Avoid Taxes when Selling Real Estate

Physician's Money Digest, March15 2004, Volume 11, Issue 5

Many holders of appreciatedreal estate continue to lookfor the magic bullet that willallow them to sell theirproperty and avoid the tax bite. Such bulletsare available, but each carries a price.The following are two possible solutions:

• Installment sales. An installmentsale allows the seller to spread out thepayment of the tax over the life of aninstallment note, recognizing the taxablegain only when the principal is collected,at the price of giving up a lump sum at thetime of sale. The interest rate and term ofthe note are negotiable. Interest rates onthis type of a transaction are usuallyslightly higher than those the buyer couldget from conventional sources. If the interestrate is not spelled out in the contract,an imputed rate based on the applicablefederal rate determined by the length ofthe contract is used for calculating taxes.The seller may also repossess the propertyif the buyer defaults on the note. Whilethere is the advantage of starting overwith a new buyer, the seller may have toreport a taxable gain on the repossession.

Installment sales rules contain severalimportant limitations. First, gains ondepreciable real property sold to a spouseor a partnership or corporation in whichthe seller owns an 80% or more interestmust be realized in the year of the sale,regardless of the terms of the sale. In addition,if you sell property to a relative andthat buyer sells the property within 2years, you are required to realize any additionalgains in the year of the resale.

• Tax-deferred exchanges. Commonlyreferred to as 1031 exchanges, tax-deferredexchanges allow a seller to indefinitelydefer all taxes due on a sale byexchanging a property for a replacementproperty. Properties do not have to bephysically exchanged to qualify. A sellermay sell the property, put the proceedsinto an escrow account, and identify areplacement property for later purchase.This can also be done in reverse, with theseller buying a new property in advance ofselling the original property. Specific timelinesapply, however, so it is advisable toconsult a tax professional before enteringinto an exchange transaction.

The 1031 rules require that propertysold must be replaced with like-kind property.Leases with at least 30 years remainingat the time of the exchange qualify aslike-kind. The rules of qualifying for like-kindtreatment are quite flexible, as longas the seller holds both the property beingsold and the replacement property forinvestment or another type of businesspurpose for 6 to 12 months prior to andfollowing the transaction.

Louis P. Ingargiola, a financialconsultant since 1992, is an independentwith LPL FinancialServices based in Dunmore, Pa.He welcomes questions or commentsat 800-440-1776.