Paying Capital Gains in Real Estate

Let's start this out by learning what a capital gain is. A capital gain is considered the difference between what you paid for your investment and what you received as a return on that same investment.

The United States government already offers many homeowners all kinds of tax breaks. The biggest ones are the property tax deductions and the mortgage interest. Now if you're a home seller you also have a great advantage. You won't owe the government anything off the sale of your home. The way it works is like this. When you decide to sell your home and your single you can make up to a $250,000 profit and not have to worry about paying any capital gain taxes. What's even better is if you're married you can make up to $500,000 in profit and not owe a dime. Many home sellers are shocked by this huge break. You can utilize this new law an unlimited number of times. There are still some requirements that need to be met. The first requirement is the home has to be your principal residence. It doesn't apply to investment housing. You also must live in the home for at least two out of the five years prior to the sale of it.

The first step in the calculation of capital gains in Canada is you need to determine whether or not the property sold was capital property and then determine if the proceeds of this sale exceed the total sum of the adjusted cost base. Adjusted cost base along with the expenses that were incurred at the time of the sale. Claiming any type of reserve or any kind of capital gains deduction could have an affect on your capital gain reporting as well as your capital gain tax amount. If the payment will be received over several years claiming a reserve will allow you to report any capital gains from only the portion of the proceeds of the disposition you had received during that year. The lifetime total exemption for any person is $250,000. This isn't too bad especially if you made a small investment.

Real Estate Tax Deduction - Have Your Cake And Eat It Too

Owning a property can help you benefit from the property tax deduction. This can actually be broken down in to several separate advantages. This tax deduction is actually a general deduction encompassing many. Some of the areas that advantages can be taken in that are included in the deduction are listed below.

One area that is included in this tax deduction is any interest paid on your mortgage. This is because the interest you collect on your house is also deductible up to a maximum of $1 million.

Another part of this deduction is what is called fee points, which are points that are associated with a home acquisition mortgage. Because each one is worth 1% this can really add up when it comes to taking advantage of this portion of the deduction.

Something else that is part of this deduction is equity loan interest. This interest that is the amount that you would pay on a home equity loan is only partly deductible, not fully. This part of it has a few regulations that must be followed according to the Internal Revenue Service.

A few other things that can be included in applying for the tax deduction includes home improvement loan interest and the home office deduction. With the home improvement interest you cannot include anything considered a repair. But with the home office deduction you can include any part of your home used for business, and can include repairs.

One thing that is a fairly big part of the deduction is the selling costs. These can include the real estate broker's commissions, title insurance, legal fees, advertising costs, administrative costs, and inspection fees. By taking advantage of this part of the property deduction you can lower your taxable capital gains.

This leads us to the capital gains exclusion that is part of the property tax deduction. If you have lived at your residence for at least two of the last five years then you are excluded from having to pay a capital gains tax. Married who file jointly have a limit of $500,000, while single or married filing single have a limit of $250,000 in the amount than keep in profits from any sale.

A small side note regarding moving and this deduction, is that if you relocate due to your job, you can include deductions related to the cost of this move. This deduction though is not quite as easy to take advantage of because of some of the IRS regulations regarding it.

The fact also that your property tax deduction is completely deductible from your federal income taxes among these other benefits, definitely makes it worth looking into.

Find Your Real Estate Investing Tax Breaks

Real estate investing tax breaks are one of the big reasons many investors buy property. As an investor, you can write off all sorts of things that will end up reducing your taxable income, and therefore, reducing the amount that you owe.

Just to give you a feel, here are some of the things you can deduct that you're probably already spending money on in your real estate investing activities:

Travel to go see your property (Maybe it's even in the same city as your in-laws or your favorite beach vacation spot)
Interest on your mortgage for the property
Insurance on the property
Property Management, Accounting, Legal Fees, Accounting, and other professional advice
Training and education associated with your property
Repairs and Maintenance at the property

But remember, you can't charge for your own time working at the property, you can only account for things that you pay someone else to do. So, the next time you're wondering whether to pay the neighbor's kid to mow the lawn at your rental property or do it yourself, remember, you'd be paying him with pre-tax dollars.

Don't buy a property JUST to save money on taxes...

Tax savings can really add up! They can turn a property that puts money into your pocket every month into a tax write-off. But remember, it's not all fun and games. You still have the responsibility of finding a good deal, managing your property, and selling it when the time is right. Don't buy a property JUST for the tax benefits alone (a lot of people who did that got wiped out - bankrupted! - in the 1980's when the tax law changed and their tax write-off's went away.) Always make sure your property fundamentals are sound!

Knowing When To Sell To Maximize Tax Breaks

Knowing When To Sell To Maximize Tax Breaks Speaking of selling property, bear in mind that one of the purposes of the tax law is creating incentives for you to do certain things. The government is rewarding you (with tax breaks) for taking desired actions.

In the case of real estate investing, the government wants to reward you for holding property long term (over 1 year) as affordable rental housing in many cases - rather than having you get rich with short term fix-and-flip strategies.

If you hold the property for less than a year, the government treats your income as short-term capital gains tax, which is taxed at your ordinary income tax rate (that's HIGHEST of your tax brackets, usually).

To get the lowest tax rates, hold the property for at least a year and your profit on the sale will be considered long-term capital gains and the tax treatment will be much better. Currently, long term capital gains tax rates are just 15%, but President Obama has suggested he will raise the tax rates to 20-25%... so stay tuned!)

If you don't want to pay any taxes at all when you go to sell your property, consider participating in a 1031 Exchange, or Starker Exchange (same thing, different names). This is a transaction in which an intermediary helps you sell one property and then buy another similar investment property. You can roll all your profits from the sale of the first building into the purchase of the second building. If you do - you won't pay any tax on the new building! Do your own research, but it's worth getting more information on 1031's if you're selling a property with a lot of equity and want to make sure you'll minimize your tax bill!

Real Estate Professional Status

Long term capital gains tax treatment isn't the only real estate investing tax break in jeopardy... The Real Estate Professional status is also getting harder to qualify for. Real Estate Professional is an IRS designation which says you spend at least 750 hours a year working in real estate investing, and that real estate is your primary business. If you qualify for this designation, you have the ability to deduct ALL your losses from real estate, even if they are in excess of $25,000/year. If you don't qualify, your real estate deductions may be limited, especially if you are a passive investor not actively involved in real estate investing, or you have an especially high income.

Another bug-a-boo in the land of real estate investing tax benefits is the AMT or Alternative Minimum Tax. This is a tax that hits high income earners if they have too many tax deductions, even if those deductions are legitimate. Congress keeps patching this, but it's hitting - and hurting the middle class. If you earn more than about $130,000/year this may affect your family, so consult with a tax advisor to see if you'll be able to take advantage of the real estate tax breaks you're expecting.

More Real Estate Investing Information

Please, as you read through this article, bear in mind that I am not an accountant or tax attorney. I am another investor like you and I am just sharing from my own personal experience. Tax law is complicated and changing, so I encourage you to consult with your own team of professionals on any topics that you need more information on or strategies you plan on implementing.

Estate Tax - The 2010 Step Up Basis Nightmare

The old saying is the best laid plans of mice and men so often seem to go wrong. When it comes to the government, this is a statement that is used the vast majority of the time since the bumbling of politicians creates some situations that are simply head shakers. This is exactly the case with the step up basis in estate tax for 2010.

This can get confusing, so let's start off with the basics. The step up basis is simply the value of some asset at a date in time from which a gain is calculated. Let's say I buy a share of Microsoft in 1990 [I wish!] and I sell it today. I would pay rather large capital gains taxes on the gain in value of that share of stock between 1990 and 2010.

The passing of an asset from a deceased person to their heirs triggers a bit of a different calculation. Let's assume the same situation as above. Instead of selling the stock in 2010, I die after being attacked by a bear [might as well make it exciting] in 2002. At that point, my stock is transferred to my daughter per my written will. This transfer constitutes a taxable event. Historically, she would pay tax on the gain from the date of my death till she sold the item. The use of my date of death allows her to "step up" the value of the stock instead of pay taxes on all the gains since 1990.

The Bush tax cuts were designed to reduce a number of taxes, but they went a step farther with the estate tax. They were designed to phase it out. In fact, there is no estate tax in 2010. That is nice and all, but the problem is the step up basis for capital gains above is now gone for the year. Instead of paying capital gains on the increase in value from the date of my death, she will have to pay them on the gains from 1990. That is a huge difference and constitutes a massive amount of money going out of my family and to the government. What did the government do for this money? Nothing, I just died!

Is there anything one can do about this mess with the step up basis? Unfortunately, there is not. It is simply another example of the government creating a mess with the best of intentions.

Canadian Tax Write Offs From Real Estate - Part 1

If you are paying taxes, it means you are making money. If you are paying a lot of taxes, then it stands to reason that you are making a lot of money. However much you make, it doesn't make it any less painful to pass it along to the government though. Unfortunately I haven't been faced with the problem of paying a big bundle of tax to the government (but I am hoping I have that problem really soon!!), but I have been through enough in the last seven years to give you a few pointers on some ways to minimize taxes surrounding the sale of your real estate investments.

As a real estate investor, you will pay tax on the rental income you earn on the property as well as on any capital gains when you sell. The amount of tax you pay on rental income can be reduced dramatically by expenses such as maintenance, property management, capital cost allowance (depreciation), interest on your mortgage (but not the principal pay down), and other money spent to run your property. In Part 2 of this article series, we'll address some of these write offs. For this edition, let's focus in on the second major area you will pay tax on, and that is on Capital Gains when you sell your investment.

A Capital Gain occurs when you sell your property for more than you paid for it. You do not realize your capital gains until you sell.

To calculate your capital gain take the:

Money from the sale of your property

SUBTRACT

Costs of disposition (real estate agent fees, lawyers etc.)

SUBTRACT

What you paid for the property.

You will owe tax on 50% of the amount from the above calculation if the resulting number is positive (a capital gain). This amount gets added (or subtracted if it's a net loss) to your personal income and you are taxed accordingly.

If the property you are selling is your principal residence, then it is exempt from tax. According to Canada Revenue Agency, a property qualifies as your principal residence if in that year of filing:

* you acquire only to get the right to inhabit

* you own the property alone or jointly with another person

* you, your current or former spouse or common-law partner, or any of your children lived in it at some time during the year

* and, you designate the property as your principal residence.

Now, what if you live in the home for a few years, and then move out and rent it out for a few years as I did with the condo that I owned in Toronto? In that situation, the answer for me was that the condo could still be considered my principal residence for four years after I changed it's use. The catch is that I could not claim capital cost allowance on the condo, nor could I claim any other property as my principal residence at the same time. For me, this choice was easy because I moved into a property Dave and I already owned and had been treating as a rental property from the accounting sense of things. It was easier to keep the condo as my primary residence and continue to treat my new "home" as a rental property for accounting purposes. It's important to note that you and your significant other (including common law or same sex partner) cannot own two principal residences at the same time for tax purposes. You must choose one during the over-lapping period.

It's complicated and that is why both my husband Dave and I have accountants that we consult with on a regular basis to get the best advice.

Deferring Taxable Gain on the Sale of Your Business Or Real Estate Assets

Business owners who sell a business, assets held or used in their business, or real estate used in their business operations can face significant capital gain taxes.  These capital gain taxes due from the sale of your company, assets or real property can be minimized or even eliminated with the proper tax deferral or tax exclusion planning in conjunction with your legal and tax advisor. 

There are numerous tax deferred and/or tax exclusion strategies available for the sale of businesses, assets and real estate.  It is critical that careful tax planning be a priority in order to properly deal with the potential capital gain taxes that will be generated by the sale of your property.

The 1031 Tax Deferred Exchange May Not Be Suitable

Owners of real or personal property, such as a business interest, assets used in a business or real property that have been held for rental, lease, investment or used in a trade or business, frequently structure tax-deferred exchanges pursuant to Section 1031 ("Section 1031") of the Internal Revenue Code ("Code") in order to defer the payment of their taxable gains.

However, tax-deferred exchanges pursuant to Section 1031 are not always feasible, suitable nor appropriate for taxpayers when they are selling their company, assets used in their company or real property used in their business operation. 

Section 1031 Exchange transaction structures require business or property owners to exchange equal or up in net sales value by acquiring one or more replacement properties that are of like-kind.  Locating suitable replacement properties to be acquired as part of the Section 1031 Exchange in order to replace the relinquished property (business) can be extremely challenging, very stressful, and virtually impossible in some cases. 

The taxpayer may have absolutely no wish to reinvest his or her net sale proceeds into another business operation of like-kind, or any kind, for that matter.   Taxpayers may just wish to "cash out" and pay their taxes. 

Taxpayers may have reached a point in their life when they merely wish to sell, cash out, pay the taxes, and absolutely not reinvest in another business, assets or real estate. They may not even want to see another business as long as the live.  Some taxpayers may opt to sell and pay their capital gain taxes in the current year, but many would prefer to implement some kind of tax deferral or tax exclusion strategy that would allow them to defer the payment of their taxable gains over a period of time of their choosing rather than get hit with them all in the year of sale.

Deferring Capital Gain Taxes Without a 1031 Exchange

There are a number of tax deferred and tax exclusion strategies available that a taxpayer can use to defer the payment of taxable gains, so it is important that the taxpayer meet with his or her tax advisor to review all of their tax strategies. The following are the two most common tax-deferral strategies available for the sale of businesses, assets used in your business or real estate:

Seller Carry Back Note (Seller Financing)

The taxpayer could structure the sale of his or her business operation by carrying back a note, which is often referred to as seller financing or a seller carry back note. Seller financing is merely an installment note or promissory note where the buyer of the business entity or assets/property makes periodic payments to the seller. Depreciation recapture taxes, if any, are due and paid in the year the business, assets or real estate were sold. The capital gain taxes are partially or fully deferred over the term of the note and are taxed as principal loan payments are made to the taxpayer.

The installment note or promissory note strategy has positive and negative features. The obvious positive is that you can sell your business, asset or property and defer the payment of your taxable gains by structuring a seller carry back note.

However, the risk of buyer default on the installment note is a considerable negative. The process to foreclose or otherwise take back the business or asset/property can consume significant amounts of time and money and the business, asset or property may have been irreparably damaged during the buyer's ownership and management.

Deferred Sales Trusts or DSTs

Deferred Sales Trusts or DSTs are highly effective tax-deferred strategies, similar to the installment sale or seller carry back note, but without the risk of buyer default.  The Deferred Sales Trust receives all of the net cash proceeds from the buyer at the closing of the sale transaction, thus removing the buyer from involvement in the Deferred Sales Trust  transaction.  Deferred Sales Trusts can provide other great tax and estate planning strategies as well.

Deferred Sales Trusts are drafted pursuant to Section 453 of the Internal Revenue Code, just like the installment sale note or promissory note in seller financing. The capital gains tax is realized or triggered, but not recognized or paid, because it is deferred over a period of time selected by the taxpayer.

The capital gains tax liability is partially or fully tax deferred over the term of the installment sale note created within the Deferred Sales Trust account, which you will negotiate in advance directly with the Trustee of the Deferred Sales Trust. 

Tax Example For Commercial Real Estate

First, if you buy and sell property and make a profit, you incur capital gains. Long-term capital gains are generally taxed at a rate lower than your personal income tax rate. That is a bonus and another reason to leave your 9 to 5 job and start a career in real estate. The IRS considers long-term investments as those lasting over a period of one year. Short-term capital gains are taxed at your normal income tax rate, which could be as high as 35 percent for some taxpayers.

Although the capital gains rate and holding periods seem to fluctuate with changing administrations, the recent tendency has been to keep the rate below your ordinary income tax rate. Before May 6, 2003, the rates were 20 percent for most long-term gains and 10 percent for taxpayers in the 15 percent category. Currently, the long-term capital gains rate is 15 percent for most taxpayers. If you fall into the 10 or 15 percent tax brackets, the capital gains rate is only 5 percent. The incentive is simple. Hold on to real estate longer than a year before selling to reduce your tax liability. For foreclosures and properties that you were planning to resell, it will be necessary to rent out the property for at least one year before selling. Capital gains occur when you buy a property and sell it for more than what you paid for it or the basis of the property. The basis can be affected by expenses, but for simplicity if you bought a property for $50,000 and sold it a few years later for $65,000, then you have incurred a capital gain of $15,000 and it will be taxed at 15 percent. So, you owe Uncle Sam $2,250.

That's pretty easy so far. Now, how about depreciation? If you depreciate a rental house, then there will come a day of reckoning. In essence, the government has loaned you money and now it's time to pay back your debt. Depreciation recovery is taxed at your tax rate, or 25 percent in most cases. In our previous example, you may have depreciated the property for a few years. Let's say the depreciation taken is $5,000. This $5,000 is recovered and taxed at 25 percent. To summarize, you bought an investment property at $50,000 and sold it for $65,000. You depreciated the property so that its new basis is now $45,000. You owe taxes on $20,000, but at two different rates as shown below: Investment Property Example Purchase Price = $50,000 Purchase Price Sale Price Tax Rate Taxes Due Appreciation = $15,000 15% $2,250 Original Basis = Depreciation = $5,000 25% $1,250 $50,000 New Basis = $45,000 Not Applicable $0 Total $3,500 So are there any ways around paying these taxes? The simple answer is yes.

What a Canadian Should Know Before Buying U.S. Real Estate

Many Canadians are dreaming of heading south for the winter, but not just to beat the cold. They have real estate investing on their minds. Our strong dollar combined with a collapsing housing market in the U.S. spells opportunity for many. But Canada and the U.S.A are not the same country, and as much as we have in common we have differences. Any Canadian investor considering putting money in the U.S. should have a basic understanding of some key differences between buying real estate in Canada versus buying real estate in the U.S. So, before you start putting your loonies in Florida or Texas, read on.

Tax Systems:

Talk to an accountant that is experienced with American real estate investment as the countries differ considerably in terms of taxation of investment properties.

In the U.S.

1031 Exchanges allow the capital gains from the sale of an investment property to be deferred and rolled into a purchase of a similar type of property if it's bought within 180 days. This can be done many times allowing capital gains to be deferred until the end asset is finally disposed of and not replaced;


If capital gains are realized (property is sold and cash is received), the seller is taxed at 15% of the total net gain (as long as the property was owned for more than 1 year, if less than, the rate is much higher);


Property taxes tend to be similar to those in Canada, however, if you are a Canadian and own a property in a Southern state like Florida or California, you may have much higher "non-resident" property taxes than either the locals or if you invest in other U.S. States;


Similar to Canadian tax laws, you will not be taxed on your primary residence, however, in the U.S., you can write-off the interest charged on your home.

Compare this to Canada

Sell your investment property in Canada and you'll pay capital gains tax on 50% of the net gain. Canada does not yet have the option of deferring the gain through an exchange. The "gain" or "loss" gets added to your income and your are taxed at the applicable rate (which could be much higher than the standard 15% rate in the U.S.);


Similar to in the U.S., expenses associated with holding an investment property can be written off against your taxable income. See two previous articles for tax time tips: Part 1 and Part 2.

Before you send your loonie south this winter:

Determine if there are "non-resident" property taxes applicable in the city/state you are considering;


If you already own in the States and sell the property (and don't buy another there to use the 1031 Exchange strategy) you'll be required to pay U.S. taxes on the sale. You pay the U.S. first, but still have to file the tax return in Canada (showing the taxes paid in the States). Thus, you'll only pay once (you get a tax credit applied to your Canada taxes), but you have to file 2 returns (February/March 2008 Money Sense has a great article on this issue);


Rental income requires two filings for taxes as well. You must claim the income (and expenses) in both countries, pay the applicable taxes, and get a credit for your Canadian taxes.

Lending differences between Canada and the U.S.:

The "credit crunch" or "subprime market meltdown" has had a dramatic impact on the U.S. lending environment, and has trickled over the border to Canada. Because of the economic crisis, lender guidelines and policies have changed dramatically in both countries. In the U.S., there were many mortgages given to just about any candidate. The phrase "ninja" loan was coined in the U.S. The acronym standing for "no income, no job, no assets". Many individuals were given mortgages beyond their means. When the first large phase of ARM (adjustable rate mortgages) began to raise their rates, foreclosures began popping up all across the nation. Canadians need not fear the same crash here thanks to very different lending environments.

In the U.S.

Hundreds of banks across the country with hundreds of differences in lending policies and guidelines;


Licensing varies across each state for who can be a mortgage broker. In some states no testing or licensing is required at all!


Bank regulation is controlled at the state and federal level, again possibly leading to less strict lending criteria from one bank or lender to another.

And in Canada

One federally-regulated Bank Act that controls what banks can and cannot do across Canada;


Only 5 major banks in Canada that control a large majority of all banking divisions;


All of the Big 5 Banks in Canada are able to lend funds for mortgages, but they have also acquired (and oversee) many of the licensed trust and brokerage companies (which lend money as well);


Mortgage brokers are provincially regulated in Canada, but the majority of provinces require extensive training, and the successful completion of a licensing test.

Economic Conditions in Canada and the U.S.:

The Canadian economy continues to enjoy good economic times with historically low unemployment rates, increased wages, and housing appreciation. At the same time, a recession has been lurking in the U.S. Many areas of the U.S. are experiencing depreciating houses, high unemployment rates, and deteriorating consumer confidence.

There could be some real bargains to be found in the U.S. as foreclosures pile up, property/houses depreciate (well into double digits in some States - Florida, Michigan, California), and our Canadian dollar continues to sit around par with the greenback. But before you take the plunge, do your research. Most economists still believe we are in the midst of the subprime fiasco. They forecast continued depreciation across the nation (obviously much worse in some areas than others) for the better part of two years. So, unless you really know an area is going to get better soon, I personally, would wait and see what the summer and early 2009 has to bring. The election, the war, federal policies to "bail-out" millions of credit-burdened borrowers, and the worst part of the subprime scenario which is predicted to hit in the fall of 2008, are all factors that will impact investment in the coming year, and it's a gamble to buy without knowing what will happen. But, with the strong dollar, it's a good time to head south and start looking for that dream home in Florida, isn't it?

Some final thoughts (in this article anyways) on investing in the U.S. real estate market. If you are intent on purchasing in the U.S. and are a Canadian citizen residing in Canada, the following three ways may help you obtain financing:

Take out a mortgage in the U.S. through a U.S. based bank owned by a Canadian one such as RBC Centura or Bank of Montreal's Harris Bank;


Purchase using all cash so you don't have to deal with cross border financing issues (e.g., pull equity out of your home or other Canadian properties or ask your rich aunt for money!) to buy down south; and


Create a corporation in the U.S. with assets (a holding company will not work as it needs to have equity or be generating revenue) which can obtain the mortgage from a U.S. lender.

The 1031 Exchange Alternative - How to Sell Commercial Real Estate Without Paying Capital Gains Tax

When it comes to tax planning, eliminating the capital gains and depreciation recapture taxes on the sale of appreciated commercial real estate is a hot topic. In fact, there are countless numbers of would be sellers who don't because of this. Many would be sellers simply want out of the real estate - they're tired of landlording, fixing toilets, and never ending maintenance and management. They would like to sell, reinvest elsewhere and simply receive a check, spending their time doing what they like. Unfortunately, the only way to get out of real estate without losing control of the "asset" is to sell it outright-and pay the tax. You could implement a property exchange (1031) directed by a Qualified Intermediary, but the key word here is "exchange"- you've simply traded one for the other. You're still in real estate.

Other sellers may want to buy more real estate, but don't want the restrictions and rigid timeframes of a 1031 Exchange. What can you do? Is there any other way to get out without paying these taxes? The answer may lie in the use of a specialized trust, designed in accordance with strict IRS guidelines and a private letter ruling. It can be used as a tax deferral tool and as a 1031 Exchange alternative.

This tax deferral tool could, if implemented, save you tens of thousands of dollars in taxes that you would have otherwise voluntarily paid to Uncle Sam. These are dollars that you can use to generate a higher income and to potentially profit from. It's as if Uncle Sam let you keep the tax dollars, invest them somewhere, and use the income they generate for you. It really is like "free" money. As a result, it comes as no surprise that this strategy is gaining popularity among owners of highly appreciated commercial real estate who have properties marked for sale. With a better understanding of the process, you too can take advantage of this program.

The process begins when an owner of commercial property sells it to a special trust owned by a third party company. Then, the trust sells the property to a buyer. There are no taxes to the trust because the trust "purchased" the property from you for what it sold it for. At the completion of the sale, the money from the buyer is now in the trust. At this point, the trust begins to "pay" you. This payment isn't is a lump sum, but a payment contract, referred to as an "installment contract". This contract is similar to that of an Installment Sale, but without the restrictions and with many added benefits. This contract promises to make payments to you over a pre-specified period of time.

You can choose when and how payments are to be made. You may not need the income right away-or ever. It's up to you. The tax code requires the payment of tax to the IRS only when you begin to take installment payments. Therefore, tax is paid incrementally. It is paid in proportion to the number of years in your "installment plan". In the case of a 1031 exchange, money for a new purchase can be acquired anytime from the sale of the old property and use of this trust without paying taxes, thereby eliminating the restrictions and rigid timeframes of the 1031 Exchange. Either way, your equity is no longer "tax trapped".

This special type of trust gives you the potential to generate much more money over the long run than you would with the taxes lost in a direct sale.

This may be the most suitable or appropriate tax strategy depending on your circumstances. Contact the author for a complimentary tax analysis and to discuss your specific circumstances and goals.

Down Size With Reverse Mortgage, Move Your Tax Base & Take A Capital Gains Exemption? It's Possible

A future trend for Southern California Boomers? For Boomers and Seniors living in other areas, two out of three isn't bad either.

The house is big, the kids are gone, you're tired of maintaining the yard and you and your spouse only use half of the house. Could it be time to move and at the same time increase your retirement nest egg and cash flow?

The passing of HR. 3221 and the modernization of FHA and reverse mortgages is a step in the right direction in helping boomers and seniors plan for their retirement. The improvement is yet to be measured but here are some interesting thoughts.

Within the last couple of weeks the president signed into law HR 3221. Amongst many things, this law will do is dramatically change reverse mortgages. It will:

o Increase the loan limits for reverse mortgages (limits have yet to be defined publicly by HUD) - which means more liquid cash for reverse mortgage recipients.
o Capped origination fees - 2% of the first $200k of the maximum claim amount, plus 1% of the balance above $200k to a maximum origination fee of $6000. On average this will reduce origination fees by over $1200 for Southern California reverse mortgage borrowers.
o Enable to use the FHA HECM reverse mortgage for HOME PURCHASE
o Enable the FHA HECM reverse mortgage to used on co-ops, amongst other improvements

In 1986, California voted to provide tax relief (Proposition 60) to homeowners older than 55 by allowing (with some restrictions) to transfer their existing property tax base to replacement homes of the same or a lesser value within the same county or a participating reciprocal county (Proposition 90). As the boomers begin to retire and look to trade into smaller, age friendly single story homes, or consider 55+ communities, using this proposition may become more popular. You can use this benefit one time. There are numerous restrictions including a single person or spouse must be 55 years old when selling your original property. Your new property must be a principal residence with the current market value equal or less than your original residence. Proposition 60 covers property transfers within the same county. Proposition 90 allows property tax base transfers with participating counties of Alameda, Los Angeles, Orange, Santa Clara, San Diego, San Mateo and Ventura counties. Be sure to contact your tax assessor's office for current information.

Taxpayer Relief Act of 1997 changed the way real estate capital gains taxes are calculated. The IRS issued updates in 2003. This rule offers up to $250,000 tax free sales home profits for a single person and up to $500,000 profits for a couple. To qualify the seller must have owned and occupied their principal residence a total of two of the five years before the home sale. (Consult your tax expert for updated advice)

Even with today's softened housing market, many home owners have substantial equity in their homes. There is an opportunity to take advantage of these gains and improve your retirement plan with multible opportunities.

Here is an example:
Mr. & Mrs. Jones both age 70, sell their current home for 1 million in Los Angeles County; Original cost of home: $250,000; Mr. & Mrs. Jones decide to buy a home for $500,000 in Ventura County. Gain on the sale: $500,000; Exclusion for couple filing jointly: $500,000; Taxable gain: $0. Mr. and Mrs. Jones transfer their original property tax base with them, keeping their original property tax base. They take their $500,000 exemption and buy their home in Ventura County with a FHA HECM reverse mortgage. The FHA HECM reverse mortgage allows them to either pay $300,000-$320,000 for their $500,000 home, they have no mortgage payment and they pocket the difference tax free. Mr. and Mrs. Jones may also purchase their new $500,000 home with a reverse mortgage and further increase their monthly cash flow by $6-700 a month buy opting for the tenure payment option for life.

All three of these opportunities will soon be available to many Southern California retirees. The capital gains exemption is available to everyone. As soon as HUD issues the green light, FHA reverse mortgages will be available for use in home purchases for borrowers 62+ years old, throughout the USA.

The Boomer generation turned 62 this year. With the increasing popularity and practical application of reverse mortgages into the main stream, it is not unreasonable to expect to see the incorporation of these and other cash flow tools in retirement planning on an increasing basis.

Avoid Capital Gains Tax When Selling Real Estate

You can cut the capital gains tax out of a real estate sale with the use of Exchange 1031. Exchange 1031 provides that if you are going to use proceeds of the sale of a real estate property to purchase additional property, you can avoid paying the capital gains tax.

The idea is to bolster real estate sales by allowing taxpayers to waive this tax on your property sale if the main purpose of the sale is to purchase another property. This provision gives an incentive for both the buying and selling of property.

Capital gains taxes assessed in the sale of real estate are estimated at around 20%-30%. If a taxpayer is engaged in a "like kind" real estate purchase, the tax reduces his ability to purchase a similar property by effectively cutting the resale value of their property by 20%-30%. This, in turn, will reduce the amount of money that they are likely to spend on a "like kind" purchase of another property.

There, of course, are conditions to deferment of capital gains tax under Exchange 1031.

The value of the property you are purchasing with the proceeds from the sale of your property must be equal to or more than the net profits from the selling of your property.

The full equity realized from the sale of your property must be used to purchase the "replacement" property.

If the replacement property you purchase under an Exchange 1031 provision turns out to be of lesser value than the property you sold, you will be liable to pay an accrued tax. The amount of your tax liability will be determined by the amount the replacement property fell short of the full equity of the sold property.

In other words, the amount of tax liability you incur will depend upon your given situation and the amount of full equity you realized after the sale of your property. Therefore, part of the tax is deferred in this instance, rather than deferring all of the capital gains tax.

The hope of this provision is that such a substantial tax savings will encourage real estate sellers to purchase "replacement" property rather than invest the income from such a sale of real estate into some other venture. It is a good provision for people looking to "buy up" in the housing market.

Tax Tips for Real Estate Investors Using IRA Funds

You've seen the advertisements and news articles. IRA funds can be used to make real estate investments. But before you jump on this bandwagon, make sure you understand some of the tax planning angles related to this opportunity.

Passive Loss Deductions

Almost always, an important component of your real estate profits comes from the tax savings associated with depreciation. These paper losses, referred to as passive losses by the Internal Revenue Code, can save both small and professional real estate investors thousands of dollars a year in income taxes. Unfortunately, passive losses from depreciation and related, similar tax deductions won't benefit real estate investors investing through IRAs.

Capital Gains Preferences

If you sell an investment for a profit--whether a stock or real estate--you get a tax break because your profit gets taxed at a preferential capital gains tax rate. In the best case scenario under current tax law, for example, your capital gains get taxed at 15% rather than at 35%.

Unfortunately, by putting real estate inside of an IRA, you lose this benefit. In effect, the appreciation you enjoy from your real estate investment gets taxed at your marginal income tax rate rather than at the capital gains rate. (Fortunately, the tax gets paid when you withdraw the money.)

Note: This "problem" also exists for other investments that produce capital gains, such as stocks and mutual funds that invest in stocks.

Unrelated Business Income Tax

In certain special circumstances, an IRA needs to pay income taxes on the profits it generates. These taxes, called unrelated business income taxes, essentially put the IRA investor in the same position as a regular taxable investor.

For example, if you're developing and then flipping properties inside your IRA, you may actually be an active trade or business. And in this case, your real estate investment--even though it's inside an IRA--may be subject to income taxes. (Your IRA custodian is supposed to report your taxable income and tax liability, and then pay the taxes but many don't...)

And here's another example of a situation where the unrelated business income tax can trip you up. If you borrow money to invest in real estate--the typical situation in any leveraged real estate investment--the profit you earn on the money you've borrowed is treated as unrelated business income. Accordingly, that profit is subject to unrelated business income tax.

Unrelated business income inside an IRA is taxed according to trust taxation rules, which means that as soon as you've made much money at all, you're taxed at the highest marginal tax rates. Ouch.

Closing Caveats

Real estate is a great investment. And real estate belongs in any investor's portfolio. But you need to think carefully about buying into the idea of using your IRA to make real estate investments. If you do decide to invest in real estate through your IRA, first consult with your tax advisor.

Investing in Real Estate, Flipping Houses, and Income Taxes

Understand the tax consequences of flipping houses, rehabbing houses, and how to defer taxes with the 1031 Exchange before you get into real estate investing. Problems arise when real estate investors don't follow federal and state tax laws. This is why you need professional advice. Although I am not a tax advisor, here are some common mistakes beginning real estate investors make by not understanding tax liabilities:

Flipping Houses

The reason flipping houses is a mistake for some beginners is that they don't know the income tax consequences. One problem with flipping houses, or selling too many properties too quickly, the IRS could say that your real estate business is your trade, subject to ordinary income and self-employment taxes.

Self-employment tax, a social security and Medicare tax primarily for individuals who work for themselves, is similar to the social security and Medicare taxes withheld from the paycheck of most employees. The self-employment tax rate costs you 15.3% of your profits. (However, this may provide retirement benefits.)

Rehabbing Houses

Another common mistake that beginning investors make is selling a property after holding it for almost a year. Some rehabbers work part time on a fixer and take six months to get the house ready. Add on two months to sell with a 60 day closing, and they're up to ten months. To take advantage of the low 15% capital-gains tax rate, you must keep the investment property for at least a year before selling. If you sell before a year, your tax rate, the usual capital gains rate of 35%, could eat up a significant amount of your profits.

If you're rehabbing houses, be patient. You could save thousands in taxes by holding your property just a few more weeks.

1031 Exchange

However, the Internal Revenue Code provides real estate investors away to defer capital gains taxes indefinitely. Section 1031 of the Internal Revenue Code provides a tax-free exchange. Also known as a "like-kind" exchange, this code allows you to sell a business or investment property and defer capital-gains taxes by immediately reinvesting the gains into a similar piece of property. The key, replacing a business or investment with similar property, means that no gain gets paid to the investor. Any profit taken out of escrow gets taxed. This means that beginning investors might take out a portion of the profit after they carefully explore their tax liabilities. In other words, talk to an accountant and find out what your tax would be according to your current usual income. Many business owners take advantage of this because they have many business deductions.

The big mistake beginning real estate investors make doing a 1031 tax-free exchange, taking possession of the profits, voids the tax deferment. You must declare the sale of your property to be a part of a 1031 exchange before you sell the property. Then you have the money placed in a trust account held by an intermediary until you purchase the new investment property. You have 45 days to identify a replacement property and 180 days to close on the new investment. You can't purchase a primary residence or a vacation home with funds from an investment property and defer taxes in a 1031 exchange.

The best advice for beginning real estate investors:
Talk to an accountant.

Would you be better off making extra money, even if you must pay taxes?

© 2005 Jeanette J. Fisher.