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Strategies to Reduce Capital Gains for Your Clients

Aug 16th 2016
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What are strategies tax professionals can use to minimize a client’s capital gains on the sale of property?

First, it’s important to determine what kind of property we’re talking about. Is this Code Section 1250 property with a long, slow depreciation period, or is this Section 1245 property that has faster, more rapid depreciation schedules?

With real estate, oftentimes the property is 1250 property, but it’s important to double-check. With agricultural property, like grain silos and other items that may be taxed and depreciated as 1245 property, you need to know what your client has so you can match up suitable replacement property in a like-kind 1031 exchange.

What your clients need to know is they need to reinvest their equity into a like-kind property of equal or greater value, and they need to offset their debt relief on the sale of the old relinquished property.

Inheritance and Estate Tax
The 1031 exchange is a very powerful tool for tax professionals because it allows their clients to defer the gains on the sale of their property indefinitely. If a 1031 exchange is later combined with a death and a corresponding inheritance, Section 1014 allows them to have a step-up in basis, which may eliminate the gains entirely.

They may also have to worry about estate taxes and other issues, but for long-term tax planning, the mantra is defer, defer, defer, and die so that the taxpayer takes those gains to the grave. The recipients of the property after the death – the people who inherit the property – those heirs get the step-up in basis.

Rental Properties and Principal Residences
Another tax strategy that people employ is conducting a 1031 exchange and reinvesting the money into a like-kind investment rental property, then later converting that rental property into a principal residence (a property they will occupy as their home and later sell under Section 121 to take advantage of the $500,000 exclusion for one’s principal residence if married or $250,000 if single).

The caveat is that a taxpayer only gets a fraction of the exclusion amount based on the ratio of the time the property was rented out, which would be a nonqualifying use of the property under Section 121, and a portion of the time the taxpayer resided in the property as his or her domicile (the principal residence).

So, hypothetically, if the person rented the property for two years after completing exchange and lived in it for another three years after completing exchange, he or she would get three-fifths of the $500,000 exclusion (assuming the taxpayer is married to file a joint tax return, that would be a $300,000 exclusion).

However, the Section 121 exclusion is inapplicable to any deprecation recapture, so it’s a good idea for taxpayers to consult with their CPA or tax accountant to know exactly how much could be saved in taxes and how much gain may be triggered upon the eventual sale of the then-principal residence.

Post-Exchange Refinance
Another strategy tax professionals can use for their clients is they will reinvest all of the net proceeds from the sale of the relinquished property into the new replacement property. But later if the taxpayer needs to get his or her hands on some of that equity in the replacement property, they will do a post-exchange refinance and pull some of the equity out by borrowing against the replacement property.

By delaying the taxpayer’s gratification and not taking the cash during the exchange period, they are able to treat the borrowed funds as a tax-neutral transaction, as opposed to a taxable receipt of boot if they are taking the same amount of cash during the exchange period.

A refinance should be conducted in a separate subsequent transaction after the exchange has been completed and should not be baked into the closing or part of the closing of the purchase of the replacement property.

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