LIENS, TAXES AND FORECLOSURES
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LIENS, TAXES AND FOR ECLOSURES
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Welcome
Welcome to the Liens, Taxes and Foreclosures course presented by Mckissock LP.
This course will provide a comprehensive study of all aspects of liens, titles and
foreclosures, addressing all types of liens and their classifications.
The course also will discuss taxes and their importance in the real estate industry.
Finally, it will cover foreclosures and how to delay and dispute them.
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TABLE OF CONTENTS
OBJECTIVES .........................................................................................5
Chapter 1. Liens .....................................................................................6
Chapter 2. Real Estate Tax Liens ......................................................... 20
Chapter 3. Taxes .................................................................................. 37
Chapter 4. Foreclosures .......................................................................49
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G U I D E
OBJECTIVES
At the completion of this workshop, you will be able to.
Understand the difference between general and specific liens
Describe Ad Valorem taxes and the governmental bodies that impose
them
Describe special assessment taxes and why they are in place
Identify the two components of depreciation and the basis of
depreciation
Understand installment sales and how they are determined
Identify capital gain on home sales and the types of capital gain
Comprehend various types of foreclosures
Understand how to delay a foreclosure
Identify the obligations required of a buyer in a foreclosure
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1
Chapter
Liens
INTRODUCTION
A lien is a claim against property, made in order to secure payment of a debt. The
lien makes the property collateral against monies or services owed to another
person or entity. Collateral is an asset that has been pledged by the recipient of a
loan as security on the value of the loan. If the recipient of the loan is unable to
repay the loan, the lender will look to the collateral as a source for payment on the
debt.
Liens are of two kinds: general and specific. In addition, there are voluntary and
involuntary liens. Voluntary liens are imposed by a contract between the creditor
and the debtor (e.g., when a lender holds a mortgage on a property, it has a lien
against the home). Involuntary liens are imposed by law, such as when a lien is
placed on a property for outstanding taxes and other unpaid debts.
An encumbrance is a claim against, limitation on, or liability against real estate.
Encumbrances include liens, deed restrictions, easements, encroachments, and
licenses.
An encumbrance can restrict the owner's ability to transfer title to the property, or
it can lessen the property’s value. It represents some right or claim of another to a
portion of the property or to the use of the property.
Liens may be voluntary or involuntary, statutory or equitable, general or specific.
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LOOKING AT TAX LIENS
On January 1, when the assessment roll takes effect for the next tax year, a lien is
placed on all assessed real property in the amount of the tax due. Taxes on
personal property also may be liens on secured real property if they are listed with
or cross-referenced to real property on the secured assessment roll. The assessor
determines whether the real property is sufficient security for the personal property
tax. At the taxpayer’s request, real property owned by the taxpayer elsewhere in the
county also may secure the personal property tax lien. Before the lien date, the
assessor issues and records a certificate to that effect.
The real and personal property are cross-referenced in the tax rolls. The property
tax lien takes priority over all others, with some exceptions. The exceptions are for
the following:



a judgment lien creditor who acquired a right, title, or interest, prior to the
recording of the property tax lien;
holders of a security interest or mechanic’s lien;
a person or entity who bought the property or took title to it without
knowledge of the lien.
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GENERAL LIENS
A lien is general when it affects all property of the debtor or all property in a
certain class. There are several types of general liens.
Judgment Liens
A judgment lien is a court ordered lien that is placed against the home or property
when the homeowner simply fails to pay a debt. This doesn’t seem like a big deal,
but when the homeowner has a judgment lien against his or her home and wants
to sell it, the judgment lien has to be paid in full before the home or property can
be sold. Judgment liens can be placed against the property for a variety of reasons
such as unpaid credit card bills, utility bills, department store bills, landscaping or
home improvement bills, and just about any bill that the homeowner has failed to
pay in a reasonable amount of time. Any bill that can cause an individual to end up
in court can result in a judgment lien.
A judgment lien is different from a trust, in that the judgment lien holder cannot
foreclose on the home or property as the trust holder can. Judgment lien holders
can demand payment, but ultimately they must wait for the homeowner to sell the
property before they can expect to be paid the money that they are owed according
to the judgment. Luckily for the judgment lien holder, the court will typically assign
an interest rate to these liens so that the lien holder is compensated for waiting; the
interest will continue to accrue until the debt is paid in full. Because the majority of
people will live in their home for quite some time, the interest can make a
judgment lien grow, and grow, and grow over the years so that it is quite large.
Estate and Inheritance Tax Liens
Estate tax liens help protect the government's interest in collecting federal estate
tax liabilities.
A general estate tax lien arises when a decedent's estate fails to pay its estate tax
liability. The general estate tax lien attaches to all of the property that is included in
the decedent's gross estate. The decedent's gross estate includes all property owned
at death, plus certain other assets over which the decedent had sufficient control.
The lien does not attach to property that is outside of the decedent's gross estate or
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property which (as part of the gross estate) is used to pay court-approved estate
expenses. The general estate tax lien is enforceable for a period of ten years
following the decedent's death.
If the estate tax is not paid when due, then "the spouse, transferee, trustee,
surviving tenant, person in possession of the property by reason of the exercise,
non-exercise, or release of a power of appointment, or beneficiary, who receives,
or has on the date of the decedent's death, property included in the gross estate" is
"personally liable" for the estate tax. In this event, the general estate tax lien then
disappears and is replaced with a transferee tax lien. The transferee tax lien attaches
"to all the property of such spouse, transferee, trustee, surviving tenant, person in
possession, or beneficiary, or transferee of any such person, except any part
transferred to a purchaser or a holder of a security interest."
The IRS may also seek to impose a special estate tax lien in certain instances, such
as where the estate consists primarily of a closely-held business and it elects to
defer payment of the estate tax liability. Special estate tax liens are "not valid as
against any purchaser, holder of a security interest, mechanic's lien, or judgment
lien creditor" prior to their being properly secured. The special estate tax lien is in
lieu of, not in addition to, the general estate tax lien and transferee liens described
above.
If the taxpayer does not fit into one of those categories, he or she may be able to
negotiate with the IRS to reduce or abate tax penalties and interest. The IRS may
be willing to reduce or abate tax penalties and interest if the taxpayer can show that
he or she made an honest mistake. In some cases it is incumbent on the taxpayer
to request that the government remove the interest.
An experienced tax attorney can help determine what, if any, estate tax lien a
property may be subject to and can help structure the client’s financial affairs in a
way to minimize the imposition of estate tax liens.
Corporation Franchise Tax Liens
State governments generally levy a corporation franchise tax on corporations as a
condition of allowing them to do business in the state. Such a tax is a general
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statutory involuntary lien on all real and personal property owned by the
corporation.
IRS Tax Liens
In the United States, a federal tax lien may arise in connection with any kind of
federal tax, including but not limited to income tax, gift tax, or estate tax.
Internal Revenue Code section 6322 provides:
Sec. 6322. Period of Lien.
“Unless another date is specifically fixed by law, the lien imposed by section 6321 shall arise at
the time the assessment is made and shall continue until the liability for the amount so assessed (or
a judgment against the taxpayer arising out of such liability) is satisfied or becomes unenforceable
by reason of lapse of time.”
The term "assessment" refers to the statutory assessment made by the Internal
Revenue Service (IRS) under 26 U.S.C. § 6201 (that is, the formal recording of the
tax in the official books and records at the office of the Secretary of the U.S.
Department of the Treasury). Generally, the "person liable to pay any tax"
described in section 6321 must pay the tax within ten days of the written notice
and demand. If the taxpayer fails to pay the tax within the ten-day period, the tax
lien arises automatically (i.e., by operation of law) and is effective retroactively to
(i.e., arises at) the date of the assessment, even though the ten-day period
necessarily expires after the assessment date.
Under the doctrine of Glass City Bank v. United States, the tax lien applies not only
to property and rights to property owned by the taxpayer at the time of the
assessment, but also to after-acquired property (i.e., to any property owned by the
taxpayer during the life of the lien).
The statute of limitations under which a federal tax lien may become
"unenforceable by reason of lapse of time" is found at 26 U.S.C. § 6502. For taxes
assessed on or after November 6, 1990, the lien generally becomes unenforceable
ten years after the date of assessment. For taxes assessed on or before November
5, 1990, a prior version of section 6502 provides for a limitations period of six
years after the date of assessment. Various exceptions may extend the time periods.
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SPECIFIC LIENS
A lien is special when it affects only specific property. If a judgment were
recovered against a person, that judgment would be a claim against all the property
he or she owns or acquires, and is a general lien. But if person A employs person B
to build a house for him and does not pay for it, B has a claim on the house he has
built, not on all A's property; and his claim is a specific lien. There are several types
of specific liens.
Property Tax Lien
Some states are “tax deed only” states, which gives their governments access to
immediate funds to function properly and perform their normal operations. If an
owner does not pay property taxes, the property becomes tax defaulted and the
owner has five years to redeem it. The owner of the property has two choices:
redeem the property and pay a fortune in taxes and interest, or not redeem the
property and let the government sell it.
Unlike tax deeds, tax lien certificates let the investor earn a high rate of interest on
the delinquent property taxes in addition to collecting the property if the owner
fails to redeem. Tax lien certificates are a low-risk, high-return alternative to the
constantly changing economy. Buying tax lien certificates is probably the best-kept
secret in investing. It is safe and simple to do.
Real Estate Tax Liens
Unlike personal debts, tax liens on real estate occur when property owners become
responsible for payment even if the tax obligation was incurred by a prior owner.
Depending on the law of the state or jurisdiction, the owner of the property may
also be personally liable for payment of the taxes.
Payment of a tax lien may occur through various methods:
 Payment may be made directly by the property owner or, in many cases,
indirectly by the mortgage holder using an escrow account. Notice is given both
to the property owner and mortgage holder when a property tax is delinquent;
thus, even if the property owner does not have an escrow account on the
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mortgage, the mortgage company will receive notice of the delinquency and
may pay the tax. The mortgage company will then demand repayment from the
owner/borrower and/or create an escrow account to recoup the proceeds,
since the mortgage company might lose some of the value of its mortgage lien
if the property were sold by the taxing agency to satisfy unpaid-taxes
foreclosure.
 If a property is sold by the owner prior to tax foreclosure by the government
body, the tax lien (which is generally discovered as part of a title search) is
usually paid from the sale proceeds as part of closing costs.
 Procedures vary from state to state. Generally, in the event a tax lien on
personal property is not paid within a specified time (and after several notices
are given), the property may be seized and sold at a foreclosure sale. On real
property, one of two methods may be used: either the property may be seized
and sold (a tax deed sale), or in some States the tax lien may be offered to
investors (in the form of a tax lien certificate) with an accompanying right for
the investor, after a specified period of time, to institute foreclosure
proceedings (a tax lien sale).
Mortgage Liens
A mortgage lien is a legal claim against a mortgaged property that must be paid or
assumed when the property is sold. The person who holds the lien against the
property can claim the property if the loan defaults. The mortgage lien typically
belongs to the lender in order to secure the mortgage loan.
Mechanic’s Liens
A mechanic's lien is a security interest in the title to property for the benefit of
those who have supplied labor or materials that improve the property. The lien
exists for both real property and personal property. In the realm of real property, it
is called by various names including, generically, construction lien. It is also called a
materialman's lien or supplier's lien when referring to those supplying materials, a
laborer's lien when referring to those supplying labor, and a design professional's
lien when referring to architects or designers who contribute to a work of
improvement. In the realm of personal property, it is also called an artisan's lien.
Mechanic’s liens on property in the United States date from the 1700s.
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With respect to real property, mechanic's liens are purely statutory devices that
exist in every state as legislative public policy to protect contractors. More
specifically, the state legislatures have determined that, due to the economics of the
construction business, contractors and subcontractors need a greater remedy for
non-payment for their work than merely the right to sue on their contracts. In
particular, without the mechanic’s lien, subcontractors providing either labor or
materials may have no effective remedy if their general contractor isn't sufficiently
financially responsible, because their only contractual right is with that general
contractor. Without the mechanic's lien, the contractor would have a limited
number of options to enforce payment of the amounts owed.
Further, there is usually a long list of claimants on any failed project. To avoid the
specter of various trades, materialmen and suppliers attempting to remove the
improvements they have made, and to maintain a degree of equality between the
various lienors on a project, the statutory lien scheme was created. Without it,
Tradesperson A may try to "race" Supplier B to the courthouse, the project site, or
the construction lender to obtain payment. Most lien statutes instead mandate
strict compliance with the formalized process they create in return for the timely
resolution and balancing of claims between all parties involved – both owners and
lien claimants.
Utility Liens
Municipalities often have the right to impose a specific, equitable, involuntary lien
on the property of an owner who refuses to pay bills for municipal utility services.
Bail Bond Liens
A bail bond lien happens when a family member needs to be bailed out of jail and
a relative puts up his or her home for collateral. The bail company will place a bail
bond against the relative’s property, which works as an insurance policy for the
court. If the individual does not show up for the court date, the bail is paid to the
court through the bail bond company.
In most cases, bail bond liens are secured with a deed of trust, allowing the bail
bond company to foreclose the property if the bond is not repaid.
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Case Study: Mechanic's Lien - RTBH, Inc. v. Simon Property Group
Dick's Sporting Goods, Inc. entered into a lease with Simon Property Group for a
property that Simon owned at a mall. Dick's planned to build a new store on the
property, which would required the deconstruction of the existing units. Simon
agreed to pledge to finish the construction of the building if Dick's failed to
complete it. Dick's used S.C. Nestel, Inc. as the general contractor for the project.
McAndrews was then subcontracted by Nestel to do the window and glass work.
Throughout the construction process, a representative from McAndrews was in
contact with representatives from Dicks' and Nestel, but not with anyone from
Simon. The store was eventually completed without the need for Simon to
intervene. Nestel refused to pay McAndrews for the work and, instead, filed a
complaint for damages against them. McAndrews filed a counterclaim against both
Nestel and Simon stating that there was a valid mechanic's lien on the property.
Simon made a motion for a partial summary judgment. They claimed there was no
mechanic's lien on their interest of the property.
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THE EFFECTS OF LIENS ON TITLE
Unlike personal debts, tax liens "run with the land" in that a property owner
becomes responsible for payment even if the tax lien obligation was incurred by a
previous owner. Depending on the local state and county law, the new owner of
the property may also become personally liable for any and all payment of the tax
lien.
So, when a property owner doesn't pay his property taxes, the county government
puts a lien on the property, making it a tax lien property. The county government
will then look for investors to pay the property owner’s back taxes owed, so that
the local government can continue to run on budget.
PRIORITY OF LIENS
The usual rule as to priority of liens is that they rank in the order of their filing or
recording in the office of the proper officials. A mortgage recorded yesterday has
precedence over one recorded today, and both are prior in lien to a mechanic's lien
that may be filed tomorrow. As to judgments, there is an exception to this rule; a
judgment is not good against the rights of those claiming under a deed or mortgage
actually delivered prior to the date of docket of the judgment, even though the
deed or mortgage has not been recorded.
The creditor who secures a judgment does so regardless of what a debtor may or
may not own. The creditor asserts an existing claim in an action at law; when a
judgment is secured, it becomes a lien on what the debtor actually owns at that
time. It must, of course, be recognized that deeds and mortgages given to defraud
creditors may be set aside, and that reference here is only to those given in good
faith for value. It must also be noted that the lien of all taxes and assessments
imposed by any governmental authority is superior to every other lien, regardless
of the date of the lien or its recording. Of course, the relative rank of any two or
more liens can be changed by agreement between their holders; this is often done
with respect to mortgages by means of an instrument known as a subordination
agreement.
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PERFECTED AND UNPERFECTED LIENS
Liens may be "perfected" or "unperfected." Perfected liens are those liens for
which a creditor has established a priority right in the encumbered property with
respect to third party creditors. Perfection is generally accomplished by taking
steps required by law to give third party creditors notice of the lien. The fact that
an item of property is in the hands of the creditor usually constitutes perfection.
Where the property remains in the hands of the debtor, some further step must be
taken, such as recording a notice of the security interest with the appropriate
office.
SELLING PROPERTY
If you are planning on selling property that has a lien on it, it is unlikely that the
sale will close unless the debt is taken care of. A buyer will expect liens to be paid
to allow for a transfer of clear title.
PURCHASING PROPERTY
When purchasing real estate, it is important to make sure there is no lien on the
property that will prevent the securing of a clear title to the property. Generally, a
bank or other mortgage lender will not provide mortgage financing until all liens
on the property have been removed. A title search will usually indicate whether or
not a lien exists and whether the seller is the legally recognized property owner. It
should also indicate the exact legal description of the property, as well as providing
details regarding a lien or other encumbrances against the title.
Anyone can conduct a search at the county clerk's office. Some county clerks have
Websites which allow for title searches on the Internet, but these may not provide
complete records. Therefore, it may be wise to hire an attorney or an abstract
company to conduct the title search.
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TRANSFERRING PROPERTY WITHOUT REMOVING LIENS
The law does not require that liens be removed before title to property can be sold
or transferred. But the lien will need to be cleared up if the buyer needs financing
or wants clear title. If property is transferred without the lien being paid off, it
remains on the property. In transfers between relatives, the new owner may be
willing to take title to property that already has liens encumbering it.
PROPERTY LIEN DISPUTES
If there is a property lien dispute, an experienced real estate attorney should be
contacted to help resolve it.
HOW ARE REAL ESTATE LIENS RELEASED/ASSIGNED?
Obviously, a full payoff of one's debt will lead to the removal of a lien upon
providing evidence to the County Records Office, but suppose you are ready to
sell your home or trade in your vehicle but you've been told you have to obtain a
"Release of Lien" first. Normally, you would go back to the bank or Savings and
Loan and ask them to prepare a release for you. But, where do you go if the bank
or Savings and Loan has failed?
The Federal Deposit Insurance Corporation (FDIC), which is best known for
insuring bank depositors to at least $250,000 per insured bank account, may be
able to help by providing you with a Release of Lien on your home, vehicle, boat
or other personal property if:
 The lien holder is a bank or Savings and Loan Institution that failed and has
been placed in FDIC receivership. Also, in some cases, if the lien holder is a
Subsidiary of a failed bank or Savings and Loan. If you're not sure, please call
the appropriate DRR Customer Service Center at 972-448-6000 or toll-free at
888-206-4662.
 The loan was paid off before the institution failed.
 The loan was paid off to the FDIC after the institution failed.
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A request for a Release of Lien must be made in writing and be detailed. Mail,
email or fax your request to the appropriate DRR Customer Service Center with
the recorded document to be released or to be assigned showing the closed
institution as the lien holder. Also, a proof of payoff must be provided to expedite
the completion of your request and avoid researching the records of the closed
institution which will delay the completion of your request.
When an Assignment of Lien is needed to complete a chain of title, you must
obtain an Assignment of Lien from the FDIC. The following documents are
needed to obtain an Assignment of Lien:
 A copy of the Mortgage or Deed of Trust Document that you are requesting to
be assigned. The copy must be readable and clearly show the recording
information. This document can be obtained from the Public Records in the
County where the property is located or from your title company or title
attorney.
 Copies of any subsequent assignments that show the chain of title leading to an
FDIC receivership.
 Proof that the party to whom the assignment is being made is the current
holder of the mortgage. Proof can be in the form of a Note Endorsement,
Loan History, Sales Contract or Indemnification Agreement.
If the lien holder of record is not a Bank or Savings and Loan that failed and has
been placed in FDIC receivership, please provide copies of any and all assignments
that show the chain of title leading to an FDIC receivership.
It is highly suggested you also provide the following documents, if available:
 A copy of a recent Title Search or Title Commitment, or
 Attorney's Title Opinion on the property for which you are requesting an
assignment showing the breaks in the chain of title. This is especially helpful in
cases where the Mortgage documents are of poor quality and hard to read.
Your Title Company or Title Attorney can usually provide you with this.
Source: Federal Deposit Insurance Corporation to view the website click here.
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WHERE TO SEND YOUR REQUEST
A request for a Release of Lien must be made in writing.
You can mail your request to: FDIC, 1910 Pacific Ave, Dallas TX 75201
Attention: DRR Customer Service Center/Inwood
OR it can be faxed to 703-812-1082
We ask that you either fax your request OR mail it in. Please do not do both. Hard
to read documents should be mailed or sent overnight, rather than faxed.
Unreadable documents cannot be processed.
Be sure to include your address and phone number with your written request.
Because of the large volume of release requests we get, it may take up to 30
business days to obtain an assignment so you may want to plan accordingly.
If you have any questions you may call the DRR Customer Service Center at 972448-6000 or toll-free at 888-206-4662 between the hours of 8:00 am and 5:00 pm
Central Standard Time, Monday through Friday (except Holidays). A Customer
Service Representative will be happy to answer your questions, OR check out our
Frequently Asked Questions.
Source: Federal Deposit Insurance Corporation to view the website click here.
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2
Chapter
Real Estate Tax Liens
GENERAL AD VALOREM TAX
An ad valorem tax (Latin for “according to value”) is a tax based on the value of
real estate or personal property. An ad valorem tax is typically imposed at the time
of a transaction, as in a sales tax or value-added tax (VAT), but it may be imposed
on an annual basis (real or personal property tax) or in connection with another
significant event (inheritance tax, surrendering citizenship, or tariffs). These taxes
are specific, involuntary, statutory liens.
Ad valorem rates, which have come into increased use, have the important
advantage of adjusting the tax burden according to the amount the consumer
spends on the taxed items. They thus avoid the serious discrimination of specific
rates against low-priced commodities. The primary difficulty with the ad valorem
taxation, especially in the case of tariffs, is in establishing a satisfactory value figure.
Sales taxes of broad scope must, of necessity, have ad valorem rates. Property taxes
are sometimes considered ad valorem taxes (since the rates are applied to the value
of the property) as opposed to special assessments, which are frequently imposed
on a specific unit basis (e.g., front footage).
Ad Valorem taxes are a substantial source of revenue for local governments. The
basis of ad valorem property taxation is the fair market value of the property,
established as of January 1 of each year. The tax is levied on the assessed property
value which is established by law. The amount of tax is determined by the tax rate
levied by various entities.
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Ad Valorem taxes are imposed by taxing bodies of government, including:

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States and counties
Cities, towns, and villages
School districts
Drainage districts
Water districts
Sanitary districts
Parks, forest preserves, and recreation districts
Sales Tax
A sales tax is a consumption tax charged at the point of purchase for certain goods
and services. The tax is usually set as a percentage by the government charging the
tax. There is usually a list of exemptions. The tax can be included in the price (taxinclusive) or added at the point of sale (tax-exclusive).
Ideally, a sales tax is fair, has a high compliance rate, is difficult to avoid, is charged
exactly once on any one item, and is simple to calculate and collect. A conventional
or retail sales tax attempts to achieve this by charging the tax only to the final end
user, unlike a gross receipts tax levied on the intermediate business which
purchases materials for production or ordinary operating expenses prior to
delivering a service or product to the marketplace. This prevents so-called tax
"cascading" or "pyramiding," in which an item is taxed more than once as it makes
its way from production to final retail sale. There are several types of sales taxes:
Seller or Vendor Tax, Consumer Excise Tax, Retail Transaction Tax, or ValueAdded Tax.
Value-Added Tax
A value-added tax (VAT), or goods and services tax (GST), is a tax on exchanges,
levied on the added value that results from each exchange. It differs from a sales
tax because a sales tax is levied on the total value of the exchange. For this reason,
a VAT is neutral with respect to the number of passages between the producer and
the final consumer. A VAT is an indirect tax, in that the tax is collected from
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someone other than the person who actually bears the cost of the tax (namely, the
seller rather than the consumer). To avoid double taxation on final consumption,
exports (which by definition are consumed abroad) are usually not subject to VAT
and VAT charged under such circumstances is usually refundable.
Property Tax
A property tax, or millage tax, is an ad valorem tax that an owner of real estate or
other property pays on the value of the property being taxed. There are three
species or types of property: Land, Improvements to Land (immovable man-made
things), and Personalty (movable man made things). Real estate, real property and
realty are all terms for the combination of land and improvements. The taxing
authority requires and/or performs an appraisal of the monetary value of the
property, and tax is assessed in proportion to that value. Forms of property tax
used vary between countries and jurisdictions.
AD VALOREM IMPORTANCE
Ad valorem duties are important to those importing goods into the United States,
because the amount of duty owed is often based on the value of the imported
commodity. Ad valorem taxes (mainly real property tax and sales taxes) are a major
source of revenues for state and municipal governments, especially in jurisdictions
that do not employ a personal income tax.
"Ad valorem" is used frequently to refer to property values by county tax assessors.
In many states, the central appraisal district sends certified values to the county tax
assessor, who determines the final tax rate to be imposed on the property. Other
states use a state tax commission, which notifies the appropriate taxing authorities
of the assessed value of property within their billing jurisdiction.
Ad valorem tax relates to a tax with a rate given as a proportion of the price. For
example, virtually all state and local taxes on restaurant meals and clothing are ad
valorem.
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WHAT PROPERTY IS TAXED?
Taxes on Real Property
"Real property" for property tax purposes generally includes the land, building,
structures, and all improvements or fixtures annexed to the building or structure.
The definition of real property often excludes business personal property such as
tools, implements, machinery, and equipment attached to or installed as real
property for use in the business.
Taxes on Personal Property
Taxing authorities may also tax personal property. The items taxed vary by
jurisdiction, but most jurisdictions do not impose property taxes on household
goods, inventories, and intangible personal property such as bonds. Motor
vehicles, however, are often subject to ad valorem taxation.
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DETERMINING THE AMOUNT OF AD VALOREM TAXES
Generally, ad valorem taxes are assessed as of January 1 each year and are
computed as a percentage of the assessed value of the property being taxed. The
assessed value of property generally is a fair percentage of fair market value. "Fair
market value" is usually defined as the price that a willing buyer would pay and a
willing seller would accept for property, neither being under any compulsion to
buy or to sell. It is also defined as the price at which property would change hands
between a willing buyer and a willing seller when both have reasonable knowledge
of all the facts necessary and neither is required to buy or sell.
Appraisers hired by the taxing authority most often value the property. Most taxing
authorities require periodic inspections of the subject property as part of the
valuation process and establish appraisal criteria to determine fair market value.
Such criteria include factors analyzing:




the cost of the property and subsequent depreciation;
comparable market data;
the use of the property; and
estimated annual net income generated by a business property.
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DISPUTING VALUATION
Upon notification of assessment, the property owner may dispute the valuation.
Generally, taxpayers may request a hearing at the local level and, if necessary,
appeal the valuation to a higher agency and, ultimately, a tax court.
LEVY OF TAX AND CLASSIFICATION
Once a value is determined, the tax is levied, and the property owner is notified.
The actual tax rate may vary depending on the property's classification. Property is
often classified according to its use. Common classifications include
commercial/industrial property, multiple dwelling property, residential homestead
property, agricultural property, and business property.
PARTIES INVOLVED
Here are some of the entities that may be involved in the ad valorem tax process.
The terms for these individuals or entities may be different in your area, but there
will likely be an individual or board that has similar duties and responsibilities in
the county where you live:
The County Tax Commissioner, an office established by the Constitution and
elected in all counties except one, is the official responsible for receiving tax
returns filed by taxpayers or designating the board of tax assessors to receive
them; receiving and processing application for homestead exemption; serving as
agent of the State Revenue Commissioner for the registration of motor vehicles;
and performing all functions related to billing, collecting, accounting for, and
disbursing ad valorem taxes collected in this county.
The County Board of Tax Assessors, appointed for fixed terms by the county
governing authority in all counties except one, is responsible for determining
taxability and also for the appraisal, assessment, and equalization of all
assessments within the county. The Board of Tax Assessors notifies taxpayers
when changes are made to the value of property, receive and review all appeals
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filed, and insure that the appeal process proceeds properly. In addition, the Board
approves all exemptions claimed by the taxpayer.
The County Board of Equalization, appointed by the Grand Jury, is the body
charged by law with hearing and adjudicating administrative appeals to property
assessments made by the Board of Tax Assessors. (Note: An arbitration method
of appeal is available to the taxpayer in lieu of an appeal to the Board of
Equalization at the option of the taxpayer at the time the appeal is filed.)
The Board of County Commissioners, or County Governing Authority (or the
sole Commissioner in some counties), an elected body, establishes the annual
budget for county government operations and then levies the mill rate necessary
to fund the portion of the budget to be paid for by ad valorem tax.
The County Board of Education, an elected body, establishes the annual
budget for school purposes and then recommends the mill rate, which, with very
few exceptions, must be levied for the School Board by the County
Commissioners.
The State Revenue Commissioner exercises general oversight of the entire ad
valorem tax process. In addition, the State levies ad valorem tax each year in an
amount which cannot exceed one-fourth of one mill (.00025).
SPECIAL ASSESSMENT (IMPROVEMENT TAXES)
Special assessment is the term used in the United States to designate a unique
charge government units can assess against real estate parcels for certain public
projects. This charge is levied in a specific geographic area known as a Special
Assessment District (SAD). A special assessment may be levied only against
parcels of real estate which have been identified as having received a direct and
unique "benefit" from the public project
This type of tax is always a specific and statutory lien. It can either be voluntary –
meaning the property owners in the area that is going to be affected can petition
for the improvement – or involuntary, which means that a government authority
can initiate the process.
Special assessment taxes are imposed on real estate that requires property owners
to pay for improvements such as streets, alleys, street lighting, curbs, and similar
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items that benefit their real estate. Such taxes are enforced in the same manner as
general real estate taxes, with the same lien priority after the general real estate tax.
Examples
The most universally known special assessments are charges levied against lands
when drinking water lines or sewer lines are installed, or when streets are paved
with macadam or some other impervious surface. However, special assessment
taxes can be levied for police or fire protection, parking structures, street lighting,
and many other purposes permitted by state and local government statutes.
SPECIAL ASSESSMENT DISTRICT
A Special Assessment District (SAD) is a unique geographic area in which the
market value of real estate is enhanced due to the influence of a public
improvement and in which a tax is apportioned to recover the costs of the
improvement.
Individual special assessment levies may be made only in a Special Assessment
District. The SAD is one of two kinds of geographic areas commonly associated
with a special assessment levy.
The other kind of geographic area is the "service district." Circumstances vary
according to state law, but the essential distinguishing feature between these two
types of districts is this: a service district is composed of all individual parcels of
land that are somehow connected to the public improvement for which the special
assessment is to be levied. The special assessment district consists of only those
properties which are designated by the applicable law as having received a specific
and unique "benefit" from the public improvement.
Examples of properties which may be connected in some way to a public
improvement and are therefore included within a service district, but may be
excluded from the special assessment district, are properties associated with a dam
and properties associated with a business parking structure.
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In the case of a dam, all properties located within a scientifically defined
"watershed" and all properties lying within the floodplain of the dam are connected
by how water drains from an entire watershed into a lake and how water within the
lake may flood specific areas downstream. Since the area of a watershed and the
area of a floodplain are often very, very large when compared to the area of a lake,
it is possible for some portions of the watershed and floodplain to be physically
located in a government unit other than the one in which the lake is located. It is
also possible that the government unit authorizing a special assessment levy does
not have jurisdiction to include all land within the watershed and floodplain. In this
example, the service district would be large enough to include all properties
connected to the lake by how water flows. The Special Assessment District would
be a smaller area within which the government unit proposing the special
assessment has the power to levy a special assessment tax.
In the case of an economic development project (e.g. a parking structure for a
business district) circumstances which would cause the service district and Special
Assessment District to have differing geographic boundaries relate to the existing
and permitted use of property rather than political subdivisions. That is, economic
forces within the market would be the key to including or excluding a specific
property.
The service district for a parking facility is generally limited to the geographic area
in which pedestrians would walk between businesses and the parking structure. An
example might be that users of a parking structure will traverse an area defined as
being within six blocks or less of a parking structure. In this example, the service
district would consist of all properties lying within six blocks of the parking
structure.
However, there may be more than just retail business structures within the sixblock area. All classes of properties lying within the distance shoppers can
reasonably be expected to walk to and from retail outlets could include a block of
homes or an industrial facility. The commercial properties would be assessed
because surveys would illustrate that retail sales depend upon adequate parking for
customers. It could also be demonstrated that residential properties (homes),
would be excluded because users of those properties might not reasonably be
expected to "benefit" from the parking structure. Depending upon various
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scenarios, industrial properties might, similarly, not benefit from a parking
structure.
Benefit
There are variations between state governments as to what constitutes a “benefit”
under special assessment laws.
In general, the "benefit" must result directly, uniquely, and specifically from the
public project. For example, when water and sewer lines are installed by
government units, nearby land often increases in value. The presence both of safe
drinking water and of sewer lines means that expensive wells and septic systems do
not have to be installed by affected property owners. It also means the potential
for contamination of ground water and surface areas from improperly treated
sewage will be eliminated. Land that might have been “unbuildable” before may
become buildable once government-provided water and sewer services become
available. Providing water and sewer service are situations which may adapt
formerly unusable land for residential or commercial use. A storm sewer or a dam
or dike may mitigate flooding and make properties within the former flood zone
more valuable.
The term “benefit” most frequently means an increase in the market value of the
benefited property. However, some states historically have defined the term to
mean more than an increase in market value. For example, it may refer to a special
adaptability of the land or a relief from some burden.
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SPECIAL ASSESSMENT VS. AD VALOREM TAX
The property tax most citizens are aware of is the ad valorem tax. Special
assessment levies are not ad valorem property taxes, even though they may be
collected on a property tax bill. A special assessment is based strictly upon the
concepts of "need" and "benefit." Special assessments require a finding that the
public improvement is "needed" for a reason consistent with the law which
permits the special assessment and that each property specially assessed receives a
unique, measurable and direct benefit from the public improvement that was
needed. The basic idea is, if government funds make a property more valuable, the
government has the right to get money back from a property owner.
This contrasts significantly with the ad valorem tax, which is extracted to fund
government operations designed to benefit all citizens. An ad valorem tax is based
upon the legal principles of equity and uniformity. That is, everyone must be
treated fairly and equally. In special assessments, proportionality is a key element.
A special assessment is premised upon the necessity for the public improvement
and the fiscal burden imposed must be reasonably proportional to the benefit
created. Unlike ad valorem taxes, special assessments are not expected to be
uniformly levied (the same millage rate for each parcel). The fiscal burden is spread
among only those properties within the special assessment district and apportioned
to each property based upon the unique, specific, and direct benefit the property
receives from the public improvement. Thus, a vacant lot might be assessed the
same fee as an adjacent lot which has a million-dollar home on it.
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TAX SALE
As one means of generating lost income from delinquent taxpayers, county
governments offer tax sales at auction to the public. During Tax Lien Sales, what is
purchased at these auctions is not land, rather a debt to be collected on. By
purchasing the right to collect past due taxes, a buyer is in essence loaning money
to the property owner to pay their taxes. During Tax Deed Sales however, the
winning bidder will own the deed and the land, having purchased it from the
county or authority performing the sale.
A Tax Lien or Tax Certificate Sale is a public sale, usually at auction, of the right to
collect on a delinquent taxpayer's debt. This sale is held by the County, generally
once each year. What is purchased by the winning bidder is not the deed to a
property. The purchaser's money pays the delinquent taxes to the County on
behalf of the delinquent property owner. In exchange, the purchaser is given first
lien position on title, ahead of mortgages, deeds of trust, and judgments,
subordinate only to State tax liens.
Under the terms of the sale which may differ greatly from county to county, if the
debt is not repaid with interest (rate determined at the time of sale) within a
specified time period, the purchaser of the tax lien may foreclose upon the
property, and all junior (subordinate) liens are dissolved, forgiven, or otherwise not
the responsibility of the purchaser. If you are interested in participating in a Tax
Lien or Tax Certificate Sale, contact your county for specific information and
details both about the sale and the properties.
A Tax Deed Sale is a public sale, usually at auction, of the deed to the property of a
delinquent taxpayer. The Owner and all lien holders have been given ample time
and have received proper legal notification that the property will be sold if due
taxes are not satisfied. Different than a Tax Lien Certificate Sale, the winning
bidder purchases the deed to a piece of property, becoming the new owner and
obtaining all rights to the property free and clear of liens, mortgages, deeds of
trust, etc.
The more people who do bid generally means prices get higher and ultimately may
not be such great deals. Sometimes, though, not that much interest exists in
property, and people can acquire it for extremely low rates. It should be stated that
a few people feel moral qualms about making money on the misery of others,
which is clearly the case with many tax sale situations, especially when taxes owed
were very low, and could have been met with a little charity.
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It is extremely important to know and understand which type of sale you are
attending, a tax deed or tax lien/certificate sale. Each has specific rules and
guidelines which must be followed promptly, and which can differ greatly county
to county. It is strongly recommended that anyone interested in attending a tax sale
be aware of the method and timeliness required for payment and delivery of a
property. For further information, familiarize yourself with property tax law,
consult a legal attorney, and contact the government agency conducting the sale.
Redemption
The “right of redemption” is the right of the foreclosed homeowner to buy the
home back from the person who bought it at foreclosure. Once the sale is
complete, if the home was sold by judicial foreclosure, you may buy it back. This
is a statutory right, meaning there has to be a specific law providing for the right.
Therefore if there is no statute there is no right of redemption.
Under a trust deed with a power of sale, there is no right of redemption after the
trustee sale. The sale is final. On June 8 of the tax year, the delinquent tax list is
published in a local newspaper of general circulation. Unpaid taxes are subject to
delinquency payments. Over time, the amount owed also is increased by additional
costs, interest, and redemption penalties. If a taxpayer begins making currently due
payments, such arrearages may be paid in five annual installments. At the time all
past due amounts have been paid, the country tax collector issues a certificate of
redemption.
The right of redemption or Equity of Redemption as it is known in those states
using mortgages rather than trust deeds, usually allows a borrower in default to
redeem the property within three months after foreclosure sale if the proceeds are
sufficient to pay off all indebtedness plus any other foreclosure costs. If the sale
does not bring enough money to pay off the debt, the mortgagor has one year to
redeem the property by paying off the amount owed, plus costs.
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Understanding Property Reassessment
Buyers of commercial properties are supposed to have their properties reassessed
and pay taxes on the full value of their property when “a change in ownership has
occurred.” Some states’ property tax laws require in general that real property be
reassessed when there is a change in ownership. But loopholes in the law allow
buyers to avoid reassessment even if 100% of a company changes hands. The
current system provides property owners with innumerable ways to structure
change of ownership transactions to avoid paying higher taxes.
The laws governing “change of ownership” reassessments could be tightened to
require reassessment if at least 50% of a corporation’s stock or ownership shares
change hands. To qualify for reassessment, the following is required:
 A written “Application for Reassessment” (reverse) must be filed with the
Assessor-Recorder within 60 days of the misfortune or calamity, or as otherwise
provided by law, but in no case more than twelve months after the occurrence
of said damage. If no application is made and the Assessor determines that
within the preceding twelve months a property has suffered damage caused by
misfortune or calamity that may qualify the property owner for relief under an
ordinance adopted under this section, the assessor shall provide the last known
owner of the property with an application for reassessment. The property
owner shall file the completed application with the Assessor within 60 days of
the date of mailing which appears on the notification by the Assessor, but in no
case more than twelve months after the occurrence of said damage.
 The damage to taxable property is $10,000 or more of full cash value, not
including non-taxable items such as household and personal effects. The
damage or destruction is not attributable to fault by the owner.
 Upon receiving a proper application, the Assessor will verify damage or loss by
reappraising separately the land, improvements, and any personal property
subject to property taxation. If the total value loss is $10,000 or more, the
Assessor shall determine the percentage of loss to land, improvements and
personalty. A ratio of damaged to undamaged full cash value will be established,
and the current taxable value shall then be adjusted by the same ratio. The
assessor shall notify the applicant in writing of the amount of the proposed
reassessment and state that the applicant may appeal the proposed reassessment
to the local Board of Equalization within six months of the date of mailing the
notice.
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TRANSFER TAX ON PURCHASE PRICE OF PROPERTY
The transfer of title to real estate with consideration is taxed in many states. The
methods and tax rates vary by state. Some states use "tax stamps" that are affixed
to the deed and cancelled. Generally, the calculation begins with the purchase price
of the property. Exemptions in some states include:
 The balance owed on an assumed mortgage
 Some states exempt property transfers below a certain stated dollar amount
 Rates and methods of rate application also vary. On the next slide we will show
you some examples of these rates and methods.
An amount may be determined based upon a rate of $X for each $XXX or
fractional part of the taxable value.
For this example, we will assume that the tax rate is $0.90 for each $1,000 of
taxable value.
Suppose the taxable value is $225,000. We will need to divide the taxable value by
$1,000 (Remember the equation $0.90 for each $1,000 - there are 225 1,000s in
$225,000).
Once we have the equation set up correctly, all that is left to do is to multiply the
tax rate ($0.90) by the taxable units (225). This gives us a tax amount of $202.50.
The tax amount may also be calculated based upon a percentage of the taxable
value.
For this example, we will use the same taxable value of $225,000.
The tax rate, for this example, will be .0055. You could also express this as .55%.
To determine the tax amount, you will need to multiply the taxable value
($225,000) by the tax rate (.0055). This gives you a property transfer tax amount of
$1237.50.
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For investors that are assuming mortgages, there are states that exempt the balance
due on the mortgage from the taxable value, thus using only the cash paid at
closing for the property transfer tax.
Let's say an investor is purchasing a property for $350,000, and is assuming the
existing $218,000 mortgage. The tax rate is $0.45 per $500 or fraction thereof. So,
we can start the equation with $0.45.
Finding this number is similar to the first example, but with an additional step.
Since we are assuming that a portion of the taxable value will be exempt, we must
first calculate which portion is actually taxable. We mentioned in the last step that
the investor is assuming the $218,000 mortgage. In this scenario, the amount that
was assumed will be exempt and the remainder is the taxable value ($350,000 $218,000 = $132,000). We then apply the tax rate like we did in the first example.
Divide $132,000 by $500 to get the taxable units (264).
To get the property transfer tax amount, we multiply the tax rate ($0.45) by the
taxable units (264). This gives us a tax of $118.80.
Remember that this varies by state, and also by area of the state in many cases.
Check your state's rates and methods.
The documentary transfer tax applies on all transfers of real property located in the
county. Notice of payment is entered on the face of the deed or on a separate
paper filed with the deed. If a portion of the total price paid for the property is
exempt because a lien or encumbrance remains on the property, this fact must be
stated on the deed or on a separate paper filed with the deed.
A merger, reorganization or other corporate transaction that is “tax-free” for
purposes of federal income or state franchise or corporation income tax is not
necessarily free from transfer tax. In addition, tax-free transfers of realty involving
partnerships or LLCs may be subject to transfer tax, even though partnerships and
some LLCs are treated as “passthrough” entities for federal and state income tax
purposes.
For example, a transfer of realty to a corporation or partnership that is not subject
to federal income tax under IRC § 351 or IRC § 721, respectively, may be subject
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to transfer tax. Similarly, transfers of realty pursuant to a reorganization under IRC
§ 368 or a spin-off under IRC § 355 also may be subject to transfer tax. Thus, the
transfer tax generally should apply to transactions involving the transfer of realty,
including “tax-free” transactions, unless otherwise exempted.
EXAMINING TAX CONSIDERATIONS
The tax benefits of home ownership may differ from those available to owners of
investment property. The legal reduction of tax liability, otherwise known as tax
shelter, is available to all owners of a primary residence as well as to a taxpayer who
owns investment property. Different rules apply to each type of property, however,
and must be followed carefully to earn the desired tax shelter.
For the Homeowner
Improvements to real estate owned as a personal residence, whether house,
condominium, or stock in a cooperative apartment, cannot be
depreciated. Homeowners receive other forms of preferential treatment, however.
As of August 5, 1997, homeowners are allowed an exemption from federal income
taxation of up to $250,000 (single taxpayers) or $500,000 (for a couple married at
time of sale) of the profit on the sale of the principal residence.
The full $250,000 single/$500,000 married exemption is available every two years.
If qualified property is owned for less than two years, a proportionate share of the
exemption can be taken.
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3
Chapter
Taxes
FEDERAL INCOME TAX
When the Tax Reform Act of 1986 reduced most tax rates and simplified the rate
structure, certain real property tax benefits were changed or repealed. The 60%
deduction for long-term capital gain was repealed, and capital gain was treated as
ordinary income and taxed at a rate no higher than 28%. Mortgage interest also
became subject to different rules that could limit its deductibility, especially if the
home was refinanced, or a second mortgage, home equity loan, or line of credit
was obtained. The rules regarding depreciation also changed, so that all tangible
property placed in service after December 31, 1986 was subject to the modified
acceleration cost recovery system.
The federal government taxes individuals based on their earnings by means of a
progressive income tax. The important consideration of a progressive tax is that
the tax rate on which the taxpayer’s obligation increases rises with additional levels
of income. One of the major reasons for buying real estate is to get relief from
taxes.
A federal income tax return must be filed by April 15 for the preceding calendar
year if adjusted gross income is high enough or federal income tax has been
withheld and a refund is due. Both individuals and corporations are taxed. The
amount of gross income required before a tax is imposed on an individual depends
on:

Whether the income earner is married or single, including the divorced or
legally separated;

Whether there are any dependent children;

If there is a spouse, whether the income earner is living with the spouse and
whether income earner and spouse are filing jointly or separately.
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Ten percent of the sales price of property sold by a foreigner must be withheld to
make sure any capital gain tax is paid. Residential property under the sales price of
$300,000 is exempt from the Foreign Investment Real Property Tax Act (FIRPTA)
disclosure requirements. The tax law revisions and clarifications passed by
Congress in 1986, 1990, 1993, 1997, 1998, and 1999 have been phased in
gradually. Future tax law revisions are inevitable. Your local Internal Revenue
Service office has complete details on the current law.
Mortgage Interest Payment Deductions
Mortgage interest payments on first and second homes are deductible from taxable
income on loan amounts up to $1,000,000. Interest on loans secured by a personal
residence, but not used to purchase the residence, is deductible on loan amounts
up to $100,000. Local property taxes are also deductible. For most homebuyers,
such deductions make the difference between an affordable home payment and
one that is not.
Tax Credits
A tax credit is a direct deduction, not from income but from tax owed. Credits for
home solar energy system installations, as well as energy and water conservation
measures, have been available in the past. Whether they will be available again
depends on whether conservation and development of alternative sources of
energy are again viewed as desirable goals to be pursued, even at the expense of a
loss in tax revenue.
For the Investor
An active investor is an investor who materially participates in managing the
property on a regular and substantial basis. A passive investor is an investor who
does not materially participate in managing the activity. Investment transactions are
even more complex than normal transactions. Unless a real estate licensee is
qualified as an income tax or investment counselor, offering advice on tax and
economic factors should be left to the client’s tax preparer or advisor.
An investor is someone who buys property for its appreciation or income potential
and who does not plan to occupy it personally. An investor cannot take advantage
of the homeowner’s exemption from federal income taxation, but receives other
benefits of property ownership. Mortgage interest and property taxes are
deductible from property income. Property income also can be reduced by such
operating expenses as maintenance, utilities, and property management.
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DEPRECIATION
Depreciation has two important components. The depreciable basis of the
property is the amount that may be depreciated. For real estate property, this is
generally the price of the property plus acquisition costs, minus the value of the
land. The second component, useful life of an asset, is the number of years the
asset will be useful to the investor, as determined by IRS tax laws.
Depreciation is a deduction from income for the loss in value through wear and
tear of property used in a trade or business or held for the production of
income. In effect, depreciation allows the cost of property to be spread over its
useful life. An owner-occupied residence, even though purchased for its
appreciation potential, is not considered a depreciable investment. The cost of
improvements to qualified real property can be depreciated over a certain number
of years. Land is not depreciable.
One of the most important tax benefits for the real estate investor involves the
depreciation of property improvements. Property that can be depreciated, which
includes buildings used in business or for rental or other income-producing
activities, is called recovery property. The cost of real estate is recovered through
deductions from taxable income over a certain number of years.
The 1986 tax reform law provided for the depreciable value of real estate owned as
of January 1, 1987, to be deducted over 27½ years for residential rental property or
31½ years for most other real property, in equal amounts each year. This is called
the straight-line method of computing depreciation. In 1993, tax law revisions
increased the depreciation period for commercial nonresidential property from
31½ to 39 years.
Investors in a real estate partnership may take allowable deductions, but only up to
the amount at risk. Losses from partnership investments cannot be used to offset
wages and other income. The longer depreciation term currently in effect has
forced many would-be investors to carefully examine the cash-flow potential of
investment property. With the tax advantages of property ownership of somewhat
less importance, the property buyer must consider the traditional goal of
investment: the ability to generate profit through income or long-term
appreciation.
Basis of Depreciation
Depreciation for tax purposes is not based on actual deterioration, but on the
calculated useful life of the property. The theory is that improvements, not land,
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deteriorate and lose their value. A building is thought to have a certain number of
years where it can generate an income and after that is no longer a practical
investment. The investor is compensated for the loss by being allowed to deduct a
certain dollar amount each year based on the useful life of the property until, on
paper at least, the property no longer has any value as an investment.
Tax laws regarding depreciation change so often, it is advisable to check current
Internal Revenue Service rules for calculating depreciation. A common method
that may be used to determine the dollar amount per year that may be deducted is
referred to as “straight line”, where the same amount is deducted every year over
the depreciable life of a property. When using the straight line method to calculate
depreciation, the value of the improvements is divided by the depreciable life of
the property, to arrive at the annual depreciation that can be taken.
Using the straight-line method, equal amounts of depreciation are taken annually
over the asset’s useful life. To calculate depreciation using this method, divide the
basis by the number of years of useful life. For real property, the useful life is 27½
years for residential property and 39 years for nonresidential property.
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INSTALLMENT SALES
The seller pays tax on the gain from the sale of real estate in the year the gain is
collected. In most cases, the entire gain is received in the same year as the sale
occurs. In an installment sale, a taxpayer sells property and receives payments over
a term that extends beyond the present tax year. The seller finances the portion of
the purchase price that is received in future installments. The taxpayer can elect to
report any profit on the transaction at the time of sale or as installment payments
are received. The taxpayer’s basis in the property plus costs of sale are totaled and
deducted from the purchase price, or deducted proportionately from each tax
year’s installment payments, with the remainder reported as taxable income.
Interest income is always taxable. The IRS will impute an interest rate on the
purchase balance if the sales contract does not provide for one or if the rate in the
contract is below market rates. Another requirement is that the sales price must be
more than $3,000, and at least one payment must be due six months after the date
of sale.
Spreading out the reporting of income usually favors the taxpayer/seller, who may
avoid a step up to a higher tax bracket or who may not be able to pay the required
tax in the year of sale. Investment property probably will have been depreciated by
the taxpayer, and the taxpayer’s cost basis in the property reduced accordingly. To
the extent that the installment contract price exceeds the property’s reduced basis,
it must be reported as gain in the year of sale.
Taxpayers selling real property and receiving one or more payments in a later year
or years must report the sale as an installment sale unless the taxpayer specifically
elects otherwise. By selling on multi-year terms, a taxpayer avoids bunching
gain/income in the year of sale. Rather, recognition of gain is deferred by
spreading it over a number of tax years. The installment sale method may be used
for any kind of real estate, including vacant land. The taxable part of installment
payments is calculated by applying to each payment the profit percentage realized
on the full transaction. This percentage is found by dividing the realized profit on
the sale by the full contract price. IRS instructions should be followed for
determining this percentage, based on the contract price, selling price, gross profit,
and payments received.
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CONSIDERING HOME VALUATION AND PROPERTY TAXES
Assessed value is price placed on land and buildings by a government tax assessor
for use in levying property taxes. The assessed value of the property may be
different than the appraised value. Appraised value or market value is rarely the
same as assessed value. Most appraisers use one of three approaches to establish
the value of a property.
Sales Comparison Approach
The Sales Comparison Approach is normally considered to be the best indication
of value for residential property.
In this approach, the appraiser finds three to four comparable properties in the
neighborhood which have recently sold. Ideally, these properties are within a onehalf mile radius of the subject property and have sold within the last six months.
The principle states that the maximum value of a house and property tends to be
set by the sales price of an equivalent, equally desirable, similar substitute house
and property, for a certain moment in time. The appraiser compares the sold
properties to the subject property.
Cost Approach
This approach considers the value of the land, assumed vacant, added to the cost
to reconstruct the appraised building as new on the date of value, less the accrued
depreciation the building suffers in comparison with a new building.
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Income Capitalization Approach
In this approach, the potential net income of the property is capitalized to arrive at
a property value. This approach is suited to income-producing properties and is
usually used in conjunction with other valuation methods. The process of
converting a future income stream to a present value is known as capitalization.
The first step in house tax reduction is to determine the value of the home. This
process is referred to as an appraisal and is used to determine the market value of a
home. The formal name given to this process is market analysis, or fair market
value comparison. A market value is “the most probable price which a property
should bring in a competitive and open market under all conditions requisite to a
fair sale, (whereby) the buyer and seller, each (are) acting prudently, knowledgeable
and assuming the price is not affected by undue stimulus.”1
CAPITAL GAIN ON HOME SALE
Before the 1997 Tax Act, capital gains were taxed at a 28% maximum tax rate if
the capital assets were held more than one year. The new tax Act brought a new set
of rules. The 1997 Tax Act cuts the top tax rate on capital gains of individuals and
introduces new holding period rules. Since July 28, 1997, there have been two
different types of capital gains for non-corporate taxpayers:
 Short-term gains, which are taxed at ordinary income rates;
 Long-term capital gains.
For tax years beginning after the year 2000, the maximum capital gains rate for
long-term gains is 15%.
The cost of capital improvements or physical improvements made to the property
– such as the cosmetic addition of a new roof, swimming pool, or driveway – may
not be deducted yearly, but may be added to the cost basis of the property when it
is sold. The cost basis is usually the original cost of buying the property.
1
“FDIC Law, Regulations, Related Acts,” 200 Rules and Regulations. FDIC, Feb, 2009. Federal
Deposit Insurance Corporation, Feb. 16, 2009 <http://www.fdic.gov/regulations/laws/rules/20004300.html
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Types of Gain
The gain on the sale of a capital asset – including a residence – may be placed in
one of the following categories:
 Realized Gain (Loss) – When a home is sold, a gain or loss is generally
realized; in other words, there usually is a potentially taxable event.
 Recognized Gain – The part of the realized gain for which income tax must
be paid is called recognized gain. Losses on a personal residence cannot be
recognized; that is, they may not be written off.
 Deferred Gain – The part of the realized gain that may be postponed from
recognition is deferred gain; the taxpayer may postpone paying it.
 Excluded Gain – The part of the realized gain for which there is no tax
obligation is the excluded gain. Excluded gain can be used with a personal
residence up to $500,000 for married persons filing jointly and $250,000 for
single taxpayers.
The important point is that taxes are paid on only the recognized gain. In the sale
of a home, non-excluded realized gain must be recognized. If the seller meets the
two-out-of-five-years occupancy requirement, then the gain will likely be excluded
from taxation in its entirety. If the occupancy requirement for exclusion is not met
or the profit exceeds the exclusion, then the gain exceeding the exclusion, or a
portion thereof, will be subject to taxation.
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CALCULATION OF GAIN OR LOSS
When calculating capital gains, one must first understand the basis. “Basis is the
amount of an investment in property for tax purposes,” according to IRS
Publication 551. “Use the basis of property… to figure gain or loss on the sale or
other disposition of property.”
The amount of gain from the sale of a principal residence is the difference between
the net sales price and the adjusted cost basis. The net sales price is the selling price
less selling expenses. To calculate the gain on the sale of a primary residence, the
cost basis usually is determined to be the original purchase price. So to compute
the gain or loss, subtract the adjusted cost basis from the net sales price. The
taxable gain generally is the difference between the purchase price plus capital
improvements and the price when sold. Closing costs on the sale also may be
added to the cost basis. When capital improvements plus costs of the sale are
added to the original cost basis, the “adjusted cost basis” is the result.
The adjusted cost basis is the owner’s original cost plus buying expenses, plus
capital improvements, less certain deductions. Deductions include the nontaxable
gain deferred from the sale of a prior residence and any depreciation or casualty
losses taken. Adjusted basis is used in calculating capital gain or loss. Adjusted
basis reflects increases or decreases in the book value of an asset through time. The
book value is the value which will be used to compute depreciation write-offs.
Increases in basis result from improvements that add to book value. Decreases in
basis result from depreciation, casualty loss, and other reductions in book value of
the property. Adjusted basis is not a result of inflation and consequent change in
the market value of assets.
Increases in Basis – Increases in basis result from improvements to property that
has a useful life of more than one year. Generally the costs of improvements which
add to the basis of an asset include supplies and materials purchased for major
repairs or additions, legal fees, recording fees, and similar charges. Such increases
in the basis are added to the capital account of the asset improved, resulting in a
higher book value.
Decreases in Basis – Basis is reduced by any event that represents a return of
capital. This includes depreciation, expensing deduction (under the Internal
Revenue Code Section 179), casualty losses, and depletion. Basis is decreased by
the amount of any casualty related insurance or other reimbursement received, as
well as by any deductible loss not covered by insurance. Amounts spent after the
casualty for restoration of property to its pre-casualty state of repair increase the
basis.
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CAPITAL IMPROVEMENTS VS. MAINTENANCE
Improvements are additions that add value to the property. Repairs are
expenditures to maintain the current condition of the property. For example: a
homeowner may paint the house, fix some windows, replace a broken gutter, or
add aluminum siding over the existing wood siding. These items are ordinary
repairs and maintenance except for the new siding, which is a capital improvement.
Capital Gain Exclusion
The tax laws allow a taxpayer who sells his or her principal residence to exclude the
gain on the sale if certain conditions are met. A principal residence is considered
for tax purposes to be the primary place where the taxpayer resides. The taxpayer
may reside in more than one place, but can have only one principal residence.
Therefore, second homes and summer homes do not qualify. Generally, some or
all of the gain from the sale is excluded from income taxes if:
 The exclusion is limited to $250,000 for taxpayers filing singly and $500,000 for
married couples filing joint returns.
 A married couple both occupied the home for two out of the last five years and
one of them owned the home.
 The two years do not have to be the most recent years, nor do they have to be
consecutive.
 The exclusion cannot be used more than once every two years.
 The taxpayer owned and occupied the property as his or her principal residence
for at least two of the five years before the sale. A prorated exemption can be
claimed if sold before two years because of a job-related move or for health
reasons.
If the homeowner does not meet these criteria or if the homeowner’s capital gains
exceed these maximum exclusions, then the regular Long-Term Capital Gains rates
apply on the excess. The rates are 10% for those in the ordinary 15% tax bracket
and 20% for those in the ordinary tax brackets of 28% and above. If the property
has been owned for one year or less, then any profit is a short-term capital gain,
which is taxed at the ordinary rate for the taxpayer’s income tax bracket, from 15%
to 39.6%.
Determining Gain
The seller’s escrow statement lists a number of expenses. The expenses are writeoffs or deductions, selling expenses, or nondeductible expenses. The mortgage
interest and real estate taxes are deductions. Selling expenses, however, are not
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deductions; they are used to reduce the gain. When sellers pay points for a buyer’s
loan, the points are not considered to be interest paid by the buyer. For the seller,
they are a sales expense that will reduce any gain.
DETERMINING TAX ON A PROPERTY
The fraction used to determine assessed value from market value is called the
assessment ratio. Furthermore, some jurisdictions exempt certain amounts of a
property’s assessed value to provide tax relief for certain types of property owners.
Subtracting the amounts of exemptions from assessed value gives the property’s
taxable value. In determining property taxes, we could consider a property with a
market value of $210,000 in a jurisdiction that applies an assessment ratio of 40%.
From the government’s perspective, the steps in administering the property tax are:
 property value assessment;
 development of the budget and tax rate;
 tax billing and collection.
Taxation is an indirect yet significant controlling device affecting estimates of
value. It is important for those engaged in the real estate business to know the
variety of taxes and their effect on property transfers. Full consideration may
involve retaining the services of accounting, legal, and tax specialists. There are
many categories of property that may be exempt from taxation. Local governments
assess taxes directly on the property, such as ad valorem property taxes, special
assessments, and transfer taxes. Most state governments have an income tax. The
federal and state governments tax property indirectly through the taxation of
ordinary and capital gain on income earned from real estate. Federal and state
governments also tax property indirectly when it is transferred through an estate or
gift to others; i.e., estate and gift taxes.
A Certificate of Taxes Due is a written statement or guaranty of the condition of
the taxes on a certain property made by the Treasurer of the county in which the
property is located. Any loss resulting to any person from an error in a tax
certificate shall be paid by the county which such treasurer represents.
Federal law requires that a buyer of real property must withhold and send to the
Internal Revenue Service (IRS) 10% of the gross sales price if the seller of the real
property is a “foreign person.” The primary grounds for exemption from this
requirement are: the seller’s non-foreign affidavit and U.S. taxpayer I.D. number; a
qualifying statement obtained through the IRS attesting to other arrangements
resulting in collection of, or exemption from, the tax; or the sales price does not
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exceed $300,000 and the buyer intends to reside in the property. Because of the
number of exemptions and other requirements relating to this law, it is
recommended that the IRS be consulted for more detailed information.
The price of a property may be less important than the financial or tax position of
the buyer or seller for purposes of developing acquisition and/or disposition
strategies. Tax planning should start in the pre-acquisition stage. Real estate has
historically enjoyed a favorable position in both federal and state income tax laws.
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4
Chapter
Foreclosures
Foreclosure is the most commonly used legal process by which a lender or other
real property lien holder may dispossess you of your home and sell the home in
order to obtain repayment of a debt. A foreclosure most often results from a
failure to make timely mortgage payments, or some other default on your home
loan. In most states, a lender may either foreclose judicially through a court action
or non-judicially through a statutory power of sale. Typically your loan documents
will give the lender the option to proceed either way, but most often a lender will
choose a non-judicial foreclosure because it takes about half of the time of a
judicial foreclosure. Lenders are in the business of lending money. They are not in
the business of owning and selling homes, so they are usually reluctant to proceed
with a foreclosure unless they feel like they really need to. A lender will usually not
commence a foreclosure action unless you have missed multiple consecutive
payments and have not made prior arrangements with them to do so.
The foreclosure process (judicial or non-judicial) in most states is a very technical
process which the lender must follow. It is also time-consuming and may take a
minimum of a couple months. If the lender does not strictly adhere to the
technical, statutory requirements, then the foreclosure may be set aside or the
lender may have to redo the foreclosure, which could add more time to the
process. It is common for state statutes to provide a redemption period for
homeowners, whereby an owner who is being foreclosed on may stop the
foreclosure at any time up to the minute of the foreclosure sale by paying all
amounts owed on the loan, including late fees, accrued interest, and the lender’s
costs of foreclosure up to that point.
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It is also worth noting that, if a lender completes a foreclosure and the proceeds
obtained from the foreclosure sale are less than the amount owed on the loan, then
the lender may also be entitled to seek a deficiency judgment from a court against
the homeowner for the difference between the amount of the sale proceeds and
the amount owed on the loan. Conversely, if there are leftover proceeds from the
sale of the property at a foreclosure sale, after payment of all amounts owed to the
lender and to additional junior lenders or secured creditors, then the foreclosing
lender is typically required by statute to return such additional proceeds to the
homeowner.
Foreclosure auctions are usually public – in fact, in Reno, Nevada, foreclosure
auctions are still done on the front steps of the Courthouse once a week.
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TYPES OF FORECLOSURES
Foreclosure by Judicial Sale
This is more commonly known as “judicial foreclosure.” It is available in every
state and required in many; involves the sale of the mortgaged property under the
supervision of a court, with the proceeds going first to satisfy the mortgage, then
other lien holders and, finally, the mortgagor/borrower if any proceeds are left. As
with all other legal actions, all parties must be notified of the foreclosure, but
notification requirements vary significantly from state to state. A judicial decision is
announced after pleadings at a (usually short) hearing in a state or local court. In
some fairly rare instances, foreclosures are filed in Federal courts.
Foreclosure by Power of Sale
This type of foreclosure is also allowed by many states if a power of sale clause is
included in the mortgage or if a deed of trust was used instead of a mortgage. In
some states so-called mortgages are actually deeds of trust. This foreclosure
process involves the sale of the property by the mortgage holder without court
supervision. It is generally more expedient than foreclosure by judicial sale. As in
judicial sale, the mortgage holder and other lien holders are, respectively, first and
second claimants to the proceeds from the sale.
Other types of foreclosure are considered minor because of their limited
availability. Under strict foreclosure, which is available in a few states including
Connecticut, New Hampshire and Vermont, suit is brought by the mortgagee. If
successful, a court orders the defaulted mortgagor to pay the mortgage within a
specified period of time. Should the mortgagor fail to do so, the mortgage holder
gains the title to the property with no obligation to sell it. This type of foreclosure
is generally available only when the value of the property is less than the debt
("under water"). Historically, strict foreclosure was the original method of
foreclosure.
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FORECLOSURE PROCESS
There are three ways to acquire distressed property, based on where the property
lies in the foreclosure process. The three stages are as follows: pre-foreclosure,
foreclosure, and post-foreclosure.
Pre-Foreclosure
In the pre-foreclosure stage, investors will likely be able to do the most good for
the distressed homeowner and for themselves. Pre-foreclosure is where further
damage to the homeowner's credit rating can be forestalled and the home may be
transferred at a mutually-agreed-upon price before it is necessary to get the lender
involved. This stage can last from one month to a year, depending on your local
laws.
Foreclosure Stage
The best way to identify a potential property is through the County Clerk's office.
Find out where the notices of default are filed and determine how to sort through
the general index to discover pending foreclosure sales. You may also be able to
request that your address or e-mail address be placed on an advance notice list or a
list of pending defaults.
The foreclosure auction is the most commonly known way in which a foreclosure
can be purchased. If the homeowner does not reinstate their mortgage, the
property goes to a public auction, where anyone can bid. Auctions can be tough
because they sometimes occur on short notice and don't allow you much time to
do research and analysis of the property.
The foreclosure process itself will vary from one state to the next, depending on
whether it is a title or lien state, which determines whether a judicial or non-judicial
form of foreclosure is involved. Judicial foreclosures pertain to mortgages, rather
than deeds of trusts, and take significantly longer to complete.
Non-judicial foreclosures pertain to deeds of trust where a third party, called a
trustee, handles the entire process in a matter of two to four months after a
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borrower has defaulted and stopped making payments. Once the property passes
through either the judicial or non-judicial phase, it is then ready to be sold at
auction to the highest bidder.
Post-Foreclosure
At the post-foreclosure stage, the lender has already taken control of the property.
The home is then in the possession of the lender's REO (Real Estate Owned)
department, or in the hands of a new owner or investor who purchased the
property at auction.
Refer to the foreclosure notice to determine the name of the lender as well as the
balance owed on the mortgage. Lenders are typically extremely willing sellers,
because an REO on the books is an obvious sign of having made a poor lending
decision. Both the overhead and losses involved with an REO – reflected in both
the added reserves a lender must maintain as well as any potential property
management fees incurred – means the bank is likely a willing negotiator.
After the sale is completed, the homeowner will be notified on the number of days
they have to vacate the home. If they do not vacate the home by the date that is
given, then the eviction process will begin and the local sheriff will come to the
home to make sure the eviction is carried out if someone is still residing in the
house.
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CONTESTING A FORECLOSURE
Because the right of redemption is an equitable right, foreclosure is an action in
equity. In order to keep the right of redemption, the debtor can ask an equity court
for an injunction. If repossession is imminent, the debtor would need to seek a
temporary restraining order. However, the debtor may have to post a bond in the
amount of the debt. This would protect the creditor if the attempt to stop
foreclosure were a naked attempt to cheat the lender and skip on the debt.
A debtor may also challenge the validity of the debt in a claim against the bank in
order to stop the foreclosure and sue for damages. In a foreclosure proceeding, the
lender bears the burden of proving that there was a valid debt. There is case law to
support the debtor's case: First National Bank of Montgomery v. Jerome Daly, 1969, in
the Justice Court State of Minnesota; the Judge ruled in favor of the debtor on
December 9, 1968:
IT IS HEREBY ORDERED, ADJUDGED AND DECREED:
1. That the Plaintiff is not entitled to recover the possession of Lot 19, Fairview
Beach, Scott County, Minnesota according to the Plat thereof on file in the
Register of Deeds office.
2. That because of failure of a lawful consideration the Note and Mortgage dated
May 8, 1964 is null and void.
3. That the Sheriff’s sale of the above described premises held on June 26, 1967 is
null and void, of no effect. That because of failure of a lawful consideration the
Note and Mortgage dated May 8, 1964 is null and void.
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DELAYING A FORECLOSURE
As stated previously, banks are in the business of lending money, not in the
business of owning and selling homes. Lenders are reluctant to foreclose if they
feel like they have a better option to remedy a default. There are several ways a
foreclosure can be delayed.
Forbearance – the lender may agree to forbear, or hold off on, foreclosing for a
specified period of time, during which time the lender may agree to allow the
homeowner to pay less than the full amount of their mortgage; however, in the end
the homeowner will eventually have to pay all amounts owed under the loan with
applicable interest and late fees;
Reinstatement – in many states a homeowner has a statutory right, regardless of
the lender’s attitude, up to a certain point in the foreclosure process, to reinstate
the loan or cure the default on the loan by paying all unpaid monthly payments
with applicable interest and late fees, in which case your loan is reinstated, the
foreclosure is stopped, and the homeowner has the right to continue making
monthly payments on their loan as if a default had not occurred;
Repayment Plan – the lender may agree to allow the homeowner to continue to
make regular monthly payments on the loan and allow you to pay additional
amounts each month to repay amounts owed for previously missed payments,
interest and late fees;
Mortgage Modification – the lender may agree to refinance or modify the
homeowner’s loan so that they can pay smaller amounts over a longer period of
time. This option works well if the loan amount is less than the value of the home
or interest rates are currently lower than the existing interest rate;
Refinance – the homeowner may be able to find a different lender to provide
them with a new loan, which will pay off the existing loan in default. This may be a
particularly good option if the homeowner has significant equity in the home
(which may allow you to avoid having to pay mortgage insurance as part of the
loan payment, etc.) or if interest rates or loan products currently available are more
favorable than their existing loan terms;
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Home Sale – the lender may agree to delay the foreclosure process to allow the
homeowner enough time to sell their home and pay off the loan;
Short Sale – the lender may allow the homeowner to sell their property for less
than the outstanding loan amount, in which case the lender would keep the sale
proceeds and forgive the remaining debt; however, it is worth noting that in a
short sale situation a homeowner may also experience federal and state income tax
liability for that portion of the debt that was forgiven which will likely be treated as
income to them for tax purposes;
Loan Assumption – the lender may allow the homeowner to sell the home and
allow a qualified buyer to take over or assume their loan and make the loan
payments. However, if a homeowner decided to do this, they should make sure
that the loan assumption documents specifically release them from any further
liability for the loan;
Deed in Lieu of Foreclosure – the lender may allow the homeowner to give
property to the lender by executing a deed in lieu of foreclosure in exchange for
the lender forgiving the debt. Signing a deed in lieu of foreclosure means that the
homeowner is actually conveying all of their ownership of the property to the
lender or grantee under the deed. This option can still have a negative impact on
their creditworthiness, but may not be as damaging as a foreclosure. If a
homeowner uses this method, they should try to negotiate from the lender a full
written release of any further obligation or liability relating to the debt.
No matter how you look at it, the business of buying and selling properties at or
near foreclosure is not a happy one. However, it can be a mutually beneficial
transaction for a willing investor and a distressed homeowner.
Foreclosure is the flip side of the American dream of home ownership. It's a
homeowner's worst nightmare, and can result in a lasting and devastating blow to
personal finances. Foreclosure can wipe out the equity in a home. It can destroy
personal credit for years and could mean uprooting a family from its
neighborhood, friends, family, and schools.
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THE UPSIDE TO FORECLOSURES
However, for a smart and hopefully generous investor, purchasing foreclosed
properties can be a terrific real estate deal. The hope is that both parties to the
transaction win by profiting from a timely transfer of title – which produces a good
investment for the investor and divestment for the homeowner – and it might
spare the homeowner's credit rating before things get any worse.
THE DOWNSIDE TO FORECLOSURES
Profiting from foreclosures isn't the no-brainer many assume it to be. For each
success story, there are likely five horror stories. Every real estate transaction
involves risk. While investors with the very best of intentions can help to reduce
their risk, they cannot completely eliminate it.
BORROWER'S OBLIGATIONS
The mortgagor may be required to pay for Private Mortgage Insurance, or PMI,
for as long as the principal of his/her primary mortgage is above 80% (or 78% for
FHA) of the value of his property. In most situations, insurance requirements are
sufficient to guarantee that the lender will get some pre-defined percentage of the
loan value back, either from foreclosure auction proceeds or from PMI, or a
combination of the two.
Nevertheless, in an illiquid real estate market or following a significant drop in real
estate prices, it may happen that the property being foreclosed is sold for less than
the remaining balance on the primary mortgage loan, and there may be no
insurance to cover the loss. In this case, the court overseeing the foreclosure
process may enter a deficiency judgment against the mortgagor. Deficiency
judgments can be used to place a lien on the borrower's other property that
obligates the mortgagor to repay the difference. It gives the lender a legal right to
collect the remainder of debt from the mortgagor's other assets (if any exist).
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There are exceptions to this rule, though. If the mortgage is a non-recourse debt
(which is often the case with residential mortgages in the U.S.), the lender may not
go after the borrower's assets to recoup its losses. The lender's ability to pursue
deficiency judgment may be restricted by state laws. In California and some other
states, original mortgages (the ones taken out at the time of purchase) are typically
non-recourse loans; however, refinanced loans and home equity lines of credit are
not.
If the lender chooses not to pursue a deficiency judgment – or can't because the
mortgage is non-recourse – and writes off the loss, the borrower may have to pay
income taxes on the un-repaid amount if it can be considered "forgiven debt."
However, recent changes in tax laws may change the way these amounts are
reported.
Any liens resulting from other loans taken out against the property being
foreclosed (second mortgages, Home Equity Line of Credit) are "wiped out" by
foreclosure, but the borrower is still obligated to pay those loans off if they are not
paid out of the foreclosure auction's proceeds.
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