Ownership of real property involves taxes. Taxes is one of those topics whose mere mention causes people’s eyes to glaze over and the mind to shut down. The following is an attempt to demystify the various taxes you are likely to encounter with the ownership of real property, hopefully, without your suffering the glazed eyes and the mental shut down.
Income Tax. Almost everyone is familiar with income tax. This is a tax that you pay on the income you earn. You pay a tax on this income to both the federal government and the state government. If you own real property that generates rental income, income tax is paid on the rental income that you receive. This income may be offset by available deductions for the investment property.
Excise Tax. In addition to income tax in Hawaii, we pay an excise tax on all transactions involving a gain or an economic benefit and which is not a casual sale. A four per cent (4%) tax is charged on such income. There are certain transactions which are exempt by statute.
Real Property Tax. When you own real property, you are likely to pay real property taxes on the properties you own. This is a tax assessed by the county where the real property is located and is a primary source of income for the county. The amount of tax you pay is determined by multiplying the County’s assessment of the value of your property by the tax rate the county is charging. The real property tax is paid each year in two installments.
As we discussed in prior newsletters, if the real property is also your place of residence, you are entitled to claim a homeowner’s exemption for the real property. The homeowner’s exemption excludes some of the property’s value from taxation. The amount of this exemption increases with your age. If you have a mortgage, your lender will typically collect an estimated amount each month to pay for the real property taxes. The monthly payment is typically part of your monthly mortgage payment. The collected funds are placed in a reserve account to ensure there is money to pay the real property taxes when they are due.
Conveyance tax. This is a tax imposed by the State of Hawaii on transfers of real estate or any interest in realty. The conveyance tax is presently calculating by multiplying .001 times the value of the sale. For example, for a transfer of property with a sales price of $400,000, the tax would be $400. The seller of the real property is the party who owes this tax. The tax is typically collected by escrow. Certain transactions, such as transfers between husband and wife, between parents and child, a transfer due to death or a transfer to one’s revocable trust are statutorily exempt from this tax. There has been much discussion recently about increasing the conveyance tax beginning July, 2005 to generate funds to help pay for mass transit.
Estate tax. This is a tax imposed by the federal government on the taxable value of the property owned at the time of one’s death. This property is called the decedent’s estate. All property in which the deceased owned an interest are included in the decedent’s estate, subject to certain exclusions. The estate tax is calculated on the total taxable value of the decedent’s estate. People who anticipate having a large estate often do estate planning to minimize this tax.
Inheritance tax. This is a State tax imposed on heirs for the property they inherit. The State of Hawaii’s inheritance tax is rather modest compared to the federal estate tax. Therefore, most of the tax planning is directed at reducing the federal estate tax.
Transient accommodations tax. We are a resort destination. There are people who come to Hawaii and stay for periods of time that are less than 180 consecutive days. This is a tax imposed by the State of Hawaii on the income derived from such short term rental. For example, it is a tax imposed on hotel rental pools, apartment rooms and cooperatives in which the residency is less than 180 days. Certain rentals are exempt by statute.
FIRPTA. This is not really a tax, but is a withholding from the gross sales proceeds to pay for federal taxes on the gain you receive. Sellers of real property, who are not citizens of the United States are subject to a withholding of 10% of the gross sale proceeds. Thus, for a $400,000 sale, the FIRPTA withholding would be $40,000. The withholding is a means of collecting possible taxes owed at the point of sale. The buyer is liable if the withholding is not done. Therefore, escrow is generally automatically instructed to withhold the appropriate amounts. The withholding can be modified with documentation and filings well before the sale closes. This requires a little bit of prior planning on the seller’s part.
HARPTA. This is the State of Hawaii’s version of the withholding from the gross sales price to pay the State taxes on the gain you receive. This amount is typically withheld by escrow from the gross sales proceeds whenever the seller is a non-resident of the State of Hawaii. The amount of the withholding is 5 % of the gross sales proceeds. This withholding is to ensure the State of Hawaii collects the taxes owed to the State of Hawaii. Again, the seller can possibly influence the amount withheld by providing proper proof and documentation to the State of Hawaii Tax Office. This again should be done well before the closing date.
For non-citizens, the combined HARPTA and FIRPTA withholdings can be substantial. For example, for a non-citizen who sells a property for $400,000, the combined state (5%) and federal (10%) withholding would be $60,000.
The foregoing is a very basic explanation of various taxes you are likely to encounter with the ownership of real property. Taxes should not discourage you from owning real property. Most real property owners, especially in recent years, will agree the benefits of real property ownership far outweigh any potential tax concerns.
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