How to Pay Little or No Taxes on Your Real Estate Investments: What Smart Investors Need to Know Explained Simply

How to Pay Little or No Taxes on your Real Estate Investments

What Smart Investors Need to Know — Explained Simply

By Brian Kline

How to pay little or no taxes on your real estate investment: what smart investors need to know—explained simply

Copyright © 2007 by Atlantic Publishing Group, Inc.

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Library of Congress Cataloging-in-Publication Data

Kline, Brian

How to pay little or no taxes on your real estate investments : what smart investors need to know--explained simply.

p. cm.

Includes bibliographical references and index.

ISBN-13: 978-1-60138-040-1 (alk. paper)

ISBN-10: 1-60138-040-2 (alk. paper)

1. Real estate investment--Taxation--United States.

HD255.H655 2007

343.7305’46--dc22

2007025068

LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: The publisher and the author make no representations or warranties with respect to the accuracy or completeness of the contents of this work and specifically disclaim all warranties, including without limitation warranties of fitness for a particular purpose. No warranty may be created or extended by sales or promotional materials. The advice and strategies contained herein may not be suitable for every situation. This work is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If professional assistance is required, the services of a competent professional should be sought. Neither the publisher nor the author shall be liable for damages arising herefrom. The fact that an organization or Web site is referred to in this work as a citation and/or a potential source of further information does not mean that the author or the publisher endorses the information the organization or Web site may provide or recommendations it may make. Further, readers should be aware that Internet Web sites listed in this work may have changed or disappeared between when this work was written and when it is read.

Table of Contents

Preface

Foreword

Introduction

Chapter 1: What to Expect from Three Tax Strategies

Chapter 2: Eliminating or Reducing Taxes

Chapter 3: Qualified Retirement Accounts

Chapter 4: 1031 Exchanges

Chapter 5: The 1031 Process Step-by-Step

Chapter 6: Useful Variations of 1031 Exchanges

Chapter 7: Installments When the Time Is Right

Chapter 8: Charitable Remainder Trusts Have Big Tax Advantages

Chapter 9: Wealth Goals and Strategies

Chapter 10: Business Structures to Protect Assets

Chapter 11: Estate Planning

Chapter 12: Bringing It All Together

Preface

This book is intended to be a guide for the accumulation of wealth through a variety of real estate investments that depend on the careful and effective use of existing tax codes to accelerate the growth of wealth and preserve wealth once acquired. The methods described here are not intended to dupe the U.S. government out of taxes fairly owed. Rather, these methods follow well-established Internal Revenue Code.

This book cannot anticipate all the possible investment scenarios available. Each investment is unique and requires prudent review and planning by the investor. Hopefully, the book will provide the investor with insight that improves the review and planning process. Each real estate investor should obtain expert advice addressing specific circumstances whenever needed.

Real estate investing can be one of the surest and most dependable methods of systematically acquiring wealth. Historically, real estate outperforms the stock markets, and there are multiple benefits to ownership. An important benefit is that you, as the owner, are in a much better position to make decisions affecting future value appreciation of the real estate. You are not likely to wake one day to a news headline informing you that a dishonest chief executive of the company whose stock you own has been cooking the books and pocketing money. Rather, you can predictably increase your overall wealth through careful planning and investing.

Flexibility is another advantage of real estate investing. First is the high-level choice of investing in raw land, residential residences, commercial property, or purchasing property to open your own business. Real estate investment is open to the duplex owner who invests sweat equity to improve the property and move into a better place. It is open to the deep-pocket investor who owns multimillion-dollar office space in the heart of a prestigious metropolitan city. They may not have similar business addresses, but in the United States, the same tax laws apply to both. This book levels the playing field by providing valuable uses of the tax law that the wealthy pay large sums to learn from experts.

Just as important, this book includes information on how to develop a plan effectively using the tax code at different points in an investor’s career to maximize the effect. As with knowledge of any tool, just having it in the toolbox is not enough. Knowing when to use it and obtaining the intended result is just as important. The early part of an investor’s career should focus on acquiring property and gaining a foothold. Later the investor has several choices; maybe maximizing the income derived from the property, or owning multiple properties providing multiple streams of income, or focusing wealth in only a few high value properties. Pursuing one of these strategies without paying capital gain and other taxes should be part of the successful investor’s career plan. Once wealth is ensured, it is time to create dependable, tax-minimized income streams to provide a reliable retirement income.

Properly done, a well-planned wealth accumulation strategy delivers amazing results through compounding interest and use of other people’s money to invest in the most dependable appreciating asset — real estate.

Table of Contents

Foreword

Many investors today are making huge profits on real estate investments, traditionally a surer alternative to a volatile stock market and low bond earnings. However, the key in investing in land is not the profit, but what you actually get to keep after taxes. This new book will provide a road map with hundreds of methods and insider tax secrets to help you keep more of what you earn.

Unlike stocks or other investments, owning investment property can be a very time intensive venture. The buyer must make a multitude of decisions, each one of which could lead to financial losses or gains. The day of reckoning for any real estate investor comes when he or she sells a property. What many investors do not know is that decisions made during the sale of a property can drastically affect their return on investment.

To alleviate daily demands of being aware of tax pitfalls, home owners and real estate investors need a good reference for timing their transactions to keep more of their profits. Using this book, you find out in plain English how to minimize your current income taxes and eliminate your future estate taxes while maximizing your returns on investments when buying, owning and selling real property assets. Therefore, not only do you minimize your current tax bill but you will be able to plan aggressively to reduce future estate taxes.

The author has extensive experience and has developed in-depth knowledge of issues concerning real estate taxation, providing the reader with the most financially beneficial solutions to complicated taxation issues. He also includes case studies that provide pointed examples for achieving your goal of making money without incurring undue tax losses.

You will discover how exit strategies can substantially decrease tax liability. These tactics, along with other options, including installment sales and capital gains bypass trusts, can turn a poorly performing property into a profitable sale. As a Real Estate agent in an area where investors are a primary target group of buyers, I am often asked about how to avoid capital gains tax and what type of property qualifies for capital gains tax deferment. After reading this book I feel that I can answer these questions more knowledgably.

Donna Cunningham, Realtor

Prudential Shimmering Sands Realty

148 N Tyndall Pkwy

Panama City, Florida 32404

www.donnasellsflorida.com

850-258-7435

Table of Contents

Introduction

Entrepreneurship is alive and well in America. The dynamic forces of technology, better access to higher education, ease of obtaining credit, and the desire for financial independence enable people to profit handsomely from their entrepreneurial efforts. The real estate industry has grown consistently throughout the history of the United States. The U.S. Department of Labor data shows 484,600 people with careers related to real estate activities in 2004. Forecasts call for another 155,800 to enter real estate careers by 2014, an increase of 32 percent. Many will become rich just by investing and holding property that appreciates. Making a few good real estate transactions is one of the surest ways of joining the millionaire club. However, experts know the key to becoming a multimillionaire is to be familiar with IRS tax codes that encourage accumulation of wealth by deferring, minimizing, and avoiding capital gain taxes.

Capitalism is about acquiring, preserving, and investing wealth. Tax laws are structured to do exactly this, while also including checks and balances to protect against abuse. This book will provide the knowledge that you need to profit from real estate investments and to grow your wealth much faster simply by keeping more profit for yourself.

Building Wealth — Profits Are Only Half of It

Several profit-enhancing techniques are available to anyone owning real estate. The principle is to eliminate or defer paying capital gains taxes and depreciation recapture taxes on the profit of a real estate sale, while leveraging these enhanced profits with additional financing to increase your property holdings dramatically.

Today, the federal long-term capital gains tax is at 15 percent, the lowest rate since the 1940s. Capital gains taxes have gone through many changes that make direct comparison difficult, but the fact is that preferential treatment is now being granted to capital gains. This preferential treatment makes real estate appreciation a dependable, appealing wealth-generating strategy. Capital gains taxes have always been lower than income tax rates.

Long-term capital gains are the increase in value of an investment held for more than one year. Short-term capital gains rates are higher and result when investments are held for less than one year.

When you sell property at a profit and avoid paying capital gains taxes entirely, the strategy becomes irresistible. Essentially, the profit increases 15 percent and increases the funds available for reinvestment. Financing options abound that can be added to the sale proceeds to purchase a much higher valued property. Purchasing new investment property with the sale proceeds plus the 15 percent deferred tax as a down payment and financing 70 percent of the new purchase generates real income.

Another element, known as depreciation recapture tax, can be deferred indefinitely and can add significantly to the money available to purchase replacement investment property. All this money is now in a new property, where you own all the future appreciation that will become your wealth. As you read this book, it will become clear that using other people’s money (OPM) is a great engine for generating your wealth.

Not paying capital gains seems quite simple, and something that it appears more people should take advantage of. However, it is not that simple because capital gains are included in the IRS code. This is a deferred tax because the government intends to collect the tax on the fully appreciated value at some point in time. The government is fine if you keep the wealth your entire life. Without proper retirement and estate tax planning, the government will get its share of your accumulated wealth in the end. This book includes IRS-approved strategies to eliminate or minimize these retirement and estate taxes.

Exhibit 0.1 is an excerpt taken directly from the U.S. House of Representatives Code for the Internal Revenue Service. 1031 Exchanges are also called Starker Exchanges, Like-kind Exchanges, and Delayed Exchanges. The fact is that capital gains taxes do not have to be paid when §1031 provisions are met.

1031 exchanges are a tax deferment allowing individuals to retain business profits and reinvest them to continue doing business or continue investing. That is the purpose of the language about the property being held for productive use or investment and sounds like capitalism at work.

The use of the term property is not specific to real estate property. It refers to all property — personal and real estate. Wealthy people use section 1031 to trade up in aircraft, expensive automobiles, jewelry, oil rights, and anything held for productive use or investment that increases in value over time.

Real estate owned as part of a business, such as a retail store, certainly qualifies for a 1031 exchange, as does investment property like raw land or a rental house. Section 1031 describes what does not qualify, leaving everything else included. Stocks, bonds, and other securities are specifically excluded. The exclusion of stocks and bonds is the reason financial advisers specializing in corporate stocks and bonds are unlikely to bring this tax strategy to your attention or even have a working knowledge of it.

Keep in mind that Exhibit 0.1 is only an excerpt highlighting the intent of this part of the tax code. The full section of the code is several pages, with cross references to other portions of the code. Illegal tax avoidance has been around as long as taxes have. The rest of the code goes into what must be done for the exchange to be a recognized, legal exchange. Normal for tax code, legality brings complexity into the picture. There are timing requirements, disqualified individuals, accounting requirements, and other requirements that must be followed. Working with experts in this field greatly simplifies the process and ensures the requirements are met.

Complexity is another reason that some people choose to pay capital gains tax rather than defer into a new real estate purchase. However, section 1031 is too good a tax deferral opportunity to go unused by savvy businesspeople. Professionals have grouped together their expertise to understand fully the intricacies of section 1031. These professionals will take you through the process for reasonable fees that are much less than the tax savings you will realize.

Creating an Income Stream While Deferring Taxes

Holding a sales contract from real estate you sell has both income-generating and tax advantages. Since you do not receive all the capital gains at the time of the sale, the taxes are not due until you receive payment. Collecting 7 percent interest on the installment sale includes 7 percent interest on the deferred taxes — going into your bank account. Your money compounds much more when it includes your original investment plus the profit on the sale and deferred taxes.

Exhibit 0.2 shows the sale of a $200,000 rental property to demonstrate an installment sale. With an original investment of $75,000, the capital gains tax is calculated on the profit of $125,000. In a normal sale, the seller receives the full $200,000 at closing. It includes the entire $125,000 in capital gains. Combined federal (15 percent) and state (10 percent) capital gains tax rates can be around 25 percent. The seller pays $31,250 (25 percent of $125,000) in capital gains taxes for that tax year.

Over the next five years, the normal sale proceeds of $168,750 ($200,000 2 $31,350) are invested at 7 percent and earn $59,063 in interest. When included with the $168,750 principal, the seller now has $227,813 at the end of five years, good for a beginning investment of $75,000.

In the installment sale, a seller accepts a $20,000 down payment and carries a $180,000 loan with interest-only payments. This loan creates a tax deferral advantage. At the time of the sale, only a portion of the $20,000 down payment is subject to capital gains tax (similar to the way $125,000 was only a portion of the $200,000 in the normal sale).

The $20,000 has several components (explained later). Only $12,500 is taxable at the capital gains rate of 25 percent. The installment sale results with only $3,125 of capital gains tax due the year of the sale — a tax deferral of $28,125 ($31,250 – $3,125).

The installment seller invests the net at closing ($16,875) at 7 percent while also earning 7 percent on the $180,000 contract with the buyer. The compounded interest on the $16,875 and $180,000 totals $79,252 in five years. In an interest-only sale, a balloon payment of the $180,000 principal is repaid at the end of five years. Adding up the $79,252 of interest, $16,875 net at closing, and $180,000 due from the loan shows the installment sale total $276,127 in five years. The seller pays the $29,375 in deferred taxes, as they come due, keeping $246,752, which is an improvement over the normal sale of $18,939 ($246,752 – $227,813).

Installment sales provide a stream of income and defer payment of the capital gains taxes. The calculation intentionally excluded recaptured depreciation tax for clarification. It will be discussed later.

IRS Accepted Tax Practices

One frequent problem for beginning investors is coming up with the original investment funds. Few people know that retirement accounts can be a source for real estate investing. Individual Retirement Arrangements (IRA) are commonly established with banks or other financial institutions that have products they wish to sell to the IRA owner. These might include certificates of deposit, stock accounts, or corporate bonds they underwrite. For this reason, most IRAs are invested and managed within traditional financial markets. However, IRAs can be invested in almost anything the owner believes will bring a good return on investment.

This new knowledge opens investment opportunities to those who have qualified retirement accounts and need funds to begin growing wealth through real estate investing. IRAs, Roth IRAs, Individual Retirement Annuity, a Simplified Employee Pension (SEP), 401(k), or a Savings Incentive Match Plan (SIMPLE) can all provide funds for this purpose. Even if you are covered by an employer’s retirement plan, you may qualify for an IRA, depending on your Adjusted Gross Income (AGI).

As mentioned, most IRAs are held with financial institutions that limit investing to products they sell. This book will explain how to roll over or transfer an IRA to a self-directed IRA account where you take control and begin investing in real estate, opening a door where you can dramatically outperform conventional financial institutions.

Taxpayers Relief Act of 1997

The Taxpayers Relief Act of 1997 brought substantial changes to the tax codes. Relevant changes to this subject include:

• Increase IRA phase-out range and modify active participant rule.

• Creation of the Roth IRA.

• Exclusion of capital gains on the sale of a principal residence.

• Increase in estate and gift tax exclusions.

• Removal of IRA 10 percent penalty for first-time home buyers.

• Lower tax rates on capital gain.

Although there have been several changes to the IRS tax code since 1997, it was the Taxpayers Relief Act of 1997 that put into motion many of the opportunities revealed in this book. Exhibit 0.3 shows just a few changes in 2006, and more became active in 2007.

The increased IRA phase-out range allows people with larger incomes to contribute to IRAs in 2007. Married couples filing jointly can make full contributions to an IRA if their adjusted gross income is less than $80,000. Adjusted gross incomes falling between $80,000 and $100,000 can make less than full contributions. In 2007, each spouse can contribute up to $4,000 to a traditional IRA, for a combined total of $8,000. Taxpayers over the age of 50 can contribute an additional $1,000 beginning in 2007 as part of the catch-up incentive. For individual taxpayers the tax-free contribution phases out between $50,000 and $60,000.

Contributions to a traditional IRA are tax deductible, and earnings grow tax-free. You deduct traditional IRA contributions dollar for dollar from your AGI. Taxes are paid in the year distributions are made to the IRA account owner, usually after retirement when the owner is in a lower tax bracket. A 10 percent penalty is applied, in addition to income tax, if funds are removed before age 59 ½. Distributions from a traditional IRA become mandatory on April 1 of the year following age 70 ½. This book goes into detail about using IRAs for real estate investing.

The Taxpayers Relief Act of 1997 gave taxpayers the Roth IRA. Contributions to a Roth IRA are not tax deductible, but the earnings from a Roth IRA are tax-free. This is a twist compared to other retirement accounts that defer taxes on contributions. In this version you invest with money that has already been taxed, but the entire capital gains tax is eliminated on your earnings. Tax-free compounded earnings make this appealing. The Roth IRA is highly suitable for real estate investing. Another advantage of the Roth IRA is a higher phase-out range than for a traditional IRA. The range is between $150,000 and $160,000 for married couples filing jointly and between $95,000 and $110,000 for individuals.

New in 2006 is the Roth 401(k). It provides the same favorable tax treatment, along with higher contribution limits and no income limitations.

Another real estate tax advantage from the 1997 tax relief act is exclusion of the 10 percent early withdrawal penalty for first-time home buyers. You are a first-time home buyer if you have no vested interest in a main home for two years. Up to $10,000 can