DEFER CAPITAL GAINS TAXES WITH OR WITHOUT A 1031 EXCHANGE

Do you have experience doing 1031 exchanges? Have you ever had a 1031 Exchange fail and had to pay the capital gains and depreciation recapture taxes the following year? If so, you’re not alone — more than 40% of all 1031 Exchange transactions fail! Many investors feel like they are stuck in a 1031 exchange system. Either they:

  1. keep the property,
  2. complete a 1031 exchange, or
  3. pay the capital gains taxes.

Fortunately, that isn’t the case. There are several other ways to defer capital gains taxes — sometimes for generations! These little-known strategies could potentially save you tens or even hundreds of thousands of dollars in taxes. Review the strategies in this booklet and contact us to find out which is right for you.

Capital Gains Tax Rates as of 2022 tax year

Federal: 0%, 15%, and 20%* *Subject to change at any time

  1. One or more tax reporting years before selling
  2. Set up before closing
  3. Within a 1031 exchange’s 45-day identification period
  4. Rescue a failing 1031 exchange
  5. After closing but no 1031 exchange involved
  6. Income tax mitigation strategy

1: Set Up Before Closing

Dynasty Class of Trusts Defers:

  1. Federal Capital Gains Taxes (state tax may vary)
  2. Passive Income Taxes
  3. Active Income Taxes

Iron Clad Asset Protection Avoids:

  1. Probate Upon Death
  2. Gift and Estate Tax

This ensures the transfer of your assets to your beneficiaries while protecting multi-generational wealth accumulation.

Cost: Many cost $30-$40K to set up initial trust plus the same for a separate business trust. This cost can provide long-term tax mitigation! The Asset needs to be in the Trust when sold. It's best if set up in one tax reporting year and asset sold in another tax reporting year.

Provisions of one of these types of trusts:

Charitable Trusts (CT):

  1. This is a means to eliminate capital gains taxes for any appreciated asset or business. Asset must be in the trust when it is sold.
  2. Investment properties can be part of a charitable trust.
  3. Upon sale of asset, monies can be invested while in the trust. An annual appraisal will be required to determine value.
  4. 5-10% minimum goes to charity either upon the sale of the asset (charitable lead trust – CLT) or at the end of the term of the trust (charitable remainder trust – CRT).

Cost: Attorney’s fees + 5-10% of asset sold in trust.

Limitation: proceeds are not fully liquid immediately. There are different formulas used.

  1. Distributions can range from 5-50% annually.
  2. The first distribution will be one year after CT is set up and asset is sold.

Limitation: Asset has to be free and clear of debt. There are some exceptions if the debt is 5+ years old.

Traditional Installment Sale (Owner Carry):

  1. Seller becomes the Lender for the Buyer for a specific period of time.
  2. Seller will pay taxes on payments received. Principal is capital gains – Interest is Ordinary Income Tax.
  3. When the note gets paid off, you can use the TDCO structure to defer capital gains taxes for 30 years if Balloon Payment is large enough to qualify with a capital asset dealer.

Disclaimer: While this is general information about capital gains tax strategies it does not constitute legal or tax advice. The best way to get guidance on your specific legal issue is to contact an Attorney.

Principal is capital gains – Interest is Ordinary Income Tax

LLC With Charitable Intent

  1. Minimum sale: typically $1M
  2. Can be a great strategy for sales of business and real estate
  3. Can accomplish great tax mitigation and create a significant charitable deduction at the same time.
  4. Donating assets to the LLC creates a significant charitable deduction. Then through a process of loans and life insurance, you create access to the cash for general purposes while creating a significant charitable contribution for a 503c charity of your choice - to be donated at a later date.
  5. A charitable organization will eventually benefit from 100% of the asset donated to the charity while at the same time, the client can utilize funds for personal use. It is a high leverage opportunity.
  6. Attorney's fees can range from $40k to $110k depending on whether or not you add a Tax Attorney Opinion Letter to the Transaction.
  7. Client will pay capital gains taxes on 1% of the gains.

Private Family Foundation

"A private foundation, like a public charity or public foundation, is dedicated to carrying out a charitable mission. However, a private foundation is not a public charity because, instead of receiving public support, it is funded and controlled by an individual, family, or corporation. Examples of private foundations include The Bill and Melinda Gates Foundation, the Walton Family Foundation, and the Coca-Cola Foundation, Inc.” (Source: Foundationsource)

  1. Client will pay capital gains taxes on 1% of the gains.
  2. The key to Foundations is that you have to have legitimate charitable intent with your resources.
  3. You will need to contribute to the foundation on an annual basis; therefore, this doesn't make sense to be a transactional strategy.
  4. This can eliminate capital gains taxes but there will be a nominal excise tax of 1.39%.
  5. The tax deduction can count against up to 30% of one’s AGI for the year of giving to the organization.

1031 Exchange

  1. Defers capital gains taxes for as long as you own the real estate. If the tax code still applies in the future, you can hold on to the real estate until you pass away, and the beneficiaries can get a step-up in basis, which could eliminate capital gains taxes.

  2. Have to replace with a like-kind property of equal or greater value.

  3. Like-kind is defined as:

    1. Single-family rental
    2. Hotels and Motels
    3. Condo
    4. Offices
    5. Industrial Buildings
    6. Multi-family rentals
    7. Land
    8. Retail space
    9. Farms and ranches
    10. Delaware Statutory Trust
    11. Golf courses
    12. Leases with 30 years remaining

  4. Not like-kind properties:

    1. Primary residence (You have the 121 exemption: $250K per spouse)
    2. 2nd homes
    3. Flips
    4. Developments
    5. REITS. Typically, they are a membership interest in a Trust and are not exchangeable (unless the REIT is considered real property and not a partnership interest).

  5. Have to replace with equal or greater debt. This is often a shocker to the seller!

  6. Other rules*:

    1. 45 days to identify a property
    2. 180 days to close the identified property

    Under these rules, 40-60% of exchanges will fail.

  7. If you do not identify a property, the accommodator can release your funds on the 46th day. If you do identify a property, and you do not acquire it, the accommodator cannot release your funds until the 181st day.

Structured Installment Sale

  1. The seller spreads out the capital gains taxes over many years. This could be a means to reduce the actual capital gains taxes paid by keeping more of the principal in the lower tax brackets.
  2. In some cases, the funds can go to an annuity to create security and guaranteed payments. This approach requires $300K minimum into the annuity.
  3. The annuity payments can be set up for 5-40 years.
  4. In some cases, there needs to be no debt on the property if the seller wants full tax deferral.

2: Within a 1031 Exchange’s 45 Day ID Period - Delaware Statutory Trust (DST)

  1. Securities Regulated Investment.
  2. A more settled tax solution. IRS Ruling 2004-86, Aug. 2004.
  3. Own beneficial interest in real estate and not the real estate itself.
  4. Generates "mailbox money" plus future appreciation.
  5. Passive Income – Do NOT have to manage property.
  6. Cost to set up a DST: 8-15%.
  7. Can be part of the 1031 Exchange process but does not have to be.

Accredited Investor Qualifications:

Limitations:

  1. Unanimity of all owners in the decision-making process.
  2. Lack of lending for TIC’s with more than 10-12 investors.

3: Rescue a failing 1031 exchange

There is a legal review on transitioning funds from an IRC section 1031 to IRC Section 453.

  1. Please see Tax Management Memorandum, March 19, 2007, Vol. 48 No. 6 at: DeferTheGainstax.com

Critical Point:

  1. All of this hinges on hiring the right 1031 Exchange Accommodator to begin with!
  2. Not all accommodators (intermediaries) will cooperate with the seller to release the funds to an IRC 453 strategy.

Tax Deferred Cash Out (can be set up pre-closing)

Untitled

Value of Tax Deferred Cash Out (TDCO)

Flexibility

  1. Funds received are as an Investment Business Loan.
  2. Investor DOES NOT have to replace with a like-kind property of equal or greater value.
  3. Can invest in any kind of business. This includes taking the gains of a highly appreciated asset and paying off loans on other investment properties.
  4. Can invest in any kind of financial vehicle: stocks, bonds, mutual funds, CDs, Annuities, Life-Insurance, savings account, Cryptocurrency, etc.
  5. Example: Investor can purchase other properties of lower value, invest the balance of the funds in a financial vehicle, and not have to pay taxes the following year.
  6. Great Exit Strategy! No longer deal with tenants and toilets.