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.
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).
Two 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 and M453 Installment Sales
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 a strategy like a “monetized installment sale” (M453) previously referred to as a “collateralized” or C453 installment sale.
This option is based on the installment sale rules contained in Section 453 of the Internal Revenue Code. This offers you options 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, it also offers you a great estate planning tool. This is because of the discount that an estate receives for something called ‘lack of marketability.’
Monetized Installment Sale (formerly Collateralized Installment Sale)
Another variation on the standard installment agreement is a monetized installment sale previously called a ‘Collateralized Installment Sale Agreement’ and sometimes referred to as a C453 installment sale. This strategy has a longer track record.
There are two distinct transactions as part of this strategy. The seller agrees to sell the property or a business to a dealer who resells the property to a final buyer using the original terms. Separately, the seller receives a limited-recourse loan from a lender typically equal to 95% of the resale proceeds. The seller can then take the non-taxable loan proceeds and reinvest however he sees fit. Proceeds can be used to pay off debt, invest in another business or property or in securities without the limitations of a 1031 Exchange. The dealer receives cash from the final buyer in a lump sum or through a lump sum plus one or more installments which offloads the risk of an installment sale onto the dealer. The lender’s loan to the original seller is repaid by automatic payments from the money that the dealer pays to the seller on the installment contract.
Unlike a 1031 Exchange, these installment sale variations can be used for the sale of more than just real estate. It can be used to handle the sale of an interest in an operating business as well offering more flexibility to an investor.
Ultimately, this strategy allows a seller to defer taxes while investing the proceeds today to generate replacement income and cash flow (or to use however the owner deems fit). Clients win by deferring taxation of gains and by having full control of the wealth unlocked from the sale of the highly appreciated asset. In the case of a monetized installment sale (or C453 sale), the client has full control of non-taxable loan proceeds. Clients also win by having more flexibility to invest in other property, businesses or securities that may produce higher income over time than the business or real estate being relinquished. As the saying goes, a bird in the hand is worth more than a bird in the bush and with these strategies investors have more in hand to invest.
You can read more about this and watch a video that helps explain the concept here.
Next Steps for Sellers
A monetized installment sale can be an effective way to defer taxes, but typically requires a professional tax advisor’s assistance. To learn more about setting up this strategy and how it 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.