Yes, the new 15 percent top rate on capital gains is good news for real estate investors. But if you sell investment property, your actual tax bill can be much higher than 15 percent of your gains, due to earlier depreciation deductions. (Gains from prior depreciation write-offs are taxed at a 25 percent maximum federal rate.)
If you'd rather defer the tax than pay it right away, consider this unique strategy: Sell the real estate to a private annuity trust that you create. Such a trust can then sell to a buyer you've lined up while your tax bill is spread over many years. Here's how the strategy shakes out:
Problem: Fully depreciated property
Chances are, you've taken extensive depreciation deductions on your investment property. Your basis in the depreciable portion of the property may even have withered to zero if the building is fully depreciated.
When you sell the property, all those depreciation deductions will be taxed at a 25 percent rate. So if you sell a fully depreciated building for $1 million, you'll be hit with a $250,000 tax bill.
Even worse, state and/or local capital gains taxes also may apply, pushing your tax bill higher. Finally, reporting a heap of capital gains from a real-estate sale will push up your adjusted gross income (AGI), which can negatively affect other areas of your tax return.
Answer: Sell to a private annuity trust
If you'd rather avoid such a huge tax bill upfront, the solution may be found in an established estate planning technique: the private annuity.
In essence, a private annuity is an agreement worked out between two parties who trust each other, usually relatives.
For example, a father may sell assets to a daughter under a private annuity. The daughter agrees to pay her father a certain amount each year as long as the father lives. Guidelines for such arrangements are well marked by legislation, regulations and court decisions.
Where does real estate come into play?
Example: Say you own a fully depreciated building and a buyer is willing to pay $1 million for it. Instead of selling the building to the buyer, you sell it to a trust you've created. Your children, or other loved ones, can be the trust beneficiaries.
The trust buys the building from you via a private annuity. That is, the trust will pay you a certain amount per year, for life, based on your life expectancy. At your death, the payments from the trust will cease. (If you're married, payments from the trust might cover both lives.)
After this transaction, the trust can sell the property to the buyer for the $1 million price that's been agreed upon. After all this, the trust will hold $1 million in cash and the buyer will have the real estate.
Tax impact: The trust's basis in the property is $1 million, assuming that's the fair value of the private annuity used to acquire the trust from you. If the trust holds a $1 million basis and it sold the property for $1 million, the sale won't generate any taxable gain. So the trust can invest the entire $1 million.
Under such a private-annuity arrangement, payments from the trust to you can begin right away. Or you can defer receiving payments, allowing the trust fund to grow in the interim.
When payments do begin, each will be part long-term capital gains (now taxed at 15 percent) and part ordinary income (taxed at your regular rate, which may be lower if you take this income in retirement). Some income may also be subject to depreciation recapture at 25 percent and some tax-free return of capital.
Tax impact example: Suppose you sold real estate for $1 million. You had a basis of $200,000, plus $500,000 worth of depreciation deductions to be recaptured and a $300,000 long-term gain. Your life expectancy is 20 years when the payments begin.
In this situation, each annual payment you receive for the first 20 years would contain $15,000 that is taxed as a 15 percent long-term capital gain ($300,000 divided by 20 years), $25,000 of depreciation recapture taxed at 25 percent, and $10,000 worth of tax-free return of capital. The rest will be taxed as ordinary income.
If you live beyond your life expectancy, all the money you receive will be taxed as ordinary income. You'll keep receiving annuity payments until the trust runs out of money. If money is left in the trust at your death, the remaining assets can go to the trust beneficiaries, tax free.
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