How best to structure a deal to pay the least capital gain tax?

Question

I have a question that I hope I can either get an answer or direct to someone that can help us out.

Our current situation is that an investment property we acquired in 2009 is under my sister name. She is single and does not have any children. We bought it at $530,000 with 20% down ($106,000) and it is now value around $1,300,000. The loan balance is currently at around $400,000. We have decided not to do a 1032 exchange because some of us do not believe that the market will continue to rise. In other word we might be able to acquire cheaper in the future (please no debate on which way the market will be heading).

What is the best way to minimize the tax on the capital gain or will it just be a flat rate on how much we profit after the sale? Do I need a financial adviser to help us with this?

Thanks,

Khoa

Dave Foster · Answer

@Khoa Ha, Great alternative suggestions by @Natalie Kolodij and @Matt Ward.  And a comment by @Jaysen Medhurst that deserves some thought - " I would question the logic of not doing a 1031 because you don't think the market will continue to appreciate."  The power of the 1031 exchange is that it lets you defer tax while repositioning your real estate assets.  But real estate investors use the 1031 to reposition within real estate.  Very seldom does an entire industry crash at once.  And even then historically those crashes are relatively short in duration before the markets start to improve.  So 1031 investors move from more leveraged to less leveraged positions.  Or they change sectors to something more recession resistant like student housing, self storage, or distribution facilities.  They move from appreciation plays and put their money into cash flow to ride out an anticipated storm.

You're looking at almost a million dollar gain including depreciation recapture.  If you don't do a 1031 get ready to give Sacramento and Uncle Sam over $300K.  The market would have to crash pretty significantly to warrant paying that in anticipation of a crash.

There is also generally a contra cycle between Oil and real estate.  So some investors will choose to exit real estate via a 1031 and move into oil, natural gas, and mineral resources which can qualify for 1031 treatment.

It may be the right move for you to sell and incur the tax (either now or later.  You're right to be looking at it closely.  But I'd really think hard before writing off $300K just because I thought a market might soften.  When you look at the net impact of things, selling now without the tax deferral of a 1031 is really the same as having the market correct 30% and then you have to sell the property.  I wouldn't volunteer to do that ahead of time

Natalie Kolodij · Answer

You need a tax pro.

There are a few ways you may be able to soften this tax blow but they will depend on your specific tax situation.

Installment sale

Monetized installment sale

You can also 1031 into a DST potentially, passive REI

Jaysen Medhurst · Answer

Is this a primary residence? If so, it won't be eligible for a 1031 exchange, @Khoa Ha. Who owns the property? You wrote both "under my sister's name" and "We bought it..." So, are you also on title? $250k of capital gains are exempted with a personal property. $500k for married couples. Not sure how it works if 2 people are on title. Worst case, you're paying 20% of ~$455k. So, $91k of taxes on $705k is an effective rate of <13%. That's hard to beat...

If it is an investment property, before you rule out a 1031, I'd speak to a great QI like @Dave Foster. He may be able to present options that allow you to defer capital gains taxes that you hadn't thought of. As an aside, I would question the logic of not doing a 1031 because you don't think the market will continue to appreciate.

How to minimize CG taxes beyond that depends a lot on your personal situation. Owner financing can be a way to lower those taxes by spreading out the payments.

You don't need a financial advisor, but a conversation with a good CPA is definitely in order.

Matt Ward · Answer

agree with @Natalie Kolodij

or you could cash out refi?

Khoa Ha · Answer

@Michael King any question is fair game once I submit my post. I do want to do a 1031 exchange but since the other partners do not want it the next best thing is to cash out and find something that I have 100% control over in the long run.

Thanks,

Khoa

Dave Foster · Answer

@Khoa Ha, family is more important than money !  And thanks for the kind words. And although the taxes will sting,  No one every went broke paying tax on profit :) . Well done on your investment.

Khoa Ha · Answer

Thank you @Scott Jensen @Thomas Rutkowski for providing a few terms that I can lookup and do more research on.

Hi @Michael Skoczylas

• 1) Everything is under sister name.
• 2)      Primary resident.
• 3)      Will take Natalie Kolodij advice and talk to an accountant.
• 4)      That might be another option. @Matt Ward

Thanks @Dave Foster

I spoke with you in the past about the 1031 exchange. But like I have responded to Jaysen Medhurst I cannot get it through the other that we should do a 1031 into a larger property. I gave up trying and will want to cash out and go solo. That way I can do what I wanted to do. If I ever need help with the 1031 exchange I know where to look.

Thanks,

Khoa

Khoa Ha · Answer

Hi @Jaysen Medhurst

To clarify: everything is under my sister name only. We structure the investment that way because at the time we didn't know better. You mentioned that for gain over $705 the tax will be <13%. If that is the case then it will be great. Ill do more research on this.

As for why not doing the 1031 exchange, its a long story that was why initially I didn't want to get into it. I told the other partners that we should do it if we can find a larger property that cash flow better than the current one. However, no matter how I explain it they still does not get the idea that we now have more equity in the property and the return on the investment is no longer as big as they think. For example, the down payment was $100,000 when purchase. Net Income was around $2000 per month for an annual return of 24%. Now we have around $800,000 - $900,000 in the property. The NI is around $3,000 give or take. That is a return of around 4% - 4.5%. So when they say we cannot find another property that will return around 24% so it is not good to do a 1031 exchange I stop trying to explain. Hope that make sense.

Khoa

Khoa Ha · Answer

Thanks @Natalie Kolodij. I will look into someone that know more about the tax regarding this.

Thanks,

Khoa

Michael Skoczylas · Answer

I think you got some great responses here already.

1. I think you need to clarify how this is owned, AND how this has been reported for tax purposes.

2. Type of property- investment, personal, vacation.

3. Talk to your accountant who likely knows the tax situation better than most, and possibly have him reach out to a specialist.

4. Decide if you for sure want to sell, or if a cash out refi can satisfy the current needs.

I would say anything should be on the table - including installment sales, 1031's no matter how you feel the market is, there are good deals out there.

How best to structure a deal to pay the least capital gain tax?

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