I recently received this question at USTaxAid.com. With the upturn in real estate values, there are a lot more people wondering how to reduce their capital gains when they sell their property. This question had a few more wrinkles though, so it’s a good example of making sure you know ALL the facts before you jump into a strategy.
Here’s the question:
Investor R has a portfolio 40 rental houses held for rental over 15 years. There is significant equity developed from appreciation and pay down on mtgs. (All are mortgaged – average about 60%). There is also a large reduction in basis from depreciation expense taken. Now looking for exit strategy and/or life simplification, R needs alternative to straight sale to avoid very large capital gains tax. Is looking at CRT, PAT, & 1031 all of which seem to be complicated by mortgage encumbrance. Do you have any general advice?
Let’s start with the 3 possibilities that Investor R had already consider: CRT, PAT & 1031.
The PAT is a private annuity trust. Please note that there was a law change because of some proposed Treasury Regulations in 2006. But, just so you know how it used to work. A typical PAT transaction meant that you transferred property to your heirs in exchange for their unsecured promise to make payments to you for the rest of your life. In that way, it’s somewhat like an annuity. There is a stream of cash. It was called private because the annuity was provided by a private party, not a commercial insurance company. The change came out in October 2006, when the Treasury Regulations said that you were required to recognize the gain on the transaction immediately.
So, that’s not going to work.
A CRT is a charitable remainder trust. In the right circumstances, they can be a powerful way to sell highly appreciated assets without paying capital gains tax. That’s because the asset is transferred to a trust which remains in force for your lifetime. Upon your death, the trust corpus (principal) goes to a legal, recognized charity. Since a charity gets the value of the asset eventually, there is no tax upon sale. Plus, you get a big charitable deduction on your personal income tax. The problem that normally trips people up is that they have just disinherited their heirs. The solution is to have a life insurance policy in place to cover the asset value. Some people can’t qualify for the life insurance policy and so that is a challenge.
There is one more potential issue, that is mentioned in the initial question. What if the property that has been contributed has a mortgage?
Here is an example that might help explain the mortgage issue a little easier.
Let’s say that you have a property that you want to donate that is worth $1 million. There is a mortgage on the property of $400,000. Your adjusted basis is $500,000. None of the depreciation would be subject to recapture. So far, so good.
They will receive a charitable donation deduction of $600,000 ($1 million – $400,000 of debt). But they also have income due to the debt on the property. Their adjusted basis of $500,000 is allocated 60% to donated portion and 40% to the taxable sale. Their gain equals $400,000 – $200,000 or $200,000 of taxable income. They also receive a charitable donation, though.
In the case of a CRT, there is also the issue of the mortgage itself. Has the grantor personally guaranteed the debt? If so, a CRT is not possible unless the lender releases the guarantee.
The third option mentioned in the question is a Section 1031 like-kind exchange, aka Starker Exchange. A simple Section 1031 means that you buy a replacement property in which the purchase price is equal to or greater than the basis of the sold property. You must exchange all sales proceeds. You must buy real estate.
If you additionally have a mortgage, you need to replace the existing mortgage debt with debt on the new property that is equal to the existing debt.
If you don’t have enough mortgage debt on the new property, the difference between the sold property debt and the new property debt is called mortgage boot. Mortgage boot is triggered when you have received a property with less debt attached than your own property. The tax code treats this reduction of debt as a form of income. Unless your 1031 transaction is somehow balanced out with additional cash or personal property, your debt reduction will create a tax liability.
It’s possible to do a Section 1031 with mortgaged property, but it will be more complicated.
Now let’s get to the question. What were other alternatives? Of course, I strongly recommend that Investor R talk to a CPA and/or attorney about the details of the transaction and make sure the strategy is sound for his particular circumstances.
If you move forward with a 1031, make sure you’re getting a mortgage on the new property.
Another possibility is to look at the property themselves. Pick the properties that have the most gain and then see if it’s possible to do a substitution of collateral to unencumber those properties. Or could you get a new loan on one of the other properties to pay them off? Once that is done, you have some properties that you can do a 1031 exchange or CRT on.
Remember that the issue with the CRT has to do with basis. If the basis is high enough and/or the debt is low enough, the impact of the taxable income will not be that high. Plus, of course, you have the offset of the charitable donation. Perhaps the CRT can actually work, once you’ve crunched numbers.
Would it be possible to have someone take over management or control of the properties, so the income becomes just an “annuity” for the current owner? If his desire is to get rid of the property headache, that might be a way to do it.
And finally, depending on his age and health, maybe it’s time to start gifting some of the ownership to his eventual heirs. If they’re going to end up with it anyway, they can start managing the property.
Those are just a few of my initial thoughts regarding this question. Interestingly enough, I’ve received two questions with similar themes from different people this week. It looks like real estate values are up and some owners are ready to sell.