Is Section 1031 Ready for the Trash Heap?

A much-loved tax advantage in the real-estate industry is on the chopping block.  While the current political climate in Washington D.C. appears that no comprehensive tax overhaul will be occurring anytime soon, the fact that many in Congress have their eyes set on Section 1031 of the Internal Revenue Code should cause real estate investors to pause and ponder what other alternatives exist to avoid or defer taxes on the sale of real estate.  

The good news is there are alternatives which I will discuss in this blog:

1.  Use an Installment Sale to pay taxes over time

2.  Use IRC Section 721 to invest the old property in a real estate trust and defer taxes.

3.  Use the combination of a Charitable Remainder Trust and a Wealth Replacement Trust to avoid taxes, increase personal cash flow, and increase the distribution of your estate to your children.

Use an Installment Sale

Installment Sales are synonymous with "seller financing".  The main benefit of selling on installment is obtaining a secured note at an interest rate much higher than you could earn from your bank, credit union, or other financial institution.  

In an installment sale, the seller earns interest on the gross sales amount, however, they don't pay taxes on the full amount.  With an installment sale, the seller would pay taxes as they get paid over time.  However, there is one caution the seller has to consider when the property is subject to depreciation recapture that they should discuss with their tax advisor.  

In accordance with IRS Section 453(b)(1), an installment sales is effective when the seller disposes of property and then receives at least one payment for that property after the close of the taxable year in which the disposition occurs.  The payments received are broken out into three parts:

• Interest income
• Return of the adjusted basis in the property
• Gain on the sale

Example:  Let's say you sell a rental residential property for $250,000 (net of selling costs).  The property has a tax basis of $125,000.  For installment sales purposes, you divide the gain of $125,000 ($250,000 minus $125,000) by the $250,000 net sales proceeds.  This results in a gross profit percentage of 50%.  Thus, every receipt of principal is a 50% taxable gain.  So if you receive a $30,000 down payment, only $15,000 or 50% of it would be taxable.  In addition, if principal payments on the property equal $700 per month only 50% of it, or $350 would be taxable.  

Another rule of the law requires the seller to charge a minimum rate of interest on an installment contract equal to the lower of 9% or the Applicable Federal Rate (AFR), which the IRS publishes monthly.  For August 2017, the minimum annual interest for a 15-year installment note is 1.91%, however the conditions that make it attractive for a buyer to purchase a property from a seller whose holding a secured note on the property typically allows for a higher level of interest rate.  In addition, many sellers can also ask for points on the note.  

Use IRS Section 721

Section 721 of the Internal Revenue Code states the following:  "No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership."  Section 721 includes property transferred to an operating partnership of a real estate investment trust (REIT).  In this case, the REIT acts like a mutual fund in real estate with its portfolio of real estate holdings.  

REIT investments avoid taxes on the transfer of the property and also provide liquidity.   

Use Charitable Remainder & Wealth Replacement Trusts 

The combination of charitable remainder and wealth replacement trusts can create more estate value for the heirs of taxpayers and cash for them as opposed to simply selling the property and incurring current taxes. The steps that follow explain how this works and how you receive benefits.

Step 1. Create a Charitable Remainder Trust under terms that grant the taxpayer and spouse income from the trust during their lifetime – either as a fixed income or as a percentage of trust income.

Step 2. Donate the property to the newly created charitable remainder trust.

Step 3. Stipulate in the trust that when the second spouse dies, the remaining balance of the trust goes to one or more designated charities.

1. Benefit 1: More cash is working for you. Had you sold the property, you would have paid taxes and had only the after-tax money to invest
2. Benefit 2: You create an immediately deductible charitable contribution

Limits: The law limits charitable deductions to various percentages of adjusted gross income, depending on the type and nature of the contributions.

Carryover: If the charitable contribution exceeds the limits for the current year, you have five additional years to take advantage of the deductions.

Write-off: Your charitable write-off is based on the present value of the remainder interest you donate to the charity.

Tax law provides life expectancy tables that are used to value the remainder interest and the interest given away. These are the numbers that provides the value of your charitable contribution.

Step 3. Create a wealth replacement trust

The wealth replacement trust is a life insurance trust that uses term-life insurance with a second-to-die policy that insures both husband and wife. The insurance trust is the applicant for the insurance policy, owner of the insurance policy, and payor of the insurance premiums.

When the surviving spouse dies, the insurance company pays the death proceeds to the insurance trust, which, in turn, passes the proceeds to the heirs.

1. Benefit 3: The insurance part is the “have your cake and eat it, too” part of the strategy. Without the insurance, your heirs get nothing. With the insurance, you might give them as much as or more than you would without the charitable remainder trust.

Planning tip: To make the insurance part work, you and your spouse must be insurable. If only one is insurable, the plan can still work but generally not quite as well.

Six benefits: Here are six benefits from the combined charitable remainder and wealth replacement trusts:

• No capital gains taxes on the property transfer to the charitable remainder trust
• Higher income stream because you invest the pretax value
• Good-sized charitable deduction
• Income to pay for the insurance policy
• Cash to your heirs as if you gave nothing (or little) to charity
• Big smiles all around as you benefit your favorite charity and heirs while you pay little or nothing to the federal, state, and local taxing authorities

You have choices. Pay tax, pay no tax, or pay tax at your own pace.  I hope readers find this post of value.  For the strategies above you may need to engage a CPA and an attorney to properly implement them.  However, it's well worth the cost.