How to Prevent a Tax Hit When Selling a Rental Property

1) Take Advantage of Section 1031 of the Tax Code

What It Is: IRS Section 1031 “Like-kind” Exchange

Who It’s For: Anyone can reinvest the proceeds of selling investment real estate (i.e.rental property) in new real estate

What You Get: The ability to defer some or all taxes on the capital gain

Real estate investors who aren’t aiming to cash out can put off paying capital gains taxes thanks to Section 1031 of the tax code. A Section 1031 exchange lets you sell your rental property, purchase a “like-kind” property and defer paying taxes at the time the exchange is made. You can execute 1031 exchanges as many times as you want, but when you eventually take a profit, taxes will be due. Before passage of the Tax Cuts and Jobs Act of 2017 your Section 1031 exchange could even involve certain types of personal property. Under the new law the exchange must involve real estate.

The simplest way to defer taxes is to swap one property for another. A more complicated strategy called a deferred exchange lets you sell a property and then acquire one or more other like-kind replacement properties. The term “like-kind” has a very broad meaning. You don’t have to swap one condo for another or one business for another. The main stipulation with property is that it must be for rental purposes and must have generated income. Your personal home, vacation home or other property do not count.

Timing is important. You have 45 days from the date of the sale to identity potential replacement properties and you must close on the replacement property within 180 days. If your tax return is due before that 180-day period, you must close sooner. Miss the deadlines and you will have to pay taxes on the sale of the original rental property.

2)Potentially Defer & Reduce Capital Gains Taxes by Investing in Opportunity Zones

The Tax Cuts and Jobs Act of 2017 created a new method of deferring taxes on capital gains. More versatile and robust than a traditional 1031 exchange, investments in Opportunity Funds can defer and reduce short- and long-term capital gains taxes generated by ALL types of investments, not just real estate.

Here’s how it works. Investors can invest cash equal to any capital gains realized in the previous 180 days with Qualified Opportunity Funds. Qualified Opportunity Funds invest in real estate or businesses within designated Opportunity Zones. The zones are census tracts that contain commercial, industrial, and residential areas within each of the 50 states and Puerto Rico.

With Section 1031 exchanges, investors have to roll over their entire investment basis into a new property, or they are taxed on the “boot.” With Opportunity Funds, you can retain your entire basis and defer taxes as long as you invest your capital gains. It is only capital gains that need to be invested into Opportunity Funds to defer and potentially reduce taxes. Investments held through Opportunity Funds enjoy a tax deferral until December 31, 2026, or the date of a sale, whichever is earlier. The original capital gains tax is reduced by 10% after 5 years, and by 15% after 7 years. After 10 years, investors pay no capital gains on the new investment’s increased value.

Furthermore, Opportunity Fund investors may combine these tax breaks with newly modified expensing and depreciation rules to create passive losses that can be used to offset other income.

Learn more about the potential tax benefits of investing in Opportunity Zones by downloading our white paper.

3) Deferred Sales Trust

If you are considering the sale of a business, corporation, or investment real estate, you may face capital gains taxes associated with the sale. For the investor who does not want to continue holding investment property or remain in the same business, a Deferred Sales Trust should be considered. According to section 453 of the Internal Revenue Code, the Deferred Sales Trust provides investors a solution whereby they can defer capital gains upon sale of their assets and redirect the sale proceeds into cash or whichever types of investments suit their needs, income requirements, and objectives.

What is a Deferred Sales Trust?

The Deferred Sales Trust is a legal contract between you and a third-party trust in which you sell real or personal property or a business to the Deferred Sales Trust in exchange for the Deferred Sales Trust's contractual promise to pay you a certain amount over a predetermined future period of time in the form of an installment sale note or promissory note. It is often referred to as a "self-directed note" because you have control over the terms of the note. The Deferred Sales Trust gives you the ability to control your capital gains tax exposure, reinvestment terms, and installment payments made from the trust.

How Does a Deferred Sales Trust Work?

The process begins when a property or business owner transfers his asset to a trust managed by a third-party company on his behalf. The third-party company acts as trustee over the asset, and the owner is the beneficiary of the trust that holds the asset. The trust will sell the asset for the owner and manage and distribute the sales proceeds of the trust according to an agreed-upon installment contract that the owner sets up ahead of time with the trust. The sales proceeds can be held in cash, reinvested, and distributed according to the direction of the owner's installment contract. There are zero taxes to the trust on the sale, since the trust purchases the property from the owner for the same price for which it is sold.

The tax code does not require payment of any of the capital gains taxes until an investor starts receiving installment payments that include principal. The owner then is able to control if, when, and how there will be capital gains tax exposure over the installment contract period by adjusting the installment contract. The installment contract between the owner and the trust company provides flexible options on when and how payments can be made. Initially, the owner may have other income and may not need the installment payments right away, which would defer income and capital gains taxes. If an owner wants income but does not want to pay capital gains taxes, he can set up the installment contract to pay interest-only payments from the reinvested sales proceeds. According to IRC section 453, this strategy can defer the capital gains tax indefinitely.

Guidelines for the Deferred Sales Trust to Qualify

In order for a Deferred Sales Trust to qualify for capital gains tax deferral, it must be considered a bona fide, third- party trust with a legitimate, third-party trustee.

Independent Trustee: The Deferred Sales Trust must employ a trustee that is truly independent from the owner/beneficiary of the trust. If there is not real trustee independence from the owner, the IRS considers this to be a sham trust, set up for the sole purpose of creating layers of legal documents to avoid taxation. The independent trustee is responsible for managing the trust according to the laws that govern trusts, according to the installment contract, and according to the investor's risk tolerance and investment objectives.

Asset Transfer: In order for the Deferred Sales Trust to shield the owner from capital gains taxes, the owner must not take constructive receipt of any sales proceeds from the disposition of an asset. The trust created on behalf of the investor must take legal title to sale proceeds directly from the disposition of an asset or from a third-party qualified intermediary that is holding the sale proceeds on behalf of the investor in order to qualify for capital gains tax deferral.

Asset Ownership: Asset ownership must be legitimately transferred to the trust prior to a sale for the sale proceeds to be sheltered from capital gains tax. If the owner did not transfer practical ownership over to the trust and still retains all of the benefits of direct ownership, the IRS disallows the owner from enjoying the tax-advantaged benefits afforded by the trust's ownership. In other words, the property must be legitimately transferred to the trust or it will be taxed as if it were not.

Assets Must Remain in Estate: The owner cannot use the trust to transfer any economic interest to a third party without due compensation. The IRS does not allow this type of transaction because it allows people to pass assets out of their estate without bearing capital gains, gift, income, or estate taxes.

Trust Restrictions and Law: The owner/beneficiary of the trust must be subject to the restrictions imposed by a trust agreement or the law as it applies to trusts and transferred assets. If the owner enjoys unrestricted use and control over the assets of the trust without fiduciary limitations, the IRS considers this to be a sham trust that does not qualify for capital gains tax deferral. Failed

Exchange Rescue Hammer

One of the most unique benefits of the Deferred Sales Trust is its ability to rescue an investor from capital gains taxes in the event of a failed 1031 or 721 exchange. In the case of a 1031 or 721 transaction, the investor's sale proceeds from the disposition of an asset go to a qualified intermediary (QI). The QI holds these proceeds on behalf of the investor in order to close on a replacement property to complete the investor's tax-deferred exchange. Should the exchange fail, whereby the funds cannot be reinvested into a property according to IRS guidelines, the funds held at the QI are subject to capital gains and depreciation recapture taxes once released from the QI to the investor.

The Deferred Sales Trust provides a ready solution to this problem by allowing the funds to revert to a trust rather than to the investor. The investor is saved from taking constructive receipt of the funds and bearing the capital gains and depreciation recapture taxes. The investor can tailor his investment contract with the trustee to pay him his funds in a manner that will effectively defer taxes over the installment contract.

Other Considerations

Depreciation Shelter: Some types of depreciation recapture may be deferred, but any excess accelerated depreciation over the straight-line depreciation method cannot be deferred. Fees for setting up a deferred sales trust may be higher than those of as a 1031 exchange.

Trust Legitimacy: If a deferred sales trust is improperly managed and the IRS chooses to investigate, it is possible that the trust could be designated as a "sham trust." If a trust is labeled a sham by the IRS, the income from the initial sale is taxed as though the trust did not exist. Therefore, it is very important that Deferred Sales Trusts are established and operated according to IRS guidelines and trust law.