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Pro Tax Tip: How to Sell Airbnb(s) Like the Real Estate Elite - Part 1

Updated: Mar 29, 2023



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Cashing Out Real Estate Profits without Section 1031


Paying taxes on the sale of your real estate is voluntary. You do not need to volunteer.


Real estate investors use Section 1031 to avoid taxes when acquiring bigger and better properties. But now, when you want to cash out, Section 1031 is not the vehicle of choice. So what do you do?


This article gives you three strategies to help you cash out your real estate profits:


  1. Use the combination of a charitable remainder trust and a wealth replacement trust to avoid taxes, increase personal cash flow, and increase the estate distribution to your children.

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

  3. Use an installment sale to pay taxes slowly.


1 . Use Charitable Remainder and Wealth Replacement Trusts


The combination of charitable remainder and wealth replacement trusts can create more estate value for your heirs and cash for you than can selling the property and paying taxes now. The steps that follow explain how this works and how you receive benefits.


Step 1. Donate the property to a newly created charitable remainder trust under terms that grant you and your spouse income from the trust—either a fixed income or a percentage of the trust income—during your lifetimes.[1]


Step 2. Stipulate in the trust that when the second spouse dies, the remaining balance of the trust goes to one or more designated charities.


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.


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,[2] you have five additional years to take advantage of the deductions.[3]

Write-off. Your charitable write-off is based on the present value of the remainder interest you donate to the charity. Tax law gives you life expectancy tables that you use to value the remainder interest and the interest you give away. These are the numbers that give you the value of your charitable contribution.[4]


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

  • payer 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.


Benefit 3. The insurance 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:


  1. No capital gains taxes on the property transfer to the charitable remainder trust

  2. Higher income stream because you invest the pretax value

  3. Good-sized charitable deduction

  4. Income to pay for the insurance policy

  5. Cash to your heirs as if you gave nothing (or little) to charity

  6. 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


Example. You and your spouse own real estate worth $1 million. If you sell, you would pay

$300,000 in taxes to the various taxing authorities. That would leave you with $700,000 that you could invest in certificates of deposit at 2 percent for an annual pretax return of $14,000.


Alternatively, you could create a charitable remainder trust that sells the real estate for $1 million and arranges for a 5 percent return in the investment portfolio of the college that is going to be the recipient of this trust. In this case, the trust creates a


  • $94,000 charitable deduction, and

  • annual cash flow of $50,000.


From the $50,000 annual cash flow, you take $15,000 a year to fund a $1 million term life insurance policy payable to your children.


Planning tip. Note how this plan adds $21,000 a year in extra income ($50,000 minus $14,000 minus $15,000) and a $94,000 tax deduction for our taxpayer in the example.


2 . Use Section 721


Section 721 says that when you contribute property to a partnership in return for a partnership interest, neither you nor the partnership or partners recognize any gain or loss.[5]


Section 721 includes property transferred to an operating partnership (OP) of a real estate investment trust (REIT). In this circumstance, the REIT with its diversified realty holdings becomes the equivalent of a mutual fund in real estate.


The OP units you receive in return for the property contribution entitle you to periodic distributions from the REIT. Further, you may convert the OP units into shares of the REIT.


The REIT investments not only avoid taxes on the transfer of your property but also provide liquidity.


The transfer to a special kind of REIT can solve the problem that triggers tax on a property transferred with a mortgage liability in excess of the property’s basis. With the excess mortgage, you recognize gain to the extent of that excess mortgage.[6]


The special REIT, called an UPREIT, is designed to guarantee an equivalent portion of the liabilities of the REIT so as to make the excess mortgage a nonissue and allow you to avoid taxes on the transfer.


3 . Use an Installment Sale


A regular installment sale of real estate is an easy way to increase net worth.[7]


Your main benefit of “holding paper” is obtaining a secured note at an interest rate much higher than you could earn from your local financial institution.


In an installment sale, you earn interest on the gross amount because you have not yet paid the taxes. With an installment sale, you pay the taxes as you get paid.


Caution. You pay taxes up front when you have to recapture.[8]


  • depreciation in excess of straight-line depreciation or

  • investment tax credits on low-income or certain rehab properties.



Rule. You make an installment sale when you dispose of property and then receive at least one payment for that property after the close of the taxable year in which the disposition occurs.[9]


Payments you receive in an installment sale consist of three parts:


  1. The taxable part of the principal payment

  2. The nontaxable part of the principal payment

  3. The interest


Example. You sell investment land for $250,000 (net of selling expenses). The land has a tax basis of $125,000. For installment sale purposes, you divide the profit of $125,000 ($250,000 minus $125,000) by the $250,000 net sales proceeds. This gives you a gross profit percentage of 50 percent. Thus, every receipt of principal is 50 percent taxable gain.


At closing, you collect a down payment of $30,000. This down payment is 50 percent return of capital (your basis) and 50 percent taxable gain.


Next, you receive a payment that includes $700 of principal. For tax purposes, you divide the

$700 into its 50 percent taxable part ($350) and its 50 percent nontaxable part ($350).


Minimum interest. Tax law requires that you charge a minimum rate of interest on an installment contract equal to the lower of 9 percent or the applicable federal rate (AFR), which the IRS publishes monthly.[10] (For December 2017, the minimum annual interest for a 15-year installment note is 2.64 percent.[11])


Make more money. To make the most money on your owner-take-back installment note, look for the highest interest rate that the seller will pay, and then add points if possible.


Takeaways


Whenever you can, avoid the outright taxable cash sale of investment property. To avoid taxes while you build your portfolio of real estate investments, use the Section 1031 exchange.


If you want to cash out, move on, and also take care of your estate, consider combined charitable remainder and wealth replacement trusts.


If the trusts don’t grab your fancy, consider the IRC Section 721 REIT and UPREIT strategies to defer taxes on the disposition of your old real estate investment and to gain liquidity.[12]


If you don’t mind paying the taxes but would like the tax payments spread out over a number of years, consider a Section 453 installment sale.


You have choices. Pay tax, pay no tax, or pay tax at your own pace.


There Are Thousands of Tax Planning Strategies You May Be Missing Out On.

Learn how Prosperity Tax Advisors can help you save money in taxes.



This article was reviewed by:



The material discussed on this page is meant for general illustration and/or informational purposes only and is not to be construed as investment, tax, or legal advice. You must exercise your own independent professional judgment, recognizing that advice should not be based on unreasonable factual or legal assumptions or unreasonably rely upon representations of the client or others. Further, any advice you provide in connection with tax return preparation must comply in full with the requirements of IRS Circular 230.



[1] The percentage is known in tax jargon as a charitable remainder unitrust (CRUT) [IRC Section 664(d)(2)]. Tax law refers to the flat amount as a charitable remainder annuity trust (CRAT) [IRC Sections 664(d)(1) and 453(b)]. A CRAT cannot accept future contributions of property [Reg. 1.664-2(b)]. However, a CRUT can be the recipient of future transfers [Reg. 1.664-3(b)].

[2] IRC Section 170(b)(1)(A).

[3] IRC Section 170(d)(1)(A).

[4] Regs. 20.2031-7A(f); 1.664-4.

[5] IRC Section 721.

[6] IRC Section 357.

[7] IRC Section 453.

[8] IRC Section 453(i).

[9] IRC Section 453(b)(1).

[10] See IRC Sections 483 and 1274; IRS Pub. 537, Installment Sales (2016), Dated January 13, 2017, p 11, says that for sales or exchanges of property (other than new Section 38 property, which includes most tangible personal property) involving seller financing of $5,664,800 or less, the test rate for determining minimum interest cannot be more than 9 percent, compounded semiannually.

[11] Rev. Rul. 2017-24.

[12] IRC Section 721.

Sourced with the help of The Bradford Tax Institute.




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