This guest post was written by Jackson Cooper, an investment real estate & finance enthusiast, involved with the experts at American Society For Asset Protection.
The average long-term capital gains tax rate in the United States is 28.6%, when you combine federal, state and local taxes, according to the Tax Foundation. That’s sixth highest among Organisation of Economic Co-operation and Development (OECD) member countries. California residents pay the third highest marginal rate of all OECD members when broken down by state, with only Denmark and France ahead of them.
Savvy real estate investors already know basic strategies for reducing their capital gains tax obligations on real estate sales. The two cardinals rules are to always hold a property for at least a year and to sell when your income is at its lowest. But taking a few extra steps may allow you to maximize profits further without attracting extra IRS attention. Depending on your specific situation, you might be able to use one or more of these three strategies to increase your immediate and long term income.
Defer Capital Gains
Congress has been at war with like-kind exchanges for the better part of the last three years. Internal Revenue Code 1031 allows investors to defer paying taxes on gains from a sale if they reinvest said gains into a similar property (like-kind) within 180 days of the close. Senator Max Baucus, D-MT, and Senator Dave Camp, R-MI, have both proposed repealing the law as part of a tax reform. But a 2015 study by Ernst and Young found that repeal of IRC 1031 would lower theUS GDP substantially due to decreased business investment. Repeal efforts have since been put on hold.
Reporting a like-kind exchange to the IRS is done via Form 8824. Among other thing, it asks for dates of transfer and value of the like-kind. The form must be filled out within 45 days of the original property sale.
Several of those links above go to the IRS Web site and you know what that's like to read. You may find this Ultimate Guide To Like Kind Exchanges to be much more useful.
Charitable Remainder Trusts (CRT)
The Tax Reform Act of 1969 created both charitable remainder annuity trusts (CRAT) and charitable remainder unitrusts (CRUT). The previous is an irrevocable, tax-exempt trust funded by cash or assets (in this case appreciated property). The income is paid back to you or another beneficiary in fixed payments over their lifetimes or another specified period not exceeding 20 years. When said term is complete, the remaining funds are transferred to a charity of your choice. CRUTs work the same way except payments are distributed yearly in fixed percentages ranging from 6%-15% of the value of the assets. The amount distributed from a CRUT will then depend on the market performance of the underlying assets held in the trust - if the value of the assets increase then potentially more money will be available for distribution.
Funding the CRT immediately creates a tax deduction for the donor based on the present value of the remainder interest that the charity will ultimately receive at the end of the specified term.
To understand all the potential benefits of a CRT, let’s examine the following hypothetical example:
John and Mary Smith purchased a rental property for $250,000 as an investment. Twenty-five years later, they were preparing to retire, and the property had appreciated to a value of $1,100,000. Over the years, they had depreciated the property $150,000, so the original basis of the property was only $100,000. If they were to sell the property for $1,100,000, they would have to pay capital gains taxes on $1,000,000 ($1,100,000 - $100,000). Their capital gains combined federal and state tax rate was 28.6%, which would result in a tax of $286,000 ($1,000,000 x 28.6%) on the sale of the property. If they were to sell the property and pay the tax, they would net $814,000 ($1,100,000 - $286,000).
If John and Mary first transferred the property into a CRT and the CRT then sold the assets for $1.1 million, they would owe zero capital gains tax on the sale of the property; and all $1.1 million would go into the trust. At a return of 7%, the $286,000 saved in capital gains tax would produce $20,020 income each year. John and Mary Smith would also be able to take a charitable deduction for giving the asset to the CRT. They could take a charitable donation deduction for the portion of the trust assets that will pass to the charity upon their deaths. The IRS has tables to determine the percent that can be deducted. For this example we will estimate that the charitable deduction would be approximately $150,000. At a tax rate for federal and state income tax of 35%, a deduction of $150,000 would save the Smiths $52,500 in income taxes. At a return of 7%, this $52,500 would produce $3,675 each year. Also, the transfer of the asset to the CRT will reduce the size of John and Mary’s estate, which will, in turn, reduce or eliminate estate taxes.
The Smith’s will enjoy income each year from the CRT for the rest of their lives. If one spouse passes away, the other will continue to receive monthly income. The money that remains in the trust after the death of both John and Mary Smith will go to their designated charity. In this example, we estimate that $150,000 would go to charity upon their deaths.
In summary, by giving the asset to a CRT to sell, instead of selling the asset and paying the taxes, John and Mary Smith were able to:
- Save $286,000 in capital gains taxes.
- Save $52,500 in income taxes.
- Receive $23,695 ($20,020 plus $3,675) more income each year from the sold asset.
- Give $150,000 to their charity of choice after death of both spouses.
- Reduce the size of their estate to decrease or eliminate estate taxes.
- Receive monthly payments from the CRT.
Even though the money remaining in the trust is given to charity, the financial benefits to setting up a CRT potentially exceed the amount of money given to charity. The CRT creates a win-win, where you are able to receive more money from the assets and give money to charity. If you wish to still have the assets go to your family to manage upon your death, you can set up a Family Foundation and designate this family charity as the beneficiary of your CRT.
While the above example won’t work in all situations, it’s definitely worth a talk with your financial advisor to see if a CRT can help you.
The primary reason sole proprietors establish LLCs or corporations is to protect their personal property from lawsuits. But according to financial planners at the American Society for Asset protection, entity structuring is also an integral step for lowering capital gains taxes.
S corporations are particularly beneficial to those who flip homes quickly (less than a year). You pay yourself a fair salary, then profits are distributed as dividends. The latter are taxed as capital gains, while the employment taxes on your salary are lowered because of the split. The key is to make your salary “fair” so it does not catch the attention of the IRS as a potential tax avoidance strategy.
*Note: Always talk to an attorney or qualified consultant before pursuing any of the aforementioned avenues.
#RealEstateInvesting #CapitalGainsTax #RealEstateSales #TaxAvoidance
Gary Lucido is the President of Lucid Realty, the Chicago area's full service discount real estate brokerage. If you want to keep up to date on the Chicago real estate market, get an insider's view of the seamy underbelly of the real estate industry, or you just think he's the next Kurt Vonnegut you can Subscribe to Getting Real by Email using the form below. Please be sure to verify your email address when you receive the verification notice.