A popular tax deferred program used for real estate transactions when the property has been used for investment purposes is a Real Estate 1031 exchange. First American Exchange is a company that helps facilitate these types of exchanges and is considered an expert in the field. As with any tax deferral program, there may come a time when you need a good exit strategy. FAE recently published an article that dives into the strategies involved in this program including exit strategies.
Real estate investment strategies can change over time and you may find yourself asking “Do I want to continue owning real estate, or should I sell and consider other investment alternatives?” There are many investment options an investor can pursue, but often when selling real estate to invest the proceeds elsewhere, capital gain tax will be triggered, resulting in less equity to reinvest.
If a taxpayer has owned their property for many years, or has done several 1031 exchanges in a row, they may have significant tax liability once they finally do decide that they’d like to sell their investment property. With that in mind, you may want to think of ways to “exit” your real estate investment without triggering as significant a tax consequence. Many of the strategies for doing so are complex and their suitability is 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.
Option 1: The 1031 Exchange & Retirement; Swap Until you Drop
Internal Revenue Code Section 1031 applies to real property held for productive use in a trade or business or for investment, and allows for the deferral of capital gain tax if the property is exchanged solely for property of “like-kind.” The broad definition of like-kind can help investors in many ways. For example, owners tired of the property management headaches of several properties can leverage their equity into one larger one. IRC Section 1031 also has broad geographic application, applying to real estate throughout the United States. An example of how this can benefit an investor if properly structured: a couple owning rental houses in California who have children attending college out of state can exchange their California rentals for out of state investment properties their children or children’s classmates can rent from them while attending college. Many investors exchange real estate for many years and leverage their deferred tax dollars to purchase real estate that generates greater and greater returns. Once investors retire, they can then sell real estate and take the cash, paying the lowest capital gains tax possible due to their income tax retirement bracket.
One method of avoiding capital gains taxation entirely is “swapping until you drop,” i.e., never exiting a 1031 exchange property until you pass away. If an investor continues to do exchange after exchange and ultimately dies while still owning their replacement property, the heirs inheriting the property receive a stepped-up basis – meaning, the low basis that the investor carried over is stepped up to the fair market value of the property at the time of their death. Thus, if the inheriting party subsequently sells the property, they will only pay capital gains tax on any gains from the time of the investor’s death – not on the entirety of the gains that were rolled over during the investor’s exchanges. To that end, some taxpayers may plan to hold on to their investment property to derive income during their lives, never selling the property without doing an exchange, such that their heirs may inherit the property without a tax penalty.
Option 2: An 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 upon by the seller. Taxes are not actually avoided nor totally deferred with a note; they are due yearly based upon the number of payments the seller receives. 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. Always discuss this type of transaction with your tax advisor, however, as installment sale reporting may be disallowed or restricted if not structured properly.
Option 3: The Charitable Remainder Trust (CRT)
A CRT allows an investor to receive lifetime monthly payments after transferring the asset to a trust. With this option, the asset is transferred to a trust, the trust can sell the property without paying tax and makes periodic distributions to the investor, and the charity inherits any remaining funds once the investor dies. The main advantage of a CRT is that in addition to monthly cash flow and the satisfaction of one’s philanthropic objectives, the donor qualifies for a charitable income tax deduction, which is usually the present market value of the remaining interest to the charity. Additionally, if the deduction is not all used during the first year of contribution, it may be carried forward and utilized over five years.
Option 4: Joint Use of IRC Sections 121/1031
When a personal residence is sold, IRC section 121 (the “primary residence exclusion”) allows for capital gain tax exclusion of up to $250,000 if a taxpayer is single, and $500,000 if a taxpayer is married, if the residence has been the taxpayer’s primary residence for an aggregate two of the preceding five years. If a taxpayer has converted a property previously used for investment or business purposes into a primary residence, and then sells the property, they may be eligible for the primary residence exclusion. For taxpayers who can make use of this tool, their tax burden may be greatly alleviated and allow them to exit their real estate investment with reduced consequence.
For example, Taxpayer X sells investment property A for $1M with $200,000 of gain and purchases investment property B for $1M in 2017. X holds property B for investment for three years, then converts the property to a principal residence in 2020, in which X resides for another 2 years. In 2022, X sells property B for $1.2M. At this point, the original gain plus the additional appreciation (totaling $400,000) would be taxable. However, X has resided in the property as a primary residence for two of the preceding five years, and thus would be able to exclude $250,000 from the total gain from taxation. X would only be required to pay capital gains taxes on $150,000 of gain, a 62.5% reduced tax burden (and less than they would have had to pay in taxes if they’d sold property A without doing an exchange).
There are many other strategies that can be used in lieu of these options, and often the best results come from a combination of techniques. There are also potential risks and disadvantages associated with all of the above-described alternatives; for example, Charitable Remainder Trusts can be costly to structure, and it may be difficult to find a buyer willing to give you a note as payment so that you can use installment reporting. In addition to consulting with a tax advisor, investors should seek the advice of a real estate attorney with experience in tax and business, and also consider the advice of a financial planner who can offer even more options for one’s investment portfolio, before determining what action to take to exit their real estate holdings.
Article contributed by First American Exchange.
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