Cheat the Tax Man

One of the concerns of selling your land or investment property is always the tax consequences. I get it. Who wants to give money to the government when you don't have to?

One of those ways to "cheat the tax man" is in dealing with capital gains tax. Capital gains tax directly affects your exit strategy. If you sell property that has been used as income producing, then you will owe what is called “capital gains tax.” The tax can be divided into two categories:

1. Depreciation deductions – 100% of the amount you deducted for depreciation while you owned it, will be taxed at 25%. Deprecation reduces your taxable income while you own it. However, depreciation reduces your “basis” in the property; and therefore, increases the gain on the sale by an equal amount.

2. Gain from appreciation – 100% of the amount is taxed up to a maximum of 20%.

If this tax bothers you, then you need to know that the IRS has created a way around paying it. It’s called a 1031 exchange, like-kind exchange, or Starker exchange. The 1031 comes from the section of the IRS code that allows you to defer capital gains.

In 1970, a family named Starker challenged the IRS’s ruling on capital gains and eventually won the court case against the IRS. A 1031 exchange merely allows you to swap properties without actually swapping the property.

When you sell an investment property, IRS rules will allow you to purchase a “like” property, of equal or greater value, and defer the capital gains into the new property. A third party company, known as an exchange intermediary, that’s approved by the IRS, will hold your funds from the sale of the first property until you are able to close on the second property. If done properly, this “exchange” will allow you to defer the capital gains until the sale, or another exchange, of this second property.

It is possible, upon your death, to bequeath the property, and your heirs will not have to pay capital gains either. In effect, through the use of the 1031 exchange, it is possible never to pay capital gains in your lifetime. Who says you can’t cheat the tax man?

While you may do whatever you can to avoid paying this tax, you will probably need to do the math to see if it actually makes sense. Right now, capital gains tax is 20%. Plus, a 3.8% medicare surtax (from the Affordable Care Act) on investment income will apply.

Depending upon your tax situation, it may make sense to bite the bullet and pay the tax anyway. I’ve had properties that I had huge capital expenditures on; but after calculating the intermediary’s fees, I decided it best to just pay the tax and move on. Other properties have had a sizable capital gains tax, so I preferred to defer the capital gains by purchasing another property.

One thing to keep in mind is that there is a time limit on finding a property to purchase. Many investors have made dumb mistakes because of this time limit. They purchase something that is overpriced, or they buy a property without performing proper due diligence. Many sellers salivate when they hear that a 1031 investor is looking at their property. They know that someone under a time crunch and determined not to pay a capital gains tax will do some pretty dumb stuff.

If you happen to be one of those investors, never let the seller know it – under any circumstances. If the seller catches wind of your impending deadline, they will have the upper hand in negotiations, and it will cost you money in the end.

If you need help in selling your land or investment property, let us know. We will be glad to meet with you at no obligation and no pressure. www.BrianPattonCommercial.com Brian Patton, CCIM 770.634.4848