Are You Protecting Your Capital Gains?
PHOENIXóUh-oh, the real estate market is on the upswing. But wait. Isnít that a good thing? Didnít we suffer through the long recession? Donít we deserve to be rewarded for our perseverance? Why look for the cloud in the silver lining? Well, Iím a tax planner, you see. Itís a hazard of the job.
Donít get me wrong. Itís great when your portfolio rises in value. The question before us is how to enjoy as much of that rise as we canówithout giving too much of it back to the IRS.
Itís a shift in thinking. During the recession and the agonizingly slow recovery, everyone was focused on revaluing property, restructuring investments, and working out debt. Now that the market has rebounded, itís time to pick up a new hobby (or dust off an old one): reducing the tax exposure resulting from appreciation in your real estate portfolio.
Itís especially relevant now, given higher tax rates for the upper brackets, increased capital gain tax rates, and the net investment income tax, to name just three changes in the wake of the end of the Bush-era tax cuts. There are a lot of things you can do in the tax arena, but letís focus on three key strategies that might give you the best chance to hold on to more of your money.
Also known as 1031 exchanges (named after the corresponding section of the Internal Revenue Code), like-kind exchanges are experiencing something of a resurgence lately as more and more owners and developers seek to defer recognizing tax gains by using sales proceeds from one property to invest in another qualifying property. In other words, the tax gain wouldnít be recognized today, but tax basis in the new qualifying property would be carried over from the old property. As a result, there would be less depreciable basis in the new replacement property or upon sale of the newly purchased replacement property the gain would be increased.
The reasons for doing this are clear. The capital gain rate has increased from 15% to 20%, and the net investment income tax (which is applicable to nonĖreal estate professional investors) has pushed the overall rate to 23.8%. Thatís a sizable bite, and many in the industry would rather find other opportunities for that money.
Whatís useful to know is that 1031 exchanges provide for tax deferral óand are in fact mandatoryóif these four conditions are all present: The transaction is a sale or exchange; Both the property transferred and the property received are held either for productive use in a trade or business or for investment; The property transferred and received is like-kind property; and the transaction is executed through a qualified intermediary.
Ordinarily, tax planning around 1031 exchanges involves structuring and implementing transactions so as to meet statutory requirements and thereby qualify to defer the tax gain. In appropriate situations, however, the opposite may be true. You may not want to meet the requirements of a 1031 exchange so that you can recognize gain or loss.
For example, you may wish to sell real estate to claim a loss and reinvest the proceeds in like-kind property. Or you might want to fully recognize taxable gain on the sale of property to obtain an increased basis for depreciation in the replacement property, take advantage of past low capital gain rates, or offset another loss or loss carryover.
Letís say a grandfather wishes to sell a parcel of vacant land he has owned for many years. The property has a basis of $100,000 and a fair market value of $2 million. His granddaughter owns another vacant parcel with basis and fair market value of $2 million. Grandfather and granddaughter execute a like-kind exchange of their properties. Granddaughter takes the land received in the exchange with a basis of $2 million. Granddaughter then sells the land for $2 million to an unrelated purchaser two years later. Effectively, grandfather would have recognized no gain on the sale, and granddaughter wouldnít recognize gain on the ultimate sale to a third party.
For most real estate transactions, multiple parties form a partnership to hold property. What happens if one partner wants to execute a like-kind exchange and another partner wants to cash out? Generally the partnership must fully participate in a like-kind exchange or cash out. Each partner cannot pick and choose their rollover or cash-out treatment. However, proper tax planning over several years involving distributions of undivided interest in the property to be exchanged to the partners may provide the holders the option to roll over or cash out.†
You may already know that installment sales are mandatory when you sell property for a note. However, taxpayers can choose to elect out of installment treatment. When the capital gain tax rate was 15 percent, real estate owners typically chose to elect out of installment sales because of pending political uncertainty and other tax reasons. But the rise in tax ratesóand a political environment that might see rates move even higher eventuallyómight make it time to rethink electing out of installment treatment election, depending on your situation.
Named after a US Tax Court case that the IRS ended up losing on appeal, a Bramblett transaction involves selling undeveloped real property to a related entity for an installment note qualified as a debt instrument under IRS rules. This defers the capital gain recognition on any appreciation that occurred prior to the sale until payment is received on the installment note.
This type of arrangement can work really well if youíre land rich and cash poor because all your money is tied up in the dirt, so to speak. The acquiring related entity, which in many cases is the developing entity, issues an installment note to the selling party that it pays at a later time when it has sufficient cash after the property is developed. The result is that the selling party recognizes capital gain upon payment of the installment note. The developing entity recognizes reduced ordinary income on sale of the developed property since it has a higher tax basis in the acquired land.
Setting something like this generally involves a several-year time frame, and there are some unique rules around it, so youíll want to work with your accounting firm and legal counsel to make sure you donít run afoul of the regulations. Itís also worth noting that the Bramblett technique works only with undeveloped real property. For example, if you have an apartment building you want to convert to a condominium, you canít use Bramblett; in that case it might be better to use a related-party exchange to defer capital gains.
Itís difficult to predict where tax rates are headed in the long term. But one thing is certain: The Bush-era tax cuts are in the rearview mirror, and weíre living in a different world from the one we inhabited in 2012. An increase in capital gain and other tax rates means a return to capital gain planningóand figuring out how to capture and defer the tax consequences of the inherent gains youíve made.
Some of the approaches Iíve outlined above are relatively straightforward. Some are much more complex. Either way, seeking out the assistance of a tax professional can help you avoid common pitfalls of real estate tax strategies and help your bottom line.
Kevin Seabolt, CPA, is tax professional and senior manager with Moss Adams LLP. He is based in Phoenix and serves clients throughout the Southwest. He has more than 12 years of experience advising both corporate and private equity clients in real estate and construction and specializes in federal income tax matters regarding transactional and operational issues. He acts as a key national resource for partnership taxation issues surrounding debt workouts, restructuring, and tax efficiency planning for real estate transactions. You can reach him at (480) 366-8287 or firstname.lastname@example.org. The views expressed in this column are the authorís own.