San Francisco Apartment Association

Feature

Selling Property Without Paying Capital-Gains Taxes

by Larry Weiss

Many San Franciscans have benefited greatly from the increase in real-estate prices over the last few decades. Our clients tell a familiar story: “I bought rental properties in the early 1970s for $75,000. Now I am told they are worth $1 million or more. I have worked hard to keep these properties in good shape and have been responsive to my tenants’ needs. Rent control is frustrating; and I am making 2% after expenses on my investment property. I am now tired of being a landlord and getting late night calls, but I do not want to pay hundreds of thousands of dollars in taxes when I sell my property. Surely there must be some tax-saving options when selling my property?”

When you, as a property owner, sell your appreciated properties, you face different levels of taxation. At the federal level, you face a 15% federal capital-gains tax and a 25% tax rate of depreciation recapture. In the state of California, the gain is included as ordinary income with a maximum tax rate of 9.3%. This means that for many people like you, the total tax rate from the sale of your properties can exceed 27%.
As a property owner planning to sell highly appreciated property, you should look at all your options. The right decision is greatly affected by your own personal situation and individual needs. Some of the alternatives to paying taxes immediately include:

  • Installment sale
  • 1031 Exchange
  • Private Annuity Trust and
  • Charitable Remainder Trust

While each of the above strategies can prove beneficial, only the Charitable Remainder Trust (CRT) actually eliminates the capital-gains taxes from the sale of the appreciated property

Charitable Remainder Trusts
Many of our clients find a CRT is a valuable income- and estate-tax planning tool for selling highly appreciated property. For some taxpayers, using a CRT helps increase their income potential. A CRT provides lifetime income potential, creates a charitable deduction for the taxpayer, eliminates capital-gains taxes from the sale of the appreciated property and eliminates this property from estate-tax consideration.

CRT Steps
You must undertake the following steps in creating a CRT:

  • transfer the appreciated property to a CRT;
  • the CRT sells the property and the proceeds are invested;
  • the CRT pays an annual income to the taxpayer(s) for their lifetime(s); and
  • at the death of the taxpayer(s), the remaining assets inside the trust are transferred to a charity or charities.

Additional CRT Benefits
The first benefit of a CRT is an income-tax deduction. When the appreciated property is transferred to the CRT, an income-tax deduction is created. This itemized income-tax deduction may help you pay less in federal- and state-income taxes. The amount of the income deduction will vary with the unique circumstances of your case. The amount is calculated using IRS guidelines that include the value of the property, the age(s) of the taxpayer(s), payout rates and interest rates established under IRS Code Section 7520. There may be limitations on the amount of charitable deductions that you, as an individual taxpayer, can take in the current year. If the limit is exceeded, the excess deduction is generally carried forward for up to five years.

A second benefit of a CRT is the elimination of capital-gains taxes on the sale of property. After your appreciated property is transferred to the CRT, the property is sold without capital-gains taxes. The proceeds from the sale are invested and designed to provide you with lifetime income. This means that the CRT is able to invest all the proceeds from the sale with no reduction from capital-gains taxes.

A third benefit of a CRT is to provide lifetime income potential. The CRT is required to pay income to you (a former property owner). There are different types of Charitable Remainder Trusts. The most common trusts utilized with a CRT include a Charitable Remainder Annuity Trust (CRAT) and a Charitable Remainder Unitrust (CRUT). When using a CRAT, the annual payment to you, the former property owner, will be a fixed amount each year. With a CRUT, the annual payment will be based on a certain percentage (for example, 6%, 6.5% and 7%) of the balance of the trust. The percentage amount will be fixed, but the actual amount received from the CRUT will fluctuate with the changing asset balance in the trust. The amount paid can be monthly, quarterly or annually.

The taxable nature of these annual payments is based on tiered-trust accounting. The four tiers are ordinary income, capital-gains income, tax-exempt income and tax-free income. The annual payments will likely be taxed at different tax rates based on the nature of the investment(s) inside the trust.

A fourth benefit of a CRT is that, at the time of your death, the income payments cease. The amount remaining in the CRT will be transferred tax-free to your designated charity. These assets are no longer part of your estate and are free of estate taxes. Through this generosity, a charitable organization may receive substantial funding. Your name could be on a new hospital wing; or funds could be provided for much needed scientific or medical research.

Other CRT Considerations
A CRT is not for everyone. A CRT is an irrevocable trust. Once a property is transferred to the trust, the taxpayer no longer owns that highly appreciated property. After death, the remaining investments in the trust go to a charity and not to the heirs.
CRT’s with Wealth

Replacement Trusts
Many of our clients consider CRT’s a good tax- and estate-planning tool. But often an individual will comment that “a CRT makes a great deal of sense, but I was planning to leave this property to my children. What can I do to benefit them?”

Our clients often utilize a wealth-replacement trust with their CRT. A wealth-replacement trust is designed to replace the value of the property given to the charity at the death of the taxpayer. Most people can purchase a life-insurance policy on the life of the taxpayer(s) to create value for the heirs. In many cases, a client can use a small portion of the income received from the CRT to pay for this insurance. The insurance policy is designed to pay at the death of the taxpayer(s). With proper planning, the death benefit will be paid to the heirs and will be income- and estate-tax-free; and thus it will replace the value of the appreciated property originally transferred to the trust.

With a CRT, many parties may benefit. They include you as the taxpayer, your heirs, your favorite charities and the IRS—yes, even our friends at the IRS. The IRS has long recognized the importance that charities play in our society. The federal government directly uses many charities to help achieve national goals in social, scientific and medical endeavors.

As a property owner, you have a particular financial situation. Careful consideration of your tax needs and tax implications are essential. Therefore, you should get professional advice to determine if a CRT is right for your unique circumstances. Make sure you contact your own professional tax and investment advisors or other professionals to help answer questions about your specific situation or needs prior to taking any action based on this information.

The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Consult the advice of a tax professional for any specific problem. Larry Weiss, CPA, CSA is a tax and investment professional with Lau Financial Services, with offices in San Francisco, San Mateo and Los Altos. He can be reached at (415) 586-1694 or lweiss@laufinancial.com. Copyright © 2006 by the San Francisco Apartment Magazine. All rights reserved.