Paying taxes isn’t fun, but there are strategies you can employ to cut your tax bill. If you’re trying to avoid capital gains taxes on the sale of your home, your financial planner might have clued you in on a few tips to help you avoid paying big taxes. But when it comes to a piece of investment real estate — whether residential, commercial or multi-family properties — the strategizing gets far more complicated.
Property or assets that have appreciated or grown significantly in value will generally trigger capital gains taxes upon sale or when you dispose of it. In addition to capital gains taxes, asset sales or dispositions may also trigger depreciation recapture taxes because the IRS will want its share of your profits. You should always review potential capital gains taxes and depreciation recapture taxes with an adviser prior to selling or disposing of any real estate, business or other property. That said, to give you an idea of how you might be able to avoid paying capital gains taxes on your real estate, here are a few tips.
1031 Tax deferred exchanges
Whenever you sell a property and have a gain, you generally have to pay taxes on that gain at the time of sale. But there are exceptions that allow you to postpone paying taxes on the gain — like the 1031 exchange. Investors have long relied on the time-tested 1031 exchange, an excellent tax planning tool if you wish to defer paying any capital gains and depreciation recapture taxes generated from the sale or disposition property. The 1031 exchange allows you to postpone paying capital gains or depreciation recapture taxes if you sell a property and then reinvest the proceeds in a similar property. Types of properties eligible for a 1031 include real property like commercial property, self-storage units, and single-family residences as well as personal property like cars, artwork and collectibles.
With 1031 exchanges, taxes will be deferred throughout an investor’s lifetime. That means your heirs will receive a step-up in cost basis (basically a readjustment of the value of an appreciated asset for tax purposes upon inheritance) once you die — effectively eliminating the capital gain and depreciation recapture taxes altogether, if they continue to exchange properties (and not cash out and pay the taxes).
Your capital gains taxes and depreciation recapture taxes can be deferred indefinitely by continually structuring and using 1031 tax deferred exchange strategies. But there are a few catches. All 1031 exchanges must occur within required timeframes. Also, the 1031 tax deferred exchange does require you to acquire one or more replacement properties in order to defer the payment of the capital gain taxes upon the sale of the property. If you don’t want to reinvest and acquire replacement property, you will have to pay the required taxes on the conventional sale. If you do reinvest your proceeds in a similar property, you have to purchase property that is of equal or greater value to what you sold or you’ll have to pay taxes on the difference. You also have to use all the cash proceeds form the sale of your relinquished property towards purchasing the replacement property or you’ll be subject to taxes. These are a just a few key rules of a successful exchange. Because 1031 exchanges can get complicated, you should speak with a tax adviser to make sure you meet all the requirements.
Some investors might want to sell their property and cash out, but that would of course trigger all of the tax consequences. This dilemma can be solved with an installment note, which is often referred to as a seller carry back note, seller financing or seller installment sale. How does an installment note work? The installment sale occurs when the seller basically acts like a lending institution. Investors structure the sale or disposition of property to include seller financing (the investor finances all or a portion of the acquisition of the real or personal property by the buyer).
Why do this? Perhaps the buyer is unable to qualify for a conventional loan or the lender isn’t willing to loan as much money as needed. Sometimes the seller simply doesn’t want to buy any other properties with the gains they make from selling their property, so they “take back a note” for income tax reasons. If you carry back a note, you might only be taxed on a fraction of your gain during the year you made the sale.
The installment sale — or seller carry back note strategy — has positive and negative benefits like any other tax deferred or tax exclusion strategy. Capital gains can be deferred over the period of the installment sale note — depending on how the note is drafted and how much of the transaction is financed with the seller carry back note. Depreciation recapture is generally recognized and taxable in the year of sale and cannot be deferred with the installment note.
Possibly the biggest drawback of this strategy is the risk that the buyer might default on the promissory note. The process to foreclose, repossess, or otherwise resolve the default can take significant amounts of time and money — all the while, the property or asset may be seriously damaged by the buyer.
Structured sales can eliminate the aforementioned risks. Structured sales provide some tax advantages whereby the sale or disposition of property is structured so that the investor can defer paying capital gain taxes over time rather than paying them all in the year of sale.
The structured sale can be a very effective tax deferral strategy for the sale or disposition of real estate, business interests or other personal property. This is especially true when the investor does not wish to reinvest and acquire replacement property as required through a 1031 exchange. In some cases, such as the sale of a business operation, the transaction simply doesn’t qualify for a 1031 exchange.
The structured sale is a great fall-back strategy if your 1031 exchange fails — either because no replacement property is identified during the required 45 day identification period or no replacement property is acquired during the 180-day exchange deadline.
Structured sales are drafted just like an installment sale note or seller carry back note. Your capital gain is recognized but is deferred over a predetermined period of time that you choose. The structured sale allows you to qualify for deferment on paying capital gains taxes by preventing you from receiving proceeds from the sale until a future date when the periodic principal payments are received by you.
Using the structured sale strategy reduces some of the risks you might be exposed to in the case of a seller carry back note because the buyer must pay for the property or asset. Structured sales allow you to sell your property and defer payment of the capital gains taxes, but not the depreciation recapture taxes. Note that the capital gains tax is only deferred for the period of time defined by the structured sale’s contract.
Periodic payments are made or distributed to the investor according to the payment terms they selected when they set up their structured sale. You might call it a self-directed installment note or annuity because the investor determines the payment terms of the structured sale. The investment options backing a structured sale strategy can vary depending on the investor’s goals, objectives and risk tolerance.
The pros and cons
Perhaps the biggest difference between1031 exchange and the structured sale is the end result. The sale or disposition of any real estate or personal property will trigger any accrued capital gain in the asset. The question is which strategy is right for you? The answer depends on your goals and objectives. Some investors want to defer their capital gain tax indefinitely and preserve the possibility of a step-up in cost basis for their heirs, while others may want to trigger their capital gain tax, but defer it as long as possible over a predetermined time frame.
Like with any investment or tax planning strategy, there are positives and negatives involved with the 1031 exchange and structured sale. This is why it is so important that investors seek the advice of their legal and tax advisers to ensure that they fully understand the benefits of each of these strategies.
Jeff writes about real estate, mortgages and homeownership.