Building Wealth through Deferring or Excluding Taxes
Time Value of Money
I'm not going to bore you with all of the statistics that are available on this topic. There have been so many academic and industry studies over time that prove beyond a shadow of a doubt that taxpayers/investors who take advantage of tax deferral and tax exclusion income tax planning strategies will always build substantially greater wealth than those taxpayers/investors who don't and pay their income taxes as they go. The numbers can be stagering, in fact.
It all boils down to the time value of money. The longer your money can work for you before you pay it to the Federal or state government in the form of income taxes the more wealth you will build. You can even eliminate or significantly reduce the amount of taxes paid with careful and proper income tax and estate planning.
I have found that many taxpayers/investors are not aware of many of these strategies, which range from the very basic to the very complex and sophisticated. My purpose with this blog is to briefly discuss the most common tax deferral and tax exclusion opportunities available to you for investment real estate.
You should always meet with your advisors before proceeding with any transaction. There is far too much at stake.
Tax Deferral and Tax Exclusion Strategies Available
Tax deferral and tax exclusion planning strategies abound, so it is extremely important tax taxpayers/investors consider all available options with their professional advisors before moving forward with any specific tax planning or wealth building strategy.
The following dialog is merely a basic summary of the various tax deferral and tax exclusion planning strategies available. It is not all inclusive and there are certainly more sophisticated planning opportunities available when appropriate. This blog post is merely designed to assist you in evaluating the more common real estate tax planning options available to you.
Section 1031 — Rental/Investment Property
The 1031 exchange allows taxpayers/investors who own property that has been held as rental or investment property or property that has been used in their trade or business to exchange it pursuant to Section 1031 of the Internal Revenue Code for other property also held as rental or investment property or property used in their trade or business. The 1031 exchange allows the taxpayer/investor to defer their Federal and state capital gain and depreciation recapture taxes.
Section 1033 — Condemnations or Natural Disasters
The 1033 exchange allows taxpayers/investors who own real property that was condemned by a government entity through the eminent domain process or was destroyed via a natural disaster to exchange their property pursuant to Section 1033 of the Internal Revenue Code on a tax-deferred basis for replacement real property that is similar or related in service or use to the property that was involuntarily converted.
Section 721 — Exchange into a REIT
The 721 exchange allows the taxpayer/investor to exchange rental or investment property into an interest in a Real Estate Investment Trust or REIT. This strategy is also called an upREIT or 1031/721 exchange. The upREIT is not a common investment property strategy now that the tenant-in-common investment properties have been rolled out under Revenue Procedure 2002-22.
Section 453 — Gain Deferred via Seller Carry Back Note or the Deferred Sales Trust
Selling real estate and carrying back a promissory note pursuant to Section 453 of the Internal Revenue Code allows the taxpayer/investor to defer the payment of his or her capital gain taxes over the term of the promissory note. This is often referred to as seller carry back financing or installment sale treatment.
Depreciation recapture can not be deferred with an installment sale structure and will be recognized and taxed in the year the sale closes.
Clients may also wish to consider using the Deferred Sales Trust. The Deferred Sales Trust is very similar to an installment sale, but has some siginificant improvements and benefits that should be reviewed with your tax and legal advisors.
Section 121 — Gain Excluded on the Sale of Home
The 121 exclusion allows a homeowner to sell his or her personal residence and exclude from his or her taxable income up to $250,000 in capital gains per taxpayer ($500,000 for married couple filing jointly). The homeowneris required to have owned and lived in his or her personal residence for at least 24 months out of the last 60 months.
Other Tax-Deferral and Tax Exclusion Strategies
Charitable Remainder Trusts permit you to transfer your highly appreciated real estate or other assets into a Charitable Remainder Trust (CRT) for the benefit of specified charities. The CRT provides an immediate tax deduction for the "donation" of the real estate or assets, allows the taxpayer/investor to sell the real estate or assets without paying any depreciation recapture or capital gain taxes, and then reinvest the net proceeds into other investment opportunities that provide for better cash flow.
Sections 1032, 1034 and 1035 were not addressed because they do not apply to real estate or were repealed. Section 1032 applies to common stock in a corporate and Section 1035 applies to the exchange of annuities. Section 1034 applied to the dispostion of personal residences, but was repealed in 1997 and replaced with Section 121.
There are other alternatives, including some very sophisticated strategies, that your advisors can discuss with you.
Sunday, August 31, 2008 at 11:12AM 
Reader Comments (2)
Are there changes coming for tax deferred transactions? The rumor is that 1031's and capital gains may be coming under fire. I suppose if 1031's are left alone but capital gains tax rates are raised, the net result would actually be more 1031's. Tax havens are being revoked left and right, it will be interesting to see what we are left with in the next 2 years.
There are no present threats to the 1031 Exchange. The rumors are merely that, just rumors. Capital gain tax rates go up automatically on January 1, 2011. So, I would assume there will be an increase in 1031 Exchange business, too.