The tax deferral method most investment property owners use is the 1031 exchange. This IRS code tool encourages more active management of a real estate property portfolio; owners have more freedom to swap long-held properties for new, higher-yielding real estate while deferring capital gains and other taxes. So long as the owner wants to maintain real estate ownership, it can be a very useful planning approach to defer taxes.
At some point, however, a property owner may want to jump off this merry-go-round and no longer want to own property. He or she wants out and is looking for a viable exit strategy. This usually occurs when the owner wants to retire from active asset management and roll the accumulated asset values into more liquid investments to fund retirement. Or, perhaps they are forced to sell because of unforeseen events that have impacted their family. In situations like these a 1031 exchange is not a solution because it is a replacement strategy and requires the seller to purchase another property of equal or greater value than the one that was relinquished.
Jumping off the real estate ownership merry-go-round usually triggers that large deferred tax bill the moment the property is sold, escrow closes and the cash from the sale hits the bank account.
Or does it?
It really is pretty amazing what tax planning opportunities are provided in the tax codes. One planning approach in the Internal Revenue Code, for example, allows taxes to be deferred, but in an entirely different way than what the 1031 exchange offers. Let’s step through what one Texas rental unit owner did to sell his income property and retire, but still defer that looming tax bill for decades to come.
The Texas 453-Step
Jared owned a modest-sized rental property in Ft. Worth, Texas. He was ready to exit from property management, fully retire and enjoy the fruits of his many years of working. Here is the financial picture he faced:
|Cost Basis – Original purchase price
|Estimated Tax Due||$302,415|
|Net Retirement Assets After Tax||$627,585|
Jared knew he would be relying largely on the sale proceeds to help fund his retirement, so every dollar he could keep was very important to him. He was not concerned about paying state taxes (Texas has none), but he was very concerned about having to pay the IRS about 30% of the sale price in federal taxes.
To achieve his objectives, we utilized a specific strategy that, coupled with a unique type of loan that Jared arranged, allowed him to defer all the taxes for many years to come and receive $885,000 in tax-free lump sum cash at close of escrow. This gave him $257,415 more than he would have had he sold the property and paid the taxes.
What does this planning method help to accomplish? Instead of the seller receiving “sales proceeds” at close of escrow, he receives “loan proceeds.” As tax law affirms, sales proceeds are taxable. Loan proceeds are not. Though this planning approach is not commonly known, it is, nonetheless, well established in tax law, including a Memorandum issued by the Chief Counsel of the IRS that supports it.
This Texas property owner was very pleased. As a result of effective proactive planning, he was able to proceed with his retirement plans knowing he had the financial cushion to do it comfortably.
If you are thinking about selling real estate, a business, or some other appreciated capital asset, it is well worth exploring to see if this planning approach fits your situation. It does not work for everyone, but everyone should find out if it does.