Case of the Week
Exit Strategies for Real Estate Investors, Part 17 The Double Deferral Solution
Case:Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl's passion was real estate, and he was very successful in his investments.
Karl continued to buy and sell real estate at the age of 85. His most favored tax strategy for buying and selling real estate revolved around I.R.C. Sec. 1031. In short, Sec. 1031 allows taxpayers to exchange "like-kind" investment property without the recognition of gain or loss. This tax code does not exclude the recognition of gross income indefinitely but merely defers the recognition to a later date.
Karl currently owns a $2 million building that has significant appreciation. He acquired the building pursuant to a Sec. 1031 exchange. In fact, this building is his fifth Sec. 1031 building. Like many real estate investors, Karl just kept "trading up" over the years. As a result, Karl's basis in his $2 million building is extremely low.
Karl decided he wanted to sell the building, but he did not want to pay the "ticking tax time bomb." In addition, he did not want to do another 1031 exchange because he decided he was ready to retire from the real estate investment business.
Around this time, Karl learned of the benefits of a FLIP CRUT (e.g., income tax deduction, bypass of capital gain and future income stream). He especially liked the fact the FLIP CRUT could simply invest in stocks and bonds, which was something a 1031 exchange would not allow. After learning about the benefits of a FLIP CRUT, Karl eagerly wanted to move forward.
It looked like the perfect solution. However, Karl did have one additional goal. Karl wanted a to transfer only a portion – 50% in this case – of his building into the FLIP CRUT. The remaining 50% he wanted to exchange for another investment property pursuant to Sec. 1031.
Question:In addition to the FLIP CRUT benefits, can Karl exchange an undivided 50% interest in his property for another property and still retain the benefits of Sec. 1031?
Solution:Prior to any binding sale agreement, Karl could transfer a 50% undivided interest in his property into the FLIP CRUT. Once the undivided interest in the property is transferred into the FLIP CRUT, Karl could proceed with a 1031 exchange of his remaining 50% undivided interest. In Rev. Rul. 79-44, the Service stated that an undivided interest in property might qualify for a 1031 exchange. In that ruling, a farmer exchanged his 50% interest in farmland for another 50% interest in farmland. (See PLR 80500062). Accordingly, Karl would have no capital gain recognition on his 1031 exchange of his 50% undivided interest in the property. If done properly, he would enjoy a complete deferral of capital gains tax.
With respect to the FLIP CRUT, the trust would owe no taxes on the 50% undivided interest in the property it sold because the trust would be exempt from income taxes. Therefore, Karl would defer all of the capital gain attributable to the 50% undivided interest in the trust. Furthermore, it is likely that Karl would never pay any of the capital gains attributable to the contributed property. In short, Karl might bypass up to 100% of the capital gains tax!
Editor's Note: This double "deferral" option is an excellent solution for real estate investors, especially when another 1031 exchange is desired. This case study illustrates that there is a great deal of added flexibility, investment options and tax benefits when a FLIP CRUT is combined with a 1031 exchange.
To prevent any issues of self-dealing with split interest transactions, it is suggested that certain "safety steps" be taken. For example, it would be advisable for the FLIP CRUT trustee to handle the sale of Karl's 50% portion as well. See GiftLaw Pro 4.7.5 for a full discussion on this issue.