Any real estate investor is happy when the value of his property goes up. The flip side of that growth is taxes, known as capital gains taxes.
Let’s look at a simplistic example. If you originally bought a property for $100,000 and later sold it for $160,000, you made $60,000 on the deal. The IRS will call that $60,000 “capital gain” and demand taxes. If you held that property for longer than 1 year, the tax rate will usually be 15%, or $9,000. This is serious money, and most investors detest paying taxes.
In fact, the situation is worse than that – due to what is known as “depreciation recapture.” Over the years that you were holding the rental property, you were entitled to an income tax deduction known as depreciation. Every year, you paid less taxes because of depreciation. Now, when the property is sold, the IRS will “add back” those savings and tax them. Worse, the tax rate on this depreciation recapture can be up to 25%. In our example, if you had previously used $20,000 worth of depreciation, you’re looking at an additional $5,000 recapture tax. Beware that this tax will be due even if you had not taken advantage of depreciation in the past.
Between $9,000 capital gain tax and $5,000 depreciation recapture, the tax bill will be $14,000. Ouch. Let’s consider your options.
Pay the tax.
Yes, this sometimes makes sense. You may be in a situation where tax-deferring alternatives (such as a 1031 exchange) are either not available, not practical or simply not a good deal. It is also possible that paying capital gain taxes at 15% will look good compared to potential alternatives – such as paying an estate tax at nearly 50%.
Avoid the tax with “residence” exclusion.
If you used the property as your personal residence for at least 2 out of last 5 years, you may qualify for this special tax break. Up to $250,000 of capital gains ($500,000 for a married couple) will be tax-free, except for the depreciation recapture mentioned above. Of course, there are conditions and exceptions, so check with your tax advisor.
Avoid the tax with “basis step-up” at death.
If you keep the property for the rest of your life and never sell, you heirs may be able to sell it completely tax-free. This is due to a special “step-up” rule that your accountant can explain. Unfortunately, holding the property indefinitely could be a bad business decision, even though it may eliminate the capital gain taxes.
Avoid the tax with charitable “basis step-up.”
Yes, it does mean giving away the property. However, it does not necessarily mean losing money. Certain financial planning techniques may allow you to donate while leaving your wealth intact. Also, if you planned to make a big charitable donation anyway, using your appreciated property for that purpose is a very smart idea.
First, you may qualify for a tax deduction up to the full current value of the property. Second, neither you nor the charity may have to pay the capital gain tax. Charitable Remainder Trust (CRT) is a popular tool to donate property and still receive some money in the exchange. Besides avoiding the capital gains tax, CRT may also eliminate the estate tax on the property and accomplish a number of other financial goals. Professional advice is highly recommended.
Avoid the tax with “self-directed” IRAs.
Self-directed IRAs are retirement accounts that are invested outside of the conventional investment choice: mutual finds. The IRS allows you to invest your IRA funds into almost anything, including businesses and real estate. If your investment properties were owned by your self-directed IRA, the profits from the property sales go into the IRA. The IRA does not pay capital gain taxes or depreciation recapture taxes. This is usually promoted as tax-free investing.
Not so fast! Roth IRAs are indeed free from taxation, under the current law. However, traditional (non-Roth) are not tax free! There is no tax when you sell the property, but there will be tax when you eventually take the money out of the IRA. And it makes the taxes worse, because you will end up replacing the capital gains (normally taxed at 15% or less, but never above 24%) with ordinary income (taxed as high as 40%). There are other potential problems too, so get independent professional advice before making your decision.
Defer the tax with a “Section 1031 exchange.”
This neat (and under-utilized!) technique allows you to exchange instead of merely sell: you buy a replacement property and defer the capital gain tax. This does not eliminate the tax, but rather “rolls your profits” into another property. Such exchanges can be done over and over again, but eventually the combined capital gains tax will have to be paid. Meanwhile, you can enjoy your tax savings.
One critical warning: 1031 exchange is not a do-it-yourself project. You must use an independent third-party facilitator, officially called a qualified intermediary. They will guide you through this tricky process and ensure compliance with the IRS rules. And they must be engaged before you sell the property. Once it is sold – it is too late, game over!
Defer the tax with an “installment sale.”
Basically, you will agree that the buyer of your property will not be paying you up front. Instead, he will be paying you in installments over several years – similar to a mortgage. Seller-financing or owner-financing are probably the more familiar terms for this strategy.
The payments that you receive each year will be taxed under a rather complex formula. Only a small portion of each payment will be considered capital gains. As a result, you spread out your capital gains tax over several years. Installment sales have to be carefully structured, especially considering the extra risks of buyer’s default (failure to pay you as agreed) or early payoff.
Defer the tax with a “private annuity trust.”
This is another powerful, but little-known, technique. You give property to a specially designed trust in exchange for a “private annuity” contract. Per this contract, you will receive specified regular payments for the rest of your life. Just like with installment sales, each payment contains only a small portion of your overall capital gain, effectively spreading it out.
Interestingly, the deferral of taxes is not the most important feature of PATs – private annuity trusts. They offer many other benefits that are outside the scope of this brief overview. It is a good idea to learn more about them, especially if you’re looking at a very large gain.
With so many options, how will you know which way to go? Most likely, you won’t. Ask a competent tax professional knowledgeable in Real Estate.