Between the demands of the federal government and the State of California, the “Tax Man” has played a key role in the current housing shortage in Silicon Valley. Although area real estate has been a remarkably good investment over the past 30 years, the sale of one highly appreciated property can result in a tax on the gain at a maximum marginal rate of over 37%. Yikes!
To make matters worse, the low property tax payments enjoyed by many long-time homeowners usually disappear when their properties are sold. Therefore, it is not surprising that many homeowners are reluctant to put their homes on the market. The reduced inventory naturally exacerbates the problem by driving up prices, leading to even bigger tax bites.
But don’t fret. Some solutions remain if you plan in advance and understand the rules. Generally, three tools should be considered when trying to reduce or eliminate your tax hit, but each comes with strings attached. Specifically, these solutions are as follows: (1) like-kind exchanges, (2) installment sales, and (3) the transfer of property tax base year value (Propositions 60 and 90).
The federal government and the State of California provide for the deferral of tax when a taxpayer exchanges investment or business real property for other real property that will be used as investment or business property. Although a primary residence doesn’t qualify, a taxpayer may convert a home into investment property by renting it out for a sufficient period of time and then performing an exchange. While a number of strictly applied rules and deadlines accompany this procedure, they are fairly easy to follow.
This is a particularly good tool to use if the owner prefers the steady stream of income associated with a different type of property, such as a low-hassle triple net commercial lease. Also, all of the accumulated taxes will be forgiven if the property is properly held until the owner’s death. Although dying is a high price to pay for tax savings, it is better than having to pay a lot of taxes first, and then dying anyway. Installment Sales
Foreign buyers represent a significant portion of the buyer pool. Many foreign buyers pay cash for their homes, which makes sense given the challenges associated with obtaining financing in a foreign country. However, some buyers will pay even more if the sellers are willing to hold the financing. If properly structured (e.g., 50 percent down and a well-drafted security interest), this may result in a higher price, higher return on the lent funds, and lower taxes, which are also partially deferred.
Propositions 60 and 90
If a taxpayer is over 55 years old, Prop 60 provides that he or she may be able to transfer lower property tax payments on an existing home to a new primary residence, provided the property is in the same county and is less expensive than the one being replaced. Prop 90 expands this rule to include a handful of reciprocating counties, as well.
Although these tools are not suitable for every situation, they can each save certain sellers a lot of money. But be careful as a misstep may be very costly. Make sure your real estate agent is well-versed on the nuances of these rules, and don’t be afraid to check with tax professionals (they are actually very nice people).