By Jodi Summers

Bob calls the Gold Coast in Orange County home, but he’s got a couple of rental houses in North Beach, Venice. Back when Bob bought these single-family homes, the alleys were littered with drug addicts. Now it’s a delightful pocket neighborhood on the Venice/Santa Monica border where some properties have recently broken the $1 million mark. Bob is thinking of selling off his Venice properties but is not sure whether to cash out on his houses or reinvest the money in something with fewer management headaches. As he figures out what to do with his money, he ponders his taxable consequences. Are there ways of avoiding or deferring his tax obligations?

In many jurisdictions throughout the world, including the United States and the United Kingdom, a capital gains tax is charged on the profit realized on the sale of an asset that was previously purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property.

The tax rate on long-term gains (assets held more than year) was reduced in 2003 to 15 percent, or to 5 percent for individuals in the lowest two income tax brackets. Short-term capital gains are taxed the ordinary income tax rate. In 2013, these reduced tax rates will “sunset,” or revert back to the rates in effect before 2003, which were generally 20 percent.

Statistics show that only 7 percent of all taxpayers report capital gains in any given year, and over two-thirds of the gains reported went to people making more than $100,000 a year. Most Americans own capital assets — like homes or businesses — but they sell them only a few times in their lives.

As for what to do with your money when you exercise your capital gains option, you have a number of choices. Before taking any action, be sure to consult your financial advisor. Benny Kass, senior partner with the Washington, DC, law firm of Kass, Mitek & Kass PLLC and a specialist in real estate, said that property options can include:

1. Sell and pay the tax: Assume Bob paid $250,000 for his Venice two-bedroom, one bath unit, and has depreciated the property by $50,000 over the years. His basis in the property will be $200,000 ($250,000 - $50,000). If he were to sell the property for $800,000, he will have made a profit of $600,000 ($800,000 - $200,000). This does not take into account other costs and expenses that may reduce his gain — fix-up costs, closing fees and real estate commissions. For federal tax purposes, Bob will owe Uncle Sam $90,000 in capital gains tax — at the 15 percent rate — not including state taxes and other prizes.

When Bob’s done with the federal government, his bottom line — excluding state taxes and other expenses — will be approximately $510,000 in gross sales proceeds. Any remaining mortgage fees will have to be paid off at settlement.

Almost everything you own and use for personal purposes, pleasure or investment is a capital asset. The IRS says when you sell a capital asset, such as stocks, the difference between the amount you sell it for and your cost basis — the original purchase price, adjusted for various things including additional improvements or investments, taxes paid on dividends, certain fees and depreciation — is a capital gain or a capital loss. While you must report all capital gains, you may deduct only your capital losses on investment property, not personal property.

2. Do a Like Kind exchange: Under section 1031 of the Internal Revenue Code, Bob can exchange his property for another piece of property that will be equal to or more expensive than his current property, deferring his capital gains tax obligation along the way. Bob can purchase a replacement property for $600,000 or greater. However, since this is an exchange, his tax basis will be the basis of the relinquished property, i.e. $200,000.

There are strict rules applicable to 1031 exchanges. Net sales proceeds must be held by a neutral intermediary. Replacement properties must be identified within 45 days after the sale of the relinquished property. The title needs to be taken to the replacement property within 180 days after the sale of the relinquished property. 1031 exchanges are only if you want to continue on as a landlord and keep that income stream running in.

3. Installment sale: Bob can defer — but not avoid — paying capital gains tax if he sells the property and carries back a mortgage. This is known as an “installment sale.” Under this arrangement, you pay a portion of the capital gains tax as the moneys come in each year.

4. Donate the property to a charity: There are restrictions and limitations on such donations that Bob should fully understand before he decides to go this route.

5. Sell the property to a family member: Is the property worth keeping in the family? Bob can sell it to a family member and carry back the financing. If he is concerned about estate tax issues, he can gift up to $11,000 per person per year on the outstanding balance of the money he is owed by his family on his property.

In layman’s terms, Bob sells the property for $800,000 to his children, and agrees to carry back all of the purchase price. His lucky kids sign a promissory note in the amount of $800,000 — there will be a deed of trust (mortgage) on the property in this amount. If Bob’s two children now own the property and if Bob is married, he and his wife can gift back — tax free — $44,000 of the balance of the note each and every year. Thus, in the first year, the note balance will be reduced down to $656,000 ($800,000 - $44,000), and so on each and every year.

There are a number of ways in which you can dispose of your rental property. But talk with your family and your financial advisors before making any final decisions.

(Jodi Summers is director of the investment division at Boardwalk Realty Santa Monica. Contact her at jodis@boardwalkrealty.com, or call 310-309-4219. Visit her community history Web site at www.santamonicalandmarks.com.)