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Avoiding Taxation When Selling Real Estate

Many people that have investments in real estate would like to divest themselves of the property, and re-invest the proceeds into something that might provide them with greater income for the future.  Unfortunately, this might cause the realization of a capital gain, and the requirement that taxes be paid out of that gain.  This reduces that amount of capital available, and many investors are reluctant to list their property for fear of getting hit with this capital gains tax.


What can be done about this?  Well, there are at least 3 strategies that investors might use to either: reduce, postpone, or eliminate the capital gains tax.  If this can be accomplished, it might mean greater income to the investor, because the pool of available funds would not be reduced by the up-front tax payment


One method is to take part in what is called a “tax-deferred exchange”.  As the name implies this method “defers” or “postpones” the payment of the tax.  The investor will exchange one property for another, and the gain is “rolled-over” into a new piece of property.  The tax is the postponed until later, when the new property is sold.  This method of postponing the tax will be useful to investors that want to continue owning real estate, but would like to own different property that is either:  a different type of property, in a different geographical location, or is a larger property.


For the investor that is tired of owning property, and no longer wants the headaches and problems associated with owning raw land or managing income property, there are two different trusts that might be utilized.


The first one to look at is called a “private annuity trust”, and it is a system of converting the real estate into income producing assets without the up-front payment of the taxes associated with a normal sale.  Instead, the investor “exchanges” the real estate for an income stream that is designed to last for the rest of their life.  The “trust” pays an income to the investor in an amount that is calculated by the use of government and IRS tables to last for their expected lifetime, and at a prescribed interest rate.  The capital gains tax owed on the profit on the property is paid gradually as the investor receives income from the trust over the years into the future.  If the investor dies prior to receiving all of the proceeds from the trust, any balance will be paid to their heirs.


The advantage of this trust is that, since there is no tax taken out up-front, there is a larger “pool” of funds available to produce income, thus there is more income available to the investor.  It is not the goal of this column to explain all of the details of these strategies, so the interested party should contact his or her own financial planner or tax advisor to get the details.


The other trust is one that goes by various names, one of them being the “Capital Gains By-Pass Trust”.  This can include a combination of several trusts that are designed to completely eliminate the capital gains tax on the sale of the real estate.  This is not a deferral or an exchange, but is a complete elimination of the tax.


A special trust is set-up ahead of time to hold property and the trustee, probably the original property owner, negotiates the sale to a third party.  Once the property is sold, the proceeds are available to provide income to the person or persons that previously owned the property.  There are government and IRS tables that dictate the terms of this strategy, and it is necessary to explore it thoroughly prior to entering into this type of arrangement.


Again, there is more money to invest, because there is no tax to pay up-front.  With more money to invest, the investor should realize a greater return in the form of income because it is coming from a bigger pool of funds.  In order for the heirs of the property owner to receive an inheritance from this program, it may be necessary to set up a second trust within the system to provide for the heirs on a tax-free basis.  This needs to be explored with your advisor.


In the coming months, it might be possible to go into greater detail about these programs.  Please consult your advisor for further details.


Bill Locklin is a Certified Financial Planner that specializes in converting accumulated assets into lifetime retirement income. He can be reached at 951.676.2010 or by  E-mail.

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