By Michael Hall and Kevin Seabolt
Michael Hall is a partner and Kevin Seabolt is a senior manager at accounting firm Moss Adams.
Youre supposed to be happy when your assets rise in valueespecially those of us in the real estate business. After all, the recession, a brutal stretch that wiped out enormous sums of wealth and decimated property values, is mostly behind us, and the residential and commercial markets are, in many places, back with a vengeance.
But for many of us, that sweet rise is tainted by the sour realization that the Internal Revenue Service will come knocking to take its share of our gains.
Dont despair. With enough planning, you can enjoy as much of that rise as you canwithout giving too much of it back to the IRSby looking at ways to reduce the tax exposure resulting from appreciation in your real estate portfolio.
Its 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 a few recent changes. Lets focus on three key strategies that might give you the best chance to hold on to more of your money.
The Key Number: 1031
Also known as 1031 exchanges (named after the corresponding section of the Internal Revenue Code), like-kind exchanges are experiencing something of a resurgence as 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 wouldnt 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 15-20 %, and the net investment income tax (which is applicable to non-real estate professional investors) has pushed the overall rate to 23.8%. Thats a sizable bite, and many in the industry would rather find other opportunities for that money.
Whats useful to know is that 1031 exchanges provide for tax deferral and are in fact mandatoryif 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
· The transaction is executed through a qualified intermediary
Ordinarily, tax planning around 1031 exchanges involves structuring and implementing transactions 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.
Lets 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 originally low-basis land received in the exchange with a substitute basis of $2 million. Granddaughter then sells the land for $2 million to an unrelated purchaser more than two years later. Grandfather would recognize no gain on the sale, and granddaughter wouldnt realize or recognize gain on the ultimate sale of the originally low-basis property to a third party.
Provided Grandfather holds the substitute low-basis parcel until his death, the beneficiary of Grandfathers estate will receive the parcel he holds at a stepped-up basis equal to its fair market value.
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 the partners as tenants-in-common may provide the holders the option to roll over or cash out.
Sales Made Easy as 1-2-3-etc
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%, 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 ratesand a political environment that might see rates move even higher eventuallymight make it time to rethink electing out of installment treatment election, depending on your situation.
A Tax Case The IRS Lost, May Be Your Gain
Named after a U.S. 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 well if youre 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.
Structuring an arrangement like this generally involves a several-year time frame, and there are some unique rules around it, so youll want to work with your accounting firm and legal counsel to make sure you dont run afoul of the regulations. Its 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 cant use Bramblett; in that case it might be better to use a related-party exchange to defer capital gains.
Where to now?
For some of you, these tax-planning techniques may be familiar. You may have employed them back in the pre-recession era, before the period of debt workouts and other unpleasant features of the post-crisis landscape. Its now time to dust them off and see how you can make them work for you in a time of increasing asset values.
For others, these ideas may be new. The important thing to understand is that an increase in capital gain and other tax rates means capital gain planningand figuring out how to capture and defer the tax consequences of the inherent gains youve madeis vital to helping your business maintain its cash flexibility and competitive edge.
Either way, seek out the assistance of a tax professional to help you realize the opportunities and avoid the common pitfalls of real estate tax strategies.