HOW TO DEFER TAXES ON HIGHLY APPRECIATED REAL ESTATE
With the recent increase in home prices, many people might want to cash in on the value of their home. That might mean downsizing and pocketing the difference, or perhaps it could mean selling your second home and using the money to fund your retirement. But we certainly don’t want the government to take a big bite out of it, right? So what are the tax consequences, and what can we do to make it easier?
TAX ON THE SALE OF REAL ESTATE
As a general rule, any profits on an investment are taxed. So if you buy vacant land (real property) for $40,000 (the Basis) and sell it a year later for $50,000 (the amount Realized), you have to pay tax on the $10,000 profits (Capital Gains).
WHAT IS BASIS?
The price you paid is called your basis, and in the case of vacant land, it’s fairly straightforward – it’s the price you paid for the land… kind of. Some closing costs count toward your basis and some don’t. Generally speaking, costs directly related to the purchase of the home, such as legal fees and transfer taxes are included, and indirect costs like homeowner’s insurance or mortgage fees are not included.
For a home, the basis can be more complicated – you also can include certain improvements, like a new roof or adding a garage, but you generally can’t include regular maintenance and ordinary repairs. At the same time, you may also need to deduct some things from your basis, such as any casualty losses (such as hurricane or flood damage) that you claimed on your tax returns.
Essentially, your basis is the cost of buying the home, plus what you put into improving the home, minus any losses or deductions that you’ve already claimed.
WHAT DID I REALIZE?
The formula for Capital Gains is the amount you Realized less your basis. For those who don’t speak tax, the amount you Realized is essentially what you received for the property – at its simplest, it’s the sale price less any selling expenses. But it’s not just the cash you receive, it’s also the value of the mortgage you paid off. If you had a $300,000 mortgage and sold your home for $500,000, but the realtor took 5% ($25,000), you would receive $175,000 cash, but you will have realized $475,000.
HOW MUCH TAX DO I OWE?
It Depends
As we said before, your “Capital Gains” is the amount you Realized less your Basis. For someone who purchased land for $40,000 and sold it for $50,000, the gain is $10,000. For a homeowner, it’s more complicated, but essentially it’s the difference between what the homeowner got for the home and what the homeowner paid for and put into the home.
But not all gain is the same. Long term capital gains (classified as assets owned for more than 1 year) are taxed at a lower rate than short term capital gains (classified as assets owned less than 1 year). Essentially, a homeowner is taxed at a lower rate than a house-flipper. From a tax perspective, short-term capital gains are considered ordinary income – the house flipper’s in the business of buying and selling houses, and is taxed on their profession. There are several reasons why long term capital gains are taxed at a lower rate, but the most pertinent reason is that it incentivizes long-term homeownership.
If you only owned the home for a short time, for less than a year, you’ll need to pay tax at your ordinary income tax rate. Remember, the tax is applied to the profit, not the entire sale price.
If you owned the home for more than 1 year, you’re taxed at the lower “Long Term Capital Gains” tax rate, which for most homeowners is 15%. However, if your taxable income is over $459,750 for a single person or $517,200 for a married couple, the tax rate is 20%.
Lastly, if you are selling your primary residence (where you lived 2 out of the last 5 years) there is an exclusion – you don’t pay tax on the first $250,000 gain if you’re single, $500,000 if married. So if a married couple bought a home for $300,000 and sold it for $1,000,000, their gain would be $700,000, but only $200,000 would be taxable.
In 2021, the average U.S. home seller made less than $100,000 profit. In May the median price of a home in Lee County was $416,000, meaning that half of all homes sold for less than that. So the majority of homeowners do not need to pay any tax.
DO I HAVE TO PAY ALL THAT TAX?
Yes… and no.
While most homeowners don’t need to pay any capital gains taxes, for those who do, it can be a big hit, especially for a widow/widower who only gets the lower exclusion (but does get a step-up in basis, see below). If a person bought a house back in 1980 for $100,000, and now sold the home for $1.1 million, the tax would be $150,000.
Let’s go through it slowly. If the Basis is $100,000 and the amount Realized is $1.1 million, the Capital Gains is $1 million. A single person can deduct $250,000 of gain from the sale price of their primary residence, bringing the taxable gain down to $750,000. Even if the seller has no other income, such a large gain would place him or her in the highest tax bracket, which for long term capital gains is 20%. 20% of $750,000 is $150,000.
For any other real estate, the seller would not get the $250,000 deduction, so the entire $1 million gain would be taxable, resulting in a payment to the IRS of $200,000.
SOLUTION #1 – 1031 EXCHANGE
This is only available on investment property, and not on a primary residence or a vacation home that is not rented out.
The IRS allows you to “upgrade” your investment. As long as you take the money and invest it into a new property within 180 days, you don’t need to pay the capital gains. Instead, your new property will adopt the basis of the old property (plus any additional payment).
For example, let’s say you bought a property for $500,000, and it’s now worth $2 million; you also have an additional $250,000 to invest. You can sell your property for $2 million and use the proceeds to buy another property for $2,250,000. The basis in your new property is the $500,000 basis of the original property plus the additional $250,000 that you added, or $750,000.
Had you sold the original property without rolling it over, you would have $1.5 million taxable gain. Your new property is starting out with $1.5 million taxable gain… that you won’t need to pay until the property is sold. This is especially beneficial if used in conjunction with Solution #2.
SOLUTION #2 – STEP-UP IN BASIS
This solution is great, except for one big drawback. If the owner of the property passes away, his or her heirs (or beneficiaries under some Trusts) get what’s called a “step-up” in Basis.
For the heirs, the basis in the property will be the value of the property on the day the homeowner passed away. If the property is sold right away, there is no capital gains. If the heirs hold on to the property for a while, the taxable gain will be the difference in value between the sale price and the value of the property on the day the former owner passed away.
For a married couple owning property together, the property gets half a step-up when one person dies. So if the home was bought for $100,000, and was worth $1.1 million when the first spouse dies, the basis in the property would be ½ of $100,000 and ½ of $1.1 million, or $600,000. If the Survivor sold the home for $1.1 million, the gain would be $500,000, and there would be a $250,000 exclusion. Presumably this will keep the homeowner in the 15% long term capital gains tax bracket, resulting in a tax bill of $37,500.
SOLUTION #3 – DEFERRED SALE
Typically, when something is bought or sold, the buyer pays the price right away and the seller gets the money right away. In the case of a mortgage, the buyer borrows money from a bank, but still pays the full purchase price right away to the seller.
However, the buyer and seller can agree to a payment plan, whereby the buyer pays over a period of time and the seller gets paid over a period of time. His is called an Installment Sale. In an installment sale, each payment has the same proportion of gains and exclusions, and the capital gains are taxable in the year they were received.
Let’s say a home was purchased for $100,000, and sold for $1.1 million, but with a 10-year Installment Sale contract. Each year, the seller will receive $110,000, of which $100,000 is capital gains, and $25,000 of exclusion. Presumably, this will keep the seller in the lower 15% tax bracket for capital gains, resulting in an annual long term capital gain tax liability of $11,250. Over the whole ten-year period, the seller saves $37,500 by being in a lower tax bracket.
WARNING REGARDING DEFERRED SALES
The deferred sale must be legitimate. The IRS has listed Monetized Installment Sales on its “Dirty Dozen” tax scams for 2001 and 2002, which is often sold by unscrupulous or unsophisticated advisors (which may include lawyers or accountants). This involves using an intermediary, often an LLC or a Trust, for the sole purpose of deferring capital gains. The seller sells the property to the intermediary in exchange for an installment note (which may make equal payments, or may only pay minimal interest). The intermediary immediately sells the property to the actual buyer for an immediate payment. The intermediary will then invest the property and keep the (most of) the gains.
Such a pre-arranged setup is not a bona fide transaction and serves no legitimate purpose other than to defer taxes. Unfortunately, some professionals, presumably unaware of certain legal doctrines developed in tax court and through revenue rulings, believe that if a structured transaction follows the statute, it’s permissible. However, the IRS released an analysis listing several different reasons why such a setup is not legitimate, and is taking aggressive action against such structures.
Essentially, if the only reason for a particular structure is to avoid or defer taxes, there’s a good chance that the IRS will challenge it.
While a deferred sale may be legitimate, you should ensure independent counsel reviews any such arrangement.
SOLUTION #4 GIFT TO CHARITY
If you give the appreciated property to charity, the charity can sell it without paying capital gains while giving the donor a tax deduction. Of course, this only works if the seller doesn’t need the money and just wants to make a large donation to charity. But for those who want the best of both worlds, there is a way to give to charity without it costing you a penny.
SOLUTION #5 PARTIAL GIFT TO A CHARITABLE TRUST
This is a bit tricky, but fully legal. The seller creates what’s called a Charitable Remainder Trust, also known as a CRT (more specifically, a NIMCRUT OR FLIP CRUT, but that distinction goes beyond the purpose of this article). After creating the Trust, the seller transfers a portion of the home to the Trust.
A Charitable Remainder Trust is what’s called a “split-interest” trust, meaning part of the trust goes to charity, and part of the trust goes back to the seller (or a beneficiary of seller’s choice). The donor gets an immediate tax deduction, and gets an income stream for a number of years or for life.
Let’s take our previous example, where the home was purchased for $100,000, and is sold for $1.1 million. Ordinarily, the tax burden would be $150,000. Instead, we transfer 19% of the home into a CRT that will pay the seller 6% of its assets for 10 years.
When the home is sold, the seller will receive $891,000, and have a basis of $81,000. The taxable capital gains would therefore be $891,000 – $81,000 – $250,000, or $560,000, resulting in a tax burden of $112,000. However, the donation to the Trust provides a tax deduction of about $113,000, so not only won’t there be any tax on the sale of the home, but the seller can reduce his or her income tax a bit further.
Additionally, the Trust will provide approximately $1,000 per month for the next ten years. Assuming a modest 6% growth rate, at the end of the ten years, the seller will have received $125,400 from the Trust, and $209,000 will be donated to charity.
Keep in mind that the income the seller receives every month is taxable, but possibly at a lower tax rate – the seller will be in his or her ordinary tax bracket. If a single person’s income is below $41,675 for the year, then the capital gains are taxed at 0%.
