Tax Strategies For Rental Property

Financial Planning

December 2014

Tax Strategies For Rental Property

Updated for content correction 02/10/15

Rental property can be a great long-term investment while providing current income. However, they also can be a lot of work. And continuing the role of landlord during retirement can be downright exhausting. Another consideration is if you have paid-off properties and/or own significant equity in them, selling them to bolster your retirement savings could result in a rather large capital gains tab. After all, you won’t qualify for the same exclusion as you would for a primary residence.

Charitable Remainder Trust

One strategy to consider is the use of a charitable remainder trust (CRT) – even if you’re not charitably minded. With a CRT, you donate rental properties directly to a charitable trust. Because charities are exempt from paying capital gains taxes, the trust can then sell the properties and invest the full proceeds in an income-producing portfolio. The way a CRT works is that you receive income derived from that portfolio each year for the rest of your life, as either a fixed percentage of the value or as a fixed dollar amount. The bonus is that you’ll also benefit from an immediate tax deduction. The deduction will equal the fair market value of the assets, minus the present value of the estimated future income stream (calculated with an IRS formula). This deduction also can be carried forward for use in future year tax returns. When you pass away, the remaining trust balance will then transfer to the charity(s) you selected. If you’re worried about cheating your loved ones out of an inheritance, consider using a portion of the income stream you receive to purchase a life insurance policy with comparable proceeds, naming your heirs as beneficiaries.

Example:
Value of five rental properties: $1 million
Capital gains saved: $240,000
Tax deduction: $500,000 (which can be carried forward in subsequent tax years)
Lifetime income: Approximately $60,000/year
Annual premium for a $500,000 life-insurance policy: $9,000/year

1031 Exchange

Another way to offload rental property without paying capital gains is to make a 1031 exchange with another similar property. This is basically trading one piece of property for another of similar value, and it can include residential or commercial property, such as houses, condominiums, apartment buildings, land, marinas, retail stores, office buildings, bed and breakfasts, parking lots, golf courses, farms, trailer parks, and even certain timeshares. Multiple properties can be combined to equal the value of one or more on the other side of the deal.

One interesting strategy allows you to move out of your primary residence, convert it into an investment property and then make a 1031 exchange for another investment property. When a personal residence is sold, Internal Revenue Code 121 allows a capital gain exclusion of up to $250,000 for single and $500,000 for married taxpayers as long as it was used as the taxpayer’s primary residence for an aggregate of two of the preceding five years. If you have more capital gains than these exclusions allow, you could move out of the property and convert it to a rental for a period of time and then defer the balance of the capital gains through a Section 1031 exchange. For example, a property could serve as your primary residence for years one through three and then be converted exclusively to a rental for years four through five, therefore allowing a 1031 exchange of a former primary residence while preserving the personal capital gain exclusion. The main question is, how long do you have to hold the property as an investment property? Most Section 1031 intermediaries recommend holding the property as an investment property exclusively with absolutely no personal use for at least 12 months.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.