Real Property Exchage for Note (live deal):

[John Brackett]

Tax Question (two scenarios) - Question builds so please read all three bullet points and provide feedback:

1) Capital Gain – seller purchases a property for 40K. 20 years later property is fully depreciated and seller wants to sell for 100K. At that price what is long term capital gain? Is current rate 25%? 25K capital gain due March 15th of year earned?

2) Installment sale – wants to exchange. But is considering an offer from buyer to purchase property for 100K. Seller then carries a note for full purchase price secured by a deed 1st trust deed - $100K @ 5.5% interest, amortized over 30 years, due in 10 years (installment sale). What is capital gain tax consequence? Is there any – I would think so as property is fully depreciated. How would gain get paid if installment sale/or simply put what is tax to seller? 1) Are payment taxed at long-term capital gain rate? 2) Is interest taxed as ordinary income?

3) Is seller able to exchange gain into note (note he is carrying back for buyer in scenario#2)? If so, would gain be payable when note is paid off by Buyer? How can seller exchange gain into note if at all? Any suggestions? I’m trying to work above deal and need to present some “hypothetical” tax advantages for seller to confirm with his tax guy? Any way to exchange gain into note carried back by seller or similar concept? Suggestions encouraged.....

[Dave Toelkes]

1. In your scenario sale proceeds are $100K. $60K is long term capital gain -- current maximum long term capital gain tax rate is 20%. The $40K balance of the sale proceeds is unrecaptured depreciation, taxed at 25%.

2. Are we building on the same property as in scenario 1? If so, then net sale proceeds are still $100K with $60K treated as long term capital gain, and, $40K treated as unrecaptured depreciation. The installment sale means that the seller does not get all of his profit at once. Instead it is spread out over ten years. Each month, the buyer makes a payment to the seller. A portion of the payment is interest on the loan, a portion is a return of capital, and a portion is profit. The profit is taxed as it is received at the long term capital gain rate in effect in the year it is received. The return of capital is tax free, and the interest is taxed as ordinary income as it is received at the taxpayer's marginal tax bracket rate. The advantage of an installment sale is that the tax bite on the capital gain is paid to the IRS in installments. The pitfall is that the unrecaptured depreciation is taxed in full in the first year of the sale, even though the seller may not have received enough money from the buyer to pay the tax.

3. If the seller holds a note for the sale of the property, then the seller has received a debt instrument for his property. A note is not real estate (i.e., not like-kind property) and if the seller accepts a note, the exchange is disqualified. The way around taking a note and still preserving the exchange is to have the QI accept the note, then have the QI sell the note (probably at a discount) for cash, then hold the cash in exchange escrow for acquisition of an eligible replacement property.