Contributed By Allen Matkins Leck Gamble Mallory & Natsis LLP
When real estate is sold, it incurs transfer taxes when a new deed is recorded. A transfer tax may also apply if a controlling interest in the entity that owns the real estate is transferred. This local tax varies by jurisdiction, and may be quite high in certain cities, such as San Francisco and Los Angeles.
Unless otherwise agreed to contractually by the parties, transfer taxes are paid by the selling party.
Any appreciation or gain will generally be subject to state and federal taxes. Who pays that tax is determined by the ownership structure.
Gain from the sale of real estate is generally subject to federal and state income taxes when it is sold. The gain is generally the difference between what the asset sold for and the amount paid to acquire it. Who pays that tax is determined by the corporate structure. Gains may be subject to deferral to the extent a successful 1031 exchange is completed.
The gain will be taxed at either capital gains rates or ordinary income rates for federal income tax purposes. The highest capital gains rate is 20%. In general, the capital gains rate will apply if the property is not owned by a corporation and is held for more than a year in a taxpayer’s trade or business or for investment purposes. California state income tax rates do not differentiate between capital and ordinary gains, and the highest rate at which real estate gains could be taxed is 13.3%. Cities and counties in California do not generally have additional income tax on gains from the sale of real estate.
Generally, California real estate is reassessed for property tax purposes when it is sold. Property taxes are roughly equal to 1% of the purchase price of the asset. State property taxes are paid annually, in twice-yearly instalments, to the local county assessor.
If an LLC owns real estate, a transfer tax may be avoided if interests in the LLC are acquired rather than the real estate itself. Generally, the transfer of a non-controlling interest in an LLC that owns real estate will not trigger a transfer tax.
There are generally no taxes for occupying a business premise, although each municipality generally has its own set of ordinances with a variety of local business taxes. Any potential exemptions would be specific to the municipality and tax in question.
Income earned in the US by foreign investors is generally subject to a 30% withholding rate on certain income. Tenants are generally required to withhold 30% of the gross amount payable to the foreign-investor landlord. although this amount may be lower if there is a treaty between the US and the country of citizenship of the foreign investor. Foreign investors generally wish to avoid US tax reporting and the obligation to file tax returns. A foreign investor entity may form a corporation (sometimes called a “blocker corporation”), either foreign or domestic, with the foreign investor as the sole shareholder in order to avoid a direct US tax return filing obligation of such foreign investor or investors.
The Foreign Investment in Real Property Tax Act (FIRPTA) requires 15% tax of the total amount realized from the sale of real property by a foreign investor. Foreign investors may need to file for a tax refund if the amount withheld by the buyer exceeds the foreign investor’s tax liability. The 2017 Tax Cut and Jobs Act added a new provision requiring a 10% withholding on the sales of partnership interests by foreign persons for partnerships engaged in a US trade or business. This will be relevant when real estate deals are structured as sales of entity interests owning real estate rather than direct sales of the real estate.
Investors holding real estate directly or through a partnership or LLC may be able to clam an interest deduction. The asset may be depreciable, and the property taxes paid by the owner may be deductible. Other expenses from the operation of the property also may be deductible. An investor may be able to use accumulated losses from a particular real estate investment to offset other income from other real estate investments in their portfolio.
Ordinary income is taxed at a different rate than capital gains. Real property gains are generally taxed at capital gains rates, rather than ordinary income rates. Real property losses, however, can sometimes be categorized as ordinary losses, which are often more useful to taxpayers in offsetting a broader category of gains. Investors may be able to defer paying taxes on gains through a 1031 exchange, by investing the proceeds from the sale of one real estate investment in a new real estate investment.
There has been some discussion of eliminating like-kind exchanges, which allow investors to defer the payment of tax on profits from the sale of certain assets if the sale proceeds are reinvested in certain like-kind property. Section 1031 of the federal tax code remains applicable to real estate investment but has been eliminated for all other assets.
Corporations are taxed differently from individuals. The highest income tax rate for corporations is 21%, and the highest individual rate is 37%. The recent legislation generally allows for a so-called “pass-through” deduction to individuals who are partners or members of a partnership or LLC that owns real estate. Generally, “qualified business income” that passes through the partnership or LLC to the partner or member may be eligible for a 20% deduction, subject to certain limitations and conditions.
The tax reform also put in place certain carried-interest rules, under which an investor is generally eligible to receive long-term capital gain treatment for carried interest if the carried interest was held for more than three years.