Tax-Saving Exit Strategies for Retiring Real Estate Investors

Utilizing IRS Code Section 1031 Tax Deferred Exchanges is one of the most effective ways to create wealth in real estate. However, over time, a real estate investor may end up with valuable property and a low adjusted tax basis. This creates a very unfavorable situation when the investor reaches a point where they would like to sell their property and retire, but are faced with the potential of a substantial capital gains tax liability. All of the gains that have been deferred through careful exchanges now loom if the property is sold without a tax deferred exchange into another property.

There are numerous reasons for wanting to exit real estate. The investor may have reached a point where they no longer want to worry about the management of the real estate. They may be retiring and want passive income that does not require any work or oversight as they pursue other options. They may be widowed and have very little ability to continue with ownership of the property, or have any desire to learn.

After years of carefully avoiding taxes on appreciating real estate, the prospect of paying potentially hundreds of thousands of dollars in Federal and State income tax is unacceptable to many investors. Consequently, they continue with the burdens of ownership, many times unsuccessfully, until their death.

There are, however, some very effective exit strategies that a real estate investor can utilize to provide lifetime passive income, significant capital gains and estate tax savings, and substantial income tax deductions. These strategies involve the IRS Charitable Gift Tax Laws. Like IRS Code Section 1031 Tax Deferred Exchanges, these strategies require attention to detail so the IRS does not disallow the entire transaction and leave the seller with a tax bill simply because they failed to follow the rules.

The IRS (and the Federal Government) has consistently underestimated the creativity of American taxpayers and their advisors. As a result, the IRS often finds they are dealing with “Unforeseen Circumstances” when it comes to provisions in the code. Often, that means a period of time where there is considerable uncertainty about the legality of a particular strategy; therefore, taxpayers are hesitant to enter into arrangements where there is no clear understanding about what will and will not be allowed. That was once the case with all the strategies mentioned above, but the IRS has largely eliminated this uncertainty through a series of code revisions. These strategies are now empowered by the code, if the conditions set down in the code are followed. Since there is considerable wealth on the line, it makes sense to follow the existing guidelines closely so there are no surprises down the road.

Some of the possible exit strategies that may be beneficial to retiring real estate investors are described briefly below:

Charitable Gift Annuity (CGA): A contract between a donor and a non-profit whereby the donor transfers the ownership of the property to a non-profit. In exchange, the non-profit establishes an annuity with fixed, regular payments to the donor for life. The amount of the payment depends on the value of the gift, the age of the donor, and the annuity rate. The income tax on the annuity is partially tax free with the balance taxed in a mix of capital gains and ordinary income. The donor gets an immediate income tax deduction for a portion of the gift and the non-profit receives the remaining principal balance at the death of the donor.

Combination Life Estate and CGA: Utilizing the Life Estate concept, an investor can donate property to a non-profit, retain the use of the property for the rest of their life, and receive a substantial income tax deduction that can help offset other income. Further, the difference between the value of the property and the Life Estate can be exchanged for a CGA that will provide lifetime passive income to the donor while they still have the use of the property during their lifetime. In addition, should the donor decide they no longer need the use of the property, they may be able to exchange the remaining value of the Life Estate for a second CGA that will provide them with an additional source of passive income.

Charitable Remainder Trust (CRT): Under this arrangement, the donor transfers ownership to a CRT with a charitable “Remainderman.” A trustee is named to manage the assets in the CRT and the donor receives passive cash flow for life, or for a fixed period of time, or for some combination of the two, i.e., life plus ten years. The donor receives an immediate income tax deduction, capital gains tax savings and elimination of estate taxes on the assets in the CRT. The corpus of the CRT passes to the Remainderman at the end of the term specified. Some of the different types of CRTs are described below.

Charitable Remainder Unitrust Trust (CRUT): A CRUT is a CRT with a payout that is a fixed percentage of the annual valuation of the trust assets.

Net Income Charitable Remainder Unitrust (NICRUT): A NICRUT is commonly used when a non-income producing asset or low-income producing asset is placed in a CRUT. The donor may receive a small (or no) payout until the property is sold and the proceeds are invested. If there is a “flip” provision, the trust then begins to function as a standard CRUT.

Net Income with Makeup Charitable Remainder Unitrust (NIMCRUT): A NIMCRUT is similar to a NICRUT except for provisions that allow for the makeup of the fixed percentage income that was lost during the time the corpus of the trust consisted of property with little or no income.

Charitable Remainder Annuity Trust (CRAT): A CRAT is a CRT wherein the donor receives a fixed dollar amount each year for the term of the trust.

Combination Exchange with CGA or CRT: Most non-profits require the donated assets to be free and clear of encumbrances. There are creative ways to structure combination gift plans/exchanges utilizing other assets owned by the non-profit to eliminate debt the donor may have on their property so they can take advantage of the gift laws that require the use of a qualified non-profit.

What about the donor’s heirs? There are highly beneficial ways to provide an inheritance to heirs, some of which can be incorporated into the gift plan options previously described. Another option is to implement a Wealth Replacement Plan, which could include an Irrevocable Life Insurance Trust, funded by a portion of the increased income received by the donor due to the tax savings involved with the gift plan. This works well for couples who want to leave an inheritance to their children but need to maximize their passive income during their lifetimes.

As with IRS Code 1031 Tax Deferred Exchanges, there are a number of requirements that anyone considering a gift plan will need to be aware of so the plan has the desired outcome for the donor. Consulting with a Certified Specialist in Planned Giving (CSPG), or a Certified Financial Planner (CFP), Certified Public Account (CPA), or an attorney well versed in the gift planning laws is the first step in developing a successful plan and avoiding the pitfalls inherent with these types of transactions.

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