Dear Big Move,
My husband and I plan on selling our vacation home within the next 12 months. It has appreciated considerably since we purchased it. We are researching ways to defer some portion of the capital-gains tax.
The property is in California. It’s actually two adjacent lakefront pieces of property that we purchased in 2000. We paid $950,000 for the lot with the house and $225,000 for the adjacent, empty lot. Based on recent sales in the area, both pieces of property have at least doubled. We’re researching the 1031 route for the empty lot, which remains undeveloped.
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We would appreciate it if you could delineate the pros and cons of doing a structured-installment sale, using an annuity as well as the tax treatment of the annuity payments.
House Seller
Dear Seller,
After holding that property for nearly 30 years, you’re facing a hefty tax bill when you sell, so it’s understandable that you want to find a way to defer paying taxes to a future date.
A quick recap on capital gains: Your basis for capital-gains tax when you sell your property will be the “cost basis” — that is, the price at which you bought your property, plus the cost of any improvements. Capital-gains tax is $250,000 for single tax filers and $500,000 for married taxpayers who file jointly).
The bad news: this is your vacation home. You can only qualify for an exclusion if this has been your main home two out of the past five years and you meet other requirements (you can read more here from the Internal Revenue Service).
So here’s the good news. “There’s more than one option to consider,” says Matthew Chancey, a certified financial planner and author of “Tax Alpha Solutions: Effective Tax Management Strategies For High-Net-Worth Investors.”
Here are two ways:
The annuity route
An annuity is an investment issued by insurance companies that helps you build a guaranteed stream of income.
When you buy an annuity, you pay a lump sum up front or make payments over a set period of time in exchange for a promise from the life-insurance company to pay you guaranteed income over time, says Dan Finn, a Newport Beach, Calif.-based financial adviser with Finn Financial Group.
A one-time lump-sum payment is required up front for structured-installment sales. “A structured-installment sale annuity can provide sellers with guaranteed payments over a designated period,” according to MetLife MET.
“This structure allows the seller to defer their capital gains tax and potentially decrease the overall tax liability on the sale,” the company adds. “This results in a tax-smart stream of guaranteed income.”
With this route, you’re effectively spreading your income from the sale of the home over multiple years, so you lower your taxable income for the year. You spread out the tax liability as long as you structure it, so each payment will consist of multiple elements: your cost basis, depreciation recapture — the difference between selling price and depreciated costs — and capital gain.
Depending on your other forms of income, this gain might fall into lower brackets and be more lightly taxed depending on how long you spread out the structured payments, he adds.
Here’s how it works: If you’re getting a million dollars from the sale, instead of receiving the entire amount in one go, you and your home buyer agree to terms that become part of the purchase and sale agreement. You should consult an expert on structured-installment sales during this process.
“The parties then agree [that] the buyer’s obligation to make those payments will be transferred to a third-party assignee, which then purchases the desired annuity from the life company using proceeds from the sale,” Finn says.
The internal rate of return of such annuities are low, and payments are not flexible once they’re set up, Chancey adds.
Finn, however, pushed back on that assertion, arguing that the return will depend upon the “deferral, duration and rates in effect at time of funding,” and that rates are commensurate with other investments of similar risk. “Plus, fixed-term securities have recently been yielding higher returns than they have been in decades,” he says.
“This is an excellent deferral strategy,” he adds.
The 1031 route
Another route that you can consider: the 1031 exchange. “The simplest type of Section 1031 exchange is a simultaneous swap of one property for another,” the IRS says.
Essentially, when you sell an investment property, you have to pay taxes on the gain at the time of the sale, but there are federal tax guidelines that allow you to postpone paying that tax, if you reinvest the proceeds in a similar property. To be clear, you are not avoiding taxes, you’re just deferring them by undertaking a 1031 exchange.
Not only are you deferring 100% of the taxes, but upon your death, your heirs would receive everything tax-free and you’d be able to also capture any additional home-price appreciation as real-estate values go up, says Edward Fernandez, president and CEO of 1031 Crowdfunding.
But to do a 1031 exchange, you would need to rent the home out for the next two years to a tenant for it to be considered an investment property for tax purposes, Chancey adds. After that, you can do the 1031 exchange and defer the taxes, “but also still have all your money locked into real estate,” he says.
Good luck with the sale.
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