Tax StrategiesFor Reducing or Delaying Tax Liabilities
Tax Strategies that work…
Successful real estate investors create big tax liabilities for themselves. Sometimes those liabilities are substantial enough to make an investor think twice about selling an appreciated property. While most investors are familiar with tax-free exchanges, (they originated back in the 1920’s), they typically only delay the inevitable. Often, they hold onto properties longer than they would like, or buy into replacement properties they may not be ready to buy.
Welfont helps clients pair the 1031 Exchange with the lesser known the IRS Section 170 Bargain Sale (written into tax law back in 1917) to create a much more desirable outcome for many sellers. If done properly, the IRS Section 170 Bargain Sale will allow you to divest yourself of a property held in a 1031 Exchange, cash in your chips and pay little to no capital gains tax, depending on the specifics of the transaction.
It’s the combining of these two transactions that creates tremendous value for sellers seeking to preserve wealth by doing good things in a smart way. This is our strong suit and no one in America knows how to do this better. First, let’s cover a few basic facts…
While you can make a simple swap of one property for another, the odds are slim you’ll find someone with the exact property you want who wants the exact property you have.Robert W. Wood
In the end, it’s the tax-deferred 1031 exchange that gets massive use by Millionaire Real Estate Investors. This program in the IRS tax code allows you to sell and buy properties without having to declare capital gains or pay those taxes. It’s a very straightforward procedure, but it takes some planning.Gary Keller, Author
What is a 1031 Exchange?
It is a method of transacting a real estate purchase or sale following specific prescribed rules and procedures in a way that allows most (or all) of the capital gains taxes to be deferred to some future point in time. Here are some of the fundamental characteristics…
- Identify: You have 45 days from date of sale of current property to identify up to three potential replacement properties. (Four or more as long as the value doesn’t exceed double the amount of the property sold). If the value of the new properties is more than double, no less than 95% of said properties must be purchased.
- Replace: Seller has 180 days from closing on the first property or from extension on the Exchangor’s tax return, to purchase another property.
- Trade up: The net market value and equity of the newly acquired property must exceed that of the sold property in order to defer 100% of the tax. If not, tax will be levied on the difference. Debt and equity in the relinquished property must be equal to or less than the debt and equity in the replacement property.
- Hold: There are no specific hold times in the 1031 code, but the IRS will attempt to determine whether the property was acquired to fix and flip or was it intended to be held for productive use or investment? The shorter the time held, the more substantial the facts should be to support the investment or productive use intent of the Exchangor.
Primary Advantage: Allows the investor to re-invest the taxes that would normally be due on the sale of a property. This allows the investor to do larger deals and more of them while properties remain in the 1031 Exchange.
Main Disadvantage: At some point in the future, the investor will conceivably have built up a substantial gain inside the exchange and will want to “cash in their chips” so to speak. It’s at that point, the tax man comes for his greatly appreciated share of taxes.
What is a Bargain Sale?
The Internal Revenue Code (IRC) Bargain Sale, is a transaction in which allows a property owner to donate their property to a nonprofit entity formed under rule 501(c)(3) and receive a “charitable contribution” income tax deduction.
Transactions can be structured whereby the seller/donor can receive part cash and part tax deduction. This IRS allowed method was enacted in 1917, and actually pre-dates 1031 Exchange (Enacted in 1921). It is estimated there are roughly 20,000 of these transactions done annually with an approximate value of over $8 billion.
Requirements for an IRC 170 Transaction
- Seller must have sufficient taxable income. This may be in the form of annual income, proceeds from the sale of a business or other property, even an inheritance. It may also be proceeds from a tax deferred investment such as a 401(k) or 1031 Exchange.
- Buyer must be a Federally recognized nonprofit entity (i.e.: 501(c)(3))
- Appraisal must be done by a certified appraiser. (We recommend an MAI certified appraiser. They are the PhD’s of the appraisal world.)
- An appraisal must be performed by an independent appraiser within 60 days of the transaction and must meet the standards of Internal Revenue Code 170 and Publication 561. Learn more about the IRS 561 Appraisal.
Donating property that has appreciated in value, like stock, can result in a double benefit. Not only can you deduct the fair market value of the property (so long as you’ve owned it for at least one year), you avoid paying capital gains tax. Normally, appreciated property is subject to capital gains tax at disposition but there’s an exception for donations to charitable organizations.Kelly Philips Erb
Types of Appraisals for Real Estate
They include property tax assessor appraisals, liquidation appraisals, bank appraisals, insurance appraisals, etc. All of these will have different outcomes because they use different guidelines for valuation.
In the case of a Bargain Sale, only the guidelines spelled out in IRS Publication 561 will satisfy the IRS requirements for proper valuation. In order to incentivize affluent individuals and corporations to be generous, the valuation guidelines insist upon the full and “fair market value” as determined by the certified appraiser.
That appraiser will look at many factors a bank appraiser may not. For example, Publication 561 allows for and encourages a weighted average of the market approach, income approach and replacement cost approach. While insurance appraisals are primarily interested in the replacement cost approach, lenders are often primarily interested in the market and income approach and many times with quick-sale time frames. The IRS Publication 561 appraisal accounts for all approaches using a weighted average determined by the qualified appraiser.
IRS Appraisal Guidelines for a Bargain Sale
Not Under Compulsion to Sell: IRS guidelines state “The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being UNDER ANY COMPULSION TO BUY OR SELL and both having reasonable knowledge of relevant facts.”
In many real estate transactions one of the biggest reasons that an appraisal may be higher than list price for large and hard to move properties with large carrying costs is because the list price is often determined by a seller who is “under compulsion” to sell within certain time frames. The carrying costs and need to dispose of the property outweigh the need to wait and find the right buyer and user. Under the guidelines of IRS Publication 561, the appraisal value is determined by using the stipulation of “not under compulsion” to buy or sell regardless of the carrying cost and other factors.
Fair Market Value: Fair Market Value is greatly affected by the law of supply and demand. Greater demand usually means a higher valuation. Yet many property resellers spend the minimal amount on marketing to create demand and their advertising often fails to communicate a property’s full value. IRS valuation rules, assume a top marketing budget, that expertly conveys the FULL and TRUE value of a property and thus creates more demand.
Highest and Best Use: When determining fair market value for a 561 Appraisal, the appraiser may factor in highest and best use. So for example, if zoning allows, a historic house or vacation home may have higher value if appraised as a Bed & Breakfast, even though it is not currently being used in that fashion. If three homes were clustered together in the old town center, if valued as a package, their highest and best use might be a CVS or Walgreens.
Comparable Sales Method: The comparable sales method compares the subject property with several similar sold properties. Banks typically only want sold comps from the last six months. Sold comps for a unique, custom home may require a much broader look back in history, which the IRS allows, resulting in a more accurate and potentially higher valuation.
Capitalization of Income: This assumes optimal rental income and occupation rates at highest and best use. Net income is capitalized at current rates, considering the risks involved.
Replacement Cost Minus Observed Depreciation: Replacement cost is figured by considering the materials, labor, overhead, quality of workmanship, building size and profit. With historical properties, reproduction costs may be used instead of replacement costs and result in higher valuation. Valuation is then adjusted to allow for the current condition and remaining useful life of the structure.
Since a Bargain Sale offer is typically not contingent on financing, real estate sellers often experience a no-hassle and stress-free closing period of about 30-60 days, much faster than traditional sales where a lender is most often involved with long due diligence periods. Unfortunately, most nonprofits are not willing to take on the responsibility of owning large commercial and industrial real estate, especially if any are distressed or underutilized. And they almost never give you cash at the closing table.
However, Welfont team are experts at Bargain Sales involving real estate and work with a select group of nonprofits who are familiar with Bargain Sales who are willing to supplement cash payments for their real estate investments.
If the owner of a property has substantial income and subsequent income tax liabilities, or expects to have a taxable income in the next 6
years, the after tax cash benefit received based on the Bargain Sale could be an advantage for a seller. In addition to cash received at closing, the seller will also receive the added benefit of a charitable contribution to a qualified nonprofit entity for the difference between the cash received and the amount of the appraisal completed under the guidelines of the IRS Publication 561 Appraised Value. Plus, the added benefit, once the property is transferred, the owner is no longer liable for property taxes, maintenance or other responsibilities for the real property.
For more information on the IRS Section 170 Bargain Sale transaction, please visit these helpful links: