Don't want to be a landlord any longer? Don't want to pay the taxes if/when you sell? You do have options!
Metro Group Real Estate is not providing legal or accounting advice. All individuals considering these options should seek guidance from individuals experienced with these options.
Option 1: Delaware Statutory Trust
A Delaware statutory trust (DST) is a legally recognized trust that is set up for the purpose of business, but not necessarily in the U.S. state of Delaware. It may also be referred to as an Unincorporated Business Trust or UBO.
Delaware statutory trusts are formed as private governing agreements under which either (1) property (real, tangible and intangible) is held, managed, administered, invested and/or operated; or (2) business or professional activities for profit are carried on by one or more trustees for the benefit of the trustor entitled to a beneficial interest in the trust property.
DST Investments are offered as replacement property for accredited investors seeking to defer their capital gains taxes through the use of a 1031 tax deferred exchange and as straight cash investments for those wishing to diversify their real estate holdings. The DST property ownership structure allows the smaller investor to own a fractional interest in large, institutional quality and professionally managed commercial property along with other investors, not as limited partners, but as individual owners within a Trust. Each owner receives their percentage share of the cash flow income, tax benefits, and appreciation, if any, of the entire property. DSTs provide the investor the potential for annual appreciation and depreciation (tax shelter), and most have minimum investments as low as $100,000, allowing some investors the benefit of diversification into several properties.
The DST ownership option essentially offers the same benefits and risks that an investor would receive as a single large-scale investment property owner, but without the management responsibility. Each DST property asset is managed by professional investment real estate asset managers and property managers. It used to be that only large institutional investors such as life insurance companies, pension funds, real estate investment trusts (REITS), college endowments and foundations were able to invest in these properties. Now as a viable 1031 exchange replacement property option through a DST, individual investors have the ability to invest in a diversified selection of institutional quality, investment property types that they otherwise could not purchase individually. DST Investments are located throughout the United States. Property types may include multifamily apartment communities, office buildings, industrial properties, multi-tenant retail, student housing, assisted living, self-storage facilities, medical office, single tenant retail properties and others.
Step-Up In Basis
When a taxpayer bequeaths an asset to a beneficiary upon death, the beneficiary’s tax basis in the asset is “stepped up” to the fair market value of the asset at the time of the transfer as opposed to being recorded at the original taxpayer’s adjusted basis in asset.
For instance, assume Betty owns an investment property which has an adjusted basis of zero and market value of $1,000,000. If Betty were to sell that property, she would face capital gains taxes based on a gain of $1,000,000 (value less adjusted basis). However, upon Betty’s death, if the property is left to Betty’s daughter Susie, then (with careful advance estate planning) Susie’s basis in the property would be $1,000,000 as if she had purchased the asset. Susie would then be able to take depreciation allowances based on her basis in the property of $1,000,000 and capital gains taxes on future sales would also be based on Susie’s stepped-up basis of $1,000,000. In addition to direct property ownership, a step-up in basis also applies to Replacement Property Interests TM (RPIs) such as beneficial interests in a Delaware Statutory Trust (DST) or Tenant-in-Common (TIC) interests in a property.
Option 2: Deferred Sales Trust
If you are considering the sale of a business, corporation, or investment real estate, you may face capital gains taxes associated with the sale. For the investor who does not want to continue holding investment property or remain in the same business, a Deferred Sales Trust should be considered. According to section 453 of the Internal Revenue Code, the Deferred Sales Trust provides investors a solution whereby they can defer capital gains upon sale of their assets and redirect the sale proceeds into cash or whichever types of investments suit their needs, income requirements, and objectives.
What is a Deferred Sales Trust?
The Deferred Sales Trust is a legal contract between you and a third-party trust in which you sell real or personal property or a business to the Deferred Sales Trust in exchange for the Deferred Sales Trust's contractual promise to pay you a certain amount over a predetermined future period of time in the form of an installment sale note or promissory note. It is often referred to as a "self-directed note" because you have control over the terms of the note. The Deferred Sales Trust gives you the ability to control your capital gains tax exposure, reinvestment terms, and installment payments made from the trust.
How Does a Deferred Sales Trust Work?
The process begins when a property or business owner transfers his asset to a trust managed by a third-party company on his behalf. The third-party company acts as trustee over the asset, and the owner is the beneficiary of the trust that holds the asset. The trust will sell the asset for the owner and manage and distribute the sales proceeds of the trust according to an agreed-upon installment contract that the owner sets up ahead of time with the trust. The sales proceeds can be held in cash, reinvested, and distributed according to the direction of the owner's installment contract. There are zero taxes to the trust on the sale, since the trust purchases the property from the owner for the same price for which it is sold.
The tax code does not require payment of any of the capital gains taxes until an investor starts receiving installment payments that include principal. The owner then is able to control if, when, and how there will be capital gains tax exposure over the installment contract period by adjusting the installment contract. The installment contract between the owner and the trust company provides flexible options on when and how payments can be made. Initially, the owner may have other income and may not need the installment payments right away, which would defer income and capital gains taxes. If an owner wants income but does not want to pay capital gains taxes, he can set up the installment contract to pay interest-only payments from the reinvested sales proceeds. According to IRC section 453, this strategy can defer the capital gains tax indefinitely.
Guidelines for the Deferred Sales Trust to Qualify
Trust Structure: In order for a Deferred Sales Trust to qualify for capital gains tax deferral, it must be considered a bona fide, third- party trust with a legitimate, third-party trustee.
Independent Trustee: The Deferred Sales Trust must employ a trustee that is truly independent from the owner/beneficiary of the trust. If there is not real trustee independence from the owner, the IRS considers this to be a sham trust, set up for the sole purpose of creating layers of legal documents to avoid taxation. The independent trustee is responsible for managing the trust according to the laws that govern trusts, according to the installment contract, and according to the investor's risk tolerance and investment objectives.
Asset Transfer: In order for the Deferred Sales Trust to shield the owner from capital gains taxes, the owner must not take constructive receipt of any sales proceeds from the disposition of an asset. The trust created on behalf of the investor must take legal title to sale proceeds directly from the disposition of an asset or from a third-party qualified intermediary that is holding the sale proceeds on behalf of the investor in order to qualify for capital gains tax deferral.
Asset Ownership: Asset ownership must be legitimately transferred to the trust prior to a sale for the sale proceeds to be sheltered from capital gains tax. If the owner did not transfer practical ownership over to the trust and still retains all of the benefits of direct ownership, the IRS disallows the owner from enjoying the tax-advantaged benefits afforded by the trust's ownership. In other words, the property must be legitimately transferred to the trust or it will be taxed as if it were not.
Assets Must Remain in Estate: The owner cannot use the trust to transfer any economic interest to a third party without due compensation. The IRS does not allow this type of transaction because it allows people to pass assets out of their estate without bearing capital gains, gift, income, or estate taxes.
Trust Restrictions and Law: The owner/beneficiary of the trust must be subject to the restrictions imposed by a trust agreement or the law as it applies to trusts and transferred assets. If the owner enjoys unrestricted use and control over the assets of the trust without fiduciary limitations, the IRS considers this to be a sham trust that does not qualify for capital gains tax deferral.
Failed Exchange Rescue
One of the most unique benefits of the Deferred Sales Trust is its ability to rescue an investor from capital gains taxes in the event of a failed 1031 or 721 exchange. In the case of a 1031 or 721 transaction, the investor's sale proceeds from the disposition of an asset go to a qualified intermediary (QI). The QI holds these proceeds on behalf of the investor in order to close on a replacement property to complete the investor's tax-deferred exchange. Should the exchange fail, whereby the funds cannot be reinvested into a property according to IRS guidelines, the funds held at the QI are subject to capital gains and depreciation recapture taxes once released from the QI to the investor.
The Deferred Sales Trust provides a ready solution to this problem by allowing the funds to revert to a trust rather than to the investor. The investor is saved from taking constructive receipt of the funds and bearing the capital gains and depreciation recapture taxes. The investor can tailor his investment contract with the trustee to pay him his funds in a manner that will effectively defer taxes over the installment contract.
Depreciation Shelter: Some types of depreciation recapture may be deferred, but any excess accelerated depreciation over the straight line depreciation method cannot be deferred. Fees for setting up a deferred sales trust may be higher than those of as a 1031 exchange.
Trust Legitimacy: If a deferred sales trust is improperly managed and the IRS chooses to investigate, it is possible that the trust could be designated as a "sham trust." If a trust is labeled a sham by the IRS, the income from the initial sale is taxed as though the trust did not exist. Therefore, it is very important that Deferred Sales Trusts are established and operated according to IRS guidelines and trust law.
Option 3: Contract for Deed
Selling real estate by land contract or contract for deed can be an excellent way to turn an unwanted piece of property into a stream of payments over a short or long period of time. These contracts also have the benefit of letting you spread your capital gain over an equally long period of time, keeping more of your capital working for you for a longer time than with an outright taxable sale.
Understanding the Land Contract
A land contract, or contract for deed, is a type of installment sale in which a seller agrees to sell the property to a buyer over a period of time. During that time, the buyer makes installment payments which consist of both principal and interest. It is very similar to how a mortgage works, except that instead of engaging a bank to lend money, the seller serves as the lender, taking in payments and gradually releasing ownership of the property over time. Contracts may be structured similarly to residential conforming mortgages, where they pay down to zero, or may also be set up with balloons, requiring the buyer to make a large lump sum payment at some point in time.
Income from the Land Contract
Although buyers typically write one check when making their land contract payments, the seller actually receives two different types of income. The first type is the interest that they receive on the balance of the contract. The second type is the paydown of principal which, in most cases, is a realized capital gain or recapture income.
Federal Tax Treatment of the Land Contract
For federal tax purposes, the multiple income streams from a land contract are all treated differently. The income from the interest payments is regular income, taxed at whether the taxpayers highest marginal tax rate happens to be. Assuming that the property was sold at a profit, the principal payments are taxed as capital gains at the rate that is in effect at the time of the payment, until the balance is paid down to the property's basis. At that point, the principal payments are untaxed. In the event that the property was depreciated, the principal payments on the depreciated amount are considered recapture and taxed at whatever rate is in effect.
Tax Pitfalls of the Land Contract
Most people enter into land contracts to eliminate making a large capital gains tax payment at the time of sale. However, by doing a contract they still end up paying all of the capital gains tax--they just take longer to do it. Furthermore, if capital gains taxes increase, the amount of tax to be paid will go up in the future. Also, if the buyer makes a balloon payment, all of the taxes due on that balloon will be due in one lump sum payment, negating the contract's key tax benefit.
Option 4: Contract for Deed - 1031 Exchange
Do Land Contracts For Deed Qualify for 1031 Exchange Treatment?
Land Contracts or Contracts for Deed are often misunderstood by investors in terms of how they should be treated for income tax reporting purposes, especially when the Land Contract or Contract for Deed is part of a 1031 Tax Deferred Exchange transaction.
Land Contracts or Contracts for Deed are difficult to explain because the terms can mean different things to different people in different geographic areas. The transaction strategies, structures and settlement processes can vary significantly from state to state, county to county or even town to town. However, the issue of a Land Contract or a Contract for Deed in conjunction with a 1031 Exchange does come up frequently enough that the topic is worth addressing.
Terminology: Land Contract or Contract for Deed
The fact that Land Contracts or Contracts for Deed can mean different things depending on the way they are drafted is what makes this topic so difficult to explain to investors. Generally, a Land Contract, Contract for Deed and/or a Contract for Sale mean the same thing, but not always, so you must pay close attention to the way the legal document has been drafted. And, make sure that the terminology that you are working with is appropriate to the geographic area where the real property is located.
1031 Exchanging Property Sold Under a Land Contract
Here is an example of a sale of real property under a Land Contract with a 1031 Exchange. A real estate investor sold investment property a number of years back under a Land Contract. The buyer is now in a position to pay off the entire balance due under the Land Contract. The real estate investor is obviously going to receive a significant lump sum payment under the Contract for Deed and is concerned about his or her capital gain taxes that will be due to the IRS upon receipt of the lump sum payment. The real estate investor wants to know if he or she can structure a 1031 Tax Teferred Exchange using the proceeds received from the payoff.
1031 Tax Deferred Exchange
Real estate investors can structure a 1031 Tax Deferred Exchange and defer the payment of their depreciation recapture taxes and capital gain taxes provided they acquire like-kind replacement property as part of the 1031 Exchange. The real estate investor must relinquish an interest in real property and subsequently acquire an interest in real property during certain 1031 Exchange deadlines in order to qualify for tax-deferred exchange treatment.
Right to Own, Use, Possess the Real Property
The key issue in this case is when exactly did the buyer have ownership rights to the subject real property? We need to determine when the rights of ownership actually transfer to the buyer. Do the rights to own, use, and possess the property transfer upfront upon execution of the Land Contract or at the back end when the Land Contract is actually paid off by the buyer?
Generally, a Land Contract or Contract for Deed results in the immediate sale and transfer of rights to the real property to the buyer upfront and provides for financing or payments over a period of time. The legal title to the property is retained by the seller as a security device rather than a recorded lien against the title, but the buyer does have all of the benefits and burdens of ownership and has the right to own, use, and possess the property as he or she sees fit.
However, there are some contracts that do not transfer all of the rights to the real property until the backend of the transaction when the debt is paid in full by the buyer. This is why you must be careful to read the contract and understand what rights are transferred and when the rights are transferred to the buyer. You should consult with your legal and tax advisors to make sure that you know exactly what affect your contract will have.
Installment Sale Treatment Under Section 453
So, assuming that the Land Contract or Contract for Deed does in fact transfer all of the rights and benefits of ownership to the buyer upfront at the time of execution of the Land Contract, like most of them do, the transfer or conveyance of the real property is considered to have occurred upfront for tax purposes.
The Land Contract or Contract for Deed in this case is treated just like an installment sale contract or installment sale note, also referred to as a seller carry back note. It can be drafted outside of the 1031 Tax Deferred Exchange and would be taxable as an installment sale note under Section 453 of the Internal Revenue Code. It can also be drafted as part of the 1031 Exchange so that the investor can still defer all of his or tax liabilities.
Generally, for this reason, most real estate investors will want the Land Contract to be drafted so that it is included inside of the 1031 Tax Deferred Exchange account so that the investor can defer all of his or her depreciation recapture taxes and capital gain taxes.
However, this means that the Land Contract will complicate the investor's ability to structure and complete a 1031 exchange transaction because the transfer or closing has occurred upfront upon the execution of the Land Contract. And, the Land Contract has been drafted to be included in the 1031 Tax Deferred Exchange, but the investor is not holding all cash in his or her 1031 Exchange account in order to complete his or her 1031 Tax Deferred Exchange by acquiring like-kind replacement property. The Land Contract must somehow be converted into cash in order to complete the investor's 1031 Exchange.
Option 5: Lease Option
First, let's start with the lease option, which is really two things, a lease and a purchase option. A lease is a contract for the use and possession of land, creating a landlord/tenant (or "lessor/lessee") relationship.
A purchase option is a unilateral agreement wherein the optionor ("seller") agrees to give the optionee ("buyer") the exclusive right to the purchase the leased premises. The option price is generally set at a fixed price at the inception of the lease, although it does not have to be. At any time during the option period (which generally corresponds to the lease period), the tenant can exercise his option to purchase.
An option is not the same as a regular purchase contract, which is a bilateral agreement. A bilateral contract legally binds both parties to the agreement, whereas an option only binds the seller. An optionee is not bound to buy; it is his option do so (or not to do so).
A lease with option arrangement is not a sale, but rather a landlord-tenant relationship. In rare cases, a court may re-characterize the transaction as a sale if it looks like a sale. Furthermore, the IRS does not classify a lease option as a sale until the option is exercised (see, Tax Court Memorandum 1999-11).
Metro Group Real Estate is not providing legal or accounting advice. All individuals considering these options should seek guidance from individuals experienced with these options.