Income Tax Issues in Real Estate Transactions

Exam rule

Basis measures the owner's investment for tax purposes. A purchase usually starts with cost, plus settlement items that must be capitalized. Owner's title insurance, recording fees, surveys and certain legal fees can enter basis. Loan charges, prepaid interest and most points do not enter the property's basis. Adjusted basis changes the starting figure over time. Add lasting capital improvements and certain assessments. Subtract depreciation allowed or allowable and other required decreases. A repair keeps property in normal condition and usually does not increase basis. Amount realized is what the seller receives in the disposition. It includes cash, the fair value of other property and debt taken over by the buyer. Subtract selling expenses, such as a brokerage commission, to reach net amount realized. Realized gain equals amount realized minus adjusted basis. A realized loss reverses those terms. Recognized gain is the part taxed now after any exclusion or deferral. Appreciation is only an increase in market value until a taxable disposition occurs. It does not raise basis by itself. A loss on a personal home is normally not deductible. Holding property for more than one year generally creates long-term treatment. One year or less is short term. Cash flow is money moving in or out. It is not the same as taxable gain.

Exam rule

Section 121 may exclude up to $250,000 of gain on a qualifying main home. A qualifying joint return may exclude up to $500,000. The seller generally must own and use the home for 24 months during the five years before sale. The months do not need to be continuous. For the full joint exclusion, either spouse may meet ownership. Both spouses must meet the use test. Neither spouse may fail the look-back rule. That rule generally bars another exclusion during the two years before sale. A work move, health event or unforeseen circumstance can support a reduced exclusion. The available fraction is based on the shortest qualifying period divided by two years. Gain linked to depreciation allowed or allowable after May 6, 1997 cannot be excluded. Periods of nonqualified use can also reduce the exclusion. A personal loss on the sale remains nondeductible. The IRA first-home rule is different. It can remove the additional early-distribution tax from up to $10,000 of lifetime distributions. First-time usually means no present ownership interest in a main home during the prior two years. Qualified costs include buying, building or rebuilding a main home. They can also include reasonable settlement, financing and closing costs. The money generally must be used within 120 days. The benefit can cover a home for the taxpayer, spouse, child, grandchild, parent or other ancestor. The distribution can still create ordinary taxable income. It is not a tax-free down payment.

Exam rule

A vacation home does not receive the main-home exclusion merely because the owner calls it a second home. Mortgage interest can still qualify under the second-home rules. A second home never offered for rent can be a qualified home. If it is rented, personal use must exceed the greater of 14 days or 10 percent of fair-rental days. A dwelling used as a home and rented fewer than 15 days gets special treatment. The owner generally does not report that rent or deduct rental expenses. Mixed personal and rental use requires a reasonable allocation. Rental receipts can include advance rent, cancellation payments and property or services received instead of cash. A refundable security deposit is not income when the owner expects to return it. Rental real estate is generally passive, even when the owner makes management decisions. Wages and business earnings are generally active. Interest and dividends are portfolio income. Passive losses usually offset passive income. Active participation may allow up to $25,000 of rental loss against nonpassive income. The allowance generally phases out between $100,000 and $150,000 of modified adjusted gross income. At-risk rules apply before passive-loss rules. A real estate professional also needs material participation before a rental becomes nonpassive. Use this simplified tax-world formula for operations. Taxable rental income equals rents and other income minus deductible expenses, mortgage interest and depreciation. Multiply positive taxable income by the supplied marginal rate when an exam asks for federal tax. Cash flow uses actual receipts and cash expenses instead. Mortgage principal reduces cash but is not an income-tax deduction. Depreciation reduces taxable income without a current cash payment. That difference can create a tax shelter, subject to loss limits.

Exam rule

A homeowner must itemize to claim personal real-property tax and qualified home-mortgage interest. The 2026 federal SALT cap is $40,400, or $20,200 for married filing separately. It covers state and local income or sales tax, real-property tax and personal-property tax together. The cap begins shrinking above $505,000 of modified adjusted gross income. The threshold is $252,500 for married filing separately. It cannot fall below $10,000, or $5,000 for married filing separately. Deduct only tax actually paid to the taxing authority, including amounts paid from escrow. A charge for a specific service or local benefit is generally not deductible as real-property tax. Qualified mortgage interest requires secured debt on a qualified home with an ownership interest. Home-acquisition debt must buy, build or substantially improve the home securing the loan. Debt after December 15, 2017 generally uses a $750,000 cap. The married-filing-separately cap is $375,000. Earlier acquisition debt generally keeps the $1 million or $500,000 limit. Those post-2017 limits continue after 2025. A refinance keeps acquisition treatment only up to the old principal. Extra proceeds qualify only when they meet the secured-home use test. The same rule controls home-equity loans and improvement loans. A home under construction can qualify for up to 24 months when the finished home will qualify. Beginning in 2026, certain qualified mortgage-insurance premiums on acquisition debt are treated as qualified residence interest. Points are prepaid interest. Purchase points may be deducted in the year paid when every IRS condition is met. Refinance points are generally spread over the new loan term. A qualifying improvement portion can receive different treatment. A true prepayment penalty can be interest if it is not payment for a service or loan cost. Closing costs need sorting. Certain title, legal, recording, survey and transfer costs enter basis. Loan origination charges, lender appraisal fees and credit-report fees generally do not enter the home's basis. Deductibility always depends on the tax year and the taxpayer's facts.

Exam rule

Depreciation allocates the cost of qualifying income-producing property across its recovery period. The taxpayer generally must own the property and use it to produce income. The property must have a determinable useful life longer than one year. Land is never depreciable because it does not wear out. Allocate a purchase between land and building using supported values. Depreciable basis begins with the building's adjusted basis when placed in service. A converted home uses the lower of adjusted basis or fair market value at conversion. An improvement is usually depreciated as separate property from its own placed-in-service date. Placed in service means ready and available for its income-producing use. It is not always the purchase date or the first rent-payment date. Under the usual General Depreciation System, residential rental real property uses 27.5 years. Nonresidential real property uses 39 years. Both use straight-line depreciation and the mid-month convention. A full intermediate year's basic amount is depreciable basis divided by the recovery period. The first and last years receive partial deductions under the mid-month tables. Depreciation stops when the property is retired from service, sold or fully recovered. Depreciation allowed or allowable reduces adjusted basis. Failing to claim it does not preserve basis for a later sale.

Exam rule

Depreciation allowed or allowable reduces adjusted basis. A lower basis can make the gain larger when the property is sold. Depreciable buildings are generally section 1250 property. New York exam materials often call the gain tied to depreciation recaptured depreciation. For exam purposes, remember a maximum federal rate of 25 percent on unrecaptured section 1250 gain. It is not a flat 25 percent tax for every seller. This slice cannot exceed the total gain. Any gain left over follows the applicable capital gain rules. Tax law also draws a finer line. Section 1250 ordinary income recapture generally reaches depreciation above straight line. Modern buildings usually use straight line. Their ordinary section 1250 recapture may therefore be zero. The gain tied to depreciation can still be unrecaptured section 1250 gain. Some items or improvements may instead create section 1245 ordinary income recapture. An exam will normally give enough facts to avoid that deeper split. Use this order. First find the amount realized. Next find adjusted basis after allowed or allowable depreciation. Then find total gain. Finally separate the gain tied to depreciation from the gain left over. Use only the rates supplied or clearly requested. The home sale exclusion does not erase gain tied to post-May 6, 1997 depreciation.

Exam rule

Section 1031 defers qualifying gain. It does not erase the gain. Section 1031 now reaches real property only. Both the relinquished and replacement property must be held for investment or productive business use. A personal residence does not qualify while held only as a home. Dealer property held mainly for sale does not qualify. Stocks, partnership interests and ordinary personal property do not qualify under section 1031. Like-kind refers to nature or character, not grade, quality or identical use. Improved real estate can be like-kind to unimproved land. Residential investment property can be like-kind to commercial or industrial property. Hotels, motels and qualifying land can fit when held for business or investment. United States real property is not like-kind to foreign real property. The current IRS publication treats a real-estate lease of 30 years or longer as like-kind. It can be like-kind to owned real estate. The New York syllabus prints leaseholds greater than 30 years. Remember that printed wording for a course question. Use current federal guidance and tax counsel for a real transaction. The same taxpayer generally must transfer the old property and receive the replacement interest. A qualifying exchange defers gain and does not recognize a loss. The replacement property's carryover basis preserves the deferred gain for a later disposition.

Exam rule

A deferred exchange transfers the old property before the replacement property arrives. A qualified intermediary, or QI, uses a written exchange agreement to acquire and transfer the properties. The QI cannot be a disqualified person. Recent agents and many related persons are disqualified. The taxpayer must not receive or control the sale proceeds. Actual or constructive receipt usually turns the transaction into a taxable sale. Two calendar-day periods start when the relinquished property transfers. Replacement property must be identified within 45 days. Identification must be written, signed and delivered to a permitted person. It must clearly describe each property. The taxpayer may identify three properties regardless of value. More can be listed when their total value does not exceed 200 percent of the relinquished property's value. If both limits are exceeded, the taxpayer generally must receive at least 95 percent of all identified value. Replacement property must be received by the earlier of two dates. One is 180 days after transfer. The other is the federal return due date, including extensions, for the transfer year. Receiving a listed property during the first 45 days also counts as identification. A reverse exchange acquires the replacement first. Its safe harbor uses an exchange accommodation titleholder, or EAT, to park qualified ownership. The written QEAA is generally due within five business days. The relinquished property is identified within 45 days, and the parked exchange finishes within 180 days. Related-party exchanges have added rules, including a general two-year holding concern.

Exam rule

Realized gain measures the economics of an exchange before deferral. Recognized gain is the part taxed now. Boot means money or non-like-kind property received. Net debt relief can also act like money received. A liability assumed by the taxpayer can offset a liability from which the taxpayer is relieved. Cash paid may also affect the exchange calculation. Follow the facts rather than using a trade-up slogan. In a simple gain exchange, recognized gain is the lesser of realized gain or net boot received. No loss is recognized in a qualifying exchange, even when boot is present. The remaining gain is deferred. Replacement basis keeps that deferred gain alive. A useful shortcut is replacement property's fair market value minus deferred gain. A second formula starts with the old adjusted basis. Add gain recognized and money paid. Subtract money received and adjust for other property or liabilities as the facts require. Both methods should agree in a clean exam problem. A higher-value replacement does not by itself guarantee full deferral. Receiving cash or net debt relief can still create boot. Exchange expenses can affect the exact calculation. A real closing requires a tax adviser and careful settlement statement. Report the exchange on Form 8824 for the transfer year.

Exam rule

The federal low-income housing credit supports qualified rental housing. Owners or investors claim the credit. Tenants do not claim it as a personal tax deduction. Qualifying units must be rent restricted and occupied by income-qualified households. The owner makes an irrevocable project-level minimum set-aside election. The 20-50 test requires at least 20 percent of units at 50 percent of area median gross income. Outside New York City, the 40-60 test requires at least 40 percent at 60 percent of area median gross income. New York City projects use a special 25-60 test instead of 40-60. The average income test generally uses at least 40 percent of units. A qualifying New York City project may use 25 percent. Each unit receives a 20, 30, 40, 50, 60, 70 or 80 percent designation. The designated-unit average cannot exceed 60 percent of area median gross income. The minimum set-aside must be met by the close of the first credit year. Qualified basis generally equals eligible building basis times the smaller low-income unit or floor-space fraction. Land is not eligible basis. The owner generally claims the credit over 10 years. Federal compliance lasts 15 years, and noncompliance can cause recapture. Longer land-use restrictions may also apply outside this federal exam rule. Current Form 8609 instructions describe 9 percent and 4 percent minimum credit percentages for qualifying categories. A May 2026 IRS update added a 25 percent tax-exempt-bond route for certain post-2025 bonds and buildings. The update includes added conditions, so 25 percent is not a universal project rule.