Tax Tips: 1031 Exchanges, Installment Sales and Deferred Sales Trusts
By Ken DeLeon and Michael Repka
As the sagacious Benjamin Franklin noted, “nothing can be said to be certain except death and taxes.” While very true, death can sometimes help lessen taxes, as your heirs receive a stepped-up basis on inherited real estate after you pass. With tax day approaching, this article highlights three strategies to reduce your capital gains while you are still living and able to enjoy the savings. With DeLeon Realty having several attorneys on staff, we can guide you on which of the following strategies may work for your circumstances and how best to implement them.
Strategy #1- §1031 Exchanges
The most common real estate tax-saving strategy to take advantage of is the 1031 exchange. This powerful statute allows you to sell an investment property and defer paying capital gains taxes, so long as the timing and other requirements are met when purchasing another rental property.
With Silicon Valley homes appreciating amongst the most in the nation, coupled with California having the highest combined state and federal capital gains rate of 37.1%, many of our sellers face the prospect of paying up to seven figures in capital gains taxes.
Strategic planning can allow you to utilize a 1031 tax-deferred exchange to postpone paying capital gains. From the IRS viewpoint, if you sell one investment property and use the funds to purchase another investment property of equal or greater value, then no tax should be due.
While 1031 exchanges are used solely for investment properties, you can convert your primary residence into an investment property, thereby becoming eligible for a 1031 exchange. If you live in a highly appreciated single-family home, DeLeon Realty can guide you on how to convert it into an investment property and thereby defer capital gains.
I am a strong proponent of 1031 exchanges and have personally utilized them, as well as advised many clients on how to implement them properly.
Strategy #2 – Installment Sales
An installment sale is a legal term used to describe a transaction in which the seller finances all or part of the purchase price for the buyer. In effect, the seller acts as the buyer’s lender.
Under the installment sale rules, taxpayers are permitted to defer recognition of tax when at least a portion of the proceeds is received after the tax year of the sale. In other words, the United States and California impose tax on sellers as the sale proceeds are received, not in the year the sale is completed.
A simple example is the sale of a house for $5 million structured so that the taxpayer receives $2 million in 2026 plus $300,000 each year for the next 10 years, plus interest. The taxpayer would recognize a significant amount of gain in 2026, but the gain on the deferred portion would not be recognized until it is received. Not only does the taxpayer defer tax on a substantial amount of gain, but most taxpayers will also pay tax at a lower blended rate due to the graduated capital gains structure. Another benefit is that you earn interest on the larger pre-tax amount, since no tax is charged until the principal is repaid.
An installment sale can be particularly useful in Silicon Valley because there are many buyers from foreign countries, such as China, Vietnam, and India, who may be quite wealthy in their home countries, but face delays due to currency migration rules. As a result, these buyers may be willing to pay more for their new homes, plus interest that can be as high as 6 percent, if the seller is willing to carry a note for a portion of the sales price.
If organized properly, this can be a very secure structure. However, it requires careful analysis of several key factors before proceeding. DeLeon Realty has the legal expertise and resources to ease this burden for clients.
Strategy #3- Deferred Sales Trust
While installment sale treatment can be highly beneficial under the right circumstances, it may not work with every buyer. Ultimately, the installment sale structure requires a buyer who is willing to structure the transaction in this manner and who represents a minimal credit risk with a substantial down payment, for example 40 percent. Attempting an installment sale in the wrong circumstances can be disastrous and should only be pursued if you are using a real estate agent who is also an attorney and can address all of the potential tax and legal issues that may arise.
The good news is that there is an alternative with broader application: the deferred sales trust. Although there are several variations of this structure, they are generally consistent in approach. First, the homeowner transfers the property into an irrevocable trust managed by an independent trustee. This independence is critical because the seller must avoid constructive receipt of the sale proceeds.
The arrangement is structured so that the property is sold and the proceeds are then invested by a money manager. As with most investments, there is a wide range of options, from very conservative to more aggressive strategies. The proceeds are subsequently distributed to the seller over a structured period of time.
The beauty of this structure is that sellers invest the entire pre-tax deferred amount and therefore have the opportunity to achieve a higher return. Additionally, they may benefit from graduated capital gains tax rates by spreading the gain over multiple years.
Determining which, if any, of these tax-efficient strategies is best for you is a discussion you should have with a knowledgeable tax professional, such as a CPA or attorney, after a careful review of your personal circumstances. DeLeon Realty is the only brokerage in Silicon Valley with attorneys on staff who can provide clients with tax guidance and help explore strategies to lower tax liability.
Ken DeLeon (DRE #01342140) | ken@deleonrealty.com | 650.543.8501
Michael Repka (DRE #01854880) | michael@deleonrealty.com | 650.488.7325
DeLeon Realty, Inc. | DRE #01903224 | Equal Housing Opportunity
