Income Taxes on San Diego, California real estate

Scott S. Hamill Broker / Realtor Pacific Real Estate 7825 Fay Avenue Suite 200 La Jolla, CA 92037 (858) 405-2454 E-mail
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Income Taxes on San Diego, California real estate

In this day and age, income taxes play an important role in real estate owners' decisions, from buying or selling their personal residences to decisions involving the most exotic San Diego, California real estate investment properties. Because the tax laws are always changing, it is important to stay abreast of them. Some basic tax definitions and calculations stay the same from law change to law change. We will discuss income taxes as they relate to business and investment property as well as to a personal residence.

San Diego real estate held for business and investment has some distinct differences in federal income tax treatment from property used as a personal residence. We will begin with the concept of depreciation.

Depreciation

The two most obvious and important characteristics of real estate investments are income and expenses. San Diego real estate is one of those assets that benefit from a special accounting device for a special kind of expense called depreciation.

Depreciation is a method of accounting for the wear that results from the use of a capital good. A capital good, such as a piece of equipment or a building, does not last forever. As it is used, it wears out or becomes obsolete; at some point the owner must replace it or substantially repair it. Depreciation is used to reflect this replacement cost. The main reasons depreciation is allowed are to encourage investment in real estate and to reflect, in accounting terms, the real costs of property ownership. Only investment or income property may benefit from depreciation. (Today we use a recovery system instead of depreciation, but the word depreciation has been around for so long that it is still used.)

For depreciation purposes real estate can be divided into two categories:

Residential property
Nonresidential property

Residential property is where people live - for example, single-family residences, duplexes, triplexes, fourplexes and multiunit apartments. Nonresidential property is property that is not residential in nature - for example, industrial, commercial, and office buildings and other similar types of properties. Since January 1, 1987, all real property must use the straight-line method of depreciation.

Generally, residential rental property must use a useful life of 27.5 years and nonresidential property must use a useful life of 39 years. Either residential or nonresidential property may elect to use 40 years.

To explore the tax implications of investment properties, one must understand the concept of basis and know how to compute the original basis, depreciable basis and adjusted basis correctly. The original basis (OB) is used to determine the depreciable basis and adjusted basis. The depreciable basis (DB) is used to determine the amount of allowable depreciation. The adjusted basis (AB), which changes as time progresses, is required to calculate the gain on the disposition of a property.

Original basis

The original basis of a property is the sum of its purchase price and the buying expenses on acquisition. When a buyer purchases San Diego real estate, the escrow statement includes the sale price and a listing of other costs and expenses. These amounts can be classified into four basic groups:

Purchase price (PP)
Operating expenses (OE)
Buying expenses (BE) (nonrecurring closing costs)
Nondeductible items (ND) such as impound accounts

The purchase price

The purchase price (PP) is the amount the buyer is willing to pay and the seller is willing to accept in payment for the property. On the escrow statement the PP usually is on the top line and is called total consideration. Generally, the PP is financed in some manner. These loans do not affect the basis. Furthermore, if the buyer takes out a new loan, refinances or takes out a second mortgage, these loans also do not increase the basis.

Operating expenses

Operating expenses (usually recurring costs such as interest, insurance and taxes) are written off against the income produced by the property. Points (loan origination fees) are nonrecurring interest costs that are amortized over the life of the loan; they are not operating expenses.

Buying expenses

Buying expenses are defined as nonrecurring escrow costs (excluding points to obtain a loan). The buying expenses are added to the purchase price, making up the original basis. Points are never added to the basis.

Original basis = Purchase price + Buying expenses

Depreciable Basis

The depreciable basis is defined as the original basis multiplied by the percentage of improvements to land.

Depreciable basis = Original basis x Percentage of improvements to land

An alternative formula is Depreciable basis = Original basis - Land value