Strategic Application

Every tax-exempt planning tool has two characteristics: 1) tax-deferral of capital gains and 2) replacement investment of principal. There are different tools for different tax liabilities and reinvestment goals. It is important to understand the limits and trade-off of each tool.

A 1031 Exchange is a capital gains tax-deferred exchange from a real estate investment to another real estate investment. It is a combination tax and reinvestment solution in a familiar form to real estate investors.

• Tax Deferral: All capital gains tax realized at sale (federal capital gains tax, state income tax, recapture of depreciation) are deferred. Ultimately, there will be estate tax liability exposure to the heirs.
• Replacement investment: Investment real estate. A 1031 exchange is appropriate for the investor who wants to continue investing in real estate.

1031 Exchange Tenant-in-Common Ownership. Many investors want to defer taxes, and are most comfortable on a long-term basis with a real estate replacement investment. However, they are concerned about the problems of sole ownership. They may be tired of the headaches of actively managing the property. Or, the older investor may be concerned about his surviving family's ability to manage the property.

A tenant-in-common co-ownership addresses the tax, investment, management, and succession concerns of many investors.

A Tax-Exempt Trust is a tax-deferred "exchange" from a real estate investment into an annuity vehicle composed of a portfolio of securities.

• Tax deferral: All capital gains tax realized at sale is deferred. Investment earnings on the sales proceeds within the trust are tax-deferred as well. Distributions from trust are taxable. Property is removed from estate; therefore, all estate tax is avoided.
• Annuity payments: The investors accepts an annuity stream of payments. Loss of access and/or control of investment principal is a requisite for tax deferral.
• Replacement investment: Securities portfolio of stocks and bonds. Tax-exempt trust is appropriate for the investor who wants to diversify out of real estate.

This is a chronic point of misunderstanding, even among many financial professionals. Tax-exempt trusts are often marketed by financial planners and brokerage firms, because such an "exchange" results in a portfolio of securities to manage. Many investors, although anxious to avoid taxes, nonetheless do not want to replace their real estate investment with a securities portfolio. A common client question is, "Can I invest in real estate within a tax-exempt trust?" The technical answer is "it depends," but the larger solution is often a different tool. If the investor wants a replacement investment in real estate, a 1031 exchange is more appropriate. It offers both tax deferral and the preferred replacement investment.

A Charitable Remainder Trust is a suitable consideration for the investor who:

• Desires to cash out of real estate.
• Wants to control asset. A self-trustee charitable remainder trust is permissible.
• Has charitable intent. The charitable tax deduction mitigates, but does not eliminate the impact of the charitable gift component of this trust.

Impediments to a Charitable Remainder Trust

• Escrow has already closed. Early planning is required, even before the property is listed for sale. Once escrow has closed, all tax-exempt options have expired, and taxes are due.
• Debt. Property must be unencumbered before inclusion in a charitable remainder trust. The investor must have the ability to pay off any mortgage, permanently or through a bridge-loan arrangement.
• Children or other beneficiaries often have no intention of losing a dime of their inheritance to charity.
• Other advisors. Advanced tax planning is a niche specialty even among tax professionals. Most educational venues are provided by not-for-profit organizations, who approach such gifts as a revenue source, and assume every donor acts purely from charitable intent. As such, few advisors understand the nuances and IRS code flexibility sufficient to creatively meet an investor's goals and objectives.

A Private Annuity Trust has recently become more widely discussed as a favorable alternative to a charitable remainder trust.

• Children get assets, free of estate tax, removing a primary obstacle of the charitable remainder trust.
• Mortgaged property can be contributed to this trust.

Impediments to a Private Annuity Trust

• An October, 2006, IRS ruling essentially eliminated the tax-deferral aspect of a private annuity trust.
• Rarely used anyway. Despite recent marketing by the financial community to owners of highly appreciated property, few private annuity trusts are in fact executed. As the investor considers all financial goals (tax deferral, control, desirable replacement investment, stable cash flow, etc.), a 1031 exchange is often viewed as a more comfortable or more suitable vehicle.