A Legal, Tax-Based Strategy for Deferring the Payment of Capital Gains Taxes
By Greg Reese, Certified Trustee for the Deferred Sales Trust
Today we bring you Part 2 of our series covering the Deferred Sales Trust (DST). The DST is a legal, tax-based strategy for deferring the payment of capital gains taxes. Greg Reese, AmeriEstate Legal Plan, Inc., President and CEO and Principal of Reef Point, LLC, will cover these topics in this and future newsletters:
- What are capital gains?
- What are the components of your assets for tax purposes?
- How does depreciation work?
- How are appreciated assets taxed upon sale?
- What is a Deferred Sales Trust (DST)? …with sample case studies.
- How does the Deferred Sales Trust work?
- How are distributions taxed to the seller/taxpayer?
- Who offers the Deferred Sales Trust?
- Are you a candidate to establish a Deferred Sales Trust?
How Does Depreciation Work?
The IRS allows you to depreciate real estate held for investment purposes over a 28-year schedule.
Continuing the example that we began in Part 1 of this series:
Assume you have purchased a property for a total cost of $300,000, including improvements. If 75% of your purchase price represents the structures or improvements on the property, then you can depreciate $225,000 in equal amounts over 28 years: $225,000 / 28 = $8,035 per year. This is the annual amount you may use as a deduction against income for the next 28 years.
NOTE: In some cases, a property owner may elect to use accelerated depreciation where they prepare a detailed schedule of every depreciable component of their property, from appliances to roofs, and depreciate each over their particular useful life. (E.g. A roof typically lasts longer than a range oven, so a range oven may be depreciated over a shorter period.) Accelerated depreciation may not be fully tax-deferrable using the Deferred Sales Trust even though capital gains are. This is a much less common occurrence and is a deeper, separate topic. For purposes of this article, we will assume we are not working with accelerated depreciation.
Impact on your taxes: If this property generates $15,000 in annual net income, you can deduct the $8,035 depreciation expense so that your taxable income is only $6,965. In this example, over one-half of the income you earned is tax-free because of the depreciation write off.
However, if you sell the property outright in the future, the government will “recapture” the tax break you were given as a write off during the time you owned it. The “recapture” upon sale would be waived if you give the property to charity before or after your death, or if you die still owning the property, whereby the property transfers to your heirs.
How Are Appreciated Assets Taxed Upon Sale?
Capital Gains taxes are imposed on the difference between your original cost (plus the cost of any capital improvements) and the net sales proceeds (after selling expenses):
Capital Gains are taxed in three ways:
- Federal Capital Gains Rate = 20%
- Medicare (aka Obamacare) Tax = 3.8%
- Marginal State Income Tax = max 13.3% in CA*
(*) most other states have a lower state income tax rate than California, and a few states such as NV, TX, and FL have 0% state income tax.
Additionally, a Seller will also be taxed on what is known as Depreciation Recapture. That is, upon selling your property, you will also be required to pay taxes on the amount of depreciation expense you have claimed during the time you owned the property.
Using our example, let's say you have owned the property for 10 years before selling it (for a net price of $700,000). During the time you owned it, you would have deducted $8,035 x 10 years = $80,350. This amount — the depreciation recapture amount — will be taxed to you as ordinary income in addition to the capital gains taxes you owe on the sale of the asset.
In California, you could be subject to the following tax rates on your depreciation recapture income:
- Maximum Federal Income Tax @ 37% (est)
- Maximum California State Income Tax @ 13.3% (est)
So, in our example, you would pay the following taxes:
- $148,000 = $400,000 capital gain x 37.1% (combined Federal, State, Medicare long-term capital gain tax rate)
- $40,416 = $80,350 depreciation recapture x 50.3% (combined tax rate in California on ordinary income)
Total taxes paid (on the net sales proceeds of $400,000) = $188,416
There are two ways to completely avoid paying these taxes:
- Die and let your heirs inherit your property at a full step-up in basis.
- Donate your property to charity.
There are also two ways to defer your taxes upon sale:
- Exchange your property for another property through a 1031 exchange.
- Sell your property using a Deferred Sales Trust.
Deferring taxes means that while you still owe the tax, you can pay them in the future. The longer you can defer them, the more you can benefit.
Many real estate investors decide to use the 1031 exchange to acquire other property as a means to grow the value of their real estate investments while also deferring taxes. If they choose to hold their property until they die, then their heirs can inherit and sell the properties without paying taxes.
There are other real estate investors who prefer to get out of the business at some point. They prefer to retire with an alternative income and without the real estate management headaches of dealing with tenants, toilets, and trash, not to mention repairs, improvements, and the liability that comes with owning investment property.
This is where the Deferred Sales Trust can help these sellers make their dreams come true and preserve more of their net worth.