Which would benefit you more - a 1031 exchange into a tenant in common property or an Deferred Sales Trust™? Or might it be another option like a CRT, a Charitable Installment Bargain Sale or a Structured Sale?

The Answer

The answer is, it depends. Some of the considerations are:

1. Are you in the accrual or distribution phase of your life?
2. What type of investment do you wish to sell? Real estate, stocks, a business, a rare collection of art or cars?
3. Do you need income now or later in retirement?
4. Do you have a large estate and heirs subject to estate tax?
5. Do you wish to defer capital gains tax forever, or spread it out over a long period of time?
6. Do you have a large amount of depreciation recapture or something called a mortgage over basis problem?
7. What is your risk tolerance and your investment experience?

Each situation is different and a plan should be devised to suit your individual needs and to minimize the taxes that would be due. The capital gains tax strategies available change and evolve as tax laws change and evolve. There is no one best strategy- the most important consideration should be to know what options you have available, compare the pros and cons, and choose whichever you feel most benefits you and your family.

Let's take an example of when someone has an investment property that has appreciated greatly.
I run into a number of clients with the same dilemmas on a regular basis. They purchased investment property years ago and now it is worth double or triple of what they paid. They are tired of being landlords and of all the headaches of property management. They are also in a position where they could use additional passive income to either live on or invest towards their retirement.

They feel this may be a good time to sell and enjoy their profits. They get a rude awakening, however, when they find out how much they will owe the IRS in capital gains tax, recaptured depreciation, and additional income tax in the year in which they sell. In California, they even get another 3.3% withheld for up to a year until all taxes are settled. Some cities levy their own taxes. The sale may even trigger the dreaded Alternative Minimum Tax. Ouch!

7 options!

As an investor, you basically have 7 options. Some are definitely more appealing than others.

1. Sell and pay lots of real estate or investment capital gains tax.
2. Do a 1031 exchange and buy another like-kind property of equal or greater value
3. Set up a Charitable Remainder Trust
4. Set up a Deferred Sales Trust™
5. Set up an Charitable Installment Bargain Sale
6. Set up a Structured Sale or do your own Installment Sale
7. Do a 1031 exchange into a Tenant in Common property.

The first one is without a doubt the least desirable. Let's explore the others one at a time.

The Traditional Option For Investment RE- 1031 Exchange

If you, as a real estate investor, do a traditional 1031 exchange, you must buy a property of at least the same value as the property which you sell. Yes, you do defer the capital gains tax owed, but this often means obtaining a new mortgage unless you own the property outright. Maybe the new mortgage will have a higher interest rate and higher payments. Also you may also incur higher property taxes and insurance costs. And, you are still a landlord with the same headaches you are trying to avoid. You must decide if this suits your current needs.

The Charitable Remainder Trust

A charitable remainder trust has its place as a valid capital gains tax saving strategy. Although designating your principle to your favorite charity upon your death is a worthy goal, you may not wish to be quite so philanthropic if you have another choice. A trust must be established, the property placed in the trust before sale, and then basically, the proceeds are earmarked for charity upon death. You do get the benefit of any interest which accrues on the principle during your lifetime, and perhaps the lifetime of your spouse. You will pay ordinary income tax when you receive this money. You also get a tax deduction for the amount pledged to the charity. If healthy enough, a life insurance policy may be purchased to pay your beneficiaries an amount equal to what they won't inherit. This can be costly, depending on your age and the face amount of the policy. This is fine if you don't need the income to live on, want the property removed from your estate, and want to leave the largest legacy possible to your favorite charity. Once again, the capital gains taxes are not paid because charities don't pay taxes, but you no longer have control of your asset and the associated principle. This option is often used by fairly wealthy people with multiple assets and sources of income, who also have a favorite cause.

The Deferred Sales Trust™

The details of this strategy are a bit complicated to try and explain in a brief format, but the benefits can be great. I'll try and summarize as best I can, but don't be afraid to get in touch with me directly to go over it in greater detail. This strategy was developed in early 2002 and has become the best alternative to the Private Annuity Trust, which is no longer available for use as a capital gains tax deferral strategy per the IRS as of October 2006. It is important to know that this strategy must be in place before the initial Buy/Sell agreement is signed, as the sale to the buyer will be between the trust and the buyer. It involves creating a special entity called the Deferred Sales Trust™ and naming a third party trained and approved Trustee to administer the sale proceeds. The property is then sold by the seller to the trust in exchange for an installment agreement. The trust is now obligated to make payments to the seller as per the terms of the agreement- which meets the seller’s goals. The trust now makes the sale to the buyer for cash and uses this money to make the payments to the original seller. Again, please note there is a lot of detail I am leaving out, but I want to state just the basics to introduce the concept. The benefits are end-to-end control of the transaction, a fixed term income stream determined by your needs, and the deferral and spreading out of capital gains tax and normal (not accelerated) depreciation recapture tax over many years. If you pass away before receiving all of your payments due, the remainder goes to the beneficiaries of your choice. The total set-up, investments and administration are taken care of by the company setting it up – The Estate Planning Team – and the designated Trustee.  Those in need of a higher annual payment may prefer this strategy because it means keeping more actual proceeds from the sale, but it can also be structured so that a charitable contribution can also be made and a deduction received if one also has a charitable intent. Other problems it may address are a mortgage over basis issue, where a direct sale may mean immediate tax payment for any loan amount over the adjusted cost basis which can reduce or eliminate any gains whatsoever. If put in place prior to doing a 1031 exchange, it can be used as a rescue for a failed 1031 exchange so that an immediate tax liability is not created and you have a “Plan B” to fall back on.  For more information and an immediate no cost illustration for your particular situation, please go to http://www.mydstplan.com/savegainstax or call me direct and I will walk you through it.

The Charitable Installment Bargain Sale

The Charitable Installment Bargain Sale is a hybrid vehicle which incorporates some of the best parts of a Charitable Remainder Trust and a Structured Sale, while eliminating some of the less desireable features of each. It is a combination of a Charitable Bargain Sale and an Installment Sale. In very basic terms, it allows you to donate a portion of the fair market value of your asset and receive the remainder back as a series of fixed installment payments at a fixed interest rate over a fixed period of time. Because a non-profit organization 501(c)3 transacts the sale for you and receives the proceeds, you are also afforded some very nice tax breaks. These include a charitable deduction which can be used to lower your taxable income, a partial forgiveness of capital gains tax and recaptured depreciation (if applicable), and it spreads out the repayment of the remainder of the capital gains tax and ordinary depreciation recapture tax over many years. . The asset is partially removed from your estate, so your heirs will not occur the entire estate tax consequences (further planning can be done to remove it entirely if this is a concern), and the monies have an additional layer of protection from creditor access. The total effect is that you actually keep a greater amount of your proceeds, are repaid your principle less the inital bargain sale portion with interest, have the peace of mind which comes from a fixed payment stream, and you also provide funds to a good cause. Any monies left not paid out at the time of your death pass to the beneficiaries of your choice, and they even have the option of continuing the payment stream. The tax laws which govern this strategy are IRS codes 453, 1011(b) and 501(c)3. This strategy is available for sales of most capital assets with the exception of qualified money and publically traded stock. These are commonly real estate, businesses, privately held stock portfolios, rare collections, etc. There are even instances where cash, annuities, life insurance policies, real estate options and stock options on privately held stock are used.

The Structured Sale

The Structured Sale is a form of Installment Sale. It became an option in 2005 and is currently offered through a couple of major insurance carriers and their associated Assignment Companies. The basic concept is that instead of receiving a lump sum for the total purchase price from the buyer, the buyer passes the lump sum to an Assignment Company and assigns the obligation to make payments back to you, the seller, over a period of time at a fixed interest rate. The Assignment Company which is partially owned by an Insurance Company, backs its obligation by investing the proceeds in a single premium fixed annuity product offered by the associated carrier. You are able to determine how long you would like those payments spread out (number of years), and thus your capital gains tax obligation is spread out as well. The payments are broken down into return of cost basis (non-taxable), capital gain (amount you owe capital gains tax on) and interest (taxed as ordinary income). If you sell a real estate investment property which you have depreciated over time, you will owe the associated recaptured depreciation as of time of sale (next tax return). The Structured Sale, as well as an installment sale between two parties are both legitimate options and should be used as part of the basis of comparison to determine which strategy best suits your individual needs.

The 1031/Tenant in Common Exchange

Another option is a 1031 exchange into a tenant in common property. As a real estate investor, you remain in control of your asset, the capital gains taxes can literally be deferred forever (as long as you never sell outright), you can get a substantial passive income, and you no longer have the headaches of property management. The investment property is sold, and before the close of escrow, you file paperwork with a qualified intermediary that a 1031 exchange will be performed. The QI handles the exchange of monies, and you choose a tenant in common property to purchase. It is a clean and total like-kind exchange. You receive a deeded interest in a quality commercial investment property (should you choose wisely). It is proportionate to your overall contribution in the 1031 exchange. All capital gains taxes are deferred, you usually will not have closing costs to worry about, and you will have non-recourse debt on the new property. This means you will not be responsible for making additional mortage payments on this debt (it is factored into the cost of management) and if something does happen with the building, your other assets are protected. You will also most likely receive tax advantages of depreciation and interest deductions.

You are able to maintain control of your asset for future exchanges and appreciation potential.

Upon your death, the tenant in common property passes to your heirs at the stepped up fair market basis (under current tax laws) and no capital gains taxes or recaptured depreciation is owed!

Compare the options above and decide for yourself which option, or combination of strategies give you the most monetary gain, flexibility, income, tax savings, control and potential for appreciation. Education is the number one priority. It increases your ability to make an informed choice.

Please note, for several of the above choices you may need the assistance of other professionals such as realtors, attorneys, CPAs and other financial professionals. I believe in working with your advisors so everyone is on the same page and also informing you when someone else can better assist you in a certain area than I.

Allow me to help you determine the right tax saving vehicle(s), facilitate your strategies from beginning to end, and see that you keep as much of your gains as legally possible. Fill out a questionnaire now if you are currently selling an asset or sign up for my next informative teleconference call.

Once again your 2 choices!