pay on a replacement residence.

By considering the seller’s relocation intensions, the relative values of the

properties to be sold and purchased, and the contents of a title profile for the
home to be sold, the agent determines:
• the couple is vested in ownership and occupies the property as their
primary residence;
• the property qualifies for or has a homeowner’s $7,000 assessment
exemption;
• at least one spouse will be over 55 years of age on the closing date for
the sale of their residence;
• the sales price and FMV of their current residence is $700,000;
• the current factored base year value of the residence is $250,000; and
• the couple is willing to pay up to $1,000,000 for a replacement residence.
3 RTC 218 (b)(1)
286 Tax Benefits of Ownership, Fourth Edition

Thus, the purchase price of the replacement residence of the quality they
seek may greatly exceed the current assessed taxable value of the residence
they are selling.

The agent first advises the couple that the replacement residence may be
located anywhere in California, not in another state. Also, that the base
year value and assessed taxable value for setting property taxes on their
replacement residence will be the sum of:

factored base year

• the factored base year value of $250,000 for their current home - the
value amount transferred to the replacement home to set the replacement
The base year value property’s base year value assessment for the portion of the price paid
adjusted upward
annually by the
to acquire it up to the amount of the price received for the home they
County Assessor to sold, plus
reflect consumer
inflation limited • the portion of the price they pay for their replacement home which
to 2% annually, exceeds the price they receive for the home they sold.
compounded.
By simply claiming the exclusion, the buyer of a replacement residence
pays property taxes on a new base year value assessment set entirely or in
large part on the assessment on their current residence. Critically as a sort of
conditional reassessment, when the price paid for the replacement residence
exceeds the price received for their current residence, that price difference is
added to the factored base year value assessment transferred from the home
sold to the replacement home. The assessed taxable value for property taxes
on the replacement residence will be its new base year value assessment, less
a homeowner’s exemption of $7,000 they may also claim.

For example, a retired couple’s primary residence has a factored base year
value assessment of $300,000, and is sold for $600,000. On the other hand, the
replacement residence they are buying has a market value of $700,000.

Since the market value of the replacement residence is $100,000 more than
the price received for the primary residence they sold, the factored base year
value transferred to the replacement residence is increased for the difference
in value. Thus, the new base year value for the replacement home, and thus
its first year assessed taxable value will be $400,000 ($300,000 + $100,000).

The California housing policy transferring the amount of the factored base
The transfer year value from the primary residence which is sold to a replacement
of assessment residence is available to:
stabilizes • homeowners aged 55 or more
housing • persons with severe disabilities;
• victims of natural disasters; and
expenses
• victims of wildfires.
Further, homeowners aged 55 or move and those with severe disabilities may
during their lifetime sell and replace their primary residence and transfer
the factored base year value from the home sold to the replacement home
three times. However, only one assessment transfer is permitted per natural
 Chapter 32: Change of ownership and assessment of replacement home 287

disaster or wildfire and then only when the value of the improvements is
diminished more than 50% by the wildfire or a natural disaster declared by
the governor.

As California’s housing policy, a factored base year value which is below

market value for a primary residence that is sold may be transferred to a
replacement residence. This tax code result is designed to encourage retirees
to own the residence they occupy, not rent it, by keeping their property
tax payments low. Also, the taxing policy tends to keep them as California
taxpayers rather than their moving to another state for personal financial
reasons.

As a direct result, turnover of long-standing ownership by retirees, and the

disabled, is increased. Turnover allows for a home larger than the owner
needs to be sold and more efficiently used by another household. An example
of such a relocation is empty-nest retirees aged 55 or more who move into a
more compact home of any price, anywhere in the state.

This result helps reverse part of the adverse effect on low homeownership
turnover experienced in California before the 2020 recession in order to
keep homeownership taxes low, and the disruption of a proper allocation of
national wealth by the unused excess housing space brought about by reverse
mortgage originations, advanced surveillance installations, and shelter-in-
place requirements in 2020-2021 during the COVID-19 pandemic. A further
point: use of the tax code to achieve public policy objectives constitutes a
subsidy, an investment in keeping elderly Californians efficiently housed in
California.

To qualify, homeowners need to: Qualification

• own and occupy a primary residence so they qualify for a $7,000 requirements
homeowner’s exemption from assessed taxable value;4
• be at least 55 years aged or severely and permanently disabled on
closing the sale of the residence sold or the residence significantly
damaged in value by wildfire or natural disaster;5
• close the purchase of a replacement principal residence or complete
construction during the period beginning two years before and ending
two years after closing the sale of the residence sold.6
While the owner’s original and replacement residences need to qualify for the
$7,000 exemption, the owner does not need to actually take the exemption to
qualify on their claim for transfer of the current assessment.7

To qualify for the age requirement, only one of the sellers needs to be aged 55
or more on the date they close the sale of the residence sold. The replacement

4 Rev & T C §69.5(b)(4)

5 Rev & T C §69.5(b)(3)
6 Rev & T C §69.5(b)(5)
7 Rev & T C §69.5(g)(10)
288 Tax Benefits of Ownership, Fourth Edition

property can be acquired before age 55 during the two-year period before
turning age 55 and then on turning age 55 close escrow on the sale of the
primary residence.

To qualify as “bought” or “sold,” the properties need to close escrow and

the conveyances recorded with titles vested in the owners as sole owner,
community property, joint tenants, tenants-in-common or as individuals, or
in their intervivos “living” trust, but not vested in the name of an entity such
as an LLC, partnership, or corporation.

Further, simply entering into a purchase agreement without closing

documentation does not qualify the homeowner to carry forward the factored
base year value from the residence sold to the replacement residence.

Occasionally, a homeowner retains their residence by converting it to a rental

when the move to their replacement residence. When they retain their prior
primary residence and rent it and do not sell it within two years after taking
title to the replacement residence, they are unable to transfer its assessment
to the replacement residence.8

8 Rev & T C §69.5 (e)

 Chapter 32: Change of ownership and assessment of replacement home 289

Since 1978, the dollar amount of annual property taxes an owner pays Chapter 32
have been limited to 1% of a property’s assessed taxable value. As a
result, each time a property has a change of ownership, the County Summary
Assessor determines the fair market value (FMV) of a property.

This assessment is referred to as a property’s base year value. This base

year value amount is factored annually and adjusted for consumer
inflation, minus any qualified exemptions or exclusions claimed by the
owner.

The inflation adjustment rate is the lesser of California’s consumer price

index (CPI) figure for the prior year or 2%. Exemptions are a type of tax-
avoidance claim made by an owner to either subtract a fixed dollar
amount from the property’s base year value or set its annual taxable
value to zero.

Similarly, yet different, exclusions are a type of tax-avoidance claim

arising out of exceptional circumstances, such as the replacement of a
primary residence with a base year value assessment lesser than its FMV
or intergenerational transfers of a family home or farm. The distortions
between assessment figures and current FMV are partially the result of
the annual base year value adjustment being restricted to consumer
inflation rather than asset inflation.

As interest rates rise, annual market value increases will align more
closely with the 2% consumer inflation maximum and be reflected in
assessed taxable values.

assessed taxable value ............................................................... pg. 283 Chapter 32

base year value............................................................................. pg. 282
change of ownership.................................................................. pg. 282
Key Terms
exclusions...................................................................................... pg. 282
exemptions.................................................................................... pg. 284
factored base year value............................................................ pg. 286
Notes:
 Chapter 33: Parent-to-child transfers of family home and farm cap property taxes 291

Chapter
33
Parent-to-child transfers
of family home and farm
cap property taxes

After reading this chapter, you will be able to: Learning

• explain the reassessment limitations on the transfer of a parents’
principal residence and farm to their children or parentless
Objectives
grandchildren;
• analyze the financial benefits of the taxable value exclusion on
transfers of the parents’ family residence and farm to children or
parentless grandchildren; and
• identify recordings which indicate a change in property
ownership triggering base year value reassessment to fair market
value (FMV) under Proposition 13.

apportionment Proposition 19 Key Terms

Before discussing the parent-to-child limited reduction of assessed taxable Base year
value on a change of ownership of family home and farm, one needs to
consider the transfers of property interests which constitute a change of value reset
ownership and trigger a base year value reassessment at current market
value.
on change
of ownership
On parent-to-child transfers of a parcel of real estate, its assessed base year
value is reset at fair market value (FMV) by Proposition 13 (Prop 13). In turn, under Prop 13
the Proposition 19 (Prop 19) $1,000,000 intra-family exclusion is claimed
292 Tax Benefits of Ownership, Fourth Edition

Proposition 19 to set the assessed taxable value on which property taxes are calculated. Both
Constitutional the base year value and the taxable value are adjusted annually as factored
amendment excluding for up to 2% consumer inflation.
up to $1,000,000
property value from
assessments which A change of ownership triggering reassessment occurs when a property
apply only to the owner transfers an ownership interest in real estate which includes:
replacement of a
primary residence by • the beneficial use of the real estate; and
those aged 55 or more
and to transfers from • a value substantially equal to a fee interest. 1
parent to children of
their family home and Each person on acquiring an ownership interest in real estate files a change
farms when occupied
and operated by the
of ownership report with the County Assessor to claim any exemption from
children. property taxes or exclusion to limit assessed taxable value and thus property
taxes.

When the real estate interest conveyed constitutes a change of ownership,

the County Assessor resets the base year value for the parcel at its FMV on the
date of transfer, called reassessment. Typically, the purchase price the new
owner paid for the property in a conventionally negotiated open market
transaction establishes the property’s FMV the County Assessor uses to set
the base year value.

Most assessment exemptions indicate the ownership of the property is not

taxed at all, such as real estate owned by:
• the local, state, or federal government;
• churches and religious organizations;
• universities and colleges; and
• charities and nonprofit hospitals.2
The exclusion claimed for the replacement of a primary home by an
individual aged 55 or more avoids the reassessment of the base year value
at FMV. On qualifying for the primary home exclusion, the base year value
assessed is the sum of:
• the inflation-adjusted base year value carried forward from the home
sold;
• plus;
• any excess in the price paid for the replacement home over the price
received for the home they sold. [See Chapter 32]
Unlike the replacement home exclusion limiting the base year value, the
parent-to-child exclusion does not reduce the base year value assessment
below FMV. Instead, the amount of the parent-to-child exclusion allowed is
subtracted from the base year value reassessment – as is the homeowner’s or
disabled veteran’s exemption - to set the property’s taxable value. The result
is lower property taxes, as discussed later in this chapter.

1 stantially equal to a fee interest.

2 Rev & T C §§202, 203, 214
 Chapter 33: Parent-to-child transfers of family home and farm cap property taxes 293

A mere change in the vesting of title by an owner or owners does not Revesting and
constitute a change in ownership, an excluded activity that does not trigger
reassessment. transactions
To qualify as a change in vesting, not ownership, the proportional interests not classified
held in the property by the co-owners before revesting needs to remain in the as a change
same percentages under the new vesting.
of ownership
Examples of a change in vesting by the current owners of a property include
changes in joint tenants, tenants in common, community property, living
trust, or these changes among co-owners’ of a partnership, LLC or corporation.

A further exclusion addresses the syndicated ownership of a property vested

in a partnership or LLC. Here, the transfer is not about title to ownership of
the property but is a transfer by assignment of a co-owner’s percentage share
of ownership as a member of a partnership or LLC which is the vested owner
of the property. When the partner’s assignment does not alter control of the
partnership, reassessment of the real estate owned by the partnership is not
triggered.3

However, a change in control by assignment of interests held by partners

or members in a partnership or LLC which is the vested owner of real estate
does trigger reassessment of the property.

When more than 50% of the ownership interests in the entity are assigned,
a change in control has occurred which constitutes a change in ownership
and triggers reassessment of the property at current FMV. This threshold
percentage of transfers by partners before reassessment is one reason several
persons who join together hold title in a limited partnership or LLC rather
than as tenants in common (TIC).4

Conversely, the transfer of a fractional interest in the vested ownership of

the real estate, such as the transfer of a person’s TIC interest in title, triggers
reassessment of only the percentage of ownership transferred. The entire
property is not reassessed, just the percentage transferred is reassessed.

For a TIC vesting, an exclusion exists for the transfer of fractional TIC
ownership interests which are less than 5% of ownership and have a FMV
less than $10,000.5

Also, the double-up claim of two exclusions in the same transfer or series of
related transfers denies both exclusions. When attempted, the property is
reassessed. These multiple transfers of an ownership interest in a property,
though staged as separate steps, are collapsed and viewed as a one-step
transaction. Again, the property interest transferred is reassessed.6

3 Rev & T C §64(a)

4 Rev & T C §§64(c), 25105
5 Rev & T C §65.1(a)
6 Crow Winthrop Operating Partnership v. County of Orange (1992) 10 CA4th 1848
294 Tax Benefits of Ownership, Fourth Edition

Family Editor’s Note – Prop 19 legislation is now law. However, this material was
published prior to the legislature enacting codes to implement Prop 19
transfers not procedures. When enacted, the codes may alter some of the minor details
reassessed presented below.

to share the Transfers between spouses, called inter-spousal transfers, are also excluded
from reassessment. Inter-spousal transfers are not considered a change in
wealth ownership triggering reassessment when the transfer:
• adds a spouse to title;
• reports the death of a spouse; or
• settles a divorce.7
The exclusions from assessed taxable value on a parent-to-child transfer of
a principal residence and a family farm while limited in amount are also
available, as discussed below.

The replacement home exclusion from base year value assessment for a
primary residence by an individual aged 55 or more, acquired within two
years before or after the sale of their prior primary residence, is fully addressed
in Chapter 32.

For the family farm exclusion, the rules applied when the conveyance
is of a family farm to a child are the same as the rules for the family home
from parent to child. Thus, in all discussions below about the family home
exclusions, the reader can substitute the family farm for the family home and
get the same result. In the context of a family farm, occupancy of the property
is replaced with the need for the child to be the operator of the family farm.

A parent’s Consider a couple who occupies a single family home as their principal
residence, a property they have owned for decades. They want to sell it and
dwelling of move into housing accommodations they will not own. The home has a
average FMV, FMV of $600,000 and an inflation-adjusted base year value of $120,000.

sold to an Their son, who lives locally in a rental property, intends to move into the
family home as his principal residence. The parents and the son agree on
adult child a below FMV price and terms for payment that is satisfactory to all family
members - no down payment and payments including interest. The interest
rate will be the lowest permitted by the applicable federal rates (AFRs) for
loans to family members. Thus, the parents avoid annual imputing of
principal as interest.

Here, the sale (or gift) of the parent’s principal residence to a child will,
on recording the conveyance of title, disclose the change of ownership
and trigger reassessment of the property. The County Assessor will set the
property’s new base year value at $600,000, the property’s FMV, not the
pricing agreed to by the family.

7 Rev & T C §63

 Chapter 33: Parent-to-child transfers of family home and farm cap property taxes 295

Along with the recording of the conveyance to the son, the son files a claim for
a homeowner’s exemption and a claim for the family home exclusion (then
or within one year) as occupant of the property as their principal residence.

Accordingly, the County Assessor determines the amount of family home

exclusion the son qualifies for by subtracting the parent’s inflation-adjusted
base year value of $120,000 from the FMV of the property.

Here, the son qualifies for a $480,000 amount of exclusion as a subtraction

from the new base year value of $600,000 to set the taxable value assessment
at $120,000, which is further reduced by the $7,000 homeowner’s exemption.

Here, the result for the son’s assessed taxable value is the same amount as
the property’s assessed taxable value set for the parent’s ownership. What
the Assessor changed on the change in ownership is the base year value
assessment for the property – it was reset at the property’s FMV. However,
the son did not retain the parents’ inflation-adjusted base year value which
is set by the price the parents paid for the property decades ago.

In the future, the son might vacate the property with no intent to return
to use it as his principal residence. Then the son no longer qualifies for the
homeowner’s exemption or the family home exclusion. As a result, the
County Assessor will reset the assessed taxable value at the amount of the
inflation-adjusted base year value assessment of $600,000 plus the inflation
factor for the Tax Collector to calculate property taxes of 1%. Thus, the amount
of the exclusion lost – $480,000 – is now taxed annually.

Consider parents who own a single family residence (SFR) near the coast A high-
that for previous decades was their second home. For the past few years,
the parents occupy the home as their principal residence. They qualify for tier priced
a homeowner’s exemption due to their occupancy though they have not principal
claimed one.
residence and
The SFR has a fair market value (FMV) of $2,500,000, currently assessed at a
factored base year value of $600,000, which is also the assessed taxable value. the exclusion
The parents convey the property to a child who intends to occupy the home
as their principal residence.

Upon the transfer or within one year of transfer, the child files a claim with
the County Assessor for the homeowner’s exemption and the family home
exclusion. The County Assessor notes a change of ownership has occurred
with the recording of the deed transferring title to the child, triggering
reassessment. The County Assessor determines the FMV is $2,500,000 and sets
the new base year value assessment at $2,500,000.

Upon receiving the child’s claim for exclusion (and the claim for a
homeowner’s exemption), the County Assessor now sets the assessed taxable
value of the home for use by the County Tax Collector.
296 Tax Benefits of Ownership, Fourth Edition

Here, the FMV of the home ($2,500,000) exceeds the parent’s inflation-
adjusted base year value ($600,000) by more than the $1,000,000 family home
exclusion ceiling. Thus, the County Assessor sets the taxable value of the
home as the sum of:
• the home’s new base year value assessment (FMV) of $2,500,000;
• minus the full $1,000,000 exclusion;
• resulting in $1,500,000 as the assessed taxable value for the child’s first
year of ownership.
The Tax Collector calculates the taxes due for the fiscal year at 1% of the
assessed taxable value, a property tax bill of $15,000, plus any voter approved
bond payments. Thus, the child effectively garners a $10,000 annual savings
on property taxes that a conventional buyer of the property would otherwise
pay into the city’s coffers.

A wealthier Consider the parents of a son and daughter. Both children are married and
have children of their own. The daughter later dies and her husband does not
family’s use remarry. The parents own the following real estate:
of exclusions • an apartment building, one unit of which they occupy as their principal
residence;
• two farms they operate, one that grows and markets ornamental trees
and another that produces citrus; and
• other properties consisting of single family rentals and a strip mall.
All these properties are vested in the parent’s inter vivos trust. On the
death of the parents, the transfer of these properties as directed by the trust
agreement will be distributed as follows:
• the apartment building in which a unit is their principal residence is
to be transferred to the husband of the deceased daughter, and if the
husband has remarried, the transfer is to the parents’ grandchildren;
• both farms are transferred to their son;
• the remaining single family rentals and strip mall are transferred
to the son and deceased daughter’s unremarried husband, in equal
undivided interests (50:50) as tenants in common.
The parents qualify for a homeowner’s or veteran’s exemption on their rental
property which contains their principal residence, though they have not
claimed the exemption. The family-owned and operated farms qualify as
property which produces an agricultural commodity.

On transfer of the principal residence, to qualify for the family home exclusion,
the daughter’s husband (or grandchildren if the husband is remarried) needs
to:
• occupy the property as their principal residence; and
• file a homeowner’s exemption claim within one year of transfer.
 Chapter 33: Parent-to-child transfers of family home and farm cap property taxes 297

The apartment building is a single appraisal unit with one parcel number. On
the date of the transfer, the building has a FMV of $3,500,000. The apartment
unit used as their primary residence within the building has a FMV of
$350,000, 10% of the FMV of the entire building.
The inflation-adjusted – factored – base year value on the building is $2,100,000.
This amount is also the assessed taxable value used to calculate property
taxes owed since the parents have claimed no exemptions or exclusions. The
portion of the factored base year value assessment attributable to the unit
which is the family home is $210,000.

Here, the transfer of the apartment building to the deceased daughter’s

husband is a change of ownership triggering a new base year value
assessment at its FMV of $3,500,000.

The intra-family family home exclusion reduces the assessed taxable value,
not the new base year value assessment. If in the future the daughter’s
husband no longer qualifies for homeowner’s exemption by ending
occupancy of the unit as his principal residence, the exclusion is lost and the
inflation-adjusted base year value becomes the assessed taxable value.

When the daughter’s husband takes possession of the family home unit as
his principal residence, he will file a claim for homeowner’s exemption with
the County Assessor at the time of the transfer of ownership or within one
year of transfer. Here, the $1,000,000 family home exclusion kicks in to set
the property’s assessed taxable value as the sum of the unit’s base year value
minus the amount of exclusion allowed.

Again, the unit occupied as the principal residence has a FMV of $350,000
and as 10% of the building’s FMV the parents have an inflation-adjusted
base year value of $210,000. The family exclusion allowed is based on the
difference between the FMV and assessed value.

Thus, $140,000 is the amount of the family exclusion allowed to set the
building’s taxable value. Thus, the $140,000 value excluded from property
taxes is subtracted from the building base year value ($3,500,000 FMV) to set
the building’s reduced taxable value used by the Tax Collector to calculate
property taxes due on the building.

No exemption or exclusion from reassessment exists for the remaining 90%

of the building’s FMV.

Thus, the base-year assessed value is $3,500,000 while the assessed taxable
value is 3,360,000. The reduced amount reflects the portion of the $1,000,000
family home exclusion available, so long as the daughter’s husband occupies
the unit as his principal residence.

In other cases where the FMV of the family home or family farm involved
in the transfer exceeds the sum of the parent’s factored base year value
assessment figure and the $1,000,000 exclusion, the entire $1,000,000 is
subtracted from the new base year value FMV assessment to set the taxable
value.
298 Tax Benefits of Ownership, Fourth Edition

Who The parent-child exclusion only applies to transfers between parents and
children, or grandparents and grandchildren when the grandchildren are
qualifies? the only direct line of descent remaining due to deaths.

A “child” includes a parent’s:

• natural child, unless that child has been adopted by another parent;
• stepchild or the stepchild’s spouse;
• son-in-law or daughter-in-law; and
• foster child or adopted child unless the child was adopted after turning
18.
Further, the family home exclusion only includes the portion of land
surrounding the improvements used as the principal residence, also called a
dwelling. The exclusion separates the portion of land and improvements used
for other purposes, such as the apartment example above, from the portion of
apportionment the land or building containing the residence, called apportionment.
The separation of land
into the portion used Thus, a principal residence on a large parcel or one of several adjacent
as a principal residence
properties owned by the parents and held for other uses, such as an
and the portion used
for other purposes. agribusiness, rental, or sub-divisible acreage — with the exception of family
farms — is subject to apportionment of FMV on a transfer.

Filing the To qualify for an intra-family taxable value reduction, the child receiving
ownership of a property needs to file a claim with the County Assessor
claim for when the deed transferring the property is recorded, or within one year. The
exclusion assessor notes this on the change of ownership report form used for tracking
the parents’ and children’s limitation or exclusion amounts through the
California Franchise Tax Board (FTB).

The FTB acts as a clearing house to monitor the total exclusion amounts
claimed by property owners.

An asset inflation adjustment resetting the $1,000,000, whether up or down,

will be calculated and published by the State Board of Equalization (SBOE)
on February 16 every odd numbered year after 2021.

The asset inflation figure used is the FHFA Home Price Index for California
figure for the prior even numbered year.
 Chapter 33: Parent-to-child transfers of family home and farm cap property taxes 299

Proposition (Prop) 13 triggers reassessment of a home’s base year value Chapter 33

to be reset at FMV upon parent-to-child transfers of a family home or
farm they occupy or operate. Subsequently, Prop 19 excludes $1,000,000 Summary
from an intra-family transferred home or farm’s assessed taxable value
at which property taxes are calculated.

The base year value and assessed taxable value of a home are both
factored and adjusted annually for up to 2% consumer inflation. A
new owner’s purchase price paid for the property in a conventionally
negotiated open market transaction typically establishes the property’s
FMV used by the County Assessor.

Replacement of a primary home by an individual aged 55 or over avoids

a base year value reassessment at FMV. Upon qualifying for the 55 and
over primary home exclusion, the base year value is reassessed as the
sum of the inflation-adjusted base year value of the home sold plus
any excess in the price paid for the replacement home over the price
received for the home sold.

Contrastingly, the parent-to-child exclusion doesn’t reduce the base year

value below FMV, but rather the $1,000,000 exclusion is subtracted from
reassessed base year value to set the property’s assessed taxable value,
resulting in lowered property taxes. A change in vesting or change
in control between vested owners of real estate in scenarios such as
joints tenants, tenants in common, community property and LLCs or
corporations does not trigger reassessment.

apportionment............................................................................. pg. 298 Chapter 33

Proposition 19.............................................................................. pg. 292
Key Terms
Notes:
 Glossary 301

Glossary
#
§1031 cooperation provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
A condition in purchase agreements advising participants about §1031 reinvestment planning and
providing for mutual cooperation prior to closing for the disbursement of net sales proceeds when a
participant decides to purchase or sell other property in §1031 reinvestment plan. [See RPI form 159
sec 11.6]
§1031 investment property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 6
Business-use and investment real estate which qualifies the owner to exempt profit realized on its
sale from income taxes by acquiring like-kind property in a §1031 reinvestment plan.
§1031 reinvestment plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1
A sales transaction of like-kind property which generates net sales proceeds, some or all of which the
seller will use to purchase like-kind replacement property under Internal Revenue Code §1031. The
cost basis and unrecaptured gains are carried forward to the property purchased and the seller avoids
reporting some or all of the capital gains realized on the sale.
§1031 trustee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
A third party who, in lieu of the seller in a §1031 reinvestment plan, receives and holds the net sales
proceeds from the sale of property, and on demand from the seller deposits the funds in a purchase
escrow the seller opens to acquire replacement property.

A
active management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 1
The responsibility of a rental property owner under a rental or gross lease to care for and maintain
their rental real estate, needed to qualify a property’s income and expenses to be classified as passive
category income.
active participant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .92
An owner-operator of rental property who owes a duty to tenants under rental and gross lease
agreements for the care and maintenance of the property and retains ultimate authority over key
landlord decisions.
adjusted gross income�������������������������������������������������������������������������������������������������������������������������������������������������������10
Gross income remaining from the three income categories after taking expenses and deductions.
agency duty ��������������������������������������������������������������������������������������������������������������������������������������������������������������������������� 179
The fiduciary duty a broker and their agents owe a client to use diligence in attaining the client’s real
estate objectives. [See RPI Form 305]
Agency Law Disclosure ������������������������������������������������������������������������������������������������������������������������������������������������ 180
Restatement of agency codes and cases summarizing the agency conduct of real estate licensees. It is
delivered to all parties in consumer sales and leasing transactions.
aggregating ������������������������������������������������������������������������������������������������������������������������������������������������������������������������������70
Combining the reportable operating income and losses from all sources within the passive income
category.
all-inclusive trust deed note (AITD) �������������������������������������������������������������������������������������������������������������������� 113
A note entered into by a buyer in favor of the seller to evidence the amount remaining due on the
purchase price after deducting the down payment. This amount includes mortgage debts remaining
of record which the seller remains responsible for paying. Also called a wraparound mortgage or
overriding mortgage. [See RPI Form 421]
302 Tax Benefits of Ownership, Fourth Edition

alter ego ������������������������������������������������������������������������������������������������������������������������������������ 65

A corporation or LLC whose earnings and assets are used directly for the
personal advantage of its owner, resulting in insufficient separation between
the owner and the corporation or LLC to shield the owner from personal
liability for the entity’s debts.
alternative minimum tax (AMT) ���������������������������������������������������������������������������� 11
A supplemental income tax paid by taxpayers in higher income tax brackets.
annual property operating data sheet (APOD) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
A worksheet used to gather income and expenses on the operation of an
income producing property for an analysis of the property’s suitability for
investment.
Applicable Federal Rate (AFR)���������������������������������������������������������������������������������162
Rates set by the Internal Revenue Service and used by carryback sellers to
impute and report minimum interest income when the note rate on their
carryback debt is a lesser rate.
apportionment ������������������������������������������������������������������������������������������������������������������298
The separation of land into the portion used as a principal residence and the
portion used for other purposes.
appreciable asset �����������������������������������������������������������������������������������������������������������������75
A tangible collectible, such as property held for investment or productive use
in a business, the value of which increases over time at a rate greater than the
rate of consumer inflation.
assessed taxable value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
The annual valuation of property set by the County Assessor as the sum of
the base year value, factored for inflation, minus exemptions and exclusions,
for use by the County Tax Collector to levy annual property taxes, commonly
referred to as the assessed taxable value or current taxable value for a property.
asset price inflation���������������������������������������������������������������������������������������������������������117
A rise in the value of assets, such as stocks, bonds, and real estate. Contrast
with consumer price inflation.

B
balloon payment �������������������������������������������������������������������������������������������������������������138
Any final payment on a note which is greater than twice the amount of any
one of the six regularly scheduled payments immediately preceding the date
of the final payment. [See RPI Form 418-3 and 419]
base year value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
A conveyance of title to real estate resulting in transfer of the beneficial use
of the property which triggers reassessment of the property by the County
Assessor to set the property’s new base year value.
bid-equals-value presumption ����������������������������������������������������������������������������� 167
The IRS’s presumption a mortgage holder’s successful bid at a foreclosure sale,
limited in amount to the remaining principal, costs and advances, is equal
to the FMV of the interest acquired in the property leaving no reportable
income in the exchange.
book value ������������������������������������������������������������������������������������������������������������������������������ 43
The value of an asset expressed for accounting purposes as the original cost of
acquisition and capital improvements, minus accumulated depreciation and
destruction, also known as cost basis. Contrast with current market value.
 Glossary 303

C
capital asset ���������������������������������������������������������������������������������������������������������������������������� 55
Real estate held by an owner as their principal residence or for investment,
excluding properties held as inventory for sale to customers or for productive
use in a trade or business.
capital expenditure������������������������������������������������������������������������������������������������������������68
An expenditure incurred to fund the purchase, improvement, or carrying
costs of real estate.
capital gain ���������������������������������������������������������������������������������������������������������������������������135
Profits from the sale of a capital or business-use asset at a price exceeding the
cost of acquisition and further improvements. Contrast with unrecaptured
gain.
capital investment �������������������������������������������������������������������������������������������������������������43
The capital invested in a property, comprising cash and mortgage proceeds
used to purchase, improve or carry the property, as well as any adjusted
cost basis carried forward in the disposition of other property in a §1031
reinvestment plan.
carryback sale ������������������������������������������������������������������������������������������������������������������������98
Financing provided by a seller of real estate by extending credit to a buyer for
the deferred payment of a portion of the sales price, typically repaid monthly
with accrued interest — also known as an installment sale.
cash boot �������������������������������������������������������������������������������������������������������������������������������� 251
Items of value received on a sale of property or contributed to purchase
replacement property in a §1031 reinvestment plan which include money,
carryback notes, purchase-assist financing for the replacement property,
and equity in property not qualified as §1031 like kind property. Also called
money and other properties.
cash-out transaction �������������������������������������������������������������������������������������������������������� 57
Selling a like-kind §1031 property without a concurrent reinvestment plan
for acquiring a like-kind §1031 replacement property to exempt profit realized
on the sale from taxes.
common interest development (CID)���������������������������������������������������������������� 160
Condominium projects, cooperatives, or single-family residences in a planned
unit development. [See RPI Form 135]
Consumer Price Index (CPI) ������������������������������������������������������������������������������������� 116
An index of fluctuations in the general price of a wide selection of consumable
items consisting of goods and services to measure and track the rate of
consumer inflation.
consumer price inflation ������������������������������������������������������������������������������������������� 117
An increase in the general price level of all goods and services consumed in
the economy. Contrast with asset price inflation.
cost basis ����������������������������������������������������������������������������������������������������������������������������������� 20
The cost incurred to acquire and improve an asset subject to adjustments for
destruction and depreciation, a term used primarily for tax reporting.

D
dealer property ����������������������������������������������������������������������������������������������������������������� 195
Real estate held for sale to customers in the ordinary course of an owner’s
trade or business, where the earnings on the sales of the properties are taxed
as business inventory at ordinary income rates.
304 Tax Benefits of Ownership, Fourth Edition

deduction ���������������������������������������������������������������������������������������������������������������������������������10
An expenditure or allowance offsetting net operating income (NOI) or
subtracted from adjusted gross income, both lowering the amount of taxable
income.
deed-in-lieu of foreclosure ������������������������������������������������������������������������������� 168
A grant deed from the owner of mortgaged real estate conveying it to the
mortgage holder in exchange for cancelling the mortgage debt and avoiding
foreclosure.
deferred exchange corporation ���������������������������������������������������������������������������� 241
A corporate facilitator retained to act as a trustee in a delayed §1031 transaction
to receive, hold and disburse proceeds from the sale of a property under safe
harbor rules for the seller to avoid receipt of their sales proceeds.
deficiency judgment ����������������������������������������������������������������������������������������������������� 128
A money award obtained by the holder of a recourse mortgage debt to recover
money losses experienced when the value of the mortgaged property is less
than the mortgage debt at the time of their judicial foreclosure sale.
depreciation��������������������������������������������������������������������������������������������������������������������������� 74
Loss of property value brought on by age, physical deterioration, or the
functional or economic obsolescence.
depreciation deduction ������������������������������������������������������������������������������������������������� 74
The annual before-tax withdrawal from income, deducted from the NOI of
a rental property, expensed from trade of business income, or deducted from
the NII for portfolio investments, to provide a return of invested capital
allocated to property improvements which reduces the owner’s cost basis in
the property. To be distinguished from a return on capital.
depreciation schedule ���������������������������������������������������������������������������������������������������� 75
The number of years over which an owner’s capital investment in a trade
or business, passive, or portfolio category property is recovered as an annual
expense or deduction from income, limited to the portion of cost basis
allocated to property improvements.
direct expense ������������������������������������������������������������������������������������������������������������������������32
A deductible expense attributable to the home office area used exclusively
for business.
discharge-of-indebtedness���������������������������������������������������������������������������������������� 126
Reportable income resulting for an owner from a mortgage holder’s discount
on a payoff of a mortgage debt. Also called a short pay.
disposition ��������������������������������������������������������������������������������������������������������������������������� 150
The act of transferring or otherwise giving up an asset, such as property or a
trust deed note, which triggers the reporting and taxing of profit.
disposition property�������������������������������������������������������������������������������������������������������200
Replacement property acquired in a §1031 reinvestment plan and
immediately resold in a cash-out sale or conveyed to another individual or
taxable entity, disqualifying it as like-kind property when received.

E
equitable ownership������������������������������������������������������������������������������������������������������159
Held by a person who purchases a property and has possession but has not
yet received legal ownership with title vested in their name, such as occurs
under an unexecuted purchase agreement, land sales contract or lease-option
sales agreement.
 Glossary 305

equity�����������������������������������������������������������������������������������������������������������������������������������������188
The value of an owner’s capital interest in real estate exceeding the mortgages
encumbering it.
exchange�������������������������������������������������������������������������������������������������������������������������������� 187
A means of trading the equity in a property, owned for the equity in another,
treated as a single transaction involving two properties conveyed through
tandem escrows. Also called barter.
exclusive use ������������������������������������������������������������������������������������������������������������������������� 34
The use of a designated area in a residence only as an office, one of two
conditions needed to qualify for a home office deduction.
exclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
Types of property-tax avoidance claims arising when a primary residence is
replaced resulting in a base year value reassessment less than FMV and on
transfers of the family home or family farm between parents and children
eliminating up to $1,000,000 from assessed taxable value.
exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284
Types of property-tax avoidance claims made by the owner for setting the
annual taxable value at zero or by subtracting a fixed dollar amount from the
property’s base year value.

F
factored base year value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
The base year value adjusted upward annually by the County Assessor to
reflect consumer inflation limited to 2% annually, compounded.
fair market value (FMV)���������������������������������������������������������������������������������������������� 166
The price a reasonable, unpressured buyer and seller would agree to for
property on the open market, both possessing symmetric knowledge of
material facts.

G
gross equity����������������������������������������������������������������������������������������������������������������������������� 43
The portion of the market value of a property calculated by subtracting
the amount of mortgage debt, unpaid property taxes and any bonded
indebtedness secured by the property from the property’s market value.

H
home office deduction ��������������������������������������������������������������������������������������������������� 32
A deductible expense resulting from business use of a taxpayer’s home.
homeowners’ association (HOA) �������������������������������������������������������������������������� 159
An organization made up of owners of units within a common interest
development (CID) which manages and operates the project through
enforcement of conditions, covenants, and restrictions (CC&Rs).

I
imputed owner��������������������������������������������������������������������������������������������������������������������� 23
Someone who for tax purposes is deemed to be a co-owner of a principal
residence but does not have a vested interest in the property.
incidental property �������������������������������������������������������������������������������������������������������232
Personal property used in the operation and management of real estate.
306 Tax Benefits of Ownership, Fourth Edition

indirect expense��������������������������������������������������������������������������������������������������������������������32
An expense incurred in the upkeep and operation of a taxpayer’s entire
residence, a part of which is deducted as a business expense, the amount
deductible based on the percentage of the area in the residence exclusively
used as a home office.
Individual Tax Analysis (INTAX) ����������������������������������������������������������������������������99
An estimate of a seller’s tax liability incurred due to unrecaptured and capital
gains realized on a proposed sale of a property.
itemized deduction�������������������������������������������������������������������������������������������������������������� 2
Deductions taken by a homeowner for allowable personal expenditures
such as mortgage interest (MID) and state income and local property taxes
(SALT) as itemized on Schedule A which reduce their taxable income and tax
liability. Contrast with the standard personal deduction.

L
land sales contract���������������������������������������������������������������������������������������������������������� 158
A security device used for the sale of real estate when the seller retains title
to the property as security until all or a prescribed part of the purchase price
has been paid.
life-of-loan accrual������������������������������������������������������������������������������������������������������������ 11
The monthly accrual of mortgage origination fee over the life of a mortgage.
liquidation theory��������������������������������������������������������������������������������������������������������������63
When, to facilitate the sale of investment property, the owner develops it
only as necessary to cash out their capital interest in the property and still
qualify the profit for capital gains treatment.

M
market value��������������������������������������������������������������������������������������������������������������������������� 42
The highest price a property will bring in a competitive and open market
between a buyer and seller given time to act prudently and knowledgeably.
material participant��������������������������������������������������������������������������������������������������������� 86
An owner of rental property in the passive income category who participates
in its management or a real estate profession on a regular and substantial
basis.
mortgage boot �������������������������������������������������������������������������������������������������������������������� 255
The amount by which the mortgage balances existing on the property sold,
whether assumed or paid off by the buyer, exceeds the sum of the mortgage
balances taken over on the replacement property purchased in a §1031
reinvestment plan and the net value of cash items contributed in the plan.
Also called net debt relief. Contrast with cash boot.
mortgage interest deduction (MID)������������������������������������������������������������������������� 1
An itemized personal deduction permitted for interest accrued and paid on
mortgages secured by a homeowner’s principal and second residence.
mortgage origination fee ��������������������������������������������������������������������������������������������� 13
A fee paid to a mortgage holder for originating a mortgage at a below-par
interest rate, taxwise considered prepaid interest.

N
net cash items��������������������������������������������������������������������������������������������������������������������� 265
The sum of the amount of cash items from the sale of the property sold
received prior to acquiring replacement property, plus the amount of cash
 Glossary 307

items received on or after the purchase of replacement property which

exceed the contribution of cash items toward acquisition of the replacement
property.
net debt relief ��������������������������������������������������������������������������������������������������������������������� 257
The amount of the existing mortgage balance encumbering the property sold
not offset by the assumption of mortgage balances or contribution of cash
items on acquiring replacement property in a §1031 reinvestment plan. Also
called mortgage boot.
net investment income (NII) ������������������������������������������������������������������������������������� 71
Income less expenses related to portfolio category assets. For real estate
investors, this includes income, profits and losses from the operations and
sales of management-free, net-leased rental property, land held for profits on
resale, and interest-bearing assets.
net investment income tax (NIIT)������������������������������������������������������������������������ 112
A surtax on income from investment assets such as income, profits and losses
from the operations and sales of rental property, interest income, stocks,
bonds, and land held for profit on resale.
net operating income (NOI) ���������������������������������������������������������������������������������������� 10
The net revenue generated by an income producing rental property before
accounting for mortgage PI payments or the depreciation allowance. NOI
is calculated as the sum of a rental property’s total operating income less the
property’s operating expenses. [See RPI Form 352 §4]
net profit �������������������������������������������������������������������������������������������������������������������������������� 101
Gains on the sale of business-use and capital assets calculated as the sales
price minus transactional costs minus the remaining cost basis.
net sales proceeds�������������������������������������������������������������������������������������������������������������109
The amount of a seller’s receipts on closing a sale of their property after
deducting all costs of the sale and mortgage assumptions/payoffs from the
gross price, but before payment of taxes on any profit on the sale.
nominal interest rate������������������������������������������������������������������������������������������������������� 11
The interest rate agreed to between a homebuyer and a lender as stated on a
promissory note, also called the note rate. To be contrasted with par rate of
interest.
nonrecognition of gain�������������������������������������������������������������������������������������������������175
The exemption from taxes on profits or losses realized on disposition of
investment or business-use property when the net equity in the property
is replaced by acquiring other investment or business-use property in a
continuing ownership of property.
nonrecourse debt������������������������������������������������������������������������������������������������������������� 124
A mortgage debt recoverable on default solely through the value of the
security interest held by the lender in the mortgaged property. Contrast with
recourse debt.

O
occupancy rule �������������������������������������������������������������������������������������������������������������������� 89
Rental properties are passive income category property when tenant
occupancies average more than 30 days.
occupancy-to-ownership ratio �������������������������������������������������������������������������������� 21
A ratio of the years a homeowner has occupied a property as their principal
residential to the years they have owned it. Used by the seller of a residential
property to calculate the percentage of profit realized on the sale which
qualifies for the principal residence profit exclusion.
308 Tax Benefits of Ownership, Fourth Edition

offsets���������������������������������������������������������������������������������������������������������������������������������������� 255
A reduction, typically reducing an amount received by an amount
contributed by an individual in a §1031 reinvestment plan.
operating expenses ������������������������������������������������������������������������������������������������������������10
The total annual costs incurred to maintain and operate a property for one
year. [See RPI Form 352 §3.21]
option to buy ���������������������������������������������������������������������������������������������������������������������� 131
A unilateral agreement entered into by a property owner granting a
prospective buyer the right to buy property by exercising the option within
a specified time period or on an event, at a determinable price and terms for
payment. [See RPI Form 161]
ordinary income asset����������������������������������������������������������������������������������������������������� 56
Real estate held by an owner primarily as inventory for sale to customers in
the ordinary course of the owner’s trade or business, called dealer property.
owner-operator �������������������������������������������������������������������������������������������������������������������� 83
An owner of rental property in the passive income category who renders
professional real estate services, manages property, or invests in real estate
for their own accounts and collectively spends a minimum amount of time
on real estate-related activities.

P
paid and accrued rule������������������������������������������������������������������������������������������������������ 67
Interest paid on a mortgage needs to accrue before it may be expensed or
deducted from income.
par rate ��������������������������������������������������������������������������������������������������������������������������������������� 12
The lender’s base interest rate without any positive or negative adjustments
producing a variation set as the nominal interest rate in a promissory note.
partial §1031 reinvestment ������������������������������������������������������������������������������������� 213
A sales transaction triggering reporting and taxes of a portion of the profit
realized on the sale of property in an Internal Revenue Code (IRC) §1031
reinvestment plan when less than all the sales proceeds are reinvested in
replacement property.
partial exclusion����������������������������������������������������������������������������������������������������������������� 21
A prorated portion of the principal residence profit exclusion available to a
homeowner who sells due to personal difficulties.
passive income category����������������������������������������������������������������������������������������������� 48
Income, profits and losses from rental real estate operations and sales, and
from businesses not operated by the owner or co-owner.
passive ownership������������������������������������������������������������������������������������������������������������ 51
Ownership of a business without materially participating in its management.
personal-use mortgage �������������������������������������������������������������������������������������������������� 11
A mortgage which funds a personal use such as the purchase or improvement
of an owner’s principal residence or second home, or the payoff of personal
debt such as costs of education and healthcare or credit cards.
pledge �������������������������������������������������������������������������������������������������������������������������������������� 145
To provide an asset, such as an existing carryback note, as collateral or security
for repayment of a borrowing. Also known as hypothecation. [See RPI Form
242]
portfolio income category�������������������������������������������������������������������������������������������� 52
Unearned income from interest on investments in bonds, savings, stocks and
mortgage notes, and income, profits, and losses from management-free net-
leased income property and unimproved land held for profit on resale.
 Glossary 309

portfolio property �������������������������������������������������������������������������������������������������������������� 10

Property held for investment that is management free, such as stocks, bonds,
savings, notes, land not used in a trade or business, and rental properties
under net leases.
prepaid interest ��������������������������������������������������������������������������������������������������������������������12
Interest paid which has not yet accrued.
principal place of business������������������������������������������������������������������������������������������� 35
The location where a broker or agent conducts the majority of, or the most
significant activities related to their business.
principal residence ����������������������������������������������������������������������������������������������������������� 12
The residential property where the homeowner resides a majority of the year.
principal residence profit exclusion �������������������������������������������������������������������� 20
A tax reporting exclusion of profit realized on the sale of the owner’s principal
residence limited to a maximum dollar amount and by an occupancy-to-
ownership ratio.
property appreciation����������������������������������������������������������������������������������������������������� 74
The portion of the increase over time in a property’s market value exceeding
the rate of inflation.
Proposition 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Constitutional amendment excluding up to $1,000,000 property value from
assessments which apply only to the replacement of a primary residence by
those aged 55 or more and to transfers from parent to children of their family
home and farms when occupied and operated by the children.

Q
qualified interest������������������������������������������������������������������������������������������������������������������ 5
Mortgage interest accrued and paid on up to $750,000 of mortgage principal
used to fund the acquisition or improvement of the homeowner’s principal
residence or second home. The interest is itemized on Schedule A as an
itemized personal deduction which reduces the homeowner’s taxable
income and tax liability.

R
real profit�������������������������������������������������������������������������������������������������������������������������������� 117
The price received on the sale of property less the owner’s capital investment
in the property as adjusted for consumer inflation over the period of
ownership.
real rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .118
The nominal interest rate minus the rate of inflation.
recapitalization ���������������������������������������������������������������������������������������������������������������� 258
The restructuring of an owner’s capital interest in a property between equity
and mortgage debt or vice versa, often achieved by refinancing or further
financing of the property.
recharacterization ��������������������������������������������������������������������������������������������������������� 162
The depiction of a lease-option agreement as the economic equivalent of a
sale and financing arrangement rather than by the function of a landlord/
tenant transaction.
recourse debt����������������������������������������������������������������������������������������������������������������������� 127
A mortgage debt which exposes a borrower to personal liability when a
judicial foreclosure sale of the secured property does not fully satisfy the
debt. Contrast with nonrecourse debt.
310 Tax Benefits of Ownership, Fourth Edition

regular use������������������������������������������������������������������������������������������������������������������������������ 35
The consistent repeated use of an area of a residence as a home office, one of
two conditions needed to qualify for a home office deduction.
reportable operating loss�����������������������������������������������������������������������������������������������82
A passive category loss resulting from operating expenses, depreciation
deductions and interest deductions for passive category properties, which
exceeds income in the category is carried forward as a suspended loss unless
the owner qualifies to offset income in trade or business and portfolio
category income or reduce taxable income as a deduction.
reverse §1031 transaction�������������������������������������������������������������������������������������������235
An Internal Revenue Code (IRC) §1031 transaction in which an investor
controls title to replacement property before disposing of the property to be
sold. Also called a parking transaction.

S
seller’s net sheet���������������������������������������������������������������������������������������������������������������� 109
A document prepared and used by a seller’s agent to itemize expenditures and
charges incurred on a sale of a property, disclosing the financial consequences
of a sales price set in a listing agreement or a buyer’s offer to purchase.
short sale �������������������������������������������������������������������������������������������������������������������������������� 124
A sale of mortgaged property by the owner when at closing the mortgage
holder accepts the owner’s net sales proceeds in full satisfaction of a greater
amount of mortgage debt.
straight note������������������������������������������������������������������������������������������������������������������������ 141
An instrument evidencing a debt on which the entire amount of principal
together with accrued interest is paid in a single lump sum when the
principal is due. [See RPI Form 423]
suspended loss���������������������������������������������������������������������������������������������������������������������. 49
An operating loss incurred on passive income category rental property that is
not recognized in the tax year incurred but is carried forward for use in future
years to offset operating income or profit on a sale only from the property
incurring the loss.

T
taxable income�������������������������������������������������������������������������������������������������������������������� .99
The amount of an individual’s income subject to tax, determined as adjusted
gross income (income and profits less allowed losses from all income
categories) minus deductions.
tenants in common (TIC) ������������������������������������������������������������������������������������������ .225
Co-ownership of real estate by two or more persons, who each hold equal or
unequal undivided interest, without the right of survivorship.
tracking. �����������������������������������������������������������������������������������������������������������������������������������. 49
The separate accounting record of the operating income, expenses, and
deductions for each assessor-identified parcel of real estate classified as
passive category property.
trade or business asset����������������������������������������������������������������������������������������������������� 56
Real estate used to house or facilitate the ongoing operation of a trade or
business.
trade or business income category������������������������������������������������������������������������� 47
Income, profits and losses from the taxpayer’s trade or owner-operated
business, sales inventory, and real estate used to operate the trade or business.
 Glossary 311

trust account����������������������������������������������������������������������������������������������������������������������� 205

An account in the name of the trustee in which funds held for a client are
deposited, separate and apart from the trustee’s personal funds.

U
unforeseen circumstances������������������������������������������������������������������������������������������� 25
Events not reasonably foreseeable by a homeowner which qualify the profit
on the sale of a residential property for partial exclusion from taxation, such
as a natural disaster, divorce or death.
unrecaptured gain������������������������������������������������������������������������������������������������������������� 25
The accumulated annual adjustments to a property’s cost basis for depreciation
deductions which on a sale of the property are reported and taxed at greater
rates than the rates for capital gain.

V
vacation home��������������������������������������������������������������������������������������������������������������������220
Any dwelling unit, such as a house, apartment, condominium, mobile home,
recreational vehicle, or boat, personally used by the owner or co-owners
and their families or friends as a residence other than the owner’s principal
residence.