In this episode, host Toby Mathis, Esq., joins regular guest Eliot Thomas, Esq., Manager of Tax Advisors at Anderson Business Advisors, to discuss several options that can protect homeowners and investors from paying exorbitant taxes on the sale of property. Eliot and Toby share important information and tactics for passive losses, installment sales, 121 and 1031 scenarios, Delaware Statutory Trusts, UPREITs (Umbrella Partnership Real Estate Investment Trusts), and opportunity zone funds.
- Passive losses and gains
- Spreading gain over several years
- Can homeowners save taxes on the sale of their home?
- The 121 exclusion and its rules
- Changing your home to a rental property – 1031 exchange and the rules
- The DST Delaware Statutory Trust and 1031 exchange
- UPREIT- Umbrella Partnership Real Estate Investment Trust
- Qualified opportunity zones and qualified opportunity zone funds
- Recapping all the options
Full Episode Transcript:
Toby: Hey, guys. Toby Mathis here, and I’m joined by tax attorney, Eliot Thomas. We are going to dive into how you can avoid paying tax on your real estate when you sell. Eliot, are you ready to go?... Read Full Transcript
Eliot: I’m ready to go.
Toby: All right. What are the strategies we’re going to hit today just to give everybody a roadmap?
Eliot: We’re going to start off with talking about the release of passive losses, something that people are very common or familiar with in real estate, then we’re going to hit on installment sales, deferring some tax gain there. We’re going to jump over to 121. If you sell your primary residence, we’re going to talk about 1031, like kind exchanges.
We’re going to marry the two, 121 and 1031 and see what that looks like. We’re going to jump over to working with Delaware Statutory Trusts, then maybe looking at UPREITs (Umbrella Partnership Real Estate Investment Trusts). Lastly, we’re going to talk a little bit about opportunity zone funds.
Toby: All right, you just gave us a mouthful list. Let’s dive into strategy number one, if you want to avoid the payment on tax. A lot of people may not realize this, and their accountants may not realize it. But if you have passive losses that are floating forward, those may be used. How does this work?
Eliot: That’s a great opportunity. You’ve been hounded by having these passive losses that have been suspended on your return that you haven’t been able to take advantage of. But if you sell the property that created those passive losses, generally speaking, those are all released, and they’ll offset your gain. Indeed, if you have more passive losses than you do have gain, that extra gain will go off against other income on your return, maybe even your W-2 income.
Toby: That’s number one. If you have passive losses in the release, they become ordinary losses. I probably just lost half the people. The easiest way to think about this is if you’re an investor into real estate, and you hear your accountant say passive losses only offset passive gain, there are a couple of exclusions to that as active participation or real estate professional. But most of us mere mortals, we’re not going to qualify.
We’re just sitting there and they’re like, hey, you’re not going to get to use it, but it gets released. Let’s say you bought a big property and it’s got $150,000 of passive loss carry forward, that $150,000 gets released as ordinary loss. It can be used against the capital gain on that property to offset it. But more importantly, the capital gains on that property is passive.
This is what’s weird. Ready? Twist your mind. You have passive capital gains, which means any other passive losses you have. If you have a bunch of other real estate, guess what’s happening to those passive losses. They’re going to be used against that property you just sold, and it’s going to keep it from being taxable to you.
Now, we’re going to use this in another way. You can marry this with an installment sale, right?
Eliot: That’s right. First of all, let’s back up and just get a quick definition of an installment sale. That’s simply the IRS saying that you received payment from selling your property over more than one period. You sell it, maybe you take payments over five years or something like that a little bit each year. We’ll call that installment. Take an element of gain each year on each payment, a little bit of interest.
Toby: Different tax years. If I have a six month installment sale, that’s not going to do anything for me, unless it goes from year one, and then you go across December 31st into another year. All we’re doing is spreading that out, but most installment sales, where they’re going to be 5–10 years, something along those lines.
Eliot: Correct. Just as Toby was talking about under the passive losses, you sell that property or you sell other properties, your passive losses from those properties will be released and will help offset. That will come into all of the calculation against these passive capital gains. It’s a win-win. You really want to check. All of a sudden, now those passive losses really become our friends.
Toby: I’m just going to give an example. Let’s say that you’re selling a property. You got $500,000 of gain. You’re like, oh nuts. It’s long-term capital gains, so it’s going to be 0%, 15%, or 20%. Let’s say you’re in a higher tax bracket, and you’re going to be getting hit at the 20-plus net investment income tax, you’re at 23.8 plus your state, you could be sitting there at about 37%–38% if you’re in California.
You’re saying, you know what, I don’t want to pay tax on that. One of the things you could do is say, instead of half a million dollars all in one year, let’s spread it out over multiple years. Now, this does not work on your depreciation recapture. You have to recognize that in year one, boom. You’re going to have to swallow that bullet, but you could spread out the gain, the rest of it over multiple years.
Because it’s passive, you can buy other real estate, depreciate it, and take those losses and offset them. Or if you have some carry forward passive losses from other properties, you can use those to offset that gain. Again, you’re spreading it out over years. It’s almost like you’re going shopping with discounted money because you’re like, here’s what my tax bill is, but if I buy this property, I avoid the tax.
Let’s say it’s over five years, half a million dollars, so $100,000 of gain every year, I get to avoid and save myself $20,000–$30,000 whatever it might be by buying a property and using that depreciation to offset that capital gain. That’s actually a really ingenious way to look at it, but you better be working with somebody who knows what they’re talking about.
Let’s dumb it down a little bit, Eliot. What’s another one that’s simple? For me, I’m just a homeowner. I just own my house. What’s in it for me? Are there other ways for me to avoid the capital gains on the sale of my property?
Eliot: Absolutely. Probably one more popular part of the code is section 121. That’s the exclusion. This isn’t just a deferral, Toby. This is an exclusion of capital gains, you don’t pay any tax on it. It’s $250,000 if you’re filing single, $500,000 married filing jointly, really only two requirements are that you own the property, and you use it as your primary residence for two of the last five years. You meet that, you automatically could exclude completely capital gains.
Toby: Now, it’s two out of the last five years. It’s not the last two years. If you lived in a house and it was your primary residence, and you made it into a rental property. Let’s just say for example, I lived in a house, I have some gain, and I’m sitting here wondering, hey, I don’t really want to sell it yet, but I might want to turn it into a rental property. Does that screw up my 121 exclusion?
Eliot: Not necessarily. You can still as long as you sell within two of the last five years. You can rent it out for one or two, maybe up to three years would be the theoretical maximum. Now you’ve turned it into a business property, but you can still qualify for 121 because you’ve owned it for two years and used it as your primary residence for two years within the last five years.
Toby: What if I had a rental property and I converted it into my primary residence, do I have any issues there? I had it for a rental property for five years, and then I turned it into my primary residence. If I live in it for two years, does that automatically mean I can use my 121 exclusion?
Eliot: You’re still going to use the 121 as long as you meet that two of the last five years. However, we call that non-conforming time when you were renting it out. We go back and it’s a fraction. Total number of years, divided into the number of years that it was rented out. You get a fraction. We take that fraction times the exclusion, the $250,000 or $500,000 married filing joint. That will show us how much of the exclusion you cannot take. You’ll only get to use the percentage, if you will, of the exclusion representative of the years that you did use it as a primary residence.
Toby: All right, now I’m Joe taxpayer. I’m just like, hey, you know what, I just lived in my house, and I’m going to convert it. What about those folks that bought a house on the West Coast, and they paid $300,000 for it, and now it’s worth $1.5 million or some silly number, and they’re selling it and they’re like, how do I avoid capital gains? The 121 is not going to get it done. Let’s say they’re married, they have a half a million dollar capital gain exclusion. But under that example, there’s another $700,000 of gain on top of it. What’s the strategy for those folks?
Eliot: There, we can use both. We can use the 121. If you turn it into a rental for a little bit, now you’re showing it as a business use. You’d have to move out, but you rent it out. Now you can use the like kind exchange deferment on our section 1031.
It’s now a business property, but you still had two of the last five years, so you can use your 121. Here, you’re going to exchange it for another property that you would use typically in business, rental, or something of that nature. Like kind exchange basically means they take the basis of the property that you gave up. We call it the relinquished property. You roll that over into these properties that you pick up, the replacement properties. Government allows us to defer that gain.
Toby: Okay, a 1031 exchange is a fancy way of saying, I sold some real estate and I bought more, but it requires that it be investment property. Let’s say I had a house, I lived in it, I turned it into a rental. Do I lose my 121 exclusion if I turn it into a rental? Let’s say that I sell it two years later. I lived in it two of the last five years, so I meet that requirement. Can I still use my 121 exclusion, but use this like kind exchange where I buy more real estate? Can I do that?
Eliot: Yes. You’re going to use the exclusion to wipe out gain. That’s going to be the first part of the calculation. You’re not going to be able to use it against any depreciation recapture, but you’ll be able to wipe out gain on that. Once those calculations are done depending on the numbers, the rest of it will go into the 1031 calculation for deferment.
Toby: All right. 1031, let’s just knock a couple of things out of the way there. It has to be an investment property. Let’s say it’s a single family house. Can I buy commercial property, land, or storage? Can I buy two duplexes? Can I buy three single families out of it, or do I just have to go one to one?
Eliot: No, you can get multiple properties. If you have a single family, you can still get into commercial. Really, the only requirement is real estate.
Toby: It just has to be real estate. It can even be land.
Toby: Here I am. I’m looking at this going, all right. I’ll interpret what Eliot just says. I have a house that I bought for $300,000. It’s now worth $1.5 million. I lived in it two of the last five years. Two years ago, I moved out and I made it into a rental.
What this means is that I can use my $500,000 exclusion. Let’s say I’m married. All of a sudden, my basis of the new property I buy is going to be $800,000, and then I could 1031 it into more real estate. Let’s say that I bought two properties, each were $750,000. Boom, I pay zero tax. Is that how we just worked it, plus my basis stepped up in those properties to that $800,000 or $400,000 amongst those two properties?
Eliot: Exactly right. You just grew your rental portfolio.
Toby: Absolutely. That’s why people love the 1031. Coincidently, getting out of that 1031, most people would say, all you got to do is die. You step up in basis once you die. But what if I am just sick and tired of managing rental properties and I say, you know what? This is for the birds. I want to be able to enjoy my retirement. What’s the option for somebody like that who’s been doing 1031 exchanges their whole life, and now they don’t want to sell and get a taxable event? Is there a way for them to get out of that 1031 exchange by doing something else?
Eliot: There is. Enter the Delaware Statutory Trust, DST often referred to. In a 1031, the government will look at that as an exchange for real estate. In other words, we did the 1031, we sold our property. That’s the relinquished property. Now, instead of picking up other properties that we have to manage, you can just get an interest in a Delaware Statutory Trust. You don’t have to manage anymore, you just collect the checks.
Toby: A Delaware Statutory Trust sounds like a fund that holds real estate. But the IRS has touched it with its magic wand and said, this is the same as owning the real estate. You can turn 1031 into a DST, but that sounds illiquid. Am I missing that, or is it pretty tough to get out of a DST?
Eliot: Traditionally, it has that stigmatism to it that you can’t get out that well. There are other options, though. You’re able to defer your gain by getting into the DST, but some of these DSTs are able to move over. You can exchange it to an interest of something called an UPREIT.
Toby: Tell me about that. What’s an UPREIT?
Eliot: Umbrella Partnership Real Estate Investment Trust. That’s a different type of vehicle, lots of properties in it, much, much broader portfolio than what you typically see in a DST. Tax-free typically will move from your DST into ownership of an UPREIT. Same idea. You’re not managing anything anymore if people are handling it for you.
The thing about an UPREIT is typically, they are part of a structure that has free trading stock through its general partner. What does that all mean to you? Much easier to sell those and things like that. It’s just a broader category of different types of real estate products in there and more freely trading.
Toby: The holy grail is still, you hold these things until you die, and then they step up in basis. What that means is the fair market value is the date you’re passing. It’s what that value is. It’s what that basis is on that property for your heirs. If they sell the property, they sell the upgrade, they sell the DST, or they sell the real estate, after you die, they’re probably not paying any tax.
That’s our end goal. But if you need to get cash and you want to get out of the real estate, the UPREIT is actually a nice tool because you could just sell individual securities under that situation. You’re just selling it out on the free market. Hey, I need $50,000. Instead of having to sell the whole piece of real estate, you could just sell that much and recognize whatever portion of the gain is attributed to that piece, right?
Toby: All right. I’ve heard a lot about these qualified opportunity zones and these qualified opportunity zone funds. Do they have a place in this mix when it comes to real estate?
Eliot: They can, maybe not as attractive as they were when they first came out. The tax code has progressed past a time period where you got some of the benefits. But still, if you have capital gains now, generally speaking within 180 days, you can invest them into a qualified opportunity zone fund. The fund goes out there and buys land or what have you in these areas that have been designated as such.
If it’s barren land, and you’re making improvements, or if you already got a house or a building that’s there, you may have some additional qualifications. Within about 30 months, you have to add more to it. It could be from your capital gains.
Toby: Double the value.
Eliot: Exactly right.
Toby: The improvement, not of the entire land. If you buy a big chunk of land with a little structure on it, as long as you’ve doubled the value of the structure, you’re going to meet the requirements.
Eliot: The key here is that the deferment—and this is just a deferment—only goes until the latest December of 2026. That time, you will have to pay the capital gains on that deferred.
Toby: You’re going to have a taxable event.
Eliot: Right, you’re going to pay that. But if you hold on to the whole project for 10 years at least, then all of a sudden, the cost basis in your project goes up to what’s the fair market value. Tax-wise, it just means you pay no tax. You could sell over 10 years, it goes up in value, and you’re not going to pay any tax.
Toby: Let’s make this into English. Let’s say we have a $300,000 property that’s now worth $800,000. We sell it, but we have all that capital gain. We have $800,000. Do we invest that into a qualified opportunity zone fund? Is that what we do?
Eliot: Just the capital gain amount.
Toby: So the half a million?
Toby: We have half a million of gain. We put that into a qualified opportunity zone.
Eliot: It will be deferred until the end of December 31st, 2026.
Toby: All right, let’s just say I put half a million dollars in, you could put other cash in. I could put the whole $800,000, but the only portion that’s going to be relevant for the opportunity zone is that half a million. You have two different types of basis there.
Let’s just say that we buy a property, $800,000, it goes up, and now it’s worth $2 million. At some point in 10 years, let’s say it’s worth $2 million. In the meantime, I’ve had to pay tax on that half a million dollars in what year? In 2026?
Toby: I’m going to have a capital gain hit in 2026. Is this also the depreciation recapture and everything that I’m deferring, or is it just capital gain?
Eliot: It would be just the capital gains.
Toby: Okay. I’m pushing that down the road, and now I’m getting hit at some point in the future with the gain recognition. Eventually, I will probably never going to sell, but I will hold on to it for 10 years. Now it’s worth $2 million. I only paid tax on that half a million dollars of capital gain. Now I sell it 10 years later for $2 million, and I have no other tax, right?
Eliot: That’s correct. You basically walk away with a pocketful of cash, no tax consequence.
Toby: All right. We just hit a whole bunch of different areas. Let’s go back. Unless there’s anything else that I’m missing, are there any other strategies that you got up your sleeve?
Eliot: No, I think that’s plenty.
Toby: All right. We just hit the unlocking of passive losses that are carried forward. We hit that. We talked about spreading that capital gain and using passive losses by using an installment sale to avoid taxation. We went over 1031 exchanges.
We went over 121 exclusions on your primary residence. We went over using both a 121 and a 1031 Exchange. We went over using a Delaware statutory trust. We talked about using an UPREIT for a little bit better liquidity than a Delaware Statutory Trust. And then we finished off with a qualified opportunity zone. We just hit quite a few areas.
We haven’t even dived into Charitable Remainder Trust, or using charities, or some of the other more creative vehicles as well. But I think you have an absolute mouthful of strategy that just got thrown onto your plate that you can explore as to ways that you can avoid tax when you sell real estate.
Eliot, thank you for joining me. Thanks for laying those out for us.