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Disposing of Real Property Without Paying Capital Gains Tax


1) Section 121 Primary Residence Exclusion
 
  • Since the Tax Reform Act of 1997, there is no longer the one-time, over 55 year old, exemption allowing aging Americans to purchase a smaller primary residence and not pay taxes on the first $125,000 of capital gain.
  • There is also no longer the rollover which allowed a home seller 18 months to invest the capital gain in another primary residence without triggering capital gain tax.
  • Today’s Section 121 Primary Residence Exclusion Allows a single person to sell a primary residence and not pay capital gains tax on the first $250,000 of capital gain. Married couples do not have to pay capital gains tax on the first $500,000.
  • The taxpayer(s) must have owned the home and lived in it at least two out of the last five years.
  • Married couples must be filing joint returns to obtain the $500,000. If individual returns were filed, each will receive $250,000 of exemption.
  • The home can be a rental at the time of sale, but the home sellers must have lived in it for at least 2 of the last 5 years.
  • The 2 years do not have to be continuous.
  • The Section 121 Exclusion can be taken every two years, as long as the property was originally purchased as a primary residence..
  • Taxpayers who have lived in their homes less than two years can get a partial exclusion for their time of occupancy if they had to leave their home because of unexpected change of employment, illness, or other unforeseen circumstances.
  • A primary residence converted to a rental and then sold can escape capital gains tax but recapture tax on any accrued depreciation during the rental period will still be due upon the sale.
  • Co-owners of the property do not have to be married. The group can be three men, four sisters, etc. As long as all of their names are on title and each lived in the property as a principal residence for 24 out of the last 60 months, each can claim up to $250,000 exemption from capital gains tax upon sale.
  • Title vesting is not an issue either. Title can be vested in any way, such as joint tenants, tenants-in-common, community property, etc. All parties must be on title at the time of sale and have met the 24-out-of-last-60 month residency test for the exemption.
  • Married couples must file a joint return to obtain the $500,000 exemption. Only one spouse need to be on title. If married couple files individual returns, each is separately entitled to up to $250,000 exemption.
  • If one of the spouses filing a joint return does not meet the occupancy test, the couple is only entitled to $250,000 of exemption. The one spouse that does meet the occupancy test must also be on title to obtain the $250,000. If only the spouse who does not meet the occupancy requirement is on title, there is no Section 121 exemption at all for the couple filing a joint return.
  • Only married couples filing a joint return are entitled to the $500,000 exemption. Unmarried domestic couples must both be on title for each to be eligible for the $250,000 exemption.
  • If a property is purchased as a rental property, a vacation home, or a second home and then converted into a primary residence, the property must be owned for at least five years and used as a primary residence for at least 2 out the last 5 years to qualify for the Section 121 exemption.
  • Sellers who purchase a rental property and convert it to a primary residence to take advantage of the Section 121 Exemption should be aware that they will have to pay depreciation recapture tax of 25% on all depreciation they took during the rental period.
  • Upon the death on one spouse, the property must be sold within that tax year in order to be eligible for the $500,000 tax exemption. The year of the deceased spouse’s death will be the last year in which a joint tax return can be filed, which is one of the criteria for being eligible for the $500,000. In a community property state such as California, the surviving spouse would likely receive the deceased spouse’s share of the property. This will be passed to the surviving spouse at the stepped up basis, which is the market value at the time of death. As a result, the taxable capital gain would be reduced greatly upon sale. Title of the property must have been held by both spouses. Consult your tax advisor.
     

      2) Section 1031 Exchange 

  • 1031 Exchanges are sometimes called Delayed Exchanges or Starker Exchanges.
  • The 1031 Exchange involves exchanging investment property for other investment property and deferring tax on any capital gain indefinitely. Primary residences, vacation homes, and second homes cannot be exchanged.
  • A primary residence can often be converted to a rental property by renting it out for at least two years.
  • Nearly any type of real investment property can be exchanged for nearly any type of real investment property. Examples of eligible real property include vacant land, TIC (Tenant-In-Common) shares, commercial buildings, apartment buildings, and 1-to-4 unit rental properties.
  • In a 1031 exchange, the exchanger signs an Exchange Agreement with an Exchange Accommodator. The exchanger then relinquishes (sells) his investment property. Proceeds from the sale go directly into the accommodator’s trust fund. The exchanger then identifies replacement investment property for purchase. When escrow is ready to close on the purchase, the accommodator transfers money from the trust account and closes the transaction.
  • The accommodator must be a neutral third part and not an agent or fiduciary of the exchanger.
  • The exchanger has 45 days from the close of escrow on the relinquished property to identify the replacement property and 180 days to close on it. These are very strict deadlines. The 45 day replacement identification deadline is most often the biggest obstacle to a successful 1031 exchanger. The exchanger should always begin looking as early as possible for exchange property.
  • If the due date for the exchanger’s tax filing falls before the 180th day, the exchanger must file an extension past the end of the 180 days. If the extension is not filed, the tax filing date becomes the last day to close on the replacement property.
  • The 45-day rule can be mitigated by establishing a long escrow period to close on the sale of the relished property. The extra long escrow provides more time to look for replacement property. TIC (Tenant-In-Common) shares are an excellent backup because they are often readily available and can be closed quickly should the first two designated replacement property choices become unavailable.
  • The exchanger cannot ever be in receipt or even constructive receipt of any money from the sale of the relinquished property. The accommodator must handle all money.
  • Exchanges are often done for the following reasons:                                                            
  1. Trading up to more valuable property to tap unused equity in the existing investment property that has appreciated
  2. Changing investment focus from appreciation to cash flow, or vice versa.
  3. Diversifying an investment property portfolio, or the opposite – consolidating diverse types of investment properties.
  4. Diversifying geographic portfolio of investments, or the opposite - consolidating investment properties in diverse locations to a central location.
  5. Start depreciation cycle with a new property if depreciation is almost used up for existing investments.
  6. Reduce or increase property management role in investment properties.
  7. Completely remove oneself from property management role.
  8. Acquiring control of more investment real estate.
  9. Reducing or increasing risk, and thus, expected returns for investment property.
     
  • The exchanger can ordinarily not refinance any property involved in the exchange transaction within 6 months before or after the exchange. The IRS would then consider the transaction as “Stepped-Up” and would disallow the exchange.
  • Only an “Investor” can perform a 1031 exchange. If, after an exchange has taken place, the IRS subsequently classifies the exchanger as a “Dealer” and not an “Investor,” the IRS will disallow the exchange.
  • Exchanges between related parties will be disallowed if either party sells any of the exchanged property within 2 years.
  • No capital gains tax will be due as long as the mortgage on the replacement property is at least as large as the mortgage on the relinquished property, no “boot” was given to the exchanger, and the replacement property was equal or greater in value than the relinquished property. Capital gains tax will have to be paid on any mortgage relief or “boot” the exchanger receives. When exchanging for a property of lesser value, the exchanger will nearly always receive mortgage relief or “boot,” both of which are taxable at the capital gain rate.
     

 3) Reverse Exchanges 

  • In a regular 1031 exchange, the exchanger’s property is sold first, then the replacement property is purchased. In a reverse exchange, it is the opposite. The replacement property is purchased first then the exchanger’s existing property is relinquished.
  • Reverse exchanges are used for several reasons:                                                                   
  1. A regular 1031 exchange fell apart because the sale of exchanger’s existing property could not close.
  2. The exchangers came upon a great deal
  3. The exchanger feels that the 45 and 180-day requirements are not sufficient for locating and closing on the best property.
                
  • Reverse Exchanges as authorized by Revenue Procedure 2000-37, which was issued in September of 2000. This provides a safe harbor for reverse exchanges.
  • In a reverse exchange, the exchange intermediary is called an EAT, an Exchange Accommodation Titleholder.
  • The exchanger will enter into an arrangement with the EAT. This arrangement is called a QEAA, a Qualified Exchange Accommodation Arrangement. The QEAA is in writing and states that the EAT will acquire legal title of the parked property. The QEAA arrangement can exist for 180 days. The exchanger has up to 5 days to enter into a QEAA after the EAT has acquired legal title to the parked property.
  • After the exchanger enters into a QEAA with the EAT, the EAT will take title to the new property being purchased. The exchanger can loan money to the EAT or guarantee the EAT’s bank loan to purchase the new property.
  • Title of the new property is now held by the EAT and the property is considered to be “parked.”
  • The new property can be leased to the exchanger on a triple-net basis.
  • Prior to selling the exchanger’s old property, the exchanger signs a forward exchange agreement with a qualified intermediary, usually the EAT
  • The old property is then sold and the proceeds are placed in the qualified intermediary’s account.
  • The exchanger notifies the EAT that he is ready to acquire the new property currently parked with the EAT.
  • The new property is conveyed to the exchanger in exchange for funds in the Qualified Intermediary’s account.
  • The 45 day period to identify the new property is not an issue with a reverse exchange. The 180 day period to complete the entire transaction is in effect because the QEAA relationship that the exchanger has with the EAT cannot last more than 180 days.                                                                                                
  • Reverse exchanges can cost up to $5,000. Normal exchanges generally cost less than $700.
  • The IRS does not permit the exchanger to take title to both the replacement property and the relinquished property simultaneously. The EAT must take title to one of those properties. The exchanger would prefer that the EAT take title to the replacement property for the following reasons:                                                               
  1. If the EAT took title on the relinquished property and the exchange fell through and the relinquished property went back to the exchanger, the property would have been reassessed for property tax purposes because of the change of title.
  2. The exchanger does not need cash equivalent to the equity on the relinquished property in order to avoid tax on the boot.
     
  • One of the bigger difficulties when the EAT takes title of the replacement property is to find a lender to provide a non-recourse loan to the EAT to buy the property. Only a small number of lenders will provide non-recourse loans for real estate. The nature of the reverse exchange prevents the exchanger from obtaining the loan.
     

  4) Private Annuity Trusts 

  • A private annuity trust is a trust set up to purchase appreciated capital asset in exchange for a stream of annuity payments lasting the lifetime of the property owner.
  • Private annuity trusts allow an owner of appreciated real estate to sell and defer capital gains, while at the same time provide a stream of annuity income.
  • The property owner first establishes an irrevocable nongrantor trust. The property owner, now the seller, transfers the property into the trust in exchange for a private lifetime annuity contract.
  • No capital gains tax is triggered when appreciated real estate is exchanged for the private annuity contract. The reason is that the annuity contract is established to have the same value as the market value of the appreciated real estate.
  • The trustee then sells the property. No capital gain is triggered because the price that the trust paid for the property (the present value of the annuity payments) is equal to the sales price of the property when it is sold from the trust.
  • Capital gains tax and recapture of depreciation are deferred until annuity payments are actually received by the annuitant, the seller.
  • The trust is established for the benefit of someone other that the seller. Often it is a family member. When the annuitant passes away, the trustee is in charge the trust’s assets to predetermined beneficiaries.  
  • One of the biggest benefit of the private annuity trust is that annuity payments can be deferred until the annuitant reaches 70 ½ old. This allows the trustee to invest and earn income from all capital gains taxes and depreciation recapture taxes while they are deferred. This is income that would have otherwise gone to the government.
  • The deferred payments of capital gains tax and depreciation recapture with a private annuity trust is similar to that created by the installment sale. The private annuity trust has the advantage over the installment sale in that there is no danger of foreclosure or early note repayment which would trigger full payoff of all capital gains tax.
  • A private annuity trust reduces estate tax liability by removing an asset from the seller’s estate. The annuity ceases upon the death of the seller and thus has no further value upon death.
  • The size of the annuity payments are based upon a specific formula and an expected life span of 85 years for the annuitant.
  • If the annuitant passes away before the age of 85 years old, the unpaid capital gains and depreciation recapture from the expected future annuity payments becomes due at that time.
  • Additional properties can be added into a private annuity trust at a later date. Each new property must have its own separate, stand-alone annuity contract created.
  • The annuitant cannot exhibit any overt control over the trustee, who is in charge of investing the proceeds from the sale of the property. The trustee cannot be the annuitant, the annuitant’s spouse, or annuitant’s fiduciary.
  • Private annuity trusts are complicated are require the professional assistance of knowledgeable tax and legal professionals.
     

5) Charitable Remainder Trusts 

  • A charitable remainder trust is an irrevocable trust set up to acquire appreciated assets, sell them, and invest the proceeds of the sale in order to provide a lifetime stream of income to the former property owner. Upon the death of the property owner, the remaining assets pass to a chosen charity.
  • When the trust sells the assets, there will be no capital gains tax triggered because a charitable remainder trust is exempt from capital gains tax.
  • The property owner can be the trustee.
  • The trust must be created and the property transferred into the trust before the property is put on the market.
  • Real property going into a charitable remainder trust cannot have any mortgage on it. If mortgaged property could go into a charitable remainder trust, a person could refinance a property prior to going into the trust and remove much of the value out of the trust in the form of tax-free cashout. Private annuity trusts do not have this restriction. There are ways of using a private annuity trust with a charitable beneficiary to circumvent the no-mortgage rule. See your tax advisor.
  • Transferring an asset to a charitable remainder trust creates in immediate charitable gift income tax deduction. The amount of the tax deduction depends upon the value of the asset to the charity and the type of the charity.
  • The projected value of the asset depends on the projected amount of payouts to the former property owner. The projected amount of payouts depends on the assets initial value and the age of the annuitant.
  • Charities are either classified as 50% charities (charitable contributions cannot exceed 50% of adjusted gross income or 30% charities.
  • Charitable remainder trusts can either be CRATs (charitable remainder annuity trusts) or CRUTs (charitable remainder unitrusts).
  • CRATs payout fixed payments regardless of the trust’s investment performance.
  • CRUTs payout variable payments which depend on the value of the remaining assets n the trust. There are a number of variations on how a CRUT will payout.
  • One of the biggest problems with charitable remainder trusts is that the remaining assets in the trust at the time of the death of the former property owner will go to a charity, and not to the owner’s family.
  • Professional tax and legal advice should be sought prior to the creation of the charitable remainder trust. This is especially important because the trust is irrevocable.

 

 6) Installment Sales 

  • The IRS defines the installment sale as the “sale of property where the seller receives at least one payment after the tax year of the sale.”
  • During an installment sale, the seller will finance or “carry-back” at least part of the purchase price.
  • As soon as price and terms have been agreed upon, the transaction moves forward like any other.
  • The seller pays capital gains tax and depreciation recapture based upon the amount of principal that is paid down with each mortgage payment from the buyer. If the mortgage payment is interest-only, no capital gains tax will be paid, until mortgage payments begin to amortize the principal.
  • Seller financing is generally used to defer taxes and obtain a steady stream of income.
  • Seller financing generally does not carry most of the costs of obtaining financing from a commercial institution. These including such non-recurring costs as processing, escrow, and title insurance. Buyers are usually pleased to obtain seller financing because they are the ones who pay these costs.
  • Seller financing can make a property that is difficult to sell appear more attractive.
  • Seller financing can also be used when commercial financing is difficult to obtain.
  • The dangers of seller financing are buyer default on mortgage payments, early payoff of the loan by the buyer, and the buyer allowing the underlying security (the property) to deteriorate.
  • One of the best ways to reduce the likeliness of early note payoff by the buyer is to make the conditions of the loan better than anything commercially available.
  • Some sellers include a clause in the note stating that they have a right to inspect the property and foreclose on the note if the property has not been maintained.
  • The max loan-to-value for the note should be similar to what is commercially available. The buyer’s down payment should at least cover the costs of selling and the taxes that will be due on that down payment.
  • Some sellers include an assumption clause in the note. If the buyer should later want to sell the property, the assumption clause allows the loan and loan payments to continue with the new buyer. The assumption clause should give the original seller full say in whether to allow the new buyer to assume the loan.
  • If a prepayment penalty is included in the note, sellers often make the prepayment penalty amount equal to the taxes they would have to pay at that time.

 

 7) Purchasing Real Estate with All Cash Using a Self-Directed IRA 

  • An investor can purchase real estate using a self-directed IRA.
  • Capital gains and rental income from an investment property purchased with all cash using a regular IRA will be deferred.
  • Capital gains and rental income from an investment property purchased with all cash using a Roth IRA will be tax-free. Taxes are paid up front when money is put into a Roth IRA. Money is distributed from a Roth IRA tax-free during retirement.
  • For capital gains and rental income to be deferred or tax-free, all capital gains and rental income must go directly into the IRA account.
  • Capital gains and rental income are tax deferred or tax-free only if the property is not carrying any debt. Profit from debt-financed property purchased through an IRA is considered to be Unrelated Business Income by the IRS and is taxed after it exceeds $1,000 per year.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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