Some investors seem to enjoy paying taxes on their real estate sale profits. I don’t. As a smart real estate investor, I hope you don’t either. I still occasionally get letters from readers who say their real estate broker, their CPA or their attorney advised them to sell their investment or business property and pay the capital gain tax instead of making a tax-deferred exchange.
For some unexplained reason, realty investors and their tax advisers in a few states have been the last to catch up and understand the huge benefits of tax-deferred property exchanges. I still remember receiving a letter, about two years ago, from White Plains, N.Y., where the investor said her CPA told her tax-deferred exchanges are “experimental” and haven’t been tested yet in court! Just for the record, tax-deferred exchanges are legal in every state and they are now even being done in the slow-to-catch-on New England states! But finding CPAs and tax or real estate attorneys who understand them still isn’t easy there.
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The tax theory of IRC 1031 tax-deferred exchanges is to create one continuous real estate investment, rather than a taxable sale followed by a purchase of another property held for investment or business use. Isn’t it better to have the full amount of your sale profit available for reinvestment rather than have your profit diminished by a 15 percent to 25 percent federal tax (plus any applicable state tax)? Avoidance of tax erosion is the major reason for tax-deferred exchanges.
EXAMPLE: Suppose you decide to sell your investment or business property. Your net profit (long-term capital gain) will be $200,000. If it is a depreciable property, such as an apartment building or a rental house, your capital gain will be taxed at the special 25 percent federal “recapture tax rate” on depreciation deducted after May 6, 1997, and at the 15 percent maximum capital gains tax rate on the balance of your profit including pre-May 7, 1997, depreciation deducted. Rather than paying more than $30,000 federal capital gains tax on your $200,000 profit, leaving only $170,000 to reinvest in another property, wouldn’t it be much better to have the full $200,000 available to acquire a larger investment or business property? Of course!
But there are many reasons other than “tax erosion” to make tax-deferred real estate exchanges, rather than creating a taxable sale followed by purchase of a replacement property. The “top 10” tax-deferred exchange reasons are:
1. Avoidance of income-tax erosion of property-sale profits and avoidance of depreciation recapture taxes upon the sale;
2. Minimize or eliminate the need for new mortgage financing on the property being acquired;
3. Get rid of an undesirable property, or one that is difficult to sell, and acquire one that is either more desirable and/or easier to sell;
4. Increase the investor’s depreciable basis for greater tax shelter by acquiring a larger depreciable building;
5. Acquire a property that better meets the owner’s needs, such as providing greater cash flow and/or requiring less management time;
6. Defer part of the capital gain profit tax by “trading down” to a smaller property that better suits the owner’s needs. An installment sale note will spread the profit tax over several years while providing the seller with interest income at a rate higher than is currently available with safety elsewhere, such as bank CDs and savings accounts (of course, the interest income received is taxable as ordinary income);
7. Pyramid your wealth into a large estate without paying profit tax along the way each time you trade up to a larger property. That was the basis of the late William Nickerson’s wealth pyramid in his famous best-seller classic book, “How I Turned $1,000 into $5 Million in Real Estate in My Spare Time”;
8. Refinance either before or after (but not as part of) the exchange to create tax-free mortgage refinance cash to make other investments or use the cash as you wish (the reason you can’t refinance as part of the exchange is the cash is then considered taxable “boot,” which is “unlike kind” personal property rather than “like kind” real property);
9. Accept an unexpected cash purchase offer to sell a currently owned property at a high price without owing tax on the sale profit;
10. Completely avoid capital gains tax when the investor dies while still owning the last property in the chain of tax-deferred exchanges.
Death is the ultimate tax shelter of all! Although the net market value of your real estate owned at the time of death will be included in your estate, no capital gains tax will be due on your realty upon your demise. However, if you sell your real estate the day before your death, Uncle Sam will be waiting to claim his capital gain tax!
Estates of persons dying in 2004 and 2005 have a $1.5 million federal estate tax exemption. This exemption increases to $2 million for deaths in 2006, 2007 and 2008. In 2009, for deaths that year the federal estate tax exemption will be $3.5 million. But 2010 will be the best year to die because there is no federal estate tax that year! However, unless Congress changes the estate tax law, the $1 million federal estate tax exemption returns in 2011, as do the higher pre-2002 federal estate tax rates on assets above the exempt amount.
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