You own a few rentals, maybe an apartment building or two, and you’re looking at simplifying your life by selling them and retiring, but the tax bill is daunting. In this Real Estate Edition of our Strategic Guide to Highly Appreciated Assets, we’ll look at a case study and strategies you might consider if you find yourself in this situation.

Here are links to our intro, business and real estate editions.

Here’s a common scenario. You bought your first home in your twenties or thirties and kept it as a rental when you moved. Years later, you traded that rental for a tri-plex through a 1031 exchange to defer taxes and grow your rental income. Along the way, your CPA helped you lower your tax bill each year by “depreciating the asset” – and why pass up a tax deduction?

Now you’re getting ready to retire and being a landlord is not on your bucket list, so you’re thinking about selling. The tri-plex is debt-free, income has increased over the years and your CPA says there’s no more depreciation deduction left, so the income tax bill is increasingly painful. But your property is worth $2,000,000 and, because your cost-basis is now zero, you’ll have to pay almost $500,000 in taxes if you sell.

What should you do? Here are a few strategies to consider for three common primary goals.

  1. Support your family during your life.
  2. Provide for your family after you’re gone.
  3. Maximize impact on causes you care about.

NOTE: while the main points below address rental property, we’ll discuss what to do with a primary residence separately at the end.

Goal 1 – Support my family during my life.

If you plan to check off the items on your bucket list, you’ll need the proceeds from this sale while you’re alive. But the more tax you pay, the fewer boxes you’ll be able to check. What can you do?

  1. Keep the property. Simple. It doesn’t relieve your income tax bill or landlord duties, but it provides the income you need. If you leave the property to the kids in your estate, they’ll get a step-up in cost-basis, reducing or eliminating their taxes if they sell. This makes sense if your secondary goal is to leave the property to your family.
  2. Sell the property and transfer the proceeds to a Delaware Statutory Trust. Using a 1031 exchange, you can defer the capital gain tax and transfer the proceeds to this professionally managed real estate portfolio. You’ll continue to receive income, but without the management burden.
  3. Gift the property to a Charitable Remainder Trust. You’ll get a current tax deduction, which varies, but tends to range in the 30-50% of gift amount. You’ll receive income from the property while you’re alive and, when you die, the property goes to your designated charity. This works if your secondary goal is to maximize the impact on causes that you care about.

Goal 2 – Provide for my family after I’m gone.

Whether funding generations of education or helping purchase a first rental property, you want to preserve these proceeds for your family and not lose more to taxes than necessary. What should you consider?

  1. Create a Family Limited Partnership and gift shares of the property to the kids each year. You’ll reduce taxes while maintaining control of the property. If one of the kids doesn’t want to be actively involved, fund a Wealth Replacement Trust with some of the rental income to help the other siblings to buy them out. This makes sense if your secondary goal is to have some extra income today.
  2. Gift the property to a Charitable Lead Trust. You’ll get a current tax deduction to minimize your future income taxes. Some, or all, of the rental income goes directly to your designated charity, with no taxes due on the gifted income. When you die, the kids get the property and you’ve minimized the transfer taxes you would have otherwise paid. This works if your secondary goal is to maximize the impact on causes that you care about.

Goal 3 – Maximize impact on causes I care about.

You and your family are set. You’re now focused on funding bigger initiatives to help the less fortunate and those taxes could take dollars that could otherwise go to charity.

  1. Gift the property to a Donor Advised Fund. You’ll get a current tax deduction for your contribution and be able to sell the property tax-free. You’ll reduce taxes and increase the charitable gift to charity by eliminating the capital gain tax.
  2. If you’d like to have access to income while you’re alive, consider the Charitable Remainder Trust previously mentioned – you can always give that income away if you don’t need it!
  3. To increase impact on your other goals, convert taxable 401(k)s or IRAs to a tax-free Roth IRA and use these charitable tax deductions to offset taxes you’d otherwise pay on the conversion. You’ll reduce your retirement tax bill or leave a tax-free gift to the kids.

What about my primary residence?

If you’re looking for ways to stay in your home but reduce your potential tax bill, consider the following scenario.

You’re 70 years old and own a $3,000,000 home in Washington, a state with high estate taxes. You plan to live there throughout retirement and then leave it to the kids. If it appreciates to $6,000,000 by the time you die, they could be subject to more than $500,000 in estate taxes – on a home you’ve already paid for. If you’re leaving other assets, that bill could be much higher.

Consider transferring the house into a Qualified Personal Residence Trust (QPRT) now. The IRS considers this a future gift, so you’ll use much less than $3,000,000 of your lifetime estate tax exemption and get that appreciating asset outside your estate for good – potentially eliminating any state estate taxes on it.

These suggestions should help get the strategic ball rolling but, as with any strategies you’re considering, these should be reviewed with your advisors and integrated into your overall plan. And, with a coordinated financial plan built to enjoy life, provide for loved ones, and impact causes you care about, you’ll know your legacy will last well beyond your lifetime.

Zach Hamilton

Partner, Financial Advisor

About the Author

Zach graduated from Gonzaga University with degrees in Marketing and Finance. While growing up, Zach heard stories from his grandfather about his work as an insurance agent, and other stories from his dad who was an investment manager. They both spoke financial “languages” but had completely different dialects. Recognizing the breadth of the financial vocabulary ultimately led to Zach’s passion for financial planning. He credits his family for this enthusiasm. Zach sees his time with clients as an opportunity to translate all of the different – and often confusing – information they’ve heard and provide clear guidance for each unique situation.

Zach enjoys working with people – his clients – who also appreciate that their financial decisions have an impact not just on themselves, but also on their families, charities and their own life legacy. Many of Zach’s clients have a strong desire to “make a difference”, and they rely on his financial expertise to magnify their philanthropic goals.

The “Alterra” name was coined by joining the Latin roots “alter”, the origin of the word “altruism” with “terra” meaning earth or land. This name reflects the company philosophy of “clients before profits” and providing firmly grounded advice.

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