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Overpaying taxes puts a damper on anyone’s mood. You should be paying precisely what you owe—no less, and no more. When it comes to selling your real estate, you really don’t have to pay taxes on that sale right away. One way to avoid the taxes is by using a Section 1031 exchange, but you actually have other options. This article will show you how to take advantage of them.
Option 1
With this option, you combine the strategies of creating a charitable remainder and a wealth replacement trust rather than selling the property. Then, voila! You don’t have to pay any taxes. Here are the steps:
- Create a charitable remainder trust and donate the property to the trust. With the donation, include terms that grant income to your and your spouse for the remainder of your lives. This can be either a percentage of the trust income (charitable remainder unitrust) or a fixed income (charitable remainder annuity trust).[1] The former type can accept future property donations to the trust.
- In the trust, designate one or more charities to receive the remainder of the trust’s balance upon the death of the second spouse.
- Establish a wealth replacement trust. This is a term-life insurance trust. It should include a second-to-die policy so that both wife and husband are covered. The trust acts as the insurance policy applicant, owner, and payer of premiums.
How does this option save you money? First, you avoid paying taxes on the sale of the property, which would have reduced the amount available from the proceeds for future investments. Second, you’re able to deduct the charitable expenses right away. Of course, you will be subject to the limits on charitable donations. However, if you exceed that limit for the current tax year,[2] you can carry the remainder over for the next five years.[3] Additionally, you get a tax write-off on the remainder interest that you gave away to the charity. Tax law includes expectancy tables to calculate this value, which is the value of your charitable contribution.[4]
This strategy also has another benefit, which comes from establishing the wealth replacement trust. You see, this trust receives the insurance proceeds when the surviving spouse passes away. The trust then gives those proceeds to the heirs, so you increase what is left for your children.
To sum up the benefits of this combined strategy:
- You don’t pay capital gains taxes for transferring the property to the charitable remainder trust.
- You invest at the pre-tax value rather than only have the after-tax amount to invest.
- You get a deduction for your charitable donation.
- The trust provides income to pay the insurance premiums.
- Your heirs receive a significant amount of money.
- You benefit your favorite charity, your heirs, and yourself, and pay nothing (or close to nothing) in taxes.
What kind of numbers are we talking about? If your real estate is worth $1 million and you sold it, you would pay $300,000 in taxes. You could then invest the remaining $700,000 in CODs (at 2 percent interest) and make $14,000 annually, pre-tax. But, with the charitable remainder trust strategy, the trust sells the real estate for $1 million and sets up a 5 percent return for you in the charity’s investment portfolio. In this scenario, you get a $94,000 deduction for the donation, plus annual income of $50,000. You can then pay $15,000 per year from that $50,000 for a $1 million life insurance policy with your children as the beneficiaries. Which do you think is the better deal?
Option 2
Another option for business-savvy individuals is to use Section 721, which involves transferring the property to a partnership. Section 721 negates any gain or loss (to you, the partnership, or its partners) when you contribute property and get partnership interest in return.[5] One way to do this is transfer your real estate to an operating partnership (OP) of a real estate investment trust (REIT). The REIT then acts like a real estate mutual fund with diversified holdings. Since you receive OP units as part of the exchange, you are then entitled to periodic distributions of the REIT. Additionally, these units can be converted into shares of the REIT. The primary benefit of this method is that you both avoid taxes and the transfer and increase the liquidity of your investment.
Normally, when you transfer property that has a mortgage liability that exceeds the property’s basis, you trigger taxes. That’s because the excess mortgage is considered a gain. How do you avoid the taxes? You simply need to know about a special REIT called a UPREIT.[6] The UPREIT guarantees an equivalent liability portions to the REIT, making excess mortgage cease to be an issue. Therefore, you pay no taxes.
Option 3
Another way to reduce your tax burden is to use a regular installment sale to dispose of your real estate.[7] This method is also called “holding paper”, and your primary benefit is an increase in net worth by holding a secured note at a higher interest rate than you would get at a financial institution. It works like this: you pay taxes as you get paid. That means you can earn interest on the gross amount since you don’t have to pay the taxes right away.
But, you may encounter situations where you do have to pay those taxes up front:[8]
- If you have to recapture depreciation that exceeds straight-line depreciation, or
- If you have to recapture low-income or rehab property investment tax credits.
The IRS considers your disposition an installment sale if you sell the property and then receive at least one payment after the close of the taxable year in which the sale occurs.[9] The payments are comprised of three parts: 1) a taxable portion of the principal payment, 2) a nontaxable portion of the principal payment, and 3) interest.
So, how much does this help your bottom line? Let’s say you sell a piece of investment property for $250,000 after selling expenses. The property’s tax basis is $125,000, so your profit would be the remaining $1250,000. With an installment sale, you divide that profit number by the $250,000 net proceeds, giving you a gross profit percentage of 50 percent (i.e. every receipt of principal is a 50 percent taxable gain). Upon closing the sale, you receive a down payment of $30,000, which is 50 percent return of capital (from your basis) and 50 percent taxable gain.
Afterwards, you receive a payment of which $700 is principal (the rest is interest). For tax purposes, you again divide the principal into 50 percent taxable and 50 percent nontaxable. As far as that interest is concerned, you are required by tax law to charge interest at a minimum rate for installment contracts—the lower of the Applicable Federal Rate (AFR) or 9 percent. The AFR is published monthly by the IRS.[10] To get the most from your installment sale, keep an eye on the interest rates and wait until you can get a higher rate. Then, add points to the interest rate if you can.
When selling your real estate, it’s usually best to avoid paying up-front taxes. The 1031 exchange is an efficient way to do this, but it only works if you plan to replace the property in order to continue building your real estate portfolio. In contrast, each of these options is a strategy to reduce or completely get rid of the taxes you would pay upon sale. This leaves you with more money to invest and grow in other opportunities. When it comes to real estate, you always have choices about when to pay taxes or even whether to pay them at all.
- IRC Sections 664(d)(1-2) and 453(b) ↑
- IRC Section 170(b)(1)(A). ↑
- IRC Section 170(d)(1)(A). ↑
- Regs. 20.2031-7A(f); 1.664-4. ↑
- IRC Section 721. ↑
- IRC Section 357. ↑
- IRC Section 453. ↑
- IRC Section 453(i). ↑
- IRC Section 453(b)(1). ↑
- IRC Sections 483 and 1274; IRS Publication 537 on Installment Sales (2008), page 10 ↑