I recently received a call from a long-time client who is selling a valuable piece of real estate. He was extremely frustrated by the enormity of taxes he will have to pay for the privilege of living in California! Just how bad is it? Would you believe nearly “40% bad?” The Federal long-term capital gains tax is 20%. California takes an additional 13.3% in the highest tax bracket, and in most cases, there is an additional 3.8% Medicare tax. This adds up to almost 40% in taxes on any appreciation or gains in the asset.
What is an Internal Revenue Code Section 1031 exchange, and why not use it? A 1031 exchange requires the seller to locate “like kind” property within 45 days and complete the sale within 180 days. At the best of times, this is a complex transaction with a very limited time constraint. It is especially difficult in the current San Diego market because there is so little quality inventory to “exchange” into.
There are at least five* other strategies to consider for deferring or even eliminating taxes on the sale of appreciated real estate, in addition to the 1031 exchange approach. Please note that the following are general overviews. If you would like to consider one or more of these alternatives for you or a client, we should discuss the unique circumstances of each case. Application of several of these tools is decidedly not things to “try at home.” The documents themselves are most often not “routine.”
- Installment Sale: In the typical Installment Sale, the buyer agrees to make regular payments of principal and interest, usually monthly, directly to the seller, rather than borrowing money from a bank. The amount of the down payment, length of payments, interest rate, and amount of the monthly payments are all negotiable and are set forth in an installment sale note.
- Capital gains taxes may be deferred over the period of the installment sale note depending upon how the note is structured and how much of the transaction is financed
- It provides for an ongoing income stream over a specified period of time
- It does not eliminate the tax … it merely spreads it out over time
- Depreciation recapture (if any) is taxed in the year of the sale
2. Delaware Statutory Trust: A Delaware Statutory Trust (DST) is a trust formed under the Delaware Statutory Trust Act of 1988. The IRS has approved the use of a DST if it meets the requirements of Revenue Ruling 2004-86. Investors obtain a fractional interest in commercial real property by investing in a DST along with other investors. The DST holds title to the real estate and guarantees the mortgage loan. (Note: Do not confuse this with a Deferred Sales Trust, which does not have formal IRS approval.)
- Qualifies as a 1031 exchange option for accredited investors
- A more stable and secure investment than if you acquired replacement property on your own
- Ability for greater diversification by investing in several different DSTs
- May be more expensive than directly owning a replacement property due to property management fees and maintaining adequate cash reserves for contingencies
- Although much of early income is tax-sheltered, taxes are eventually paid over time
- Tax-Deferred Installment Sale*: This is a powerful technique that for non-disclosure reasons cannot be discussed on our website or handout, but must be outlined in person. Taxes are deferred for 30 years.
- Securities-Backed Line of Credit: While this option is not applicable to the sale of real estate, it is an option to consider in lieu of selling appreciated stocks, bonds or mutual funds. Please see our January 2018 Imagine That™! article for more information about this strategy.
- Capital Gains Alternative Trust™ (CGAT): To use this technique, a CGAT must be set up and funded with the property prior to the sale going “hard.” Discussions can take place and terms discussed prior to transfer, but the buyer ultimately buys the asset from the CGAT. The seller(s) typically receive(s) an income as either a fixed income-stream each year or as a percentage of the current value of the trust property. Upon death of the final income beneficiary, whatever is left in the trust goes to a specified charity(ies) (which is often the family’s own charitable giving account.)
- Creates an asset protected income stream, often 2(+) times greater than the prior net income
- Gives an income tax deduction of at least 10 cents up to 50-60 cents per dollar transferred
- No capital gains or Medicare tax upon sale of real estate or other type of appreciated asset
- The principal is asset protected, but the seller/grantor of the trust cannot access principal either
- Limited ability for the donor to change their mind and “unring the bell” once the asset is in the CGAT
- The “Win-Win” LLC™: For this approach, a single member limited liability company (LLC) is formed, although the language and structure of this special LLC is uniquely different and owned, in part, by another party. The appreciated asset in question is transferred into the LLC prior to a liquidity event.
- As much as 99% of the gain on the sale of the asset is non-taxable
- Up to 70-80 cents per dollar contributed to the LLC is deductible over six years (subject to certain limitations) in recognition of substantial philanthropic benefits also created
- All the advantages of a CGAT above – plus access to principal and ability to give to charity(ies) now
- Income will vary between 3-10% of the asset values inside the LLC
- Higher cost to initially structure than a CGAT and involves more “moving parts”
- While the tools used in this strategy are commonplace, the combination of tools is relatively new and the IRS has not formally provided any guidance
Over the last few years, the greatest interest in the above options has been in the Win-Win, LLC™. Facebook co-founder, Mark Zuckerberg, has used this tool – placing $44 billion of Facebook stock in the structure. This is a powerful tool for those who prefer to self-direct funds towards the benefit of various philanthropic causes rather than merely sending money to the IRS in the form of capital gains taxes or Federal death taxes. The ability to act as managing member of the LLC, plus eliminating up to 99% of the taxes upon the sale, plus receiving a significant philanthropic income tax deduction make this an attractive tool in the sale of an appreciated asset, especially where there is a taxable gain of $1 million or greater.
My client thought he only had one option, and instead, discovered there are at least five more options to lessen or even eliminate the 40% tax “bite” … Imagine That™!
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