INSTALLMENT SALES TAX DEFERRED EXCHANGE
CHARITABLE REMAINDER TRUST
INSTALLMENT SALES
The benefit of an installment sell is that the seller only pays tax on the installment note when the principal is collected. In an installment sale, the seller receives a down payment and a promissory note from the buyer. The interest rate and term on the note are negotiable. In this way, with an installment note, the seller receives interest on the full amount of the note, whereas in an all cash sale, the seller must pay taxes and is only able to reinvest the amount received, reduced by the capital gains tax paid. In addition, the interest rate that can be charged on a promissory note is usually greater than the interest rate that can be earned on any other type of interest-bearing investment.
An example follows: A husband and wife purchased an apartment building in 1965 for $50,000. In 1996 they receive two offers to sell that apartment for $600,000. One is an all cash offer and the other is an offer for 20% down and a note for the balance of $480,000 at 9% interest only for 10 years.
If they sell for all cash, the couple will have capital gains tax of $200,000. They will be able to invest the remaining $400,000. Assuming they invest in 10 year US Treasury notes, they would earn 6% interest, or $24,000 per year.
If the couple accepts the offer for 20% down and an installment note for $480,000, they would only pay tax on the down payment. The tax would be approximately $40,000. They could then invest the remaining amount of the down payment of $80,000 at 6% and earn $4,800 per year. In addition, they would receive interest on their installment note of $43,200. Their total annual interest would be $48,000, In this not an uncommon scenario, the couple would double their annual earnings by taking the offer with the installment note.
Of course, US Treasury notes are typically considered to be less risky than a real estate mortgage. However, the seller of real property is frequently quite comfortable with the security. The seller has frequently owned and managed the property for many years and is aware of its true value. As long as an adequate down payment is received, sellers often feel comfortable with an installment note.
TAX DEFERRED EXCHANGE (SEC. 1031)
Tax deferred exchanges, commonly referred to as 1031 exchanges, are my favorite way of deferring tax on the sale of real estate. The benefits of a 1031 exchange is that all of that tax that would ordinarily be due upon sale can be deferred indefinitely. (In fact, if the replacement property is held by the owner until death, the tax is permanently avoided.) 1031 exchanges provide a great many more opportunities and flexibility than most people realize.
The 1031 rules require that property “sold” must be replaced with like-kind property. The good news is that virtually any piece of real property is “like-kind” with any other piece of real property. The following types of real property have been determined to be like-kind: office buildings, apartment buildings, industrial warehouses, factory buildings, vacant land and farm land. Leases with at least 30 years remaining at the time of the exchange qualify as like-kind.
To qualify for like-kind treatment, the taxpayer must hold both the property being “sold” and the replacement property either for “investment or for productive use in a trace of business.” Real property held as a rental property also qualifies. These requirements have generally been interpreted to mean that the properties must be held for six to 12 months prior to “sale” in order to qualify for 1031 treatment. However, there is no requirement that the property be held for investment or productive use in a trade or business beyond a six to 12 month period the exchange. This allows taxpayers to exchange an apartment building for a rental house and to subsequently convert the rental house to their personal residence. The reverse is also possible, i.e., a personal residence is converted to a rental and exchanged for an apartment building or other type of investment real estate.
Additional benefits are available when one considers that a single property can be exchanged for multiple properties or multiple properties can be exchanged for a single property. The possibilities are numerous.
The 1031 rules can also be combined with the rules regarding the sale or exchange of a personal residence. Homeowners are generally allowed two years in which to sell their personal residence and reinvest in a new residence while avoiding tax on any gain. When combined with the 1031 rules there are many possibilities. An example of this follows: If a taxpayer owns a duplex and lives in one-half and rents the other half, the duplex could be exchanged for two properties. Of the two replacement properties, one could be a new residence and the second could be a new investment property.
There are numerous rules that must be followed very carefully when doing a 1031 exchange. However, the rules are not difficult to comply with given adequate advance planning. The close of escrow on the sale and the replacement property do not have to take place simultaneously, i.e., the same day. There are specific provisions to allow for delayed exchanges. In a typical delayed exchange the investor sells his property and purchases the replacement property at a later date, not to exceed 180 days.
In the situation where the investor wants to purchase a new property before selling his property it is even possible to do a “reverse” exchange.
If you are thinking about selling your real property, you should consult with a tax adviser who specializes in real estate transactions well in advance of the time you plan to sell.
CHARITABLE REMAINDER TRUST
Would you like to benefit a charity, yourself and your heirs all at the same time? A charitable remainder trust is one such vehicle for doing this. With proper planning, it can provide your family with many tax and estate planning advantages.
Basically, you contribute appreciated property, such as the apartment building you have owned for years, to a trust. You designate yourself to receive income from the trust for a fixed number of years or for life. When your interest in the trust ends, the trust assets go to a charity that you choose when you set up the trust.
The advantage is that the trust is able to sell the property and avoid capital gains tax on the sale. The trust can then reinvest the proceeds from the sale and achieve a return that is generally higher than has been earned on the property that was contributed. It is not uncommon for apartment owners to receive only 2% or 3% cash flow on their apartment units, while they can receive a 10% return from a charitable remainder trust. Thus, the donor can liquidate their equity in real estate and increase their income stream.
Another immediate tax advantage is that you get an income tax deduction in the year you set up the trust. The amount of the deduction is the present value of the charity’s remainder interest, as it is technically called. You also will save estate tax because the property will not be included in your estate.
Providing for Your Heirs: One objection to contributing assets to a charitable remainder trust is that the donor’s heirs will not receive the asset. However, in the situation where this is a concern, the charitable remainder trust may still make sense. If a donor’s estate is in the 40% bracket (estates of $1 million), the heirs will only receive 60% of any assets over $1 million. The Internal Revenue Service receives 40%. In that case, a life insurance trust should be established. The assets in a life insurance trust pass to the heirs without any estate tax.
The most important factor in this strategy is that life insurance trusts do not pay estate taxes. Consequently, a $1 million life insurance policy, purchased through a life insurance trust, will pass to the beneficiaries in its entirety. The Internal Revenue Service gets nothing.
The premiums for the life insurance are frequently paid with the increased cash flow received from the charitable remainder trust. The donor of the property frequently comes out ahead on cash flow, even after payment of the life insurance premiums.
Making the IRS Work for You: Charitable remainder trusts are complex. It is these complexities that allow flexibility and benefits in a variety of scenarios. Charitable remainder trusts are approved by Congress and the Internal Revenue Service. The IRS has gone so far as to draft the wording to be used in the trust document.
There are many types of appreciated property that may be used to fund a charitable remainder trust. In addition to real estate, other assets that are frequently used are publicly traded securities, closely held corporations, life insurance policies, tangible assets (collectibles) and intangible assets.
There are dozens of ways that charitable remainder trusts can be utilized. Most large non-profit organizations are more than happy to discuss the possibilities with you. I recommend that you contact one of them to see how you might benefit from this IRS approved tax shelter. In addition, always discuss this type of planning with your tax advisor and your family estate planner.
