Monday, September 14, 2009

Strategic Management of Tax Liability

In these pages I have talked much about IR 1031 tax deferred exchanges. A new vehicle on the market this year, approved by the Internal Revenue Service in a private letter of approval, is going to prove a valuable strategic option for owners of commercial/investment real estate.

Occasionally, an investor wants to divest of properties but knows their equity is so significant, that their appreciation is so significant, that they end up holding on and continue to trade up to avoid capital gains. Long the legal way to build significant wealth with investment grade real estate, there still was always that stumbling block of what to do if you decide to get out "before your estate is activated."

If you need a translation of what I wrote in quotations above, email me and I'll clarify.

Anyway, investors worry that they will get killed with taxes and have thought, "well I may as well just let my kids inherit my assets as stepped up value when I pass away."

A new product, The Deferred Sales Trust(tm), is providing a new exit strategy for those who wonder what to do down the road. On March 10 of this year, the Internal Revenue Service issued a highly anticipated Private Letter Ruling that addresses this new tax deferral strategy.

Deferred Sales Trusts provide you with another tax-deferred strategy to defer the payment of your capital gain income tax liabilities when you sell highly appreciated real estate, personal property, business interests or other assets. The Deferred Sales Trust gives you one more tax deferred strategy to choose from when planning the sale of a highly appreciated property or asset. The Deferred Sales Trust is a legal method that allows the seller of the property to defer capital gains taxes due at the time of sale, but over a period of time, even beyond that investor's lifetime. This trust is drafted pursuant to Section 453 of the IR code, just like an installment sale note.

Here is how it works: The investor/seller, "grantor," sells his or her commercial/investment property to a dedicated trust, which in turn sells the property to a buyer. An annuity is created and the seller receives income over time, and is taxed only on that income received during a taxable year. And just as the income is dribbled in, capital gains taxes are not charged to the investor/seller all at once, but also over time. There are no taxes to the trust on the sale since the trust "purchased" the property for what it sold it for to a third party. Best of all, from what I understand in my research, there is no interest or penalty on these deferred payments of the tax. An investor's capital gain is recognized, but it is deferred over a pre-determined period of time that the investor chooses in advance. Everybody wins.

As always, if you get involved in this type of transaction, beyond your experienced real estate investment agent, you should also consult with your attorney and tax professional to make sure you are covered on all bases.

The trust can make a cash sale, also. Sometimes, in order to spread out tax liability, an investor/seller will set up a payment schedule with the buyer ( particularly if the seller finances the transaction). The Deferred Sales Trust appears to be a strong option because invstors never know whether the outside buyer will make all the payments on an installment sale. And trust payments are designed by the investor/seller, or grantor. The investor designs the payment schedule, the payment start date, and amounts to be received, depending on their needs.

Best of all, my research is showing that whatever is left in the trust at the time of the grantor's death appears to passe to the beneficiaries free of estate and gift taxes. Secondly, this transaction does not appear to triger any gift tax consequences, no matter how much trust assets are worth. And third, as is usual, trust assets do not need to go through probate when the grantor dies.

If your commercial real estate agent, CPA or tax adviser go to look up this new tool in the IR code, they will not find the name Deferred Sales Trust, or DST. Those are trademarked names from Exeter Fiduciary Holdings. . However, all of the legal and tax authority used in this type of trust are in the tax code. This is not a loophole. There has been a provision for installment sales for many years in the tax code.

Finally, once the trust is set up, additional commercial/investment property can be sold to the trust.

For some really strong Q&A on the subject, go to http://www.exeter1031.com/. This company is one of the strongest qualified intermediary firms for executing 1031 tax-deferred exchanges. In fact, Exeter is the company that has trademarked the name "Deferred Sales Trust" and asked for this ruling on this new product. They are the company I would recommend if I had a client who wanted to go this route.

Thanks go to Jim Wootten of Standard Realtors for bringing this to my attention during a recent meeting. It really got me thinking about possibilities. For those investors who don't plan to let their existing trusts that hold real estate outlive them, and want to cash out now, this approach offers many strategic possibilities well worth exploring.

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