Tax Wealth Network, service of Boston Tax Planners

How to Legally Avoid Taxes When Selling Investment Real Estate

2020-08-04

Over the nearly thirty years of practice in financial planning and banking, I have been approached by many clients seeking to avoid paying taxes on highly appreciated real estate investments. There are a few options available to investors and some are better than others. It all depends on the facts presented and the goals of the client. In other posts, I’ve spoken about some alternative strategies. Now, I’ll focus on one of those options. Here’s how to legally avoid paying taxes when selling investment real estate. [By the way, this strategy may be used when selling highly appreciated businesses, stock portfolios, and other assets, not only real estate.]

There are several options including 1031 Exchanges, Installment Sales, newer options like Opportunity Zone bonds, and various trusts. Here, we’ll focus on one trust strategy: Charitable Remainder Unitrust (CRUT) as described in the Internal Revenue Code Section 644.

While 1031 Exchanges are a good way to defer taxes, they do not offer the opportunity to get out of real estate entirely. It is a “replacement” strategy with a way to defer taxes. But deferral is not avoidance and you still end up owning real estate even if you’re trying to get out of the business of dealing with toilets, tenants, and trash. Other options provide the ability to get out of real estate and even avoid paying taxes.

CRUT Strategy

Not all CRUTs are created equal. There are six players in the CRUT strategy: the donor, the trustee, the income beneficiary, the remainder beneficiary, the trust administrator, and the investment manager.

An Example of the CRUT in Action

Let’s use the example of a $1,000,000 piece of property with a basis of only $100,000. The potential tax the client is facing is about $300,000 by the time he factors in federal and state capital gains taxes leaving him only $700,000 to invest.

First, the Donor. If the property is owned individually or jointly there is no problem. In cases where it was owned by different family members and with larger dollars, then you’ll use different CRUTs or make gifts of an undivided interest.

Second, the Trustee. The Trustee could be any charity or university or non-profit and all are eager to fulfill that role. Here is a crucial “no-no.” Never go this route because all control will be lost. The IRS has no problem with a self-trusteed CRUT as long as you cross the “t”s and dot the “i”s properly. It’s easier to make the Trustee the client and his wife jointly. Later, as years go on, the ability to have either sign makes an adviser’s life easier. But you could have the spouse be successor Trustee if you wanted.

Third, the Income Beneficiary. This should be the husband and the wife. The period of the CRUT can be a number of years or a single life or joint lives. The best practice is to use “lives” so the CRUT will continue paying income for the life of his wife even if the donor dies soon after the gift. So, now the owner of the property has given the property to himself as Trustee, and instructed the Trustee (he and his wife) to pay an income stream to the Income Beneficiary (he and his wife) until the last one dies. Also, since the CRUT is legally a split-interest trust paying income to a human and the principal to a charity, the Trustee (himself) can sell the $1,000,000 property to the buyer totally tax-free. The CRUT functions like any church or university as the seller.

Fourth,the Remainder Beneficiary. This can be any non-profit found on the IRS list. It can be multiple charities. But here again, is a “no-no” to watch out for. When the Donor creates the Trust document, he should never make the Beneficiary irrevocable. Instead, the donor should always give the Trustee the power to change the Beneficiary from one charity to another. Personally, I prefer to even make the Remainder Beneficiary a Donor Advised Fund which we call a Perpetual Family Foundation to be advised by his children, grandchildren, and future heirs making gifts to all the non-profits the Donor had in his heart.

Fifth, the Administrator. It may seem to be too good to be true. We have a way to sell his real estate 100% tax free by giving it to himself as Trustee and instructing himself to choose whatever investments to diversify he wants and the pay himself an income stream for life. Then even after his death, he is leaving it to a so-called “Family Foundation” to be administered on behalf of his family by his children and grandchildren. Again, the IRS has no problem with the self-trusteed CRUT as long as you continue to cross the “t”s and dot the “i”s prudently. So, the Trustee is given instruction/power to hire an independent Administrator to report all transactions and produce the tax return. Of course, make sure your Trustee has the power to also change administrators if needed.

Sixth, and last, is the Investment Manager. This can be any Registered Investment Adviser like Clear View Wealth Advisors, LLC. But the Trust document gives the Trustee the power to fire and replace the Investement Manager. Now, the $1,000,000 property was sold and the $1,000,000 is in cash in the CRUT Money Market fund. A fiduciary investment adviser, like Clear View Wealth Advisors, can make suitable recommendations for this portfolio. Maybe the $1,000,000 is invested in 6 or 7 conservative mutual funds, or maybe 7 mutual funds and a non-traded income producing REIT. Or perhaps one of the MarketFlex Model Portfolios of Exchange Traded Funds and Dividend-Paying Stocks that Clear View Wealth Advisors oversees. This is an effective strategy for many different investors and situations from as small as $500,000 to as large as $30,000,000.

But the keys takeaways for clients are these:

Clients Get 100% Tax Avoidance,
Clients Get More Safety of Investments Through Diversification, and
Clients Never Give Up Any Control.

This is how to legally avoid taxes when selling investment real estate or any other highly appreciated asset through proper use of a CRUT trust strategy.

To discuss how a CRUT strategy may fit into your plans, call the fiduciary advisers at Clear View Wealth Advisors, LLC at 617-398-7494.

Ways to Avoid Capital Gains Taxes on Sale of Rental Property

2018-02-25

There may come a time when you want to sell your rental property. After putting in all the time dealing with toilets, tenants, and trash, you’re looking to cash in and relax. But there’s one problem: Taxes. Despite common wisdom, you may be able to avoid them. While death is inevitable, there actually are two ways to avoid capital gains taxes on the sale of rental property.

Meet Wayne and Marcia

Let’s meet Wayne and Marcia. Back in the 1980s shortly after getting married, they decided to buy a place of their own to raise a family. Prices were rising as were interest rates. The $60,000 they paid for a four bedroom home seemed like a lot but they figured they could manage it. For several years they lived in the home raising their three children. Eventually, they decided they needed more space so they bought a new home and decided to rent out their first one. Interest rates had dropped so they refinanced a few times. The neighborhood was near good schools and in demand. The cash flow from the rent was steady.

Now with the kids grown and out of the house, Wayne is getting tired of spending weekends fixing up the property. And the kids are looking to buy their own piece of the American Dream. Both Wayne and Marcia want to help them out.

What’s Next?

When they arrived in their advisor’s office, they wanted to know how they could best sell the rental property now and split the profits between their children so that they could have money for down payments.

Wayne, as a resourceful guy, had done some research that started his mind to thinking of options. He came across IRS Publication 523 that discusses taxes and selling your property. He figured that he could add one or more of their kids to the rental property’s title. Perhaps one or more of the adult children could even live in the property and make it their primary residence.

But he was fuzzy on the details and had some questions that he asked:

If One of the Kids is Added to the Title and Lives in the Property for Two Years, Will the Sale of the House Be Exempt From Capital Gains Taxes?
Does the Adult Child Need to Own the Property for at Least Five Years and Live in the Property for Two Years to Exempt the Sale From Capital Gains Taxes?
Wayne and Marcia Are Still on the Title of the Property. Do They Have to Make the Property Their Primary Residence?

Picking Apart Wayne’s Plan

As an owner of investment real estate, you’ve decided to sell. But unlocking the value and turning it into cash can also result in a large tax bill especially if your asset has appreciated since your initial investment back in the 1980s.

First things first: Since Wayne and Marcia no longer occupy the property as their primary residence, they cannot use the Section 121 exemption of $500,000 over basis (married filing jointly) to shield themselves from a capital gain tax liability.

Second, he is correct that he could add someone to the title and that person would need to occupy as his primary residence for two of the last five years. But, no, he wouldn’t need to live there for five years to take advantage of the Section 121 exclusion.

Third, if they choose not to live in the property while their son does, they each must apply Section 121 individually. If they and a joint owner other than a spouse sell a jointly owned home, each of the co-owners must figure their own gain or loss according to their ownership interest in the home. Each applies the rules on Section 121 found in IRS Publication 523 on an individual basis. So, unless they move back into the property for at least two years out of the past five, then Wayne won’t be sheltering any of the gain for his portion of the property.

Now, you may think it’s hopeless and you should just pay the tax. While that is an option there are innovative strategies available to you if you want to lower your income tax bill when you sell and investment property (or business for that matter).

Ways to Avoid Capital Gains Taxes on Sale of Rental Property

The first way to avoid capital gains is to not sell the property but die. Why? Because when you die, those who inherit your property get a “step up in basis”. Instead of inheriting the property at the $60,000 that they originally paid back in the 1980s, the children would inherit at current market value. Let’s say that is $600,000. If they decide to sell the property that they inherit for $600,000, they will pay no taxes on the sale.

Great news. But you first have to die for this to happen.

So, what better ways are there to sell now and avoid capital gains taxes? And are there any ways to free up cash that can be used now for investment in other properties or even stocks?

Typically, when a business or real estate owner sells they will need to deal with capital gains tax, state taxes, depreciation recapture and, in some cases, the alternative minimum tax. But through savvy tax and estate planning, you can take advantage of opportunities in the tax code to minimize your current tax liability while allowing you the flexibility to control the sale proceeds.

1031 Exchanges, Installment Sales, or Trusts

Real estate investors can use a 1031 Exchange, a provision of the Internal Revenue Code which allows an owner to relinquish property and replace it with a similar type of asset without recognizing gain and deferring taxes.

While a 1031 Exchange offers tax deferral, it is ONLY a replacement option. You must replace income-producing property with other income-producing property but you may not receive cash upon the sale without paying tax on the gain. You can keep selling and exchanging property into other properties for as long as you live. Eventually when you die, your estate will inherit the last property at a stepped-up basis and then they can sell and not pay any capital gains taxes. See above.

Other options offer even more flexibility to sell highly appreciated assets like stock in a privately-held business or ownership of residential rental or commercial real estate while also controlling use of the cash that is freed up from the sale. These include strategies like a Opportunity Zone Fund investing or a type of irrevocable trust or a “structured installment sale.” (NOTE: A previous option known as a “monetized”” or “collateralized” installment sale is no longer a valid option for non-agricultural property after IRS guidance released in mid-2021).

In a structured installment sale, cash is directed to a trust that buys US Treasury bonds and in turn pays out interest to the original buyer. Since the bonds are of high quality with low risk of default, the payout may be low. A variation on this might be to have the trust also hold higher-yielding Treasury inflation-protected securities (aka TIPs) to mitigate inflation risk. The payout to the initial seller is over time and only a portion of capital gains is paid out and subject to tax with each installment.

Opportunity Zone Funds were created as part of the federal tax overhaul package for 2018. By investing in real estate projects sponsored in select zones, the taxpayer will defer taxes. And if the investment is held in the fund for a certain period of time, then the taxes on the capital gains from the original transaction that generated all the proceeds used for the OZ Fund investment will be waived.

By using a certain type of irrevocable trust, you may be able to defer taxes while increasing the amount of cash proceeds for investment. This option requires the use of a specialized network of tax attorneys, trustees, and investment advisers. But the costs may provide an investor with greater flexibility on types of investments while significantly reducing taxes on the sale of any type of assets (not just real estate).

The Opportunity Zone and irrevocable trust options offer you a chance to salvage a failed 1031 Exchange which can occur if a seller of a property cannot locate a suitable replacement property or a closing fails to occur within the 180 days required by law. In addition to deferring taxes while freeing up cash that can be used today, they may also offer you a great estate planning tool. This is because of the discount that an estate receives for something called ‘lack of marketability.’

Next Steps for Sellers

Any one of these strategies may be an effective way to defer taxes, but typically requires a professional tax advisor’s assistance. To learn more about setting up one or more of these strategies and how they may fit into your broader financial, estate and tax plan, contact Steve Stanganelli, CFP® at Clear View Wealth Advisors /Boston Tax Planners at 617-398-7494 or steve@ClearViewWealthAdvisors.com.

8 Ways to Minimize Your Taxes

2017-02-04

It’s tax time again. While taxes are the price for a civilized society, there’s nothing in the law that says you can’t lower your own tax bill. So at this time of year, I do get questions about taxes. Most folks are looking for ways to minimize taxes. Here are 8 ways to minimize taxes. You may find one or two that work for you.

You can minimize tax liability in more ways than can be counted here. You are limited only by your imagination, the creativity of your professional team and your willingness to go right up to whatever lines the IRS has.

Tax Minimization versus Tax Evasion

As noted once in a US Supreme Court opinion, tax avoidance is not illegal. Tax evasion is. Being on the right side of the line is key. There are lots of legal ways to minimize your taxes.

For some who have deep pockets and can afford to hire teams of high-priced tax attorneys and accountants, the number of creative ways found to avoid taxes can almost be limitless. But like investing, these kinds of options also come with high risks if the IRS deems the strategies to be illegal or abusive.

For most people without an entourage of professionals, there are still some conventional ways to minimize your tax liability.

Options for Self-Employed or Rental Property Owners

The best options usually involve being self-employed or owning rental real estate. For these folks there is the opportunity to use depreciation, a calculated non-cash expense, to lower one’s taxable profits from a business or rental property. Likewise, you can find ways to legally shift income.

One way is to hire family members like a spouse or minor children which shifts net profit from your tax bracket to someone who may be in a no-tax bracket. This works especially well if you help the minor child use his income to fund a Roth IRA which gives him a head start on retirement savings and is a neat way to save for college, too.

Another option is to supplement medical expenses through a Medical Expense Reimbursement Plan (MERP) sponsored by your enterprise. Let’s face it. You were going to incur and pay those expenses anyway but through these methods you can now get a legal tax subsidy.

Ways to Minimize Taxes When Receiving a W2

For those who are W2 earners, the best options relate to employer-sponsored benefits. Take advantage of any benefit that shifts income to a tax-deferred vehicle. These include employer-sponsored retirement plans, flexible spending accounts for health or dependent care.

If you don’t work outside the home but you have a spouse who does, then be sure to fund your own IRA to the max. This will help your own retirement but also reduce your current year taxable income.

Investing Strategies that Lower Taxes

If you have deeper financial pockets, you can consider investing in municipal bonds which produce tax-exempt income or in partnerships like oil and gas exploration which produce depreciation and losses that can be used to offset your other income.

Lower Taxes in Retirement: Think Roth IRA

While lowering taxes in the current year are what most people are now asking about, it’s also advisable to plan ahead for taxes in retirement. As you put aside money in your IRAs and company 401(k)s, you’re lowering your current tax bill. But you’ll find that Uncle Sam will be waiting to take his toll when you start taking distributions in retirement.

One way to lower your future tax bill will be diversifying where your retirement money is held. By funding or converting other IRA funds to a Roth IRA, you’ll have the option to withdraw funds tax-free in retirement or allow them to continue to grow because you won’t have to take a minimum distribution from these accounts.

Because of income threshold limits, you may not directly qualify for opening or funding a Roth IRA. But with a little bit of help, you can navigate the rules to fund a ‘backdoor Roth IRA’ which will save you money on taxes in retirement.

Next Steps

To really figure out your best options, you should have a plan. So, you should reach out to a qualified financial professional who knows how to integrate tax planning for your personal situation.