There are a number of options available that can be used to plan the disposition of the property to best suit the needs of the individual while minimizing the tax impact.

Outright Sale – Of course, an individual can sell the property outright and then the net proceeds will be available for other investment or spending purposes. When a rental property is sold outright, the entire gain will be taxable in the year of sale.

Whether that is good or bad depends upon whether you can offset all or part of the gain with: (1) capital loss carryovers, (2) investments that have unrealized losses that can be converted to realized offsetting losses, (3) passive loss carryovers, (4) net operating loss carryovers, (5) investment interest expenses carryovers, or (6) a combination of these situations. If the taxpayer is able to offset the gain, an outright sale may be the best option for disposing of the rental and should be considered before exploring other options.

Installment Sale – If the seller carries back a note (mortgage) for all or part of the buyer’s purchase price, the seller qualifies for installment sale treatment, which in effect spreads the taxation of the gain over the life of the note.

Let’s say that your rental is sold for $400,000 with 20% down and you carry a note for the balance. Assume that your profit is $300,000. This would mean that 75% of every dollar of principal that is received will be taxable. Therefore, in the first year, only $60,000, 75% of $80,000 (20% of $400,000) down payment plus 75% of the principal payments would be taxable. Note that in the year of sale, any ordinary income that is required to be recaptured is fully taxable, even if no payments were received.

When considering an installment sale, don’t overlook that your money may be tied up for a long period of time in a mortgage note. If the principal is not needed for other purposes, then this shouldn’t be a problem.

Convert to Personal Use – The rental can be converted for the personal use of the taxpayer and any gain deferred until the property is ultimately sold. This option presents an interesting opportunity. If the rental is residential and the taxpayer occupies the rental for at least two years after the conversion and otherwise meets the requirements, the rental would qualify for the home sale gain exclusion.

Thus, the gain, in excess of the depreciation previously claimed on the home, could be offset by the home gain exclusion. The home gain exclusion is $250,000 ($500,000 for married couple filing jointly where the spouse also qualifies). Although there are some timing issues, taxpayers can generally use this exclusion repeatedly as long as they qualify and only use the exclusion every two years.

Tax-Deferred Exchange – A tax-deferred (Section 1031) exchange can be used as a means of avoiding immediate taxation on the gain from a rental property by deferring the gain into a replacement property. To qualify for a Sec. 1031 exchange, the property that replaces the rental must be held for business or investment use and must be real estate (improved or unimproved qualifies).

Sometimes real estate is held in a partnership or other entity. Generally, an entity ownership does not qualify as like-kind, although tenant-in-common interests (sometimes referred to as TICS), if structured properly, can qualify.

If a taxpayer acquires (or constructs) property solely for the purpose of exchanging it for like-kind property, the IRS says that the taxpayer doesn't hold the property for productive use in a trade or business or for investment, and the exchange doesn't qualify for non-recognition treatment under Sec. 1031.

• Simultaneous or Delayed – An exchange can be simultaneous or delayed. If delayed, the property received in the exchange must be identified within 45 days after the property given is transferred. No matter how many properties are given up in an exchange, a taxpayer is allowed to designate a maximum of either:

(a) Three replacement properties regardless of their fair market value (FMV), or
(b) Any number of properties, as long as the total FMV isn’t more than 200% of the total FMV of all properties given up.

The receipt of the new property must be completed before the earlier of:
(a) 180 days after the transfer of the property given, OR
(b) The due date (including extensions) of the return for the year in which the property given was transferred.

• Qualified Intermediary – Generally, to qualify for a delayed Section 1031 exchange, a qualified intermediary is engaged to hold the funds from the sale until the replacement purchase is made. It is important to understand that the taxpayer cannot take possession of the proceeds from the sale and then buy another property. If that happens, the event does not qualify for exchange and is immediately taxable.

• Reverse Exchanges – It is possible to structure a reverse exchange that complies with the Section 1031 delayed exchange requirements. However, it requires that the replacement property be purchased first by the intermediary, without the benefits of the proceeds from the property given up in the exchange. Thus, only taxpayers with the cash financial resources can accomplish reverse exchanges.

Tax-deferred exchanges can be very tricky and should not be entered into without first analyzing the tax aspects.

You are cautioned not to use any of these strategies without first consulting with this office. There are certain qualifications that must be met and the information provided is only an overview.