May 2004 Newsletter
TAX STRATEGIES
Sell Real Estate Now - Defer Taxes for Decades
The new 15% rate on capital gains may tempt you to sell appreciated real estate to capture a bargain. But, there are some other tax points to keep in mind before closing the deal…
O Depreciation recapture. If you sell real estate that you’ve depreciated, you’ll owe a 25% tax on those depreciation deductions. For some properties, virtually the entire sale may be subject to this tax.
O State and local capital gains taxes. Such taxes probably will add a few points to the effective tax you’ll pay on a sale.
O Adjusted gross income (AGI) escalation. Reporting any capital gain from a sale of real estate will boost your AGI, which can increase your tax bill by putting you in a higher income tax bracket through the loss of itemized deductions, personal exemptions, and various other tax benefits.
O Bottom line: With combined state and federal taxes, you probably will have an effective tax rate of at least 20% on the capital gains and 30% on the depreciation recapture when you sell real estate. Considering the tremendous appreciation of real estate in recent years, the absolute dollars involved can be substantial.
Private annuity trusts
A savvy strategy may help you deal with this problem by spreading the gain over a period of years. It also may be possible to delay the start of tax payments for years, too.
Strategy: Sell your real estate to a private annuity trust (PAT). The PAT is your own, intrafamily trust, controlled by your family. Your heirs can be trust beneficiaries.
The trust subsequently can sell the property to a third-party buyer for cash. Ongoing payments (and the tax bill) will be spread over your life expectancy.
Example: You own a small, fully depreciated apartment building. A buyer offers you $1 million. If you accept the offer, your tax obligation might be $200,000 to $300,000.
Instead, you sell the property to a PAT. The trust agrees to buy your building for $1 million, the fair market value.
Terms of sale: Instead of paying you with cash, the PAT enters into a private annuity with you. In a private annuity, the person who transfers the property to the trust becomes the “annuitant” The annuitant is promised a lifelong stream of income, no matter how long or short that life will be.
Variation: The annuity may be paid to a married couple, as long as either spouse is alive.
The amount of the annuity payments depends on several factors, including the property’s value, the life expectancy of the annuitant when the payments begin, and the interest rates prevailing at the time of the agreement.
Fixed figure: In any event, the amount of the annuity payments will be fixed, year after year, as long as the annuitant is alive.
Cashing in
Once the property has been transferred to the PAT, the trustee can sell it to the buyer who previously had expressed interest.
Loophole: When the PAT sells the property, no tax will be due. That’s true as long as the amount the trust pays you ($1 million, in this example) is the same as the amount the PAT receives soon afterward, from the buyer.
Result: The PAT will be holding $1 million in cash. It can begin making annuity payments to you right away.
Strategy: If you don’t need the cash, you can defer payments until you retire. During this deferral period, no tax will be due on your sale of the property.
Either way, the sale proceeds will be invested inside the PAT, at the direction of the trustee. The trustee can be virtually anyone except yourself and your spouse.
Tax treatment
When payments begin, each will be part long-term capital gain and part ordinary income. There also will be some income subject to depreciation recapture (if you had depreciated the property) and some tax-free return of capital (if you had basis in the property when you sold it to the trust).
Example: You have a $300,000 long-term gain on the real estate you transferred to a PAT. You’re the sole annuitant and your life expectancy is 20 years when the payments begin.
In this situation, each payment you receive for the first 20 years would be composed of $15,000 that is taxed as a long-term capital gain ($300,000 divided by 20). Depreciation recapture and tax-free return of basis also would be spread over your 20-year life expectancy.
The rest of the money you receive would be taxed as ordinary income. If you sold the property for cash and paid 30% in combined taxes, you would have approximately $210,000 of after-tax gains left. If you invest the whole $300,000 in a private annuity bearing a 6% rate of returns versus investing the $210,000 after-tax money in a similar commercial annuity, the payout from each would be $30,062 per year for the private annuity versus $21,043 for the commercial annuity. Over the 20-year life expectancy, the private annuity pays out $180,380 more than the commercial annuity because the private annuity has the full $300,000 working for you initially. The private annuity payment would be hit with more taxes than the commercial annuity payment would, but the result would still be substantially more.
End of the line
What happens if you die before you reach your life expectancy? The balance in the trust will pass to the PAT beneficiaries.
Loophole: Assuming the private annuity has been fairly valued, no income, gift, or estate tax will be due initially or upon your death.
On the other hand, you might live beyond your life expectancy. If so, the annuity payments will continue indefinitely.
Key: After you reach the life expectancy you had at the time payments began, all subsequent payments are taxed as ordinary income.
You’ll keep getting those annuity payments until the PAT runs out of money. Alternatively, if there is money in the PAT at your death, the funds will be paid to the trust beneficiaries’ tax free.
A matter of substance
If the PAT holds, say, $1 million worth of investments and owes payments on a private annuity valued at $1 million, it will have no net worth.
Trap: The IRS might say the trust lacks economic substance and disallow the entire transaction.
Strategy: Transfer a substantial amount of assets to the PAT.
Example: You might give $50,000 to the PAT for reserve capital.
Alternatively, the private annuity might be structured so that the PAT pays you around 93% of the fair value of the property. That is, if a fair-value private annuity would pay you $100,000 a year, the PAT might pay you only $93,000.
Key: Working with experienced professional advisers can help you support the tax benefits of long-term tax deferral.
What's New in Taxes
The IRS names the "dirty dozen"
Every year thousands of taxpayers are misled into believing tax schemes that are too good to be true. Falling for these scams will cost you money and may subject you to civil and criminal tax penalties. The following scams have been identified by the IRS as the "dirty dozen" tax schemes currently being used by con artists.
1. Reparation tax credit. Con artists tell African-Americans they qualify for a reparation tax credit for slavery. They charge an upfront fee to file a refund claim for a bogus credit which doesn't exist in the tax code.
2. Corporation sole. Promoters of this scam twist the tax law and say you can incorporate yourself as a religious organization and be exempt from taxes.
3. Refunds for a fee. Again, for an upfront fee, con artists offer to give you a phony Form W-2 with false income tax withholding so it appears you qualify for a bigger refund.
4. Sharing dependents. This scheme involves reporting one person's dependents on another person's return in order to claim the earned income tax credit for both taxpayers.
5. No federal income tax withholding from wages. Some employers are misled into believing that they aren't required to withhold taxes from employees' wages.
6. Offshore transactions. The IRS cautions taxpayers that using offshore credit cards, trusts, or other arrangements to hide income or claim false deductions is illegal.
7.
8. Phony IRS collection agents. The con artist shows up at your door claiming to be an IRS agent there to collect money. IRS representatives carry picture IDs, and they will normally contact you before they visit.
9. Bogus home-based businesses. Promoters charge a hefty fee for the materials to start your own home-based business, alleging that you can write off most of your personal expenses as business expenses.
10. Identity theft. Thieves use your personal data to steal your bank accounts, run up charges on your credit cards, and file for tax refunds.
11. Phony payment checks. Con artists sell you phony checks telling you they can be used to pay your taxes and other debts.
12. Frivolous arguments. Internet ads suggest that paying taxes is voluntary and try to sell you "untax packages."
What's New in Financial Strategies
College costs and financial aid increase
Spring is college application season. According to the College Board, tuition at public colleges rose 14.1% for the 2003-2004 academic year. The increase at private universities was 6%. Financial aid is also increasing. For the 2002-2003 academic year, aid increased by 15% to $105 billion.
If you're trying to evaluate a financial aid package for your college age child, remember to keep your eye on the bottom line — what you'll end up paying out of your pocket and how much your child will have to borrow. The total amount of an aid package may seem large, but you need to focus on the dollars you and your child will have to pay or borrow.
Also, be aware that scam artists are active in the area of college financial aid. Don't be duped by services that ask you to pay a fee for help in obtaining aid.
Web sites with FREE help in navigating the financial aid process:
A comprehensive site that has information on loans, scholarships and saving plans. Even includes interactive calculators to help project what a child’s college costs will be and how much mom and dad should be saving.
Matches student profiles into a database containing over 600,000 scholarships. Alerts students to application deadlines or when new scholarships are added.
Connects student profiles to a database containing over 2,300 scholarships, internships and loans.
Contains over 150,000 resources, including scholarships, fellowships, internships and loan-forgiveness programs.
Chuckle of the Month
Did the tax-law changes reflected on your 2003 tax return frustrate you? Then you'll probably appreciate humor-writer Dave Barry's comments. He says these changes were designed "to guard against the danger that some taxpayer, somewhere, will actually understand them."
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The information contained in this newsletter is of a general nature and should not be acted upon in your specific situation without further details and/or professional assistance. For more information on anything in ONLINE ADVISOR, or for assistance with any of your tax, business, or financial strategy concerns, contact our office.