Tax Stategies for a 1M+ real estate sale

23 Replies

I know an owner (very old school) who is ready to retire and liquidate his portfolio.  He has a few buildings in DC valued at over $1M .  He has already started to sell off some of his properties.  He does not employ any tax strategies and pays the maximum tax when he sells.  Properties are paid in full.  Guy is very old school, no debt, straight deals.  We are trying to offer suggestions for him to minimize his tax obligation without making things too complicated.  Could a trust be used?  What about an exchange?  Is it always real estate for real estate?  Any ideas?

@Shadonna N. , The 1031 is always investment real estate to investment real estate.  But there are some interesting interpretations from the IRS regarding what constitutes real estate since they let the states define real estate.  For instance, Oil and gas rights and royalty interests in mineral resources are considered real estate for purposes of 1031.  Your seller could exchange into oil rights.  Or air rights or certain conservation easements.  Vacation rentals certainly qualify.  As do mobile homes when sold as part of the underlying land.  So do boat slips (dockminiums) and boat racks (rackminiums) when legally structured appropriately.

Your guy is old school and sounds like ready to retire and be done with active investing. So an exchange into either NNN commercial properties, or DSTS which is asset ownership through a specially set up trust and TICs which are actual fractional ownership of the asset itself would be very appropriate.

Your challenge is going to get him to make that emotional transition from control and active management to no control and passive lazy boy landlording.

@Dave Foster he is definitely ready to and be done with tenants. What state defines the real estate, the state where the asset is sold or where it is purchased? Could a REIT be considered real estate? Does he have to move all of the proceeds in a 1031? If not, would he be taxed on what is not moved. Could anything be passed down to family members without tax impact?

Originally posted by @Shadonna N. :

@Dave Foster he is definitely ready to and be done with tenants. What state defines the real estate, the state where the asset is sold or where it is purchased? Could a REIT be considered real estate? Does he have to move all of the proceeds in a 1031? If not, would he be taxed on what is not moved. Could anything be passed down to family members without tax impact?

A REIT is not allowed as a replacement property in a 1031 exchange. Whatever proceeds not used in the exchange will be taxed. Heirs would recieve the real estate at the then current market value (with no tax liability) after death.

Another option is to use a Deferred Sales Trust.  The pre-tax proceeds from the sale can be used to generate an income, and the taxpayer schedules what they owe, when they owe it.  There is no requirement to reinvest in real estate.

So @Kyle Kadish lets say he sells for 2M, he can put the 2M in a deferred sales trust, reinvest in something else (maybe something simple like a tax free bond) and use the proceeds from that investment to pay the taxes?  He still owes on the 2M but it scheduled.  What if something happens to him before he pays off everything?  How are heirs impacted?

Proceeds from sale are held in Deferred Sales Trust (arms' length distance from taxpayer).  Taxpayer has promissory note for proceeds on whatever terms they establish.

If sold for $2mm, and note pays 5% interest, taxpayer recieves $100k income per year, and hasnt touched principal (no capital gain).  Capital gains would be due year princioal is taken from the Trust.

The promissory note would be transferred to the heirs, and like earlier, they do not need to take principal - just use income.

@Shadonna N. , REITS are not real estate.  They are companies that own real estate.  So they do not qualify for 1031 treatment.  In a 1031 you are selling investment real estate (defined by the state you're in) and you must buy real estate (defined by the state it is in).  Except for some very exotic items like easements and maybe air and view rights, there is consistency across the states about what constitutes real estate.  

That's what I thought you would say about the seller. In that event he's really going to want to stick to passive investments - The NNN leases where the tenant manages the property and he simply collects the rent and signs the lease , and even go one step further and invest in the fractional DST and TIC properties where he doesn't even collect rent. His share comes to him every month. and the sponsor of the TIC or DST manages the lease and tenant.

There are other ways that have been and will be mentioned as alternatives to shelter tax for a while or for the long term.  But the beauty of the 1031 is that upon death the asset is given the step up in basis so the heirs inherit tax free.  I think that opportunity to leave a legacy will play well with him if he has family to think about.

@Shadonna N. Deferred Sales Trusts can last for generations. Additionally, multiple assets can be sold through the trust, i.e. sell one building today, then another next year. The property being sold is not exclusive to real estate either; others have used this strategy for a business, collectible, or shares in a partnership.

The beauty of this strategy vs a 1031 exchange is the liquiduty for the heirs. Real property does not self amortize - it is sell the whole piece or nothing. There are also work arounds that can offset the tax liabilty for the heirs (again, only created if the heirs take out the principal - which is never required).

With any strategy, the idea is to shelter pre-tax dollars after the sale. These strategies can be combined as well, i.e. $1mm via 1031 and $1mm through DST. Outcomes will be very similar, just make sure every dollar is allocated.

@Dave Foster and @Kyle Kadish thanks so much.  This is great information.  The gentleman is in his 80s and getting sick.  His kids are not interested in the properties.  Is it possible for him to sell and take the $250K tax free and move the rest into the trust?  Also, is it possible for him pay the tax liability down without taking out the principal?

@Shadonna N. There is no $250K exemption unless he is selling his primary residence.  There are plenty of ways to structure this so he doesn't pay tax and great increases his retirement cash flow.  But this may be a no win for you.  Some people just refuse to not pay taxes!

Originally posted by @Dave Foster :

@Shadonna N. There is no $250K exemption unless he is selling his primary residence.  There are plenty of ways to structure this so he doesn't pay tax and great increases his retirement cash flow.  But this may be a no win for you.  Some people just refuse to not pay taxes!

  Ha!  What a problem to have!

@Shadonna N. It might be worth your while to speak to a real estate lawyer/cpa who does this type of work all day/every day. The worst case is that you're out a few dollars for the advice but the return on the advice will probably be significant.

@Shadonna N.

Real estate capital gains are taxed at rates of 0, 15, and 20%, with depreciation recapture at 25%. This will depend on the tax payers total adjusted gross income. Making the assumption that the individual mentioned has to recapture $200,000 in depreciation, has $300,000 in non recapture capital gains, and has no other income, the total tax due would be about $83,000. The cost of trying to do a tax deferred exchange may well be at least or more the amount of taxes due. Many would consider selling their portfolio for $1,000,000 and receiving $917,000 net to be a good deal, especially if tax rates go up in the future.

It is my experience that the emotional dislike of paying taxes has clouded the judgement of many investors. I’ve seen too many bad investments made, limiting choices incurred, enjoyment postponed, and common sense abandoned, all in the pursuit of avoiding a 15 or 20% tax, which in years past would have been happily paid to avoid the 90% maximum tax rate in effect prior to 1961.

The other part of the myth goes like this: I’m an investor interested in acquiring the property of an older investor but the older investor doesn’t want to sell to me on my terms because he doesn’t want to pay the taxes that would be so. How do I structure the transaction so that he won’t pay taxes and I can buy the property on favorable terms? The answer is , despite popular believe, you don’t. Even in the rare occurrence where the seller is not familiar with a 1031 exchange, a quick meeting with a 1031 exchange expert SHOULD convince him that this method of tax deferral is oversold, over hyped, and plain disadvantageous for most small investors.

The 1031 exchange has a role in the situation where a larger size investment is to be liquidated and the investor is going to be acquiring real property anyway with the proceeds. The larger tax deferral is able to offset the exchange fees involved, make the dollar amount of immediate tax savings large enough to be worth the effort and risk, and not alter the end goal. The investor who wants out of real estate, to invest in something less active, time consuming or less risky, or to spend the proceeds on something else, does not accomplish his goals with a 1031 exchange. Altering his goals to defer taxes, when tax rates are at a 80 year low, is a foolhardy move.

Originally posted by @Don Konipol :

@Shadonna N.

Real estate capital gains are taxed at rates of 0, 15, and 20%, with depreciation recapture at 25%. This will depend on the tax payers total adjusted gross income. Making the assumption that the individual mentioned has to recapture $200,000 in depreciation, has $300,000 in non recapture capital gains, and has no other income, the total tax due would be about $83,000. The cost of trying to do a tax deferred exchange may well be at least or more the amount of taxes due. Many would consider selling their portfolio for $1,000,000 and receiving $917,000 net to be a good deal, especially if tax rates go up in the future.

It is my experience that the emotional dislike of paying taxes has clouded the judgement of many investors. I’ve seen too many bad investments made, limiting choices incurred, enjoyment postponed, and common sense abandoned, all in the pursuit of avoiding a 15 or 20% tax, which in years past would have been happily paid to avoid the 90% maximum tax rate in effect prior to 1961.

The other part of the myth goes like this: I’m an investor interested in acquiring the property of an older investor but the older investor doesn’t want to sell to me on my terms because he doesn’t want to pay the taxes that would be so. How do I structure the transaction so that he won’t pay taxes and I can buy the property on favorable terms? The answer is , despite popular believe, you don’t. Even in the rare occurrence where the seller is not familiar with a 1031 exchange, a quick meeting with a 1031 exchange expert SHOULD convince him that this method of tax deferral is oversold, over hyped, and plain disadvantageous for most small investors.

The 1031 exchange has a role in the situation where a larger size investment is to be liquidated and the investor is going to be acquiring real property anyway with the proceeds. The larger tax deferral is able to offset the exchange fees involved, make the dollar amount of immediate tax savings large enough to be worth the effort and risk, and not alter the end goal. The investor who wants out of real estate, to invest in something less active, time consuming or less risky, or to spend the proceeds on something else, does not accomplish his goals with a 1031 exchange. Altering his goals to defer taxes, when tax rates are at a 80 year low, is a foolhardy move.

excellent posts.. I have done the same thing just paid my tax's.. I did not want to be forced into something that just because I was trying to save tax and used as true cash equity on my balance sheet it enabled me to scale my business in a different direction.

but for this case were you have an elderly guy retiring.. trying to come up with complicated ( at least to him) tax schemes can be a tough sell.. I know when I was doing land and timber in the 90s this was one of our biggest obstacles..  80 YO owner bought the property in the 30s or 40s timber grew paid 20k for it then.. timber now worth a few million plus the land..   its why many of these tree farms just get handed down with the stepped up basis.. even though we cold 1031 a timber deed.. its was like talking to a brick wall  LOL 

@Shadonna N. - Another strategy similar to the DST is coupling a monetization loan with an installment sale. A DST creates a stream of income similar to an annuity. Most people prefer cash in hand. That's what the monetization loan accomplishes. You can read more here...

https://www.biggerpockets.com/forums/51/topics/569293-can-i-use-100-bonus-depreciation-as-alternative-to-1031-exchange?highlight_post=3455810&page=1#p3455810

Originally posted by @Don Konipol :

@Shadonna N.

Real estate capital gains are taxed at rates of 0, 15, and 20%, with depreciation recapture at 25%. This will depend on the tax payers total adjusted gross income. Making the assumption that the individual mentioned has to recapture $200,000 in depreciation, has $300,000 in non recapture capital gains, and has no other income, the total tax due would be about $83,000. The cost of trying to do a tax deferred exchange may well be at least or more the amount of taxes due. Many would consider selling their portfolio for $1,000,000 and receiving $917,000 net to be a good deal, especially if tax rates go up in the future.

It is my experience that the emotional dislike of paying taxes has clouded the judgement of many investors. I’ve seen too many bad investments made, limiting choices incurred, enjoyment postponed, and common sense abandoned, all in the pursuit of avoiding a 15 or 20% tax, which in years past would have been happily paid to avoid the 90% maximum tax rate in effect prior to 1961.

The other part of the myth goes like this: I’m an investor interested in acquiring the property of an older investor but the older investor doesn’t want to sell to me on my terms because he doesn’t want to pay the taxes that would be so. How do I structure the transaction so that he won’t pay taxes and I can buy the property on favorable terms? The answer is , despite popular believe, you don’t. Even in the rare occurrence where the seller is not familiar with a 1031 exchange, a quick meeting with a 1031 exchange expert SHOULD convince him that this method of tax deferral is oversold, over hyped, and plain disadvantageous for most small investors.

The 1031 exchange has a role in the situation where a larger size investment is to be liquidated and the investor is going to be acquiring real property anyway with the proceeds. The larger tax deferral is able to offset the exchange fees involved, make the dollar amount of immediate tax savings large enough to be worth the effort and risk, and not alter the end goal. The investor who wants out of real estate, to invest in something less active, time consuming or less risky, or to spend the proceeds on something else, does not accomplish his goals with a 1031 exchange. Altering his goals to defer taxes, when tax rates are at a 80 year low, is a foolhardy move.

Outstanding post Don. I couldn't agree more.

I am always stuck by how often the benefits of a 1031 are over-advertised and the limitations downplayed or ignored.

Is it a great tool to have your tool box? Absolutely, in the right situation for the right seller with the right goals. 

The minimum size threshold for its usefulness paired with the timing restrictions make it not so useful for most folks I think, compared to other tools. 

Most put the cart in front of the horse and end up rushing into a sub-par deal. Like anything, the devil is in the details and I get the feeling not a lot of folks have a firm grasp on the many difficulties that are entailed in the 1031 process. 

Stepping over dollars to pick up dimes in a lot of cases.

@Bill F. , @Don Konipol  I love the dialogue.  I certainly respect your opinions and you're both absolutely right - the 1031 is not for every transaction.  I've been doing them on my own investments for over 20 years and have to say that yes there are times when the 1031 was not the right move.  But those times were the minority.  And given that there's been an average of around 400,000 1031 exchanges accomplished every year since 1997 I wouldn't think these are all being done by short sighted tail wagging the dog kind of people.  Can I offer a bit of a counter point?

1. The $83K tax bill that was mentioned by Don - is it small in relation to a$1 mil gain? Sure.  But it also represents about $6,000 of annual income if invested at 7%.  $6000 may not seem like much but it's real money.  And if you take that $6000 out 10 years in a compounding reinvestment model over 10 years then that little bit of savings becomes $100K.  And that's how wealth is built.  What you keep is every bit as important as what you make.  

2. Of course #1 would be moot if as Don said the costs of trying the 1031 are as much as the tax savings.   But they aren't - not even close.  A 1031 of that size would cost around $1000 - $2000.  Now certainly Don was also alluding to the outcome of a bad purchase to accommodate the 1031.  That's a valid concern.  But to follow the "stepping over dollars to pick up dimes analogy.  Why would any investor intent on purchasing more real estate not be willing to spend $1000 to purchase the opportunity to save $83,000.  If they cannot find suitable replacements then let the exchange die.  You just lost $1000 and your tax plus loss is is now $84,000.  Not much of a difference is it.  And yes, we do have a few clients who do just that.  But the vast vast vast majority of folks who start exchanges find replacements that meet their investing requirements.  

3. Bill I'd actually say that the smaller the gain and the investor the more important it is to shelter as much of the profit as possible. It's not the huge contributions at the end of a working career that make your IRA look good. It's the small drips and drops over the years. The 10,000 of tax saved by a young investor now will be far more impactive on their life than the $83,000 paid by the investor above at the end of their career. Another perspective on the power of compounding.

4. Besides the "people settle on sub par replacements" deal , the other phantom fear I hear all the time is "better to pay the taxes now than when they go up".   I spose that might be true.  But since we're in an 80 year cycle of decreasing or stagnant  taxes https://bradfordtaxinstitute.com/Free_Resources/Federal-Income-Tax-Rates.aspx . and https://www.fool.com/retirement/2017/02/11/a-95-year-history-of-maximum-capital-gains-tax-rat.aspx it's a little hard to take that fear too seriously.  And if that's really then case then why the heck is my accountant and every financial advisor under the sun yelling at me to maximize my 401K and IRAs???  Because tax deferral is an incredibly powerful force that will change your life if you exercise it with discipline and consistency - particularly when you're young.

I think the situation is really more like what @Jay Hinrichs said.  Folks don't understand it.  A tool is only as good as the wielder.  Where' people falter is in not understanding the options to use it in various sectors and stages of a market.  It's a long term benefit for sure just like any other tax advantaged vehicle - from bonds to 401Ks and IRAs.

@Dave Foster , Dave, you bring up some very good points. My main points are that (1) many investors make the decision to do something that is actually detrimental to accomplishing their goals in order to defer taxes. If an investor wants to liquidate to avoid the problems associated with real estate management, a 1031exchange will not accomplish his goal. The history of 1031 is littered with failed TIC investments resulting from trying to meet 1031 requirements and passive investor requirements simultaneously. And, in many cases unraveling theTIC mess cost more than any tax savings. (2) the premise that a 1031 exchange saves taxes is not correct. It actually defers taxes. Further, the property exchanged into will have reduced current tax benefits unless the property is of significantly greater value since the depreciated basis is moved to the new property. So, paying the tax and investing in a similar property rather than 1031 exchange actually provides a higher amount of yearly tax deferral, somewhat mitigating the advantage of the "tax free" or more acturate "tax deferred" exchange. (3) The fact that most tax advisors, CPAs, retirement planners, etc. recommend something in no way leads me to believe that the thing recommended is the best move. If you look close enough, there is usually some financial incentive behind these recommendations. Even if there's not, the way our liability system works provides an incentive for professionals to recommend what everyone else is recommending, and hence not risking the liability of an outlier recommendation that happens to go south. Further, the herd instinct is in full force here. (4) my personal experience has been opposite of yours. For example my funds have averaged 12.2% return to investors since 2001. But some of our investors who wanted to invest more money into our funds didn't because they didn't want to pay taxes on the sale of real property, so they exchanged into another piece of real estate that has garnered a 6%return. Over 5, 10, or 15 years they lost much more in opportunity cost then if they paid the tax and invested in the more lucrative opportunity.

Finally, the reason small investors should be wary of 1031 exchanges are not because the absolute amount of tax savings is small; it’s because (1) the small money deals available for a 1031 exchange tend to be of a low quality and perhaps as importantly (2) the small investor might be in a lower capital gains tax bracket.  For example, if the investors only adjusted gross income for the year in question is the capital gain, then the first $78,000 of the gain is tax free, while the next $400,000 is taxed at 15%.  Say his gain is $125,000.  His tax would be about $7,000.  Should he go through the time , expense and hassle to end up with a less than ideal investment to defer an effective 5% tax rate, especially with the probability that this tax rate will be higher when the gain is realized?

@Shadonna N. The simple way to totally eliminate the tax burden would be to die with the properties and receive the full step up in basis. I would advise him to hire a full service property management company to take care of 95% of the burden of managing the properties. What he ends up paying the management company may be far less than what he would pay in taxes for selling the properties.

If he's charitably inclined there are a myriad of gifting strategies that can be used to reduce the tax burden as well as provide a stream of income.

@Don Konipol , You're absolutely right about that "danger zone" as I like to call it. The investor is ready physically and emotionally for the transition from active to passive. And has been faithful to tax deferral over the long haul so is highly monetarily incentivized to keep it going. But all of a sudden there's this brick wall. They can't let their properties just go into management, or they don't have enough horsepower for stand alone NNN. Or converting into a series of new primary residences isn't feasible. Or creating a series of vacation rentals that they get some personal use of. But they still want the end game of estate planning and tax free inheritance

So they're stuck with the 1031 compliant passive choices.  And like anything where you have to depend on someone elses expertise there's possibility for bad things.  There's always good one and bad ones.  I wouldn't necessarily say it's any more littered than than any form of passive syndication where OPM is used by someone who may or may not be actually skilled enough to produce.  But your point is well taken.  Active to passive transition is a bugger of a thing.  

Some investors when faced with that situation rightly choose to pay the tax and invest elsewhere like you suggest.  There's nothing inherently wrong with that.  And for most of these folks they've enjoyed decades of 1031 tax deferral so even though they finally pay the tax they've made a lot of money along the way using the deferred tax.  A very valid goal is to make enough profit from the deferred tax over time to pay for the tax at the end.  That's a nice zero sum equation.

Some of our investors have figured that one out and go into informal partnership with their heirs at this point.  "We need to keep the property in our name and make some or all of the income from it.  But if you choose a property you'd like to inherit we'll 1031 our holdings into it.  You manage it until we die and then you get it tax free".  

Either that or the trophy wife who's talented enough and young enough to manage actively while I play dominos and sip mojitos until I die  .  But my current wife would probably make that happen much sooner than I would wish.  So I'll keep looking for answers within the 1031 world :)

@Dave Foster excellent points that I mostly agree with. I guess the common problems I see with 1031 fall less to the instrument  and more with the user implementation. 

Granted my data set is limited to my network and what I see here on BP, so it is much smaller than yours or @Don Konipol 's. That being said, most folks I run into doing 1031's think this way: "I want to sell my 1,4,10, 25 unit and invest the proceeds in [insert asset here] but I don't want to pay taxes so I'll do a 1031". 

That mental process is bananas to me because it doesn't take into account the inherent limitations of the 1031 (that you have to buy RE) to arrive at an apples to apples comparison of returns to another non-RE asset and the person's end goals. We all know that relative return is what matters, not absolute. Folks are making money hand over fist trading futures levered 30:1, but I don't play in that space, so I have to be content with the returns of assets available to me.

For argument's sake, lets say I have a choice between 1031ing one of my MHPs into a NNN building yielding 7% and Don's fund yielding 12%. At a high level (and ignoring the details that come along with syndications), I have three options to consider. The the risk adjusted yield of 1031-ing into the NNN, the risk adjusted yield of trying to 1031 into the NNN, failing, but still having to eat the fees before I invest with Don, and the risk adjust yield of investing with Don off the bat. If the yield of the 1031'ed NNN is higher than Don's fund I have to decided if the risk premium is worth the increased work that comes along with active ownership while also paying respect to the probability of a worst case yield of investing with Don after having to pay a tax bill and 1031 fees.

That is what I meant by putting the cart before the horse. 

Make investing decisions based on a tax bill is foolish, but that is what I have seen a lot of people do.

So maybe the issues I see with 1031s are simply a symptom of people having sub optimal decision making paradigms.

All of these comments by all participants are correct.  How can this be?  Well, what’s the correct decision depends on the individual, his or her goals, risk tolerance, time availability, managerial expertise, etc.  when professionally approached and analyzed like @Dave Foster does, the 1031 becomes a powerful tool to accelerate wealth accumulation.  When blindly utilized by someone because they hate paying taxes, the consequences can be significantly less satisfactory, for the reasons I already outlined.  @Bill F. wisely points out that without the proper analysis, you can’t expect a optimum, or even a satisfactory result, because you may be doing the wrong thing for yourself.

A main takeaway, is that like it or not taxes play a major factor in reducing our net returns.  Real estate investing gets A LOT more complicated when you have some success than when you’re just starting out.  That’s why for many of us, investing is a full time job (and one which we love!).

This guy purchased the properties in pre-grentrified DC in the 40's or 50's for like 40K.  No loans, no refi, none of that fancy stuff.  He has kept them up but no major renovations.  Maybe new heat, new hot water tanks.   He has sold other buildings that investors have converted to condos.  I don't think he has an emotional hold on the properties.  He probably wants to get of them before anything happens to avoid conflict among family members.  He is definitely tired of tenants.  Introducing him to a buttoned up financial guy may be too much.  Just trying to provide him an overview of options.   I have no skin in this but he complains about what he pays in taxes and I hate to see it.

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