Creative Strategies Help
Keep Tax Burden Down

Want to cash out of a property at today's high prices, yet worried about a hefty capital-gains tax bill?

Some creative selling strategies allow one to do the former and defer the latter.

One such strategy is the installment sale, in which the owner sells the property on a long-term payment plan. In this scenario, the buyer pays the cost of the property in regular installments, with interest. The installment sale allows the seller to stretch out capital-gains taxes, typically over a five-year period, so the seller doesn't have a huge upfront tax bill.

A lesser-known strategy is using a private annuity trust. This is not to be confused with an annuity issued by an insurance company. Rather, it is a trust in which the property owner can transfer ownership of the property (often to his or her children) before completing a sale to a buyer. The trust pays the owner for the property, not in cash, but with a special payment contract called a private annuity that stipulates that payments from the sale go to the owner for the rest of his or her life, essentially in installments.

The trust then sells the property to the buyer, getting cash for the property. In a normal sale, the seller would immediately pay capital-gains tax on the full value of the property. Since the private annuity contract calls for payments to be made in installments over the seller's life, the seller is only taxed on payments when they are received, instead of all upfront. The amount of payments is determined by Internal Revenue Service life-expectancy tables.

Financial planners are increasingly recommending these strategies to clients considering selling their properties because prices have risen dramatically over the past three years.

Buyers, too, can generally benefit, saving costs and time associated with taking out a new mortgage from a lender.

There are risks for sellers. In both methods, "the seller doesn't get the entire purchase price right away so the seller needs to be comfortable deferring income and have other sources of assets or income," says Michael A. Dubis, a certified financial planner in Madison, Wis.

An additional risk with an installment sale is "rather than getting the full amount upfront and not worrying about how the new owner treats the property, the seller who takes an installment note keeps the property as collateral," notes Joseph Murtagh, a financial planner in Goshen, N.Y. "If there is a default, they have to take back the property and by then it may be worth less than when they sold it" if the new owner didn't take good care of the property. With a private annuity trust, the trustee could make bad investment decisions or commit fraud, jeopardizing the seller's payments.

While both methods appear similar, there are significant differences. A seller using a private annuity contract, for example, can postpone when payments from the trust begin, and no capital-gains taxes will be due during that time. By contrast, payments under an installment sale must begin immediately.

Sellers using the private annuity contract can also defer taxes known as depreciation recapture, in which the IRS recaptures depreciation the owner had previously received deductions for. With an installment sale, the recapture tax has to be paid immediately, notes Scott A. Leonard, a certified financial planner based in Redondo Beach, Calif.

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