How Real Estate Investors Can Pay Zero Taxes! - Part 4 22.
4. Complexity: "1031 exchanges are difficult".
Entering into a 1031 exchange with an experienced qualified intermediary
couldn't be easier.
5. Investor's Agent: "I'll just have my attorney hold the sales proceeds
in escrow while I look for Replacement Property".
Regulations specifically exclude the investor's agent, broker, attorney,
accountant, most family members and others with a relationship with the
investor.
6. Sophistication: "1031 exchanges are only for the big investors".
Anyone who owns investment property should consider a §1031 exchange
before selling. Whether they are selling a small rental unit or an office
building, they can simply pay the gain and throw away their hard earned
money, or effect a §1031 exchange preserving their capital. Any investor
should consult a tax adviser who is familiar with §1031 exchanges to
determine the most beneficial strategy.
7. Last Minute: "My closing is tomorrow, it's too late to do an
exchange".
Until title has passed to the buyer and money has been received, it is not too
late to set up an exchange. All States frequently receives calls from investors
at the closing, asking us to prepare the necessary paperwork to get the
exchange in motion.
8. Cooperation: "I need the cooperation of my buyer and seller to do the
exchange".
The regulations only require that the buyer and seller be given notice of the
exchange. Although cooperation is not required, it is recommended that the
purchase and sale agreements for both the sale and purchase of real estate
contain language requiring other parties to cooperate (provided they incur no
additional cost) because it prevents a suddenly reluctant party from pointing
to the 1031 exchange as a reason to not go forward.
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9. Out of Order: "I cannot exchange because I am about to purchase the
Replacement Property and I don't yet have my Relinquished Property
sold.”
A reverse exchange is the "flip side" of a deferred exchange, where an
investor directly or indirectly acquires a like kind replacement property
before disposing of a relinquished property.
10. Conversion: "I can never use the Replacement Property for personal
use".
Many investors purchase replacement property in a vacation haven, with an
eye towards using such property exclusively for their own personal use.
There is no hard and fast rule, but a subsequent conversion should not
prevent the exchange from satisfying the use requirements provided that the
investor did not have a concrete intention to convert the property to
personal use at the time of the exchange. The IRS has ruled that a two-year
minimum rental period was sufficient to meet the qualified use test.
11. Mixed Use: "I can't do an exchange if I use my property partially as
a residence and partially as a rental property".
In such an exchange, allocation of value between the two types of property
becomes important. For example, if an investor owns a three family house
occupying one floor as a personal residence, the allocation may be by the
respective square footage, the number of units, the quality of interior
improvements, or by appraisal. Any reasonable allocation is permissible.
(The rules for personal residence rollovers were formerly found in
Section 1034 of the IRS code. These rules dictated that you had to reinvest
the proceeds from the sale of your personal residence within twenty-four
months before or after the sale, and you had to acquire a property, which
reflected a value equal to or greater than the value of the residence sold.
24.
These rules were discontinued with passage of the 1997 Tax Reform
Act. Currently, if a personal residence was occupied by the taxpayer for at
least two of the last five years, up to $250,000 for a single person and
$500,000 for a married couple of capital gain is exempt from taxation.)
There are virtually no state or federal regulations governing the
function of facilitators, other than the fiduciary responsibilities that govern
the conduct of any entity holding or handling other people’s money. For this
reason, care in selecting an intermediary is important.
Select the facilitator as you would an attorney for personal
representation or a physician to treat your children. Look for experience in
doing exchanges and reputation in the real estate, legal or tax communities.
Talk to escrow and closing professionals that handle exchanges and get their
opinion. Choose a facilitator who is thoroughly familiar with the process,
since many times other aspects of the process will bear significantly on your
exchange.
For instance, the handling of Promissory Notes, bulk transfers or other
variations require special knowledge. Ask about the security of your funds
while under the control of the intermediary. What options you may have to
assure that your funds will be safeguarded.
Although the costs and fees for an exchange are relatively
insignificant, ask about them and get a clear explanation of what you will be
charged. With a few notable exceptions, fees are very similar among
facilitators. What is of far greater importance is the competence and ability
of the facilitator and its personnel to complete your exchange promptly,
professionally and legally.
Building wealth is fun with 1031!
25.
Never Pay the Tax!
If during your real estate investing lifetime you always leverage your
gains by exchanging you will continually be deferring your obligation to pay
capital gains taxes. Then, if your estate is arranged properly, when you die
your heirs can receive the property with stepped up basis. That means they
will pay no capital gains tax on the inherited property! Get it? The capital
gains tax has been entirely and legally avoided!
You avoided the tax using 1031 and now your property passes to your
heirs with stepped up basis, so all of your capital gains tax obligations have
vanished from the face of the earth. They never have to be paid. Sweet!
(If you give property to your heirs before your death their basis in
the property is the same as yours. You are handing them a tax problem.
And gift tax complications may also come into play.)
That's one way to avoid the taxes and pass your investments on to
heirs, but maybe not the best way? There is a strong likelihood that your
needs and desires will change as you grow older. What if you grow weary
of managing your property and you would like to have the income without
the worries?
You can sell your property, pay the tax, invest the proceeds in
something less demanding (mutual funds?) and live nicely on the proceeds
from your investment. But, oh how it would hurt to pay that huge capital
gains tax. Plus, the money that goes to pay that tax gives you less to invest.
Can you have your cake and eat it too? Yes you can, with a
Charitable Remainder Trust (CRT).
At a point when you have exchanged your way into considerable real
estate wealth and you are ready to ease off and enjoy life, you could transfer
the title of all your investment property to a Charitable Remainder Trust
(CRT). Within certain guidelines you can personally manage the trust’s
holdings including selling the transferred property.
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Since the property would be owned by a tax exempt trust the sale would be
tax-free.
You could sell your real estate held in the trust and move your money
into something less management intensive. Stocks, mutual funds, bonds,
etc. Because the CRT will pay no tax on the huge gain you have
accumulated over the years you will have more to invest and can take a
greater draw from your new investments.
You can draw a portion of any earnings produced by the trust
investments. If you managed well the value of the trust holdings would
continue to grow and produce more spendable return.
Charitable remainder trusts have two sets of beneficiaries:
•
Income Beneficiaries – That person (you) receives a set
percentage or fixed amount of income from the trust
during the course of your lifetime.
•
Designated Charity – It receives the bulk of the estate
after the income beneficiaries (you) pass away.
At least one non-charitable beneficiary (you) must be named to
receive taxable annual payments from the trust for the life of the beneficiary
or for a term of not more than twenty years. This is how the government
assures itself that it will receive at least some tax revenue.
Most people establish themselves, and their spouses, as the trust’s
income beneficiaries. The person setting up the trust (you as grantor) can
act as its trustee, maintaining full investment control of the assets inside the
CRT.
That means you can redirect the trust’s investments from time to time
to keep them in sync with the ebb and flow of the economy.
CRTs are irrevocable, so once you have committed, there is no
turning back. You can, however, change the charity beneficiary during the
course of the trust. As you will see later that won’t be an issue.
27.
Almost any type of asset from real estate to stocks and bonds can be
placed in a charitable remainder trust. After being placed in the trust they
can be bought and sold, all tax-free.
The greatest benefit of CRTs is that they allow the income
beneficiaries (you) to escape capital gains taxes. Because CRTs are exempt
from these types of taxes, they are ideal for investors whose assets have a
low cost basis but a high appreciated value.
Because of their tax perks, CRTs are often used as retirement planning
tools or to diversify a portfolio with highly appreciated assets, since the
savings rendered by the avoidance of capital gains tax can be reinvested in
higher-yielding assets. And unlike 401(k)s or IRAs, there are no limits to
how much you can contribute.
Aside from the capital gains breaks, CRTs also offer tax deductions.
CRTs are not subject to the usual annual gift limits, so trustees can
deduct the present value of the remainder interest to the trust from their
income tax. That figure is calculated by the Internal Revenue Service based
on the grantor’s life expectancy or term of the trust, current interest rates and
the rate used to calculate annual payments for the income beneficiaries.
Deductions cannot exceed 50 percent of your gross adjusted income,
but any deductions not used in the year of contribution, may be carried
forward for the next five years. This is a powerful benefit.
Another advantage of CRTs is the control these trusts give individuals
over so-called “social capital”. The concept of social capital dictates that
everyone gives back to society in one way or another, usually through taxes,
which Washington spends in a manner they deem appropriate. A CRT
permits individuals to redirect those funds as they see fit.
CRTs can be set up in various ways. Because it is simply a contract it
can be written in about any way you want if you have an experienced
attorney.
28.
The two primary types of trusts are charitable remainder annuity
trusts, or CRATs, and charitable remainder unitrusts, or CRUTs.
CRATs provide fixed payments to the beneficiaries regardless of how
the values of the assets in the trust fluctuate over time. CRUTs pay a fixed
percentage of the fair market value of the trust’s assets.
CRUT has the advantage of protecting against inflation. But some
elderly trustees, whose inflation concerns may be less urgent, may choose
CRATs.
CRUTs also allow continued contributions, so you can add other
assets from your portfolio, as it becomes prudent to do so.
With a CRAT you are allowed to make only the one initial
contribution and no other.
Under a CRAT, income interest beneficiaries are annually paid either
(1) a fixed dollar amount, or (2) a fixed percentage of the initial value of
CRAT assets. The fixed percentage must be at least 5% of the initial value
of the trust assets, regardless of the amount of income earned by the trust.
That means that at times payments to beneficiaries might have to come out
of the trust principal.
Since the grantor (creator of the trust) is not permitted to make
additional contributions to a CRAT, any appreciation in the trust’s assets
will benefit the charities that have a remainder interest. This is so because
payments to income beneficiaries are based on the fair market value of the
initial contribution. They are receiving a fixed dollar amount. Fluctuations
in principal have no effect on the payments beneficiaries receive.
A CRUT is more flexible than a CRAT. Grantors may make
additional, deductible contributions to a CRUT after the initial contribution.
Any appreciation in the CRUT assets will increase the amount of
annual income payments to beneficiaries, because these payments are
based on the current fair market value of the assets.
29.
Under a CRUT annual income payments are based on either: (1) a
fixed percentage (at least 5%) of the FMV of the assets recomputed
annually, or (2) the lesser of the CRUT’s current income, or a fixed
percentage (at least 5%) as above.
Charitable lead trusts (CLT) are another option. Like CRTs these
trusts offer income tax deductions and avoid capital gains liabilities. But
they are set up in reverse, with the charities acting as the income
beneficiaries and receiving a stream of income during the owner’s lifetime.
At the owner’s death the bulk of the CLTs assets go to a named beneficiary.
Earnings on assets within a CRT are generally exempt from federal
and state income taxes, provided specific procedures are followed. The CRT
will lose tax-exempt status if certain prohibited transactions occur.
Example: The CRT has unrelated business taxable income.
Taxes that must be paid by the beneficiary are computed in such a
way as to maximize revenue for the government. Distributions are
characterized according to the character of the trust’s income. For example,
a distribution is considered to be ordinary income to the extent of the trust’s
ordinary income, and all undistributed ordinary income from previous years.
When all ordinary income is exhausted, income is considered to be capital
gains, to the extent the trust had capital gains. Next is “other income” and
finally, if all income is exhausted, the distribution would be considered to be
a payout of trust principal.
CLTs are far less common than CRTs, but can be advantageous under
certain circumstances. For example, CLTs may help individuals who want
to leave their estates to their children, but are in urgent need of a tax break
because they exercised a heavy number of stock options or sold several
properties. Contributions to a CLT can dramatically lower their tax liability
without greatly impacting their estate in the long run. This document and accompanying materials are designed to provide authoritative information in regard to the subject matter covered in it. It is for illustration purposes only and presented with the understanding that the author and publisher are not engaged in rendering legal, accounting or other professional opinions. If legal advice or other expert assistance is required, the services of a competent professional should be sought. |
