ALEX OWNS A COUPLE OF INCOME properties in trendy Venice. He bought them way back, in undesirable days, for $75,000 apiece. Each property is now worth $950,000 or more. Alex is 61 years old. He thinks about selling off some of his holdings and traveling. But he has questions. He needs to know what his tax obligations are once he sells a property?
Should Alex decide to pay capital gains tax, and pocket the rest of the gain, the terms have become more desirable. For property sales transactions which conclude between May 6, 2003, and Dec. 31, 2008, the capital gains tax rate has been reduced from 20 percent to 15 percent. For taxpayers in the lower brackets of 10 percent or 15 percent, the tax will only be 5 percent of the gain.
As for what to do with your money, you have a number of options. Before taking any action, be sure to consult your financial advisor. Benny Kass, senior partner with the Washington, D.C. law firm of Kass, Mitek & Kass, PLLC and a specialist in real estate observed that property options can include: 1) Sell and pay the tax: Assume Alex has depreciated the property by $30,000 over the years. His basis in the property will be $45,000 ($75,000 — $30,000). If he were to sell the property for $1 million, he will have made a profit of $955,000 ($1 million — $45,000). This does not take into account other costs and expenses which may reduce his gain — fix-up costs, closing fees and real estate commissions. For federal tax purposes, Alex will owe Uncle Sam $143,250 (at the 15 percent rate), not including state taxes and other prizes. Any remaining mortgage fees will have to be paid off at settlement. 2) Do a Like Kind exchange: Under section 1031 of the Internal Revenue Code, Alex 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.
“If you want to learn how to build your real estate investment wealth without owing capital gains tax as you do so, the secret is tax-deferred exchanges, as authorized by Internal Revenue Code 1031,” confirms noted real estate columnist Bob Bruss. “The simple tax rule for avoiding capital gain tax when disposing of a rental or investment property is that the investor must trade ‘equal or up’ in both price and equity for one or more qualifying “like-kind” properties.”
There are specific 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, and the sale must close within 180 days. 3) Installment Sale: Alex 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, one pays a portion of the capital gains tax as the moneys come in each year. 4) Donate the property to a charity: FYI, there are restrictions and limitations on such donations which Alex should fully understand before deciding to go this route. 5) If the property is worth keeping in the family, Alex can sell it to a family member and carry back the financing. Let’s say Alex sells the property for $1 million to his children and agrees to carry back the entire purchase price. His lucky kids sign a promissory note in the amount of $1 million — there will be a deed of trust (mortgage) on the property in this amount. If Alex is married, he and his wife can each gift back $11,000 to each child per year, tax free — that’s $44,000 of the balance of the note each year. Thus, in the first year, the note balance will be reduced down to $956,000 ($1 million — $44,000), and so on each year for the next 22.7 years.
There are a number of ways in which you can sell your rental properties. Speak with your financial advisors before making any final decisions.
JODI SUMMERS negotiates investment properties for Sotheby’s International Realty. She Jodi Summers at or (310) 260-8269. Visit her Web sites at http://www.SoCalInvestmentRealEstate.com and http://www.santamonicalandmarks.com.
Originally published in the Santa Monica Daily Press print edition on February 14, 2007. Read the original PDF.