Keep the deal alive!: How to help seller avoid capital gains

13 Replies

We are looking to purchase a duplex from an absentee owner who acquired the place 13 years ago for $175,000. He is willing to sell it now for $250,000, but he has a $150,000 mortgage on the place. We almost lost the deal after he spoke with his accountant who told him he would owe ~$50,000 worth of taxes from capital gains.

We are trying to determine the best ways to keep the deal alive and would love some input from the BP community. Here are some ideas that I have (I didn't include a lease option in here here because I want to be the deed holder to be able to do the rehab and potentially resell; Also, a 1031 exchange is out the window because he doesn't want to own property anymore):

1) Can we assume the $150,000 mortgage and then put the remaining $100,000 in a structured sale? Are banks even allowing this still?

2) Wrap mortgage for $250,000 with a term of 5 years with no interest, just equal lump sums of $20,000 which is then used to pay off the first mortgage. With this, though, I'm worried that the bank will call the note, or the seller will find this option too risky ("Just don't tell your bank that you sold the place and you'll be fine"....yeah, right).

3) Structured sale with a 5 year term, with a $150,000 for the first year to pay off the mortgage, and then equal payments after that?

His idea was to bump the purchase price up to $300,000 to cover the capital gains and still give him his ideal margin. That idea obviously did not fly for multiple reasons.

Feedback and any more ideas would be great! Thanks in advance.

You won't be assuming the mtg, and if you did as part of the sale, it would be treated as cash received (no difference) as far as cap gains, I believe.  50k in recapture/cap gains seems high, but maybe.

Just for example's sake, sale price $250k ,let's say his current basis is $75k, after depreciation.

Any interest he receives is ordinary income.

So, ANY principle he receives (lump sums, payments, etc) would be divided as:

30% would be return of basis-non taxable (75k/250)

70% would be gain, subject to recapture and cap gains (175k/250)

@Steven Hamilton II   can correct my invalid assumptions.

Neal C. I'm not sure who told him (or you) that $50,000 would be his capital gains tax, but it's unrealistic. Assuming a 15% tax rate, the profit would need to be $333,333. So unless his basis is a negative number, which is impossible, or you got your facts wrong, that $50k tax is theoretically impossible to achieve. 

In terms of avoiding capital gains, there is little he can do. Capital gains = (Sales Price - Commissions & Fees) - (Original Purchase Price + improvements - depreciation - casualty losses and insurance payments). 

Now, he can defer his tax liability by offering seller financing. In this case, it would be considered an installment sale and he would pay capital gains as he received monthly payments from you.

Originally posted by @Brandon Hall :

Neal C. 

You failed to factor in the possible 20% capital gain rate and 25% on recapture and state income taxes that could be up to 12.3%.

Assuming originaly basis of 175k mostly building. 175k x 90% = 157,500 / 27.5( Depreciable life) = 5,727 (depreciation per year)  X 13 years = 74,454.54 of depreciation taken. Taxed at up to 25% = 18,613.64 of Federal Tax.

Capital gain 100k at 20% = 20k.  Plus assume it could be a CA resident; however, I'll utilize the highest OR tax rate of 9.9%

174,454 of income taxed at 9.9% = 17,270.95

So we have 18613.64 + 20,000 + 17,270.95 = 55,884.59

If it was a CA resident 12.3% of 174,454 = 21,457.84 + 18,613.64 + 20,000 = 60,071.482

OH don't forget commissions, assume 5% = 12,500 And seller concessions of 3% 7,500 = 20,000 less of gain:
CA Resident: 53,611.54
OR Resident: 49,904.63

Brandon, check your math buddy.

An installment sale is your best bet.  It would lower some of their tax burden; however, they would need a LARGE down payment upfront to cover the recapture.

@Steven Hamilton II  Thanks for setting it straight as I completely blew it! I was typing too fast and not thinking. I shouldn't have said "theoretically impossible."

Two things to note about your post: 

1. CA capital gains tax is 13.3% for 2014.

2. You assumed a high incomer earner with your 20% capital gains tax rate, but you failed to factor in the Net Investment Income Tax which is an additional 3.8% on the gains from sale.

So really, the estimated taxes should be higher than what you calculated. 

Buy it, payoff the basis, have the seller finance the gain, get creative with that note, more interest than gain on the price, pay interest, lump sum principal at future periods, defers gain and pays tax with cheaper dollars. He can carry it as a second as well. :)

Originally posted by @Brandon Hall :

@Steven Hamilton II Thanks for setting it straight as I completely blew it! I was typing too fast and not thinking. I shouldn't have said "theoretically impossible."

Two things to note about your post: 

1. CA capital gains tax is 13.3% for 2014.

2. You assumed a high incomer earner with your 20% capital gains tax rate, but you failed to factor in the Net Investment Income Tax which is an additional 3.8% on the gains from sale.

So really, the estimated taxes should be higher than what you calculated. 

 Glad you caught those,  I was waiting to see if you noticed.

@Steven Hamilton II  Realted question.  Back when I was first introduced to RE transactions, when dinosaurs roamed the earth, there was a clause in the code on installment sales along the lines of; on an installment sale, if you received more 30% or so of the sales price in one year, it triggered the taxes due on the entire gain, even though not received yet.  Any traps like that still exists?

Neal C. 

What about seller doing a 1031 Exchange? He could buy another investment property with the proceeds from this sale and refi the new property and do cash out to get the cash he needs tax free.

Originally posted by @Lumi Ispas :

Neal C. 

What about seller doing a 1031 Exchange? He could buy another investment property with the proceeds from this sale and refi the new property and do cash out to get the cash he needs tax free.

In the original post, it is mentioned the seller is looking to get out of Real Estate.

I don't think there is a way to avoid the taxes(even a 1031 technically delays them).  The key is finding a solution that is more desirable than a 50K tax bill this year.

It depends on why the investor wants to get out of real estate.  If they truly want to get out of real estate, then the 1031 Exchange would not make any sense.  However, if they want to get out of real estate because of property management headaches, then they may want to consider a 1031 Exchange into alternative investments that would eliminate property management issues such as:

  • Net Lease Properties
  • Tenant-In-Common Investment Properties (TICs)
  • Delaware Statutory Trusts (DSTs)
  • Oil & Gas Interests
Originally posted by Neal C.:

His idea was to bump the purchase price up to $300,000 to cover the capital gains and still give him his ideal margin. That idea obviously did not fly for multiple reasons.

Did you counter with he could sell for his basis and not owe any taxes? :)

Would the deal work for you at 275K? That would probably be the cleanest option - "basically split the tax bill".

Would he be willing to sell a partial interest(silent) and retain the mortgage?  If you bought a 25% share he would get over 1/2 the cash, but only owe 1/4 of the taxes.  With a 20/80 split you could own 40% of one unit and he could retain the other.  If you want to do improvements that should increase your proportion.

Is splitting the units into separate properties feasible?  That would take time, but may make a 300K price feasible.

Originally posted by @Bill Exeter :

It depends on why the investor wants to get out of real estate.  If they truly want to get out of real estate, then the 1031 Exchange would not make any sense.  However, if they want to get out of real estate because of property management headaches, then they may want to consider a 1031 Exchange into alternative investments that would eliminate property management issues such as:

  • Net Lease Properties
  • Tenant-In-Common Investment Properties (TICs)
  • Delaware Statutory Trusts (DSTs)
  • Oil & Gas Interests

  Wouldn't the seller have to put cash in to replace the mortgage?  I think deferred principal payments would probably be a preferable solution for the seller.

This was great. Thanks for everyone's input. We are either looking at an installment sale and putting down enough money to cover Seller's basis, assuming the mortgage, and then drawing up a note for the rest of the equity.

Or we are going with a lease option. At first I didn't like this option, but have since been educated by another very wise and friendly investor that has helped me see the light. The seller is old and not wanting to own property anymore and deal with management issues, so we are going to hopefully do a lease option with $5k down, pay the owner's note, plus pay 4% interest only payments on the equity. That gives us the ability to fix up the place and pull up the rents to market rates to get nice cash flow and forced appreciation. When the option term is up we will pay a ballon payment to the Owner. If the option to purchase is tied to the Owner's passing, then his basis goes up and his estate won't have as much capital gains. 

In the end the Owner still gets monthly cash flow, is assured in the event we stop paying, and doesn't have to deal with management issues anymore. We get monthly cash flow, appreciation, and very little money out of pocket.

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