Many people are looking to sell a highly appreciated rental property, commercial real estate property, farm, or business. They all face a similar dilemma. When the sale is completed, depending on the sales price, they could incur a capital gains tax bill of hundreds of thousands of dollars.
If you do sell your property, ideally you would like to have some cash from the sale available for immediate use and invest the rest to create more income and growth. But what about that daunting tax bill? The good news is that you can take advantage of legal strategies, straight from the IRS tax code, that allow you to position your proceeds such that you only pay the capital gains tax on the portion that you use.
For instance, if the proceeds from your property are $1 million, and you use $200,000, you would only pay capital gains tax on that first $200,000, and you could defer the capital gains tax on the remaining $800,000.
One such strategy is called a 721 Exchange or Umbrella Partnership Real Estate Investment Trust (UPREIT). You can find it in Section 721 of the tax code.
It’s important to note that, before you sell, you should consult with an experienced professional to determine if this strategy is appropriate for your financial situation and to ensure that everything is properly set up to satisfy U.S. Code 721.
The 721 Exchange allows individuals to exchange the value of their property for operating units in a Real Estate Investment Trust (REIT) and to take a disbursement of the cash they want for other purposes. By utilizing the 721 Exchange, you can defer the capital gains tax on proceeds from the sale. You gain a degree of control over your tax bill because you are only liable for the capital gains tax on the amount that is cashed out, while the balance remains deferred as long as it is held in the REIT.
As for the balance that remains in the REIT, let us take a closer look at how REITs work.
Real Estate Investment Trusts (REITs) have been around since 1960. They were formed by Congress to allow everyone access to the benefits of investing in income-producing real estate. They are structured like mutual funds, designed to spread risk across multiple investments. Equity REITs — as opposed to mortgage REITs, which invest in mortgages — own or manage properties like apartment buildings, medical/professional office buildings, and storage facilities, that lease space to tenants. Equity REITs primarily derive their income from rents, but the income from the sale of a REIT-owned property also allows shareholders to benefit from the appreciation of property values.
An equity REIT Fund is divided into 100 shares, and no individual can own more than 50% of the shares. The names of the shareholders go on the title to the property. The REIT management company is responsible for the maintenance and operation of the property, and it must pass through at least 90% of the pre-tax income produced by the REIT to shareholders in the form of quarterly dividends.
Equity REITs thus offer investors a wonderful, hands-off way to enjoy the benefits of real estate as an asset class without the headaches of trash, toilets and liability.
Even if you are not in the market to sell an asset, you may wish to consider adding real estate to your investment portfolio. Qualified investors can invest in a REIT for as little as $40,000 per share and participate in the tax-advantaged income. Equity REITs are attractive to investors looking for an income stream with capital appreciation. The income produced by a REIT can also be tax-advantaged due to accelerated depreciation. For REITs that do not intend to hold property for more than 12 years, an accelerated depreciation schedule can be applied, condensing the typical 27-29 year depreciation to a 12-year timeline. This accelerated depreciation can offset the dividend income from equity REITS, making them more tax-advantaged than dividends from traditional equities or bonds.
Equilus Capital Partners is a real estate investment trust company that manages several REIT properties in the Northwest. We specialize in tax deferral strategies.
Our team of professionals is experienced in executing 721 Exchanges as well as other kinds of tax deferral strategies. Do not hesitate to contact us and find out if we have a strategy that is right for you. The initial consultation is complimentary.