As you’ve likely already discovered, divesting yourself of substantially appreciated commercial real estate investments can be tricky at best. A straight sale exposes you to a huge long-term capital gains tax payment. A 1031 exchange has numerous rules and narrow time frames that can make it unfeasible. What to do?
Consider a Deferred Sales Trust if you face several hundred thousand dollars in capital gains taxes on the sale of your commercial real estate. Why? Because this is a safe, legal and proven way to defer these taxes while freeing you from the restrictions imposed by a 1031 exchange. In fact, a DST makes an excellent 1031 exchange alternative. It also makes an excellent alternative to a traditional installment sale.
Let’s look at two California hypotheticals: one in Orange County and the other in San Diego.
Orange County Commercial Real Estate Investment
Assume you and your spouse own highly appreciated commercial investment property in Orange County, California, for which your original basis is $1 million and the remaining mortgage balance is $800,000. Assume further that your net sales proceeds after commissions and closing costs will be $4 million. Finally, assume that you will have $320,000 in depreciation recapture by using the straight line method for 15 years.
You face a total tax of $1,235,560 based on the following rates:
- Federal tax: 20%
- California state tax: 13.3%
- Depreciation recapture: 25%
- Medicare tax: 3.8%
Suddenly, over half of your $4 million sale gets eaten up in taxes. You have only $1,964.440 available for reinvestment. Not at all a desirable outcome.
Enter the DST, a special type of installment sale. When you meet with the Reef Point Estate Planning Team prior to your anticipated sale, our legal, tax and financial professionals will structure a Deferred Sales Trust specific to your investment goals and objectives. The result? Your $1,964,440 in reinvestment funds swell to $3.2 million! The DST makes this possible by accepting and owning the sale proceeds rather than having the buyer pay them directly to you. You only pay capital gains taxes on the portion of the installment payment(s) you receive from the DST that represent a profit on your original investment.
San Diego Apartment Building Investment
Now assume you’re a single taxpayer who owns a San Diego, California, apartment building for which your original basis is $500,000 and the remaining mortgage balance is $250,000. Assume further that your net sales proceeds after commissions and closing costs will be $1.5 million. Finally, assume that you will have $200,000 in depreciation recapture by using the straight line method for 15 years.
You face a total tax of $446,780 based on the following rates:
- Federal tax: 20%
- California state tax: 13.3%
- Depreciation recapture: 25%
- Medicare tax: 3.8%
In this scenario, nearly half of your $1.5 million sale gets eaten up in taxes. You have only $803,220 available for reinvestment.
Utilizing the DST here swells your $803,220 reinvestment funds to $1.25 million! And if you’re looking to retire from your hectic management lifestyle, your DST installment sale contract can be structured so as to immediately begin paying you periodic retirement income in the amount you specify.
Want More Information?
Contact Reef Point to obtain more information about how a DST can work to your advantage when you sell one of your highly appreciated commercial real estate investments.