Avoid All Taxes on the Sale of Your Property

1. Introduction

Most of us who own and/or invest in real estate are reluctant to sell and cash out on our appreciated real estate holdings because we either refuse to pay the income tax that would be triggered by the sale or are convinced that there won't be enough left after taxes to make it worth the while to sell. For the real estate investor who wants out, this could be especially frustrating.

It is common today to find investors who own apartment buildings (or any real estate for that matter) that have significantly appreciated in value. Unfortunately the cash income generated by these properties is not necessarily adequate to retire on and worse yet, the management time necessary to maintain and run the property is increasing.

If we could only sell the property and put all the proceeds in alternate investments, the greater income would make it possible for us to retire from the day-to-day hassles of rental property management.

2. Capital Gains Bypass Trust

For those of you who have ruled out the outright sale, an exchange or an installment sale as a viable “exit strategy,” there is the Capital Gains Bypass Trust option to consider. In fact, the Capital Gains Bypass Trust option is worth while considering in a lot of situations and circumstances.

The Trust option makes a lot of sense in estate planning for those whose net worth is high (over $650,000 for a single person, over $1,300,000 for a married couple) and are potentially subject to estate taxes.

The Trust option makes sense for the parent/grandparent who wishes to pay for a child's/grandchild's costly education with tax deductible dollars. The Trust option makes sense for the individual and/or couple who are charitably inclined and wish to contribute today but are concerned about losing income from the funds/assets contributed.

In fact, when you take into account all the potential benefits associated with the Capital Gains Bypass Trust option, you may be surprised to learn that you will be further ahead even if your property is currently generating enough/adequate income and is management free! Surprised?

By now you should be asking yourself the question(s): If this is such a great deal, why haven't I heard more about it before? What are the disadvantages in implementing such a trust?

As far as the secrecy is concerned, tax-exempt trusts are not new but in fact have been around for several decades. The recent popularity in tax-exempt trusts has been a result of rising real estate values and thus an increase in potential tax liability.

As to the disadvantages of the Capital Gains Bypass Trust, on the surface there appear to be two obvious ones. The first is a perceived loss of inheritance to your heirs.

A Capital Gains Bypass Trust is synonymous to a Charitable Remainder Trust in that while you, your wife or any other designated beneficiary are alive, the income generated by the trust is made available to you, but upon the death of the surviving beneficiary, the principal within the trust is irrevocably transferred to a designated charity.

Please note that we stressed the word perceived. The reason for this is that in most cases a Wealth Replacement Trust can be set up to replace any lost inheritance by your heirs.

The second apparent disadvantage is that mortgaged property might pose a taxable “debt relief” problem for the transferor. Ideally one should consider using debt free assets for this transaction.

If you are still interested in tax-exempt trusts then there is more good news (i.e. advantages) for you to consider:

You have probably inferred by now that the property placed in the trust can be sold right away, tax free, for cash and thus you can immediately convert your marginal rental income into moderate to high yielding investment income.
Depending on your age and the desired yield you select from the trust, you will be eligible for a charitable contribution deduction on your personal income tax return.
The fair market value of the asset(s) transferred is removed from your taxable and probate estate and thus not subject to estate taxes and probate at death.
In most situations, the charities you designate as beneficiaries will pay for most, if not all, the fees associated with setting up the trust.
Since you are the creator of the trust, you can designate yourself to be the trustee of the asset(s) under trust. What that means is that you can control the timing of the sale of the property should you wish to sell it as well as designate the replacement investment(s). Remember that unlike an installment sale, you can change the investment vehicle as you wish in order to get the best possible return.

3. Comparative Example

To put all of this into perspective requires a comparative example:

Let's say you own an apartment building that is presently worth $1,000,000. You have owned this building for a number of years and therefore your basis for income tax purposes is low, let's say $75,000. Your building is presently generating a 4% return on equity. You are 60 years old and would like to realize an 8% yield on your funds.

The options you are considering are:

a. Do Nothing

If you did nothing, you will generate approximately $40,000 in annual cashflow (i.e. $1,000,000 x 0.04).

b. Sell the Property Outright

If you sold the building today for cash, you might have to pay $259,265 (20% Federal Appreciation Tax; 25% Federal Depreciation Recapture Tax & 9.3% State Tax) in taxes on the $855,000 taxable gain (i.e. $1,000,000 price - $70,000 selling costs - $75,000 adjusted basis).

That means that you would be left with about $670,735 (i.e. $1,000,000 price - $70,000 selling costs - $259,265 taxes). After all is said and done that would generate approximately $53,659 in annual cashflow (i.e. $670,735 x 0.08).

c. Transfer the Property Into a Bypass Trust

If you used the tax- exempt trust you would avoid the tax and thus generate approximately $74,400 in annual cashflow (i.e. $930,000 x 0.08).

As can be seen from the above example, by utilizing the tax-exempt trust, you will be able to increase your annual cashflow by approximately $20,000. Not bad!? Better yet, you also generate a tax deduction (charitable contribution) of about $400,000 that you can use to offset up to 30% (statutory limit) of your annual income for the next 6 years. Wow!

Depending on the actual facts and circumstances you might want to generate some taxable gain so that you could fully take advantage of the charitable deduction generated and come away with a bundle of cash as well.

4. Wealth Replacement Trust

A Wealth Replacement Trust (“WRT”) is a creative way to increase the amount of assets that will pass to your family, while providing significant benefits to the charity of your choice! Sounds too good to be true? Well it isn't.

Since a current donation to a CRT increases the donor’s income and creates income tax savings through a charitable deduction, these benefits can be utilized to fund a WRT that is designed to replace the assets that will eventually pass to charity, rather than to the donor’s heirs.

A WRT is an irrevocable trust created by the donor that holds and distributes assets to the donor’s heirs estate tax free. The donor can then go one step further by not only designing the WRT so that it avoids estate taxes, but designing the WRT so that is also avoids income taxes.

By funding a WRT with life insurance, not only will the assets pass to the donor’s heirs estate tax free, but also free of income and capital gains taxes.

This works because of the fact that the proceeds of a life insurance contract, payable upon the death of the insured, are received by the beneficiary income tax free.

This combination of two popular planning techniques namely, a Charitable Remainder Trust and an irrevocable insurance trust designed as a Wealth Replacement Trust, can be utilized by you to provide both lifetime and estate planning benefits to you and your family, and to the charity of your choice.

With this combination everybody wins. You, the donor, get the lifetime income advantages, your heirs get an estate and income tax free death benefit, and the charity(s) of your choice receive the balance of the assets in the CRT upon the donor’s death or upon the expiration of a term of years. Everybody truly does win — everybody but the government.

It is important to understand that the tax-exempt trust is only one of many strategies/alternatives that you should evaluate when you are doing your tax and/or estate and/or retirement planning.

RealTax professionals have the competence and experience to help you avoid all taxes on the sale of your property. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.