Taxpayer Relief Act of 1997
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Overview
The Taxpayer Relief Act of 1997 was the first major change in the U.S. Tax Code since the Tax Reform Act of 1986. The Act focused its tax breaks on five principle areas:
- Capital gains;
- Expanded IRAs;
- Estate and gift Taxes;
- Child tax credits;
- Education incentives.
Although the Act modified a large portion of the Tax Code, the information we address here is limited to changes affecting RHOL members in the buying and selling of real property. Unless noted to the contrary, all changes became effective for transactions occurring on or after May 7, 1997.
Marginal Tax Rates
The federal income tax is a graduated (liberals call it progressive) tax, meaning that a taxpayer's income tax burden becomes greater as they work harder and the amount of their taxable income increases.
The Tax Code creates bracketed amounts of income-called taxable income brackets-and assigns a specific taxable percentage - called a marginal tax rate-to each bracket. Once a taxpayer's taxable income exceeds the maximum limit of the lowest tax bracket, each dollar of taxable income in excess is taxed at the next-higher marginal tax rate. The marginal tax rates have remained unchanged for several years.
There are five Marginal Tax rates: 15%; 28%; 31%; 36%; and 39.6%.
Republicans usually propose decreasing marginal tax rates across the board. Democrats most often advocate lower preferential tax rates for certain types of income, or excluding some types of income from taxation altogether.
The Taxpayer Relief Act of 1997 did nothing to reduce marginal tax rates; it did, however, create new exclusions from taxable income, as well as lower preferential tax rates in certain instances.
Calculating Gain on the Sale of Real Property
The most-significant aspects of the Taxpayer Relief Act of 1997 affect owners of primary residences and investment properties. The impact of the Act is felt when these properties are sold at a profit; to better understand the changes brought about by the Act, it is first necessary to understand how profit is calculated.
Basis
Basis is the taxpayer's starting point for figuring the amount of profit (gain) or loss when the property is later sold. When compared to the resale price, a higher basis means a lower profit and a smaller income tax obligation; a lower basis means a higher profit and a larger income tax obligation.
When property is purchased, the basis is the purchase price. For new homes, this means the total cost of the site and improvements.
When property is inherited, the basis is its market value at the time of the decedent's death.
If the property is received as a gift, the basis is generally the donor's basis as of the date of the gift.
If the property is transferred from one spouse to another as the result of a divorce, the basis is the same as it was just prior to the transfer.
A taxpayer's basis in a property is likely to fluctuate over the period of ownership, resulting in an adjusted basis.
Additions to Basis
Items that increase basis in real property include non-deductible acquisition costs incurred at the time of purchase, as well as capital improvements made to the property over the period of ownership.
Acquisition Costs
Examples of acquisition costs that are not deductible in the year of purchase, but that are instead added to basis, include but are not limited to: Mortgage Points; Title insurance; Recording fees; Survey; Transfer taxes; Legal fees; and Repairs paid by the purchaser prior to closing.
Capital Improvements
Capital improvements are those that materially add to the value of the property, prolong its useful life, or adapt it to new uses, such as roofs, additions and even landscaping. These items are different from repairs, which are done to maintain the property in good condition, but do not add to its value or prolong its useful life: carpet replacement, painting and repair of broken windows (replacement windows are usually capital improvements).
Repairs done by the owner of a primary residence or second home are not deductible in the year they incurred, nor may they be added to the owner's basis. Repairs done to investment properties, however, are deductible in the year they are incurred and offset the annual incomes from those properties.
Subtractions from Basis
Items that reduce an owner's basis in a property include partial sales of the property, deduction for depreciation, and deferred gain from the sale of a previous property rolled over into the basis of the most recent purchase.
Partial Sales
If a taxpayer sells a portion of his property, he must reduce his basis in the remainder by the amount of the basis he has assigned to the parcel sold.
Deprecation
Most homeowners are not eligible to make annual reductions in their properties' bases for ordinary wear and tear. In cases where an owner uses a portion of the home for a business use (such as a home office), however, they are entitled to such deductions. Normally, the deduction is calculated by first multiplying the adjusted basis of the structural improvements (land is not depreciable) by the percentage of total square footage used for the business purpose; the result is then divided by 27.5 years.
STRAIGHT-LINE DEPRECIATION
PURCHASE PRICE |
$ 165,000 |
LESS SITE VALUE |
- 42.000 |
VALUE OF STRUCTURAL IMPROVEMENTS |
$ 123.000 |
PERCENTAGE OF OVERALL SPACE USED FOR BUSINESS PURPOSES |
X 6.0% |
MAXIMUM DEPRECIABLE AMOUNT |
$ 7,380 |
DIVIDED BY DEPRECIABLE LIFE IN YEARS |
27.5 |
ANNUAL DEDUCTION FOR DEPRECIATION (ROUNDED) |
$ 268 |
The owner of an investment property must take an annual deduction for depreciation on the structural improvements. This deduction is calculated in the same fashion as that just mentioned, except that 100% of the square footage of the structure is ordinarily deductible. Another difference may result from the type of property depreciated: although straight-line depreciation is again taken over 27.5 years for a residential property, it must be taken over 39 years for a non-residential income property.
Some property owners who purchased prior to 1987 were allowed to depreciate their investment properties using a more-rapid method than the straight-line method, called accelerated depreciation. The Tax Reform Act of 1986 ended this practice, and today the Tax Code penalizes an owner by taxing that portion of profit, in full, in the year of sale. The prior code also provided a 15-year deprecation option for "low-income" rental property. That preference (very valuable to mom and pop landlords) was wiped out in favor of Low Income Housing Tax Credits (LIHTC) that only benefit developers of large apartment communities.
Regardless of the method used to calculate depreciation, the important thing to remember is that any portion of gain attributable to depreciation is usually taxed differently than the remainder of the gain resulting from appreciation of the property. This is still true under the Taxpayer Relief Act of 1997.
Deferred Gain Rollovers
Prior to the latest tax act, a homeowner who wanted to defer the tax obligation on resale profit had to purchase a replacement home of equal or greater value. Although the Taxpayer Relief Act of 1997 eliminates the rollover provision for sales on or after August 5, 1997, the basis of any taxpayer that exercised this provision in the past will be affected on a future sale of the property. Through Section 1031 of the Tax Code, investment property owners are entitled to a rollover provision as well, but only by trading one property for another. The Taxpayer Relief Act of 1997 made no changes in the 1031 exchange.
ADJUSTED BASIS
PURCHASE PRICE (BASIS) |
$ 165,000 |
NON-DEDUCTIBLE ACQUISITION COSTS |
+ 2,100 |
CAPITAL IMPROVEMENTS |
+ 18,400 |
PARTIAL SALES, |
- 19,000 |
DEPRECIATION |
- 1,700 |
PREVIOUS GAIN DEFERRED THROUGH A ROLLOVER |
- 31,700 |
ADJUSTED BASIS |
$ 133,700 |
Amount Realized
The amount realized on the sale of a property is that portion of the gross sale price remaining after the seller pays all selling expenses (excluding the payoff of any loans against the property) and takes a further deduction for the value of all personal property included in the sale. Obviously, the Tax Code recognizes that selling costs are not profit to the seller; and personal property -although it usually has a value-is sold for far less than its cost, which further reduces the seller's profit.
Realized Gain
The realized gain on a sale is the difference between the Amount Realized and the Adjusted Basis; it is the actual profit earned by the seller when selling the property.
REALIZED GAIN
GROSS SALE PRICE |
$ 207,000 |
RESALE EXPENSES |
- 16,600 |
PERSONAL PROPERTY INCLUDED IN GROSS SALE PRICE |
- 4,200 |
AMOUNT REALIZED |
186,200 |
ADJUSTED BASIS (FROM EXAMPLE ABOVE) |
133,700 |
REALIZED GAIN |
$ 52.500 |
When the seller receives this gain in its entirety upon close of sale, it is generally fully taxable that year. If the seller uses an installment sale, however, only the portion of the gain collected in the year of sale is taxable in the year of sale. From that point forward, the seller pays the tax each succeeding year on the percentage of the gain collected, and until the installment contract is paid in full.
As mentioned earlier, any portion of gain attributable to depreciation may be taxed differently than the remaining gain, usually at higher rates. Where we use the term gain on this page, it refers to realized gain.
Under the Taxpayer Relief Act of 1997, a majority of home sellers are able to exclude all profits on a sale from their taxable incomes. As a result, they no longer have to purchase a replacement home of equal or greater value to shield their profits from taxation.
An Aside
Dr. Thomas Bier, head of the housing policy research center at Cleveland State University, argued that previous tax policy dictated central city decline; he cited the strong push toward more expensive homes in the suburbs and rural areas as home sellers attempted to shield profits from the sale of their city homes from the IRS. Dr. Beir praised the new universal exclusion as a golden opportunity for developers and an attraction to empty nesters, who can now sell their large suburban homes and move into less-expensive homes in the city without worrying about tax consequences.
We believe that it is much more likely that the trend to condo living for seniors will continue and that few of those will be located in inter-cities. Older city neighborhoods are likely to remain rental communities for some time.
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