Tony's Tax Tips

The Tax Chess Board Part 4

This article originally appeared in the Pasadena Star News on April 22, 2006.
THE TAX CHESS BOARD – Sophisticated tax planning is like playing a game of chess. One of your tax planning objectives should be to increase your net worth without paying any income tax. One of the ways of attaining this objective is by investing in real estate.

REAL ESTATE - If your real estate investments appreciate, your net worth will increase without any income tax.

C. Anthony Phillips, CPA

If you sell, you will be taxed in general at the 15% Federal capital gains tax rate. The Federal capital gains tax is less than the maximum 35% tax rate on ordinary income. By owning investment real estate you are allowed to depreciate the improvements and reduce your ordinary income, subject to certain limitations. While investment considerations may influence your tax decisions, you can choose not only, when but how you dispose of your real estate. The following are some of the tax consequences of the various methods of disposing of real estate.

SELL FOR CASH – This is not the best method, for tax purposes of disposing of investment real estate since you will have to pay capital gains tax by the next tax return due date. If you sell California real estate, 3.33% is withheld on the sales price or cash received and paid to the State.

SELL AND ELECT INSTALLMENT SALE TREATMENT – If you sell investment real estate, you may elect to pay capital gains tax as you receive principal payments on the installment note. However, you will pay the entire capital gains tax over the period of time you collect principal payments on the installment note.

DO A 1031 EXCHANGE - If you sell investment real property, exchange it for another investment real property and comply with Internal Revenue Code Section 1031, you can defer the gain from the sale of your property into the acquired property.

CREATE A PRIVATE ANNUITY TRUST – If you establish an irrevocable private annuity trust, you can sell your real property to the trust and receive annuity payments for the rest of your life. In addition to paying capital gains tax on the income you actually receive, you will also have to pay capital gains tax on any remaining capital gains upon your death.

SELL AS A PRINCIPAL RESIDENCE - If you invest in a principal residence and have owned and lived in it for two years, you may exclude up to $250,000 of gain on the sale under the provisions of Internal Revenue Code Section 121. If you are married, you may exclude up to $500,000 of gain on the sale. This is the best method of disposing of real estate since you never pay the tax on the excluded gain.

Tony Phillips, CPA has a certified public accounting firm, Phillips & Company in Pasadena and is President of Downstream Exchange Company which helps investors save taxes when they sell their investment property.

The above is not intended to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.