Tax Treatment of Common Real Estate Exit Strategies

Every real estate investor’s goal is to earn income from the cash flow and the appreciation of their investment. While it’s preferable for an investment to show no taxable income while having positive cash flow during the period of ownership, the sale or disposition of such an investment creates a challenge from an income tax perspective when cashing in on the sale of appreciated property. The only way to never recognize a taxable capital gain on the sale of a real estate investment is to never sell, but there are some options within the Internal Revenue Code that owners can utilize to minimize or defer the tax consequences of a sale.

The least tax efficient option in selling a property may be to pay taxes on the gain resulting from the sale. If the property is held less than a year prior to the date of sale, any gain recognized would be subject to the taxpayer’s ordinary tax rate, which could be as high as 37%. If held longer than a year, that gain becomes long-term and can reflect the benefit of the long-term capital gain rates, which is 20% at the highest, depending on the taxpayer’s adjusted gross income.

Unique to real estate capital gains, a portion of the gain will be subject to depreciation recapture that represents the total of the depreciation deductions taken for the period of ownership, at a rate of 25%. Sellers need to be aware of this, particularly when a cost segregation study has been done to take accelerated depreciation deductions in the initial years of ownership. The remaining tax basis may be significantly lower than expected if accelerated depreciation was utilized, leading to a much more significant portion of the gain subject to the 25% recapture rate and not the more efficient long-term capital gain rate. In a case where the depreciation recapture is a larger number than the gain calculated on the sale, the entire gain will be taxed at the 25% recapture rate.

For sellers who don’t qualify as real estate professionals, some of the gains may be offset by passive losses that were disallowed in previous years and carried forward. Upon the sale of a property, all passive losses that were previously disallowed for that property become available and can be used to offset the gain in the year of sale. Real estate professionals will typically not have suspended losses available to help mitigate the tax burden upon a sale.

Another tax implication for sellers who aren’t considered real estate professionals is the 3.8% net investment income tax (NIIT) that is tacked onto the entire gain as well, both to the portion of the gain that is subject to depreciation recapture as well as the portion that is considered long-term capital gain.

The most common alternative to a regular property sale is a sale under IRC Code Section 1031, also called a like-kind exchange. Section 1031 of the code allows taxpayers to sell a real estate investment with a gain and roll the proceeds into a new real estate investment in “like-kind” property. This allows the taxpayer to defer the entire gain or a portion of the gain to a later date if the proceeds from the sale are used to purchase a property (or properties) whose total value is in excess of the property sold and debt on the relinquished property is replaced with debt on the new property.

The benefit to a like-kind exchange is the partial or full deferral of the gain until the replacement property is sold. This method may make sense for owners who plan to stay in the real estate business long-term as they are able to exit the original investment and purchase a new one with little or no current income tax consequences. This method becomes much more difficult to utilize when the options of properties to purchase are limited, or it’s a seller’s market where it may not make financial sense to purchase property or when interest rates have increased and money is more expensive. To add to the difficulty, the IRS provides a finite window in which all of these transactions must happen and commences when the relinquished property closes:

The 45- and 180-day windows can straddle the end of the year, so for those taxpayers who have a potential gain close to the end of the year, the replacement property can be fully acquired in the following calendar year as long as it meets the 45- and 180-day windows.

If the identification of replacement property is an issue for a taxpayer looking to complete a Section 1031 exchange, or the taxpayer is not looking to be an active participant in real estate going forward, an alternative growing in popularity is investment into a Delaware Statutory Trust (“DST”). A DST is a 1031-eligible entity that qualifies as “like-kind” real estate for the purposes of a completing a like-kind exchange. The benefits of an exchange into a DST are similar in that a taxpayer still has access to real estate investments, but they are able to defer a taxable gain on a relinquished property.

DSTs have no requirement to pay monthly distributions, and there is no guarantee of future appreciation. In addition, the interest in a DST investment is a completely passive beneficial interest, and thus, from an income tax perspective, the opportunities to utilize tax planning strategies with a DST are minimal compared to direct ownership. Additionally, DSTs are very illiquid, and if an investor decides to exit the investment, they must sell the DST investment itself, and finding a buyer could prove challenging.

Another sale option is the concept of an installment sale, often referred to as a seller-financed transaction, where the seller of the property effectively acts as the bank, providing a mortgage to the buyer to complete the sale.

When a deal is structured this way, it becomes an installment sale in the eyes of the IRS, and the gain can be deferred and recognized over the term agreed upon for the payment of the mortgage. With the obvious upside being the deferral of the taxable gain and the corresponding tax paid on the sale by the seller, the downside is that the seller’s receipt of the cash is also deferred over the mortgage term. In addition, like any other mortgage or long-term note, the buyer must pay interest to the seller along with the principal of the note, and that interest income is taxed at ordinary rates to the seller.

One major item of note on seller financed deals is that the tax due on the portion of the gain that is subject to depreciation recapture is taxed in the year of sale and cannot be deferred using an installment sale. If a property has a low tax basis, and depreciation recapture exceeds the total gain, an installment sale provides absolutely no benefit to the seller. Proper planning should be done prior to implementing a structure of this kind

Author: Matthew Young, CPA, MSA | [email protected]