By Mercedes Shaffer l Published in AOA Magazine
One of the most common questions I’m asked is if there is a way to sell an investment property or home, keep the money and defer taxes. If you’re like some of my clients, you’re ready to enjoy the fruits of the wealth you’ve amassed and you don’t want to pay the government a large capital gains tax, at least not just yet.
We live and breathe investment real estate and we may have found a solution that so many have been looking for. We assembled a team to offer an IRS approved third-party trust that allows you to retain the profits from the sale of a highly appreciated investment property, without having to do a 1031.
How It Works
Typically, before you list a property for sale, a third-party trust is set up so that you won’t have what’s known as constructive receipt of the buyer’s funds, which would trigger a taxable event. It’s very similar to having an accommodator, only with a third-party trust, you don’t need to do a 1031 exchange into another property. You can leave your money in the trust account where it will be accruing interest.
What Happens To The Money Once It’s In The Third-Party Trust
When the trust account is set up, you will have complete control over the investment decisions for the trust. There are no restrictions or limitations on the types of investments the trust can make. You can invest in diversified financial instruments, equities, bonds, ETFs, insurance products, annuities, and you can also go back into active real estate. To keep the tax deferred money working, it needs to go into some sort of bona fide investment.
What Are The Different Ways This Can Be Used?
There are three main ways a third-party trust can benefit a seller.
1. You can use it as a backup while doing a 1031 exchange. Oftentimes a buyer doesn’t have a lot of negotiation power when doing a 1031 exchange because the seller knows that they have a 45-day window to identify a property, so a seller may be unwilling to negotiate on price or repairs, but if they know that you have a backup strategy, this gives you more leverage in the deal.
2. You can use it as a temporary place to keep your money until the right deal emerges so that you’re not constrained to the 45-day time limit, or if you believe the market is going to go down in a few years, you can use it to sell high and then buy low. Having your money parked in the trust allows you to make a strong offer on your next property because you will be in a position to either put down a sizeable down payment or even do an all cash quick close using the money in the trust.
3. The third use is if you want to cash out, defer taxes and receive an annual income from the sale proceeds. In this scenario, you get to select the amount that suits your particular lifestyle and can change the distribution amount to suit your changing needs.
Payback Structure
With the trust, you get to determine the annual payment amount and tailor it to your personal lifestyle needs. You can have the monthly payments be commensurate to what you were making in rent, you can have it exceed what your rental income was or you can even choose to defer receiving payments and allow the money to accumulate interest and grow if you don’t need the money right away. The payment terms are flexible and you can make changes as your lifestyle needs change.
How Am I Taxed?
The first dollars of distribution that you receive represent interest on your note. Anything that exceeds the accrued interest from year-to-year would be considered a partial return of your principle.
For example, if $1M comes into your trust account from the sale of a property, and your annual interest rate is 5%, anything you choose to receive up to $50K (which represents the 5% interest amount) would be considered interest on your note. Because you’re not touching your principle at all, you’re just receiving full interest payments, you would get a 1099 at the end of the year and your accountant would count that as ordinary income.
Now if you chose to receive $100K, the first $50K is ordinary income from interest, the second $50K is a partial return of your principle, so it has a blended rate of capital gains, depreciation recapture, and some of the money comes back to you tax free as a partial return of your original cost basis. This allows you to lower your overall annual tax burden and keep more pre-tax money in your account earning interest.
Can Everyone Benefit?
This solution is not for everyone. The minimum viable transaction is when you are either deferring paying $100K in taxes, or another way of looking at is your property appreciation that is subject to capital gains tax is at least $250,000 - this includes the amount taxed on with depreciation recapture and appreciation combined.
Fiduciary Partners
In order to execute a third-party trust you need a real estate agent like myself who is certified to execute the transaction. While I will serve as your realtor, I am not licensed to give tax or legal advice, so always consult with your CPA or attorney, additionally, your team will be constructed to include 3 fiduciary advisors to build and help maintain it in accordance with the IRS requirements.
1. Tax Attorney, who is part of the original architectural framework
2. Independent Trustee, certified and approved
3. Independent Licensed Investment Advisor. You can select from one of our advisors or use your own.
Fee Structure
1. There is a one-time legal and setup fee of 1.5% on the first $1M.
2. 1.25% of the sale price that exceeds $1M.
3. Annualized fee between .9 - 1.5% for management of the funds.
Benefits of Tax Deferral
With a third-party trust, you are deferring taxes, not evading taxes, so as you withdraw money you will be taxed on it. However, one of the big benefits is that by deferring taxes, it allows you to keep the tax dollars you would have paid at the time of sale so that the money is working for you to generate more interest income and accumulate more wealth.
So, if you sold a property for $1M, and instead of setting up a third-party trust you just paid the capital gains tax, you may only have $700K now to invest. Factor in depreciation recapture, etc. and that number could even be significantly lower. Whereas when you set up the trust and defer taxes, you have the full $1M to invest in an interest earning or potentially appreciating account. Essentially the money is put back to work for you instead of going immediately to the IRS.
It also gives you the ability to control the timing of when you pay taxes and allows you to engineer your tax bracket based on your lifestyle and income needs. Pay today’s taxes with tomorrow’s dollars.
Legacy and Estate Planning
Many people wonder what happens to the money if they pass away. With a third-party trust, you simply link it to your personal estate planning such as a revocable living trust, so that your beneficiaries have all the same options that you have to modify the trust. They can continue to take the same distributions, they can increase or decrease the income amount, they can stop taking income so that the account grows or they can cash-out. There is no penalty for early withdrawal, it just means paying the cap gains taxes.
Financial Freedom and Protection
A byproduct of having your money in a third-party trust is asset protection. Your principle is protected from future judgements and creditors, similar to a 401K plan.
Many apartment owners have seen their properties appreciate in value and now they are ready to cash-out and enjoy the money. The third-party trust offers sellers the opportunity to enjoy the wealth they worked so hard to build while maximizing their wealth and net income.
If you would like to learn more about the third-party trust, or if you would like help with buying, selling or doing a 1031 exchange, CONTACT ME. I can be reached at 714.330.9999, InvestingInTheOC@gmail.com, or you can visit my website at InvestingInTheOC.com. I’m Mercedes Shaffer, a real estate agent with Coldwell Banker, helping you build (and keep) wealth one door at a time. DRE 02114448.