There are three main methods of "avoiding" the tax on the sale of a piece of real estate. All three are valid, legal concepts, but one is being widely used as a scam.
The sale of a personal residence that you have lived in for 2 of the past 5 years is one of the 11 tax shelters left in the code. You can sell, and any gain up to $500,000 for couples filing jointly or up to $250,000 for single tax filers is just given to you tax free. That's a pretty good deal. It is written in black and white in the tax code, but it only works on your personal residence.
Taking the "You" Out of Your Property
For asset protection purposes, some people are being talked into moving their personal residence into a corporation, limited liability company, or family limited partnership. Such a move should be carefully considered, because once the personal residence has been moved into an entity, it isn't your personal residence anymore. It is the property of the entity. When "you" sell the property, you are not selling the propertyâ€”the entity is selling the property. The entity doesn't get the tax shelter like you do. You just lost the opportunity to pocket $500,000 ($250,000 for single filers) tax free. As a physician, you don't need to use entities to protect your personal residence. There are other ways. In fact, moving the residence into an entity usually doesn't give you the promised asset protection.
You might note that moving your personal residence into a revocable living trust doesn't affect the tax treatment of the sale, and such a move gives you little or no asset protection. A revocable trust is basically transparent to the IRSâ€”they look through it, directly to you.
Pitfalls of Charitable Remainder Trusts
There is another tax avoidance technique that is being heavily pitched to doctors through seminars and direct mail. The charitable remainder trust (CRT) is touted as a way you can sell real estate without having to pay any capital gains tax. The promoters are absolutely right, but what they don't mention is the fact that you have given the property awayâ€”it is not in the family anymore. If you try to keep it in the family, you are violating many IRS laws. The laws you have to comply with make having a private foundation a nightmare, and they are getting worse. The whole pitch is basically a scheme to get you to buy either a very expensive kit (on the order of $5000) that will teach you how to do the tax "trick" or a life insurance policy.
People selling the kit don't bother to tell you about the loss of the property. People selling the life insurance will say that the insurance policy is needed to replace the value of the property for your heirs. In either case, I have never seen anyone who has used a CRT for tax reasons who has been happy. If you really do have a charitable desire and the money to spare, a CRT is an excellent way to endow a charity with property. But if you are trying to avoid the tax on real estate by using a CRT, you will regret this move.
Swapping Property with a 1031 Exchange
A 1031 exchange, under section 1031 of the IRS Code, allows you to exchange one piece of property for another "like-kind" piece of property. It is absolutely a valid tax planning tool. It can become a little complicated, having lots of rules to follow, but done properly, it is a nice tax planning technique. Effectively, it allows you to sell a piece of real estate and buy a like-kind piece without recognizing any tax. This assumes that the properties are the same value, and only postpones the tax.
Postponing the tax is good in many cases for many reasons. However, when you ultimately sell, you will pay more in taxes in the future than you will pay todayâ€”that is almost a guarantee. The capital gains tax today is as low as it getsâ€”it is a gift to you. Sell the property and pay the tax. Of course, an analysis needs to be made, but if you don't want to keep managing property and want out, now is the time.
The graph above is a plot of the highest tax rates on personal income since the personal income tax was implemented. Note the two periods in history when the tax rate was very low. Rates were low in the 1990s, and the economy really moved. Rates were low in the 1920s, and people referred to the period as the "roaring twenties." You would think the politicians and economists would take note of history and control taxes, but they won't. The government is fighting wars, Social Security is going south, and taxes will go nowhere but up in the future. Now is the time to take your real estate off the table and pay the tax.
Additionally, techniques such as the Roth IRA, new Roth 401(k), and "nonqualified plans" are very attractive because you can spend your money in the future tax free. Articles have been written and calculations made to demonstrate that the Roth is no better than a regular IRA or 401(k). They are correct, provided they make the assumption that taxes are not going to go up. Even with our current low tax rates, retired physicians are being killed by taxes. Imagine what it will be like in the future when rates go up. Understanding the tax is important when you make the decision to put money in a retirement plan or sell real estate.
Lee R. Philips, an attorney of the US Supreme Court, has taught more than 5000 classes to insurance, accounting, legal, medical, dental, and other professionals, and has written hundreds of articles. He welcomes questions and comments at 800-806-1997 or firstname.lastname@example.org.