As the real estate market continues to bounce back from the 2008 crash, I find myself getting asked more and more, “What can I do to save on taxes when I sell my property?” Few realize that so many creative options exist when selling appreciated property.
In my accounting firm, we consistently discuss four options with clients each time they’re faced with this question. These options are strategies you can “hang your hat on,” and most CPAs can help you navigate the steps to implement them.
Option 1: Pay the capital gains tax
The first strategy is to simply pay the capital gains tax. Some may think this is crazy talk, but there are certainly some benefits to doing so. First, you’re “ripping off the bandage” — the tax is now paid, and you don’t have to worry about it anymore. The money isn’t locked into any other property or tax strategy, and the remaining money is yours to spend however you like.
Moreover, capital gains rates may be much better than your ordinary income tax rate. Over the past few years, rates have ranged from 0 to 20 percent, depending on your income level. These rates are a far cry from the highest marginal federal income tax rate of 37 percent, not to mention state tax rates.
Even if you don’t jump on this first option, it’s important to at least run the numbers. Determine specifically what the federal, state, and Affordable Care Act net investment tax would be to establish a baseline for comparison with your other options.
Option 2: Installment sale
This strategy involves receiving and spreading out income over time, typically including an interest payment from the buyer. This can be a very powerful long-term tax strategy if it allows you to keep your income out of higher tax brackets.
Of course, installment sales also involve some important investment and legal strategies that have nothing to do with tax planning and need to be carefully considered. For example: What’s your security as the lender over time? Is there another loan involved and assumed by the buyer? What position as a lien holder do you have against the property? What’s the interest rate you’re receiving on the note? These questions and issues vary depending on your circumstances. Though complex, installment sales can be a great tax strategy to consider when selling a property.
Finally, you want to make sure you qualify for the installment sale under IRS rules and understand how the installments will play out on your tax return over time. You might spread it over 5, 10, or 15 years — whatever you desire.
Option 3: Like-kind/1031 Exchange
The 1031 exchange, also referred to as the like-kind exchange, allows a taxpayer to sell one property and buy another of equal or greater value, deferring the tax indefinitely or until the second property is sold. A property obtained via a 1031 can be exchanged again and again. Moreover, you can exchange one property for multiple properties or vice versa. There are timing and exchange rules, but they are quite flexible.
One important consideration is that an accommodator or qualified mediator must be involved to facilitate the exchange. This is necessary because it can be difficult to find someone who wants your property and owns some property you want. The accommodator brings the parties together and acts as an escrow service so that all parties stay at arm’s length and don’t touch the proceeds until they’re allowed to under IRS rules.
Despite the seeming complexity of the 1031 exchange, if you are looking to sell one property and purchase more real estate with the proceeds, learning more and getting a consultation about the exchanges is certainly in your best interest.
Option 4: Opportunity zones
Opportunity Zone (OZ) investments were designed to jumpstart communities that struggle economically, and allow investors to reduce taxable gains and possibly obtain tax-free growth if they reinvest capital gains into real estate within designated zones. Tax incentives are available to corporations and partnerships holding at least 90 percent of their assets in OZs and must be established after December 31, 2017. Each state has designated approximately fifty tracts of land as OZs. A map of these zones can be found on the U.S. Department of Treasury site: www.cdfifund.gov.
Any capital gain amount a taxpayer wants to defer can be invested. The capital gain can be from the sale of stock, real, or personal property and only the gain amount needs to be re-invested, not the entire sales proceeds (like a 1031 exchange). In order to qualify, a taxpayer must invest in an OZ property within 180 days of recognizing a capital gain from the sale or disposition of property. The capital gain proceeds, whichever amount the taxpayer wishes to defer, must be invested into the purchase of a rental property new to the investor, or an already existing property owned by the taxpayer to be rehabbed and used as a rental property. If it’s a rehab, the investment needs to be “substantial,” which the IRS defines as improvements equal in dollar amount to the basis of the building to be rehabbed (excluding the land value).
If investors play their cards right, they will certainly see tax savings and can easily tax the benefit now and into the future.