Defer Capital Gains on Real Estate Sales

Physician's Money Digest, October15 2003, Volume 10, Issue 19

Real estate and capital gainsreduction can be a difficultsubject to understand. Becausereal estate has uniquefeatures that liquid stocks do not have(eg, real estate cannot be moved ortaken off shore) and specific prohibitivelaws, some of the traditional capitalgains reduction solutions cannot beused. However, physician-investorswho want to sell a piece of real estatewithout incurring capital gains taxes dohave a viable tax-saving option—aninstallment sale with the use of a third-partyadministrator (TPA).

An installment sale with the use of aTPA is a nice way to use the government'smoney to increase the amountyou receive (in the long run) from thesale of a piece of property. While youdon't ultimately avoid the capital gainstaxes, you are creating a scenario wherethe sale of a highly appreciated piece ofreal estate becomes much less painfulwhen you're considering the tax ramifi-cations of the sale.

Installment Sale Basics

An installment sale is a contract tosell something—in this case, real estate—where the buyer pays the seller over aperiod of time. These sales are typicallydone when financing is difficult for thebuyer, and in most cases the seller endsup self-financing the sale. By using aninstallment sale contract, you can defer aportion of the capital gains over anextended period of time (ie, 30 years).

Let's make an assumption that youown your practice's building and thatthe property is worth $2.1 million,with a cost basis of $1.1 million. Youwant to sell the property, but if you do,you'll have to pay $200,000 for capitalgains taxes at a rate of 20% on the $1-million increase in value. In addition,because you're retiring, you want totake a stream of income for 30 years.So, you decide on an installment salecontract for over 30 years.

The problem with a traditionalinstallment sale contract is that the selleris typically at risk if the buyer defaults.No seller really wants the property backwhen a buyer defaults. When it comesback, there is a justifiable fear that theproperty might deteriorate in its condition.That's why buyers use banks wheresellers get their money upfront. However,traditional financing doesn't help a sellerreduce or defer capital gains.

Third-Party Assistance

To avoid the risk associated with atraditional installment plan, you canuse a TPA. Using the same example,you would pay the entire $2.1 millionto a TPA, who would pay you (ie, theseller) by the terms of an "installment"sale. Let's assume the terms of theinstallment sale are that you will bepaid 1/30 of the sale price every year for30 years. You will pay a capital gainstax each year on 1/30 of the base saleprice of the property as you receive theinstallment payments.

What will you accomplish by doingthis? Not much, unless the TPA investsyour money. Again, let's assume youpay the entire $2.1 million to a TPAand enter into the same 30-year contract,only this time the TPA invests themoney from the sale and it earns 8% ayear. What will you accomplish if theTPA invests the money?

The first year following the sale, youwill be able to use nearly $200,000.That's money that would have normallygone to the government for capitalgains taxes. So instead of investing $1.9million (after capital gains tax) in a traditionalinvestment, the TPA investsnearly $2.1 million the first year onyour behalf and pays you that installmentsale price plus the growth on thatmoney over a period of 30 years.

If you took the $1.9 million afterpaying $200,000 in capital gains andthat $1.9 million earned 8% in the market,you would have income of$152,000 without dipping into yourprincipal. However, if you implementedthe installment sale concept, you wouldinstead have nearly $2.1 million toinvest, and if it earned that same 8%,you would earn $168,000 the first yearwithout dipping into your principal($168,000 – $152,000 = $16,000 thefirst year in extra income if you didn'tdip into the principal). A typical installmentsale will also draw down the principalover a period of time.

Conclusive Benefits

As you know, many physician-investorsaccumulate real estate overtheir lifetime. It has always been a foregoneconclusion that there will be capitalgains taxes to pay on the sale of apiece of real estate. Many times, investorswon't sell the property justbecause it's painful to cut the governmenta check for the capital gains taxes.

Physician-investors should consideran installment sale concept if they have apiece of real estate that they would like tosell but hesitate doing so because 1) theydon't want to incur the capital gainstaxes, and 2) they have no need for alump-sum payment after capital gains tolive on or maintain their lifestyle. Bychoosing an installment sale concept,you'll be able to use some of the government'smoney for up to 30 years. Over aperiod of time, that money could earnyou $100,000+ in extra income.

Of course, before you enter into aninstallment sale contract with the inclusionof a TPA, make sure you consultwith your accountant or financial advisor.They will be able to confirm thatthe transaction meets all applicablestate and federal laws governing thesale of real estate.

Roccy DeFrancesco is an attorneyand author of "The Doctor's WealthPreservation Guide." He has run amedical practice and lectured formany state and national medicalassociations. For a free asset protection,income, and estate tax reduction CD, or forquestions or comments, call 269-469-0537 or e-mailroccy@wealthpreservation123.com.