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Tax Smart Real Estate Investors Podcast
266. 7 Exit Strategies To Destroy Capital Gains Taxes When You Sell Your Next Property
00:40:20
In this episode, Ryan and Thomas discuss 7 exit s…
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- [00:00]
Tom
You're now listening to the Tax Smart REI Podcast, the number one tax podcast for real estate investors, your source for.
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Ryan
All things real estate, accounting and tax. Here we reveal our secrets that can save you thousands in taxes, streamline your accounting process, and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors, and current clients on what strategies they use to grow their business and how they steer clear of Uncle Sam.
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Tom
Hey, thanks for tuning into this episode of the Tax Smart REI Podcast. On this week's episode, we're going to be going through a recap of capital gains and then we're going to be diving into 7 tax efficient exit strategies you can use to minimize taxes when selling your properties. And we're also going to talk about two more that have a lot of gray hair on them, but we don't want to completely dismiss them, so we'll talk about those as well. And this is actually a topic from our Tax Smart REI Facebook group. So if you're not already part of our Facebook group, head on over to www.taxmartinvestors.com Facebook to join today. And we'll be diving into all of this in just one minute. Hey, are you ready to discover how to use real estate to build tax free wealth? Well, this year we're taking our annual summit to the next level by incorporating wealth building strategies alongside our traditional tax and legal insights. Thus, we proudly introduced the 2024 Tax, Legal and Wealth Summit for Real Estate investors. Taking place May 17th, 18th and 19th, right from the comfort of your own home. This extraordinary free three day virtual event is meticulously designed to arm you with the strategies the 1% use to cultivate tax free wealth through real estate. Whether you want to build, safeguard or grow your wealth, this summit is your Golden Ticket. Visit ww.tax and legalsummit.com to reserve your free tickets today. Again, that's ww.taxandlegalsummit.com to reserve YOUR free tickets. We'll see you there. But for now, we'll dive right into today's episode. So, Ryan, I know a few members of the Facebook group. They wanted a recap of capital gains. So let's just start with capital gains. What are capital gains and how are they taxed?
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Bill Exeter
Yeah, so capital gains, the way that I look at it, is effectively the appreciation of a asset property. So say you initially bought a property for 500,000 and it appreciates to selling it at 750,000. That additional $250,000 is your capital gain. That's Kind of the simplest way to say it from that.
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Tom
Right, right. And we know these, these two different categories. Short term is taxed a little bit differently than long term. How are short term capital gains taxed and then how are long term capital gains taxed?
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Bill Exeter
Yeah. So short term is effectively being taxed like ordinary income tax. So, right. Zero up to 37% on the short term capital gain and then long term is the more preferred tax rates and that can go from 0, 15 or 20%. So there's the maximum basically is 17% less than that ordinary at the short term capital gain. So it is preferred when you can, if you're, hey, I'm getting close to holding a property for right around the 12 months that year, if you can own it for just over that year, you could potentially on your tax bracket get quite a significant tax rate difference. So long term is preferred right up to 20%. Short term is up to 37% because that's at ordinary income tax rates.
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Tom
Yeah, absolutely, absolutely. Now there's another type of gain. It's not necessarily a capital gain, but it's a gain you can have on the sale of your property. It's known as depreciation recapture. And there's two types of depreciation recapture for all intents and purposes here today that's going to be straight line depreciation recapture. And for all our CPAs listening and there's obviously we know the technical terms, but there's going to be depreciation recapture from straight line depreciation and then there's going to be depreciation recapture from accelerated depreciation which includes bonus depreciation. Ryan, would you be able to kind of break those down?
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Bill Exeter
Yeah. So depreciation recapture. So I mean part of this depends, you know, are you even going to have potentially in a sale your five year property, seven, 15, say 27 and a half or 39. You might if you're doing a cost segregation study or if you're making improvements throughout the year and they might be 5, 7, 15 year improvements. So if you are and you fall into that category, so five year property, let's say you taken what you can from bonus depreciation, you sell the property. So a depreciation recapture. Right. On all the depreciation you took from that five year property is effectively going to get recaptured at ordinary income tax rates. Right. So that's a five year. That would be same for the seven year as well. Five and seven would be the same. But there's one distinction with the 15 year land improvements or site improvements. And so basically for 15 year, that's eligible for bonus depreciation. So you could, you know, depending on the year, take 100%, 80%, 60%, depending on the year that it's placed in service, you could get all that depreciation that you can. Then let's say you sell the property, right? Basically, anything that you accelerated in excess of Straight Line is going to be recaptured at ordinary income tax rates really similar to the 5 and 7. But then anything that you basically took over the 15 years, effectively anything that wasn't overly accelerated, you would be getting it up to 25%. So it kind of depends on the amount that you've taken. How long have you actually been depreciating this property and so forth. And then the last One is the 27 and a half or 39 year property that's simply that up to 25% max. If you're in a tax rate where you're below that 25% ordinary income tax rate, it's simply going to be whatever your ordinary income tax rate is. So it's up to 25%. And so as we think about our high income individuals listening, if you're at a 37% tax rate, ordinary income, you then sell this and you've got depreciation up to 25%. We've got a 12% tax rate difference there and a benefit to you. So those are kind of the various different elements. Anything you would add, not much I would add there.
- [05:58]
Tom
I think you did a pretty good job breaking that down. What I'll do is just kind of summarize this real quick and then we're going to dive into actually how to mitigate depreciation, recapture and capital gains tax. All right, so long story short, capital gains is going to be your gain from appreciation. So like Ryan said before, you buy property, 500k, you sell for 750k, you're going to have a 250k capital gain. You held it for longer than a year, then it's going to be taxed at a rate up to 20%. Okay, if, if it was held less than a year, it's going to be taxed at a rate of up to 37%. Now we have a gain from depreciation. So this is from the depreciation you taken on the property over the course of time you owned it, the portion from Straight line or the 27 and a half or 39 year depreciation taxed at a max rate of up to 25%. And then if you have Gain from accelerated depreciation that could be taxed up to a rate of 37%. So just something to be mindful here of the types of gain you might see when you're selling a property. Now, before we dive right into the exit strategies, a lot of people tend to get scared of depreciation, right? They start to hear, oh my God, it's recaptured at a higher rate than capital gains and I might even have to pay tax at 37%. Well, you know, first thing I want to say there is depreciation is mandatory. You have to take depreciation. You can't not take it. If you don't take it, the IRS will assume you did take it. When you sell your property, you'll be facing depreciation, a recapture anyway. Secondly, there's something called the time value of money. And the time value money says the dollar saved today is worth more than a dollar tomorrow. So if you can use depreciation to reduce your tax liability, your tax bills and reinvest that capital, you're putting yourself ahead of the curve. A good example, and I've used example all the time, if you have $10,000 in tax savings and you're invested in 8% compound return for 10 years, you're going to have 21,000 and change. When all is said and done, that means you have roughly $11,000 that you didn't have before. You add a zero onto that and you're looking at like $115,000 that you wouldn't have had before. So it is quite powerful when you can use depreciation to minimize your tax liability. But what makes it even better, makes it even better is you can actually defer, eliminate or minimize these taxes in some cases when you do end up selling your property. And that's what we're going to be going through right now. We're going to be covering these seven strategies. The 1031 exchange. The lazy 1031 exchange. 1031 exchange it into a Delaware statutory trust or a DST 1031 into a mineral Rights Qualified Opportunity Funds, seller financing and 721 exchanges. And then we'll dive into two more of the gray area strategies which we'll be saving towards the end. So first things first, the good old 1031 exchange. I'll be honest with you, this is my favorite exit strategy. Favorite exit strategy is going to be the 1031 exchange. So this is a time honored strategy that allows you to defer paying capital gains and depreciation, recapture taxes by reinvesting the Proceeds from the property you sold into another property. And you can continually do this over and over and over again. Now what I want to say, here's an example with the 1031 exchange can do for you, right? Say you sell property and you're going to have a hundred thousand dollars in capital gains tax. So you have this huge property big gain, right? Well, if you were to have to pay tax on that hundred thousand dollar gain, that's going to take money out of your pocket that you can use to buy your next property. But with the 1031 exchange, this $100,000 can roll right into your next property. And to make things really simple here, if you had a prop, if you were able to buy a property at a 75% loan to value ratio, so you went and got debt, that $100,000 is now worth $400,000 of additional purchasing power. So you're able to buy a bigger or better property and continue rolling your money Forward with the 10:31 exchange. Ryan, is there anything you'd want to add in here?
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Bill Exeter
A lot of people probably already know, but the thing to keep in mind with that, like you said, is you can defer if it's successful, right? You're kind of moving up, right? You sell a property for million bucks, you move up to 1.1, something like that. There's multiple elements to make it successful and we won't get into that here. But the good thing is you can defer the appreciation, right? The capital gain. And you said the depreciation recapture, which is great. A lot of people forget that it's both elements. The other thing though, just really briefly, keep in mind the timing, right, the rules that specifically go around the 1031 exchange. You've got 45 days to identify from the date that you sell your property. And you have 180 days to close on the new property from again, the date that you sold that original property. So you have some rules here that need to go into play. You just need to be mindful of that. And one other thing to lastly say you need to use a qualified intermediary. A QI is what they're commonly called. These are companies who deal in these sorts of businesses. They will help you. Basically they'll hold your funds, your proceeds and help you move it into the next property appropriately. If you ever touch that cash, those proceeds, that is an unsuccessful 1031 exchange. So just be careful out there. Work with a qualified intermediary immediately. If you're considering selling, get them in your pocket, you know. Well, in advance before the sale. And that's the last thing I'd comments on there.
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Tom
You know, I. I couldn't say that enough. That's super important to do. You want to make sure you have that QI in place, because if you get to the closing table and you take possession of that cash, meaning they give you the cash, then 1031 exchange is over. You need to get that QI in place before you. You do this transaction. And, you know, it's really interesting if you want to learn more about this. We've had Bill Exeter on the show, episode 22. I believe it's on another episode where he dives deep into 1031 exchanges. So if you do want to dive deeper into the strategy, I encourage you to check that out. Episode 22. And then there's another one somewhere in there. I can't find it off the tip of my tongue. But we do have that available for you. So that's the 10:31 exchange. Now, Ryan, I know you like this one. You're a big fan of the lazy 1031 exchange, or what some would call the 1031 exchange light. Would you want to break that one down?
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Bill Exeter
Yeah. Just a funny story. I had been telling a client about the lazy 1031 exchange and they were like, oh, I don't like the word lazy. I don't want to be associated with the word lazy. So just if you're out there and you like 1031 exchange light better, this is for you. It's all the same thing, just a different name. But at the end of the day, this is effectively like a 1031 exchange. That's why we kind of use the 1031 language, is because, similar to a 1031 exchange, you're selling a property, call it Property A, and then you're basically going to buy property B. Right. So it's very similar. Right? It's 1031 exchange. You're. You're buying and selling property. Great. But the difference is, with the 1031 light is that you're not involving a qualified intermediary in the equation. Instead, what you're doing is you're selling the property outright. No, qi, you've now got a gain on property A, but what you're then doing is going to acquire a new property, Property B. And now we've got this potential property over here where we could now do a cost segregation study and now generate losses to then kind of offset it. It might not be perfect. Right. Depending on how much you're getting and so forth from the cost SEG analysis and losses that you can get. But the point is, is now we've got some offset going on. But the other thing that I'll mention is I've just kind of mentioned, you know, buying a new property. But the thing to also keep in mind is you can use priority suspended losses too, right? Passive suspended losses. So you've got two elements potentially in your favor. You could potentially go get new losses right in that current year by buying a new property, doing a cost seg new losses. And you could look at old or prior suspended losses that you could also be using to offset any of that gain. So I like that it gives some flexibility. I think the key point to put in here is that you need to do the sale and the new acquisition all in the same tax year. That's one nuance with like a 1031 exchange that you could kind of straddle two different years with the 1031. But with the 1031 Lite, you have to do this all in the same tax year. So be careful of that, make sure that you're aware of that.
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Tom
Yeah, absolutely. That's super important to understand. The other thing to understand just to be clear for everybody, this has nothing to do with a 1031 exchange. It's just kind of been coined that because it gives you similar benefits but without having to go through the hassles of the official 1031 exchange process. But this has been a powerful strategy over the last few years and we'll see if 100% bonus depreciation comes back. And if it does, it will continue to be extremely powerful until a hundred percent bonus depreciation disappears. Moving right along, we have another strategy. This can be 1031 exchanging into a Delaware statutory trust, also sometimes referred to as a DST. So going back to strategy number one, we talked about here, we talked about the 1031 exchange. So when you do 1031 exchange, you're usually trading a property you own for another property you're presumably going to be responsible for managing. Whether you're managing it directly or you have a property manager, you're at the end of the day, you're responsible for that day to day management. Now what ends up happening is some investors, they'll be investing, they're, you know what, I don't want to deal with another property. Like maybe they had a horror story or they're just, they're over it, they're retiring. Whatever the case may be, how can you use a 1031 exchange to get into another asset? Right. And the problem is with syndications, you typically can't 1031 exchange into a syndication because a syndication is going to be a partnership interest and you have an interest in real property. So with the 1031 exchange, you can only exchange real property for real property. That's it. You can't exchange a 1031 for interest in a partnership. But to be clear, you could 1031 exchange into any type of real estate. So if you had a single family home, you could 1031 into an apartment, into an industrial property, into a self storage unit, but you just can't exchange the partnership interest. So this is where the DST or the Delaware Statutory Trust comes in. The Delaware Statutory Trust is a type of trust that the IRS quote unquote blessed for 1031 transactions. And they are similar, they're not quite the same, there's nuances, but it's similar to a syndication where you're going to invest into a typically an institutional grade asset like Walgreens or Dollar General, Best Buy, whatever and you're going to then not have to deal with the day to day management. Professional property management is going to take it over. Now there are some downsides with the dst. While yes, you're going to have presumably low risk and low, it's going to be low maintenance for it's going to be hands off. There are sometimes high fees associated with the DST and because they're typically class A institutional grade assets, there's usually not much upside in terms of a value add component nor is there going to be usually high yield. So it is a relatively conservative investment and that's why some people do not like this strategy. But the good news is there's plenty of others. So another exit strategy is one where you 1031 exchange into mineral rights and that's another way you can get out of active property management. I know we just talked about this last week, Ryan, but we'll be able to do a quick breakdown of what that looks like.
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Bill Exeter
Yeah, so I mean similar to DST, 1031 exchanging into anything, it's, it's a real property and I think just sometimes we lose sight of the mineral rights because it's almost like, oh, isn't that like an oil and gas investment? Not necessarily. You're actually buying into land, right. The mineral rights kind of underneath land. And so the IRS has said this is still real property and you can do this. So similar things. Right. It's kind of again moving a bit of a diversification into not just something that's property like we're used to thinking of, like you said, single family duplex, industrial warehouse, self storage, mobile home, right. This is effectively a little different, but it's still real property and that's the point. So dst, mineral rights. The other thing, Tom, I was just going to mention on dsts, oftentimes you do have to be, I think maybe you always have to be a accredited investor. So for some of our listeners who are not that, just be aware, that is something you need to be. But the second thing I like that you said on the dst, Tom, was it's a really good option for those who are moving into retirement. They're not looking for this huge upside. They're looking to more so be done. I want to have a conservative thing. I just want a little bit of yield. They're maybe primarily thinking about, I don't want this gain, right, this tax to go out for my wealth that I'm going to give to my kids or grandkids, whatever, or charity, right? Whatever they're going to do, they want to simply roll that into a conservative asset that's going to go to their heirs. Let them have that and they can do what they want at that point. If they're going to cash out or whatever of this DST in the future, that's fine. But I really like the DST for those who are listening, who are getting closer to that and, and they're looking to kind of be even more passive. Real estate is generally passive. We know it's not always that, right? At the end of the day, if you're kind of the sole owner, you've got a lot of responsibility. But DST is really good towards the retirement age.
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Tom
Yeah, no, absolutely. Two powerful strategies to get you out of active property management. That's the 1031 exchange into a DST Delaware statutory trust, to be clear. And then mineral rights is the second option. I think we've covered that one a lot. So if you're not sure, go check out last week's episode on that. Now, this is a super powerful one right here that I think most people misunderstand how exactly it works and how powerful it really is. So I'm going to tell you a little bit about how you get more information after we do a quick breakdown. That's going to be the Qualified opportunity funds, or QOFs, they're sometimes called. And this strategy allows you to defer capital gains tax when you invest into the Qualified Opportunity Fund. And if you hold the investment for more than 10 years, you may qualify for an exemption of the capital gains generated from the QOF investment itself. So the way this originally worked when it was introduced under the Tax Cuts and jobs act is 2017. If you were to have a capital gain, so you sell capital asset, could be stock, could be real estate, Whatever the case is, if you have a capital gain, you can invest the capital gain into the qof. And what would end up happening is you would reduce that capital gain by 10% if you held it in the QOF for five years. You would reduce your capital gain by an additional 5% if you held it for seven years. However, this component of it is no longer in play because in order to have achieved this, you would have had to make that five year investment by the end of 2021, if I'm not mistaken, and then the seven year investment by the end of 2019. So unfortunately, those two aspects of it are no longer in play. The way it works today in 2024 is if you do invest your capital gain, and this only applies to capital gains, okay, you can invest other money, other cash into the qof, but you won't get the benefit of what we're mentioning here. You only get it on the capital gains investment. So what ends up happening now? You invest your capital gain into the Qualified Opportunity Fund and you're deferring the tax on that capital gain until 2026. And then if you hold it for 10 years or more, the capital gain from the Opportunity Zone Fund itself will be tax exempt. So, for example, if you put 250k into a qualified Opportunity Fund, just for example, and the Qualified Opportunities zone fund in 10 years, 10x to 2.5 million, well, guess what? You're not paying tax on that $2,250,000 worth of capital gain. And this is where the real power of it lies, in this ability. But there's something even more interesting than that. You can continue to buy assets and trade within the Qualified Opportunity fund up until 2048. So the real power is if the fund itself keeps operating and keeps like say 1031, exchanging property after property after property, you might end up in 2048 with a massive gain, like huge gain, unbelievable gain, and it's going to be exempt from taxes. So that's powerful. I'm not going to do it justice. The full power of it right now, I'd encourage you. If you do want to explore this further, check out episode 204 of the Tax Smart REI podcast that's maximizing returns on Qoz funds with Barrett Lindbergh, who broke it down phenomenally and really opened, I think, our eyes to the true power of the Qualified Opportunity Zone Fund. It's not just about deferring your taxes until 2026 or getting that 5 or 10% step up for the people who were able to invest prior to the deadlines of 2019 and 2021 is about putting your capital gains into this fund, helping these areas that need to get gentrified, and then being able to hold your asset for 10 years or more, potentially many, many more years, and eliminating the capital gain on the sale when that fund is ultimately sold or wound down. So that, in a nutshell is Qualified Opportunities Zone funds. And again, if you want more episode 204 of the Tax Smart REI podcast.
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Bill Exeter
It will be interesting to see if anything like that gets extended. I don't really think there's talk about that, but it'll be interesting to see what happens when we get to 2026. Because like you're saying, all the tax that people have invested into these funds is now going to come due. Is there going to be an extension or is there like a new investment that they can move that money into or how are people going to do that sort of thing? So I'll be curious to see just in the future what happens there. But like you said too, you know, how do we know if I'm in a qof? Well, usually there's, you know, a census kind of tract of all these various places. You can find these on like your state websites, basically just like do the state and search Qualified Opportunity Funds. All the governors had to select various places in their state for it. But very interesting, you know, the 10%, the 15% kind of reduction, all of it coming due in 2026 and then the 10 year hold, that could be very lucrative, like you said, for a lot of people. But I'll be most curious to see what happens in 2026 and what people want to do there.
- [23:43]
Tom
Yeah, that's an excellent point because the capital gains tax is due on your capital gain that you deferred in 2026, regardless of whether or not you continue to hold your interest in the fund. And as we just discussed, it's usually in your best interest. Usually. I mean, I'm sure there's circumstances where it's not. But to hold your interest because you could defer the actual gain on the Qualified Opportunity Zone investment itself, which is quite powerful. So it'll be interesting to see how this all plays out. Hey, are you tired of working with generalist CPAs that tell you you can't use the real estate professional status, the short term rental loophole or cost segregation studies, or worse, have no idea what these things are. If so, it's time to elevate your game and work with a CPA firm that gets it. Here at Whole cpa, we worked with thousands of investors helping them save millions of dollars in taxes through proactive tax strategy and planning, tax preparation and outsourced accounting solutions. So if you're ready to elevate your game, make tax filing painless and save thousand dollars in taxes, what are you waiting for? Just head on over to www.therealestatecpa.com podcast to request an initial consultation. Today we are accepting clients for the 2023 and 2024 tax years. So if you're looking to make a change, you have nothing to lose. Again, you can request an initial consultation by visiting www.therealEstateCPA.com podcast. We look forward to hearing from you and learning more about your situation and how we can help. But for now, we'll dive right back into today's episode.
- [24:57]
Bill Exeter
So the sixth one is seller financing, or commonly called an installment sale. So effectively you own your property and you might sell it to someone who you are going to be kind of the bank, right? They might get some of their own financing potentially, but you're effectively going to say, hey, you can pay me back as the buyer, you can pay me the seller over time and you're usually going to have some sort of an agreement or where you're going to say just for example, you're going to pay me back over the course of five years. And then there's going to be kind of a big balloon payment that's due to kind of complete that within that, right? Let's say it's five years. You're going to be able to recognize that capital gain over the course evenly over five years, kind of expecting that the payments that you're receiving are even. So you've got that being recognized over five years compared to just all in one year. So that's beneficial to kind of keep things the potential maximum rate that you're being taxed at much lower throughout those five years. And right, you've got the income coming spread out so you can kind of defer a little bit of that time when you actually recognize that tax. But another benefit to you as the seller is you're probably going to have a little bit of a arbitrage, if you want to call it that. Maybe you got your financing at, you know, a couple years ago 4%. And then you're going to essentially sell or finance. You're going your portion at say 6, 7%. So you're getting a little bit of a rate there that's beneficial for you and the tax benefit like we're talking about. But the last thing I'll just comment on to be careful of is that typically depreciation recapture is recognized in the first year. So just be careful of that. Sometimes people think it's both. So be careful of that. There are nuances to that, but this can be effective if you don't need the cash. Right. That you could basically defer the payments for multiple years.
- [26:46]
Tom
Yeah. This can actually prevent you from jumping into that 20% capital gains tax bracket. Sometimes if you have a massive capital gain, you might end up having to be taxed at that 20% bracket that we mentioned before. But sometimes if you're able to structure the seller financing or the installment sale in such a way to kind of spread it out over multiple years, it's possible you could remain within that 15% threshold. So that's one reason why we see this used in some cases. In other cases, you may want to use this because you want a stream of income. Usually when you're doing seller financing or installment sale, well, the IRS requires you to put an interest rate on it. So you have to put an interest rate and you can receive an additional return in the form of interest. So there's a lot of benefits to seller financing. And more often than not, actually what I see this being used for more than the tax strategy, is a way to actually acquire property. Sometimes you're not able to get financing, so by having the seller finance it, you'll be able to actually get the finance you need to acquire the property. Additionally, another thing I see is a lot of buyers looking to help their sellers with this. Like, usually it's like some person who is, you know, about to retire, they're looking to exit property, have this massive capital gain, and they're trying to help their seller spread out those capital gains to actually help facilitate the transaction. So I would say at least my experience with seller financing or installment sales has usually been more of an acquisition strategy than a tax strategy. There are certainly tax benefits to doing it, and it's not out of the realm of possibility to see it being used as a tax strategy over an acquisition strategy, per se. So having said that, we're going to get into our last one and then we'll again dive into these two questionable ones that we always get questions on. So we do want to address them and why we typically don't recommend them. But this last one is going to be the 721 exchange. And the 721 exchange actually isn't that crazy at all. It's actually right under the partnership tax code, 721A, I believe, if I'm not mistaken. Basically when you contribute property to a partnership in exchange for partnership interest, you're typically not going to receive a tax event, right? So you can go and say, for example, there's a partnership and you contribute your property. Say you have 123 Main Street. The partnership's now going to absorb, okay, it's going to absorb that property and then you're basically going to have a partnership interest. And now these are typically done with real estate funds or REITs, sometimes called an upreit, which is an umbrella partnership for real estate investment trusts, where you would pretty much contribute this property to the fund or to the reit. And then you're going to get in exchange partnership interests. You're not going to have a tax event right away, but you will have a tax event when you eventually start selling those interests. So you don't always have to sell your interest off at one time. You could sell it off over a number of years, kind of spread out your capital gain like a, almost like a seller financing a little bit. Another way to do it is just not sell it at all. Hold it until you pass away. This is actually a big estate planning strategy for a lot of people. You get to the end and you're like, I want to give my heirs a piece of what I've built over the years, right. And you do that by putting your property into a fund that's diversified, right? You're not gonna have, you're gonna have a diversified fund. You're gonna be hands off with management. And then your heirs don't have to worry about the hassles of property management. So that's pretty much the 721 exchanges. To summarize that you're contributing your property to a real estate fund or a REIT in exchange for partnership interest. It's not immediately taxable if you do it the right way. And then as you sell off the partnership shares, you eventually will have a tax event, unless of course, you leave them to your heirs in your estate planning. You structure that the right way and they'll receive it at their step up basis, so on and so forth. Which brings me to one more point I wanted to make before we dive into these two questionable strategies. And that's going to be 1031 exchange until you die. So this goes all the way back to the first one. And I hate to be so morbid, but what ends up happening is you can use a 1031 exchange over and over and over and over again. And while it's easier said than done, I will say that we have seen people do this where the point where you get to the end and your heirs receive it at the stepped up basis, which is the fair market value at the date of your death, eliminating all the capital gains and depreciation recapture you would have paid had you sold during your lifetime. So it's not really in here as a strategy, but is part of the 721 exchange. And we see people do it. So that's why I always encourage people really take a long term view to real estate investing. It's not a fly by night scheme. It's not Bitcoin, right, Where you, you put some money in and you know, two weeks later it goes from 43 to $73,000 and you're like, holy, oh my God. It's not usually like that. Okay? But if you play the game the right way over day, decades, and not just years, you could build a significant amount of wealth and do it in a very tax advantaged way, which is why we all love real estate, don't we? All right, so now we're done with these seven strategies. What are the two dirty ones? What are the two ones that we're not really wanting to mention so readily? Okay, so the first one's going to be a monetized installment sale, and the second one's going to be a deferred sales trust, also sometimes referred to as a dst, but not to be confused with the Delaware Statutory Trust. Delaware Statutory Trust, completely above board, you're good to go. Okay, but with the DST or the Deferred sales Trust, there might be some hair there. So monetized installment sales are on the IRS dirty dozen list, which means they're heavily scrutinized. And for that reason we don't recommend those. And they're also listed transactions. So if you do end up doing a monetized installment sale, you actually have to tell the IRS that you're doing it very clearly. You're calling it out. You're like waving, you're waving to them, hey, come audit me. That's pretty much what you're doing when you do a transaction like this. All right? And the way this works is that a seller will agree to sell a Property to a middleman, exchange for a promise to pay later. Okay. And you usually get interest for that. So the way the monetized installment sales works, basically, I'm not going to go into excruciating detail here. You sell the property to a buyer, you have an intermediary accept the cash. Basically, the seller is selling it to a third party on installment basis. They're then going to a bank and getting a loan out against that installment sale for the full principal amount today. Right. So now it's all sudden, you have the loan, but now the installment sale that you did, those payments are covering your loan. So you're basically getting the upfront cash today, but you're paying the loan from the bank. You're paying it back with the installment sale from the properties sold. And the issue with that, long story short, is you're basically getting the full sales proceeds up front, but you're not recognizing the capital gain immediately.
- [33:21]
Bill Exeter
Yeah. And, boy, I can't wonder why that would be on the Dirty dozen list. You know, it's like, yeah, oh, I'm recognizing the gain over several years, whatever this agreement is, but I get all the cash. Oh, yeah, that doesn't sound, like, fishy at all. Right.
- [33:37]
Tom
Yeah.
- [33:37]
Bill Exeter
So I can see why this is, like, on the Dirty dozen list. They're like, hey, you. You basically got this. So I'm not too surprised. And it'll be interesting to see what continues to come out from them as far as guidance and ways people could do this. Maybe a legal way, a legitimate way, but we'll see if the IRS continues to come out with new information on that.
- [33:56]
Tom
Yeah. But, like, long story short, just to summarize, monetized installment sales, basically what's happening is you're selling your property on an installment sale basis to a third party, Then you're getting a loan out from the bank for generally the full amount that you would have sold it for, and you're using the installment sale to offset the loan from the bank. The IRS doesn't like that because you're now deferring your taxes while you still have access to the full capital, which is obviously not what they want. So that's why it's on the Dirty dozen list. That's why it's a listed transaction. And Ryan and I were talking about before the episode, there are some firms that will actually ban partners from signing off on deferred sales trusts. I have to manage monetized installment sales, too, for this reason. But deferred sales trusts are similar. And again, we're not going to go into the excruciating details. There's plenty of information online. But long story short, they're similar in the sense that you're typically selling this, your property to a trust on a installment sale basis. The trust is then taking the cash. This trust is then going and selling out your property to an end buyer and they're taking the cash and putting it into the trust and they're investing it into other assets and paying you out over time, minimizing your capital gains tax from the trust. So that's a similar transaction. The main difference here is that the trust is selling your asset, taking the funds, reinvesting it for you in the trust, and then you're effectively getting paid out through the trust over time, minimizing your capital gains tax and spreading those out. And again, for the same reason that monetized installment sales or similar reasons, this is also a transaction that is questionable. A lot of like we just mentioned, highly prestigious firms, including ours, do not recommend and do not sign off on such transactions because there's such a high degree of risk that the IRS may add this to their dirty dozen list at some point in the future. And if you are in this, these transactions and these transactions typically don't take place over five years. Right. These are long term. You know, you're talking about 10, 15, 20, 30 year transactions where if the IRS all of a sudden adds this to the dirty dozen list, you could have done this transaction 15 years ago and you may be facing scrutiny. Right. Which is why, you know, today the deferred sales trust is not on the dirty dozen list. But there a lot of people are questioning it and believe that it could eventually make it on there. So that's why we don't recommend those two monetized installment sales and deferred sales trust. And look, we're not trying to knock anybody out there who's involved in these, but there's just such a high degree of risk. We cannot in good conscience recommend these strategies when there's so many other. There's seven of them we just mentioned here that are viable alternatives to help you effectively reduce taxes on the sale of your rental properties when you exit real estate. Any final words, Ryan, before we wrap this up?
- [36:37]
Bill Exeter
No, I just one last comment. Like they are very similar, some slight nuances. I feel like at the end of the day they don't want you to be able to recognize tax and defer. Right. That tax that you really should be paying that tax liability over time when in actuality it's like you have access to that capital. Right. When you think of a normal seller financing installment sale, you are waiting to get access to that capital, those proceeds that you have. And that, that's legit, right? That's, that's why there's not really concern to us or it's not on the dirty dozen list. But that's the difference between an installment sale good versus a deferred sales trust. You know, the monetized installment sale, you do have access to that capital, whether it's in the form of a loan in the monetized installment sale or you have those funds through the trust being reinvested for you anyway. Right? So it's basically this difference, this disconnect that effectively they seem to not like. So just be careful out there. Make sure that you do your homework. Understand the risk at the end of the day of whether you want to take on that risk. But from us and from other CPA firms that we know of, this is a very risky transaction, transactions and you need to be well aware of the risk if you're going to move forward.
- [37:51]
Tom
Yeah, yeah, absolutely. And look, I know some people are going to tune into this who are behind these strategies and please don't send us a bunch of information on it. We already are aware of the technical details. We've reviewed the technical details and we, we understand these strategies and like we just mentioned, for the reasons we just mentioned, our position is where it's at. Having said that, if you are a CPA or you are a EA and you are looking to make a move, we are hiring. We are always hiring. You can learn more by going to ww.therealestatecpa.com careers and you can go ahead and apply today. We'd love to learn more about your situation and if there is a fit, bring you on board to the team. And then also if you like this podcast, if you are a syndicator, fund manager or large scale operator, encourage you to check out our other podcast, the Major League Real Estate Podcast with Brendan hall and Dylan Brown where they cover tax issues, investing issues, finance issues and a lot more for syndicators, fund managers and large scale operators. So you can find that on all major podcast platforms including Apple, Spotify and wherever else podcasts can be found. That's going to be it for today. I'll catch you on next week's episode of the Taxmart REI podcast. Hey, before we wrap up, I wanted to remind you about our other podcast, the Major League Real Estate Podcast for syndicators, fund managers and large scale operators. Brandon Hull and Dylan Brown dive de deep into subjects including finance, tax, market analysis, team dynamics, optimizing operations, leveraging, cutting edge technology, and a lot more. If you like the Tax Smart REI Podcast and you're a large scale operator, you're going to love the Major League Real Estate Podcast. You can check it out on all major podcast platforms including Apple and Spotify. Again, that's the Major League Real Estate Podcast available now on Apple, Spotify and wherever else podcasts can be found. That's it for today. We'll catch you on next week's episode of the Tax Smart REI Podcast.
- [39:37]
Ryan
Thanks for listening to today's show. If you enjoyed the show, please find us on itunes and leave us a review. You can also email us@contactherealestatecpa.com with any feedback or topic suggestions. We are always taking on new clients and with the new tax laws in play, you really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs to become a client. Navigate to our client page@therealestatecpa.com and fill out a web form with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.