I recently got a call from a gentleman who is selling a duplex here in Temple City, and the first words out of his mouth were,
“I want to defer capital gains without an exchange, and it says right here in your ad that you can help me do that.”
The 1031 exchange (IRC section 1031) has been one of more popular and effective strategies for deferring capital gains and depreciation recapture; however, many people just aren’t interested in exchanging one real estate headache for another. They want out of real estate altogether.
He owns his duplex free and clear, and he wants monthly retirement income. What are some of his options?
- He could use the installment sale (IRC 453) to defer most of his capital gains if he’s willing and able to ‘carry paper’ (provide seller financing) for the buyer.
- There is also the structured sale (Deferred Sales Trust), and the
- Title Holding Trust System based on the Illinois land trust.
He had listed his property and received 3 offers. He accepted the highest one, but here’s the ‘catch.’ In exchange for a high offer, the buyer was asking him to take back a note (carry some financing).
The buyer was willing to put down $500,000 cash, and was asking him to carry $225,000 in a note and first deed of trust.
From an underwriting perspective, this is a great scenario if all you’re worried about is the safety of the note. With a 69% down payment, there’s some serious protective equity there.
You wouldn’t worry about potentially having to foreclose if the buyer quits making the payments . . . in fact, you might even pray for it! But he’s more concerned with wealth preservation through deferring capital gains at this point.
As it turns out, he does plan on doing a 1031 exchange into a 4-plex with that juicy $500,000 cash down payment. What he can’t figure out is what to do with that $225,000 note, which will be considered ‘boot,’ and be taxed heavily.
I suggested that he consider having the Qualified Intermediary (the exchange accommodator), be the beneficiary on the note, instead of himself. That way, the QI could sell the note, and the proceeds could then be exchanged along with the rest of the cash from the sale.
For instance, if set up favorably, I might be able to buy that $225,000 note for as much as $200,000. Yes, he’d be taking a $25,000 discount, but he would be able to save himself the capital gains on $225,000, which his accountant told him would be about $75,000.
Yuck, nasty discount, you’re thinking. Maybe, until you realize that his next best offer was $50,000 less. He’s still coming out ahead creating and selling the note by working with this buyer.
There are many excellent exit strategies above and beyond the standard CTNL (cash to new loan) and the 1031 exchange. What you’re after is the vehicle that best delivers your desired benefits.
Related Reading:
- If I Carry, What Happens if the Buyer Quits Making the Payments?
- If You’re Going to Carry Paper, Read Some Books on Seller Financing
- I Want to Sell My Note, What is it Worth?
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