5 Strategies to Shelter Gains on Sale of Investment Property

Pearson RE Group
Sep 26, 2018
6 min read

I often meet with clients that own a highly appreciated building(s) they’ve owned for many years, decades even. Many of these individuals would love to sell and realize the fruits of many dedicated years of hard work and sacrifice. They are however reluctant to sell because of the thousands, sometimes hundreds of thousands, of dollars they would have to pay in capital gains taxes.

Anyone who has dealt with capital gains taxes knows they can be pretty high: 15% for single filers with taxable income up to $418,400 ($470,700 for married filing jointly), and 20% if you earn more than that. Plus, you’ll likely have to pay the 3.8% net investment income tax embedded in the Affordable Care Act. Then there are state taxes to deal with, perhaps another 10%. So now you’re talking about approximately 34%, and if you have a depreciation recapture tax, that’s another 25% (another 5 to 10 percentage points higher than the typical capital gains tax rate). You could easily be paying — depending on what state you’re in — 30% to 40%+ in taxes when you sell.

Most real estate investors can articulate the basics of Section 1031 of the Internal Revenue Code (IRC) (aka: the 1031 Exchange), long proven to be a tool that provides the benefit of deferring the payment of capital gains taxes on a sale by reinvesting the proceeds into a replacement property.

The problem is, some people don’t want to go back into real estate. They’ve owned property for 20 or 30 years, maybe they were a landlord, and they don’t want to do that anymore. Add to that, selling in [arguably] the latter-stages of this real estate cycle you run across the realization that yes, I can achieve a premium for my highly appreciated asset, but I now must acquire another highly appreciated asset. I don’t ever recall “sell high, buy high” as a bedrock investment axiom…

To that end, if your goal is to sell high, defer taxes, and leave yourself with options and flexibility with which to focus your investment proceeds, I introduce the below exit strategy alternatives to consider.

First things first - Internal Revenue Code, Section 1031:

Yeah, you already know the basics of IRC 1031 (aka: 1031 Exchange). But, if you’re looking to be the life of any 1031 party, click here and impress all of your friends with a mind-blowing (or numbing?) amount of IRC 1031 knowledge…

Without further ado –

5 STRATEGIES TO SHELTER CAPITAL GAINS:

1. INSTALLMENT SALE An installment sale, aka seller carryback note or seller financing, works best for real estate investors who want to sell their real estate but don’t need a lump sum payment. Instead of receiving a lump sum of money at the time of sale, buyers pay the seller monthly income at a rate and term to be decided by the seller.

Taxes are not actually avoided nor totally deferred with a note; they are due yearly based upon the amount of payments the seller receives. The Charitable Remainder Trust is also based upon this “money over time” concept. The tax benefit of installment reporting is that because taxes are not due in one lump sum at the time of sale, interest is earned on the deferred dollars over the years.

2. CHARITABLE REMAINDER TRUST (CRT) A charitable remainder trust (CRT) is an irrevocable trust that generates a potential income stream for you, as the donor to the CRT, or other beneficiaries, with the remainder of the donated assets going to your favorite charity or charities.

This charitable giving strategy generates income and can enable you to pursue your philanthropic goals while also helping provide for living expenses. Charitable trusts can offer flexibility and some control over your intended charitable beneficiaries as well as lifetime income, thereby helping with retirement, estate planning and tax management…

3. DEFERRED SALES TRUST By using Section 453 of the Internal Revenue Code, which pertains to installment sales and related tax provisions, a Deferred Sales Trust lets people sell a property or business, defer the capital gains tax and roll the money into investments other than just real estate.

Let’s say you were selling a property for $1 million. Instead of selling directly to a buyer, you would draw up an installment contract with a third-party trust with the promise that it would pay you over a predetermined period. You would transfer the property to the trust, and the trust would be allowed to sell it to the buyer.

Because you sold to the trust in agreement to be paid over time, you wouldn’t have to pay taxes on the sale until you start receiving those installment payments from the trust. So instead of having $700,000 or $800,000 left over after taxes, the whole million is there for the trust to reinvest in stocks, bonds, real estate, annuities or any other type of investment that would generate a greater income stream for the trust to pay you under your agreement with the trust.

You can agree to take your payments over a 10- or 20-year period, or over your lifetime. You can even defer your initial payments and not take anything in earlier years if you don’t need the income. Meanwhile, the money is invested and growing. All the money, not the money minus the taxes.

If you choose to take your payments over a 20-year period, and structure the payments in your installment contract to be 5% ($50,000 a year), you’ll only pay the capital gains taxes on the principal as you receive the money. The IRS code doesn’t require the payment of capital gains taxes until you start receiving the installments.

For people who have larger estates, the Deferred Sales Trust strategy also can also be integrated with your estate planning to protect your money from estate taxes.

4. DELAWARE STATUTORY TRUST (DST) Revenue Ruling 2004-86 determined that a Delaware Statutory Trust qualified as real estate and, as such, could serve as a replacement property solution for 1031 Exchange transactions. If you were tired of managing a property yourself, you could, instead, acquire a fractional or percentage interest in a DST, and become a part owner in a much larger real estate investment — a 300-unit apartment building, a grocery center, medical office building, etc.

So now instead of Mr. and Mrs. Smith as your tenants, calling you to come fix the garbage disposal, Walgreens or CVS is your tenant with a corporate lease. It’s a more hands-off way of owning income-producing real estate that’s especially well-suited to retirees. A dozen or so fairly large companies put together deals for investors to exchange into that are professionally managed and pretty much turnkey.

There is a downside (of course), and that’s liquidity. You still own real estate — it’s not like stock, where you can hit a button and sell. The holding period might be five to 10 years.

You also should be sure you’re dealing with a reputable company, called a sponsor, when you structure the deal. Preferably ones that have been in business over 10 years — which proves that they sustained the market downturn and can demonstrate a proven track record of acquiring, managing and disposing of assets on behalf of investors — and ones that manage a sizable portfolio of real estate throughout the U.S. The good news is there’s a handful of them that have been doing this for many years. If you have a trusted financial adviser, they can help you determine who to work with.

Investment strategies can run hot and cold — and DSTs cooled off for a while, thanks to the most recent recession and real estate bust. But they offer a viable solution to a common investor problem.

5. JOINT USE OF IRC SECTIONS 121 AND 1031 When a personal residence is sold, IRC section 121 allows for capital gain tax exclusion of up to $250,000 if a taxpayer is single, and $500,000 if a taxpayer is married, as long as the residence has been owned and personally used by the taxpayer for an aggregate of two of the preceding five years before the sale.

With the enactment of Rev. Proc. 2005-14, there is now a way to exclude gain in excess of the $250,000/$500,000 limits. For example, if a house was bought for $100,000 20 years ago, and it is now being sold for $1 million, the taxable gain is $900,000.

Under the old law, taxes would be owed on $400,000 of gain. Under the new law, if a married couple first converts the house to a rental, they can exclude $500,000 tax free at closing under IRC Section 121, and then perform a 1031 exchange and buy another rental house for $500,000, to exclude the remaining $400,000 of gain!

In closing – there are no one-size-fits-all perfect solutions when it comes to the sale of a highly appreciated real estate asset. The summary strategies above are meant to elicit thought and further exploration based on your individual needs and goals.

A word from Legal - there are many strategies that can be used in lieu of the options above, and often the best results come from a combination of techniques. As with any investment, there may be risks and disadvantages. Many of these strategies are complex and their suitability is totally reliant on your particular facts and circumstances - so be sure to talk with your tax or legal advisor before pursuing any one of these alternatives.

Questions or comments about any of the above? We'd love to hear from you! Our #1 goal is helping you succeed. #Make informed decisions