Monday, October 18, 2021 / by Dave Salzman
We often hear from clients that they are ready to sell but feel trapped in their homes due to the capital gains tax that would be paid upon sale. They are the lucky ones; they invested many years ago in a home and stayed in that home as their families grew up and out. Now they are thinking about buying a new home that matches their new “empty nester” lifestyle or maybe their family has expanded to include adult children or parents.
However, they see their tax advisor who gives them the bad news on the amount of taxes to be paid upon sale – even with the IRC Sec 121 Exclusion of $250,000 per resident taxpayer. They may be advised not to sell because “Uncle Sam” will end up with a healthy percentage of their net proceeds upon sale due to capital gains taxes on equity beyond the 121 exclusion.
Now what? There are other solutions by which one can use the tax code to effectively defer the capital gains tax indefinitely, thereby avoiding a significant reduction in net worth. How?
Using the IRC Sec. 1031 exchange with the IRC Sec. 121 exclusion is an effective strategy to benefit from available tax tools.
The IRC Sec. 1031 exchange is a proven technique that allows real property investors to "defer" paying capital gain tax on investment properties when they are sold, as long as the owner/seller reinvests the proceeds in another income-producing asset.
The IRC Sec. 121 exclusion, on the other hand, allows homeowner resident taxpayers to exclude $250,000/$500,000 of the capital gain from taxation upon the sale of property that is used as a principal residence.
Properly done, combining the 121 exclusion and the 1031 deferral strategies allows property owners to reduce or eliminate current capital gains taxes upon the sale of a primary residence.
But wait… there are more strategies:
Four Additional Strategies You Can Use to Mitigate Capital Gains Tax
1. Structured Installment Sale
A key tool in deferring gains on the sale of property, this strategy focuses on reducing or completely eliminating capital gains tax. Installment sales for real estate have a long and established tax history and can be used in transactions when the seller of the property wishes to defer their huge year one tax hit and instead spread it over a period of years. Taxes are paid on the principal paid down each year.
2. Tax-Exempt Trust (Wealth Preservation Trust/Charitable Remainder Trust)
Two main types of trusts one can use for deferral are a Charitable Remainder Trust (CRT) and Wealth Preservation Trust (WPT). For example, a Charitable Remainder Trust is a gift of cash or other property to an irrevocable trust. Any capital gains tax will be deferred until the time it is distributed out to the income beneficiary. A donor can contribute highly appreciated concentrated positions to the CRT and diversify his/her position in a tax-effective manner as the tax burden will spread out over time. If you own any investment or commercial property and are worried about depreciation recapture, a CRT will help it go to 0%.
3. Intermediated Installment Trade Trust (Deferred Sales Trust/Installment Sales Trust)
An Intermediated Installment Sale spreads the delivery of income from the sale over the life of the installment note. This defers the payment of capital gains and can provide greater financial benefits compared to the payment of taxes in the first year of sale. The goal of this strategy is to defer the payment of CGT for 10, 20, or 30 years.
4. Delaware Statutory Trust
A Delaware Statutory Trust (DST) is a legal entity created and often used in real estate investing that allows for a number of investors to pool money together and hold fractional interests in the holdings and assets of the trust. The DST has become a widely used structure for pooled real estate investment following a 2004 IRS ruling that allowed ownership interests in the DST to qualify as a like-kind property for use in a 1031 exchange, which allows sellers of real estate to defer capital gains.
The above possibilities are not all the strategies available. However, for any of these strategies, it is critically important to plan well in advance as the timing of the various sale and purchase transactions must occur within a well-planned exit from a highly appreciated home, commercial property, or business. Awareness. Education. Planning. Execution.
[The Advisors at Salzman Real Estate Team are CA licensed Real Estate Agents, not tax advisors. We have educated ourselves on Planning Options and work closely with tax advisors to reach each clients’ goals.]