Thirty percent of all commercial rental property is owned by individuals. Your own office building, rental houses, commercial buildings, etc., are among this group. Your values have probably risen nicely, but now how do you avoid the tax man when you sell?
You may be aware that you will receive favorable long-term, capital-gains treatment on the gain, so you may presume this means you will pay a 15 percent federal tax. Unfortunately, it is not that simple. You may pay taxes of 25 percent on any depreciation “recapture.”
For example, say you bought a building for $1,000,000 several years ago, and it is now worth $1,500,000 - an apparent gain of $500,000 over the original purchase price. However, let’s also assume you have taken depreciation deductions of $400,000 over the same period. As far as the IRS is concerned, the taxable gain is based on your “tax basis” of $600,000 ($1,000,000 minus $400,000 depreciation). So, your gain for tax purposes is $900,000 ($1,500,000 minus the tax basis of $600,000). That gain is typically taxed at two rates: 25 percent on the $400,000 depreciation “recaptured” and 15 percent of the $500,000 true growth in value.
There is a technique that can delay the gain by reinvesting your proceeds into another piece of real estate. This is known as a “1031 Tax-Free Exchange.” This is not a “do-it-yourself” project because there are very precise rules that must be followed to qualify. Generally, you must have a third party involved who is a “Qualified Intermediary.” Also, you must identify the replacement property within 45 days after you “sell” the old property, and you must actually close on the new property within 180 days. This technique is limited to property held for business or investment, not personal real estate. Your realtor or attorney should know who to put you in touch with to help with such a transaction.
There is a clever strategy based on the 1031 technique where you can take the profit out of your office building tax-free, not just defer taxes. The strategy works like this: You “sell” your dental office (or other business real estate) and do a 1031 exchange for a rental house at the beach, mountains, etc., in anticipation of retirement. Later, you sell your long-time residence and pocket up to $500,000 profit tax-free under the exclusion for a primary residence, and then you move into the beach property as your new primary residence. Two or more years after the move, you become eligible to sell the beach house as your primary residence and enjoy another $500,000 in profit tax-free! That may include profit on the original dental office that was deferred, so you avoided some taxes altogether. The only problem is that you used to have to treat the beach house as rental property for two years before you could convert it to your residence. For exchanges after Oct. 22, 2004, you must hold the beach house as rental property for five years instead of two.
In addition, there are several more serious “gotchas,” and they are really the reason for this article. What if you can’t identify and close on a desirable replacement property within the 45-to-180-day requirement? Or what if your proceeds are so large that you can’t find a suitable replacement property? Remember, you have to reinvest all the proceeds to defer all the gain. Also, Section 1031 does not apply to partnership interests. This means if you own your office (or other real estate) in a partnership, you can’t defer the gain when your partners buy you out!
The solution to the above “gotchas” is an ownership option known as Tenants In Common (TIC). An “association of TICs” is used instead of a partnership, so each TIC owner has maximum flexibility.
If you run out of time or money to find a replacement property, you simply buy a precise dollar amount of a much larger property, such as a hotel or apartment complex, which is organized as an association of TICs. If your office building is owned in a partnership, you should convert your interest into a TIC at least one year before you are ready to sell.
Although TICs have been around for a long time, they have not been used that much until recent IRS changes gave them new life. As a result, many attorneys are not used to working with TICs. This is a very technical area, so be sure you have good advisors. The tax advantage can be huge, so see if you should get TIC’d!
Raymond “Rick” Willeford, MBA, CPA, CFP, is president of Willeford Haile & Associates, CPA, PC, and Willeford CPA Wealth Advisors, LLC. As a fee-only advisor, he has specialized in providing financial, tax, and transition strategies for dentists since 1975. Mr. Willeford is the president of the Academy of Dental CPAs, a consultant member of AADPA, and is available as a speaker nationwide. Contact him by phone at (770) 552-8500 or by email at email@example.com.