In the spirit of tax season, My Financial Coach is excited to bring you another guest blog post from one of our newest Subject Matter Expert’s Wealth Legacy Group®, Inc. Their Founder and Chief Visionary Officer, R. J. Kelly, has written extensively on a number of subjects covering everything from wealth building, estate & legacy planning, and retirement among so many other financial planning topics.
The following article, which originally appeared on Wealth Legacy Group’s website titled “You Had Me At ‘Capital Gains Taxes Are Optional”, serves as a preview of the value that their team of professionals can bring to optimizing and minimizing your tax situation.
I recently received a call from a long-time client who is selling a valuable piece of real estate. He was extremely frustrated by the enormity of taxes he will have to pay for the privilege of living in California! Just how bad is it? Would you believe nearly “40% bad?” The Federal long-term capital gains tax is 20%. California takes an additional 14.63% in the highest tax bracket, and in most cases, there is an additional 3.8% Medicare tax. This adds up to nearly 40% in taxes on any appreciation or gains in the asset.
A solution for this situation historically has been an Internal Revenue Code Section 1031 exchange. What is that, you ask? A 1031 exchange requires the seller to locate “like kind” property within 45 days and complete the sale within 180 days. This is a complex transaction with a very limited time constraint. It is especially difficult in the current San Diego market because there is so little quality inventory to “exchange” into at a reasonable price.
There are at least five other strategies to consider for deferring or even eliminating taxes on the sale of appreciated real estate besides the installment sale, in addition to the 1031 exchange approach. Please note that the following are general overviews. If you would like to consider one or more of these alternatives for you or a client, we should discuss the unique circumstances of each case. Application of several of these tools is decidedly not something to “try at home.” The documents themselves are often not “traditional” and need to be properly drafted.
Delaware Statutory Trust
- Delaware Statutory Trust: A Delaware Statutory Trust (DST) is a trust formed under the Delaware Statutory Trust Act of 1988. The IRS has approved this structure as qualifying as a 1031 exchange option if it meets the requirements of Revenue Ruling 2004-86. Investors obtain a fractional interest in commercial real property by investing in a DST along with other investors. The DST holds title to the real estate and guarantees the mortgage loan. (Don’t confuse this “DST” with a Deferred Sales Trust, which lacks formal IRS approval.)
- A more stable and secure investment than if you acquired replacement property on your own
- Ability for greater diversification by investing in several different DSTs
- May be more expensive than directly owning a replacement property due to property management fees and maintaining adequate cash reserves for contingencies
Capital Gains Alternative Trust™
- Capital Gains Alternative Trust™: To use this technique, a Capital Gains Alternative Trust™ (CGAT) is set up and funded with the property prior to the sale going “hard.” Discussions can take place and terms discussed prior to transfer, but the buyer ultimately buys the asset from the CGAT. The seller(s) typically receive(s) an income as either a fixed income-stream each year or as a percentage of the current value of the trust property. Upon death of the final income beneficiary, whatever is left in the trust goes to a specified charity(ies) (which is often the family’s own charitable giving fund.)
- Creates an asset protected income stream, often two times (or more) greater than the prior net income
- An income tax deduction of at least 10 cents (up to 50-60 cents) per dollar transferred
- Eliminates capital gains tax and Medicare tax upon sale of real estate/other type of appreciated asset
- Principal is asset protected, but the seller/grantor of the trust cannot access principal
- Limited ability for the donor to change their mind and “unring the bell” once the asset is in the CGAT
The “Win-Win” LLC™
- The “Win-Win” LLC™: A single member limited liability company (LLC) is formed, although the language and structure of this special LLC is uniquely different and owned, in part, by another party. The appreciated asset in question is transferred into the LLC prior to a liquidity event.
- As much as 99% of the gain on the sale of the asset is non-taxable
- Up to 70-80 cents per dollar contributed to the LLC is deductible over up to six years (subject to certain limitations) in recognition of substantial philanthropic benefits also created
- All the advantages of a CGAT above, plus potential access to principal – ability to give to charity(ies) now
- If acting as managing member, an income between 3-10% of the asset values can be earned
- Higher cost to initially structure than a CGAT and involves more “moving parts”
- This technique has recently come under Dept. of Justice scrutiny. While still likely a viable technique, there are certain precautions and limits that should be implemented in this technique
Tax-Deferred Installment Sale
- Tax-Deferred Installment Sale: This is a powerful technique that for non-disclosure reasons cannot be discussed on our website or handout but must be outlined in person. Taxes are deferred for 30 years, and the seller receives (on average) 92½% of the net sales proceeds days after closing.
Private Placement Variable Life Insurance Contract
- Private Placement Variable Life Insurance Contract: This is an insurance contract not purchased in most cases for the insurance component. It is purchased to create a growth environment where growth occurs inside the “wrapper” and is therefore without tax. It is unlike any life insurance contract you have probably ever seen. How so? For starters, you can make your premium payments in cash, but also with stocks, bonds, mutual funds, real estate, etc. Also, the mortality expenses are a fraction of the cost of traditional “retail” products. The money inside the contract grows without tax, and when sold, creates no taxable event when set up in compliance with U.S. tax laws.
- 100% of the gain on the sale of an asset inside the private placement contract is non-taxable, and withdrawals are without tax if properly designed to comply with U.S. tax laws
- Assets inside the contract are beyond the reach of creditors after 2 years + 1 day, including the IRS, and are not subject to the 10-year Federal bankruptcy “look-back rule”
- Since there is no tax upon sale, there is no need for a 1031 exchange for real estate transactions. A stock or bond portfolio can be repositioned, also, without tax on gains. At death, assets become part of the income-tax free death benefit (although there may be Federal estate and/or State inheritance tax)
- This is only for accredited investors as it requires $1M of contributions – either lump sum or over time
- While not typically purchased for death benefit, there is a “friction” on returns because of the mortality expenses in the contract
- While domestic versions of this exist, the most powerful form is using an international situs where costs are generally lower than in the U.S. If an international location is selected, it is imperative that required disclosure forms be filed annually. IRS tolerates neither ignorance nor carelessness
My client thought he only had one option, and instead, discovered there are at least five different options to lessen or even eliminate the 40% tax “bite”.
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Written by R. J. Kelly – January 2018
Founder & Chief Visionary Officer
Wealth Legacy Group®, Inc.