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Dodge a Real Estate Tax Trap With a Like-Kind Exchange
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The real estate slump of recent years has reduced the value of many investment properties. Therefore, you may expect to owe little or no tax on a sale. You may, however, have to pay a surprising amount to the IRS because of a “recapture” provision in the tax code.
Repaying prior deductions
Owners of investment property generally reduce their taxes each year with depreciation deductions. Those deductions, however, also reduce your basis in the property and thus result in increased tax on a future sale.
Example: Paul Matthews bought a small apartment building many years ago for $500,000, of which $50,000 was allocated to nondepreciable land. The remaining $450,000 of the purchase price has been fully depreciated over the years.
Paul has seen the building’s value rise to $800,000 and then fall back towards $500,000 in recent years. He wishes to relinquish property management responsibilities and relocate to a distant state in retirement. He assumes that a sale that nets him $500,000 would result in no tax: paid $500,000, received $500,000.
However, Paul has taken $450,000 worth of depreciation deductions, as noted. Consequently, his basis in this property is only $50,000, not $500,000. If Paul sells the property for $500,000, his $450,000 of depreciation deductions would be recaptured at 25% and he would owe the IRS $112,500.
Trading places
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In this scenario, Paul can execute a so-called “like-kind exchange” under Section 1031 of the tax code. If he meets all the requirements of Section 1031, some of which are outlined in the following section, taxes can be deferred. Such exchanges can involve any kind of investment property and they don’t have to be a straight one-for-one trade.
To give a simplified illustration of how a like-kind exchange might work, suppose Paul lives in New Jersey and wants to retire in North Carolina. He sells his New Jersey apartment building, and nets $500,000 from the sale, but he does not pocket the money. Instead, Paul arranges for the proceeds to be held by a qualified intermediary, sometimes known as an accommodator. (The accommodator can’t be Paul’s agent or relative. Many financial and real estate companies offer to serve as qualified intermediaries; if you are interested in a like-kind exchange, check prospective accommodators’ experience and safety procedures carefully.)
Next, Paul finds a storage facility near his desired retirement home that he can buy for $500,000. He instructs the accommodator to purchase the property with the $500,000 from the sale of his apartment building. As a result, Paul has “exchanged” his New Jersey investment property for one he’ll be able to manage once he retires in North Carolina.
Deferral defined
Like-kind exchanges can take many forms in addition to the one in the previous example. Regardless of the exchange’s form, you must follow many rules in order to defer the full amount of tax due on the sale of your original property. In a deferred like-kind exchange, certain deadlines regarding the identification and receipt of the replacement property must be met (see the Trusted Advice column “Deferred Like-Kind Details” for further explanation).
Assuming you follow all the rules, here are the requirements for a full tax deferral:
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You must pay at least as much for the new property as you received for the original property you relinquished.
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You must reinvest any cash you receive from the original sale into the new property.
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If you are relieved of any debt on your old property, you must replace that debt with a combination of new debt or cash, or both, that you add to complete the purchase of the new property.
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If you implement an exchange and wind up with cash in your pocket or a smaller mortgage than you had before, the amount by which you benefit will be considered “boot” and subject to income tax. Like-kind exchanges are complex but they may result in substantial savings; if you’re interested, our office can help you meet all the requirements. 
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Trim the Tax on Your Social Security Benefits
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While politicians consider changes in Social Security, millions of people continue to receive benefits. Are those benefits taxable? That’s determined by a complicated formula, and if you know how it works, you may be able to reduce or eliminate the tax you owe on your Social Security benefits.
To begin the calculation, determine your combined income (CI) for this purpose. To find your CI
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start with half of your Social Security benefits, then
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add that number to all of your other income, including tax exempt income and other exclusions from income.
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Once you’ve determined your CI, compare it with certain base amounts. The first base amounts are $25,000 for single taxpayers and $32,000 for married couples filing jointly.
Numbers crunch
If your CI is over the relevant base amount, you’ll owe tax on some of your Social Security benefits.
Example: Kim Phillips receives $14,000 in Social Security benefits in 2011. She also has $20,000 in other income. Thus, Kim’s CI is $27,000: $7,000 (half of $14,000) plus $20,000.
Kim is single so her base amount is $25,000. With $27,000 of CI, Kim is $2,000 over the threshold.
The next step is to compare the excess ($2,000) with half of Kim’s Social Security benefits ($7,000). The smaller of the two numbers—$2,000, in this example — will be added to her taxable income. Here, Kim receives $14,000 in benefits and owes income tax on $2,000 of those benefits.
If your CI is high enough, you will encounter a second set of base amounts: $34,000 for singles and $44,000 for joint returns. Over those thresholds, up to 85% of your Social Security benefits may be added to your taxable income. Note that this doesn’t mean you would owe 85% tax on your Social Security benefits. If you receive $20,000 in benefits and you owe the maximum tax, you’d add $17,000 (85% of $20,000) to your taxable income. Assuming a 28% tax rate, you would owe $4,760 in tax on the $17,000. That’s an effective tax rate of less than 24% on your Social Security benefits.
Tax tactics
Once you understand the process, you can see whether tax planning makes sense.
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If your CI is under $25,000 (single) or $32,000 (joint) and likely to stay there, you don’t need to do anything. You won’t owe any tax on your Social Security benefits.
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If your CI is now or is expected to be above $25,000 (single) or $32,000 (joint), you may be able to profit from tax planning. Our office can let you know if there are practical strategies you can use. By lowering your CI, you might be able to reduce the tax on your Social Security benefits.
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If you expect your CI to be far above the $34,000 (single) or $44,000 (joint) thresholds, there might be nothing you can do in this area. Our office can help you determine whether you are in this category. If so, you may have to resign yourself to having 85% of your benefits taxed.
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Possible tactics for reducing your CI include taking losses to offset capital gains and investing in growth stocks rather than dividend paying stocks. Tapping an immediate annuity for income or taking out a reverse mortgage also may provide cash flow that won’t count towards your CI. Make such decisions carefully because their impact can go beyond the tax on your Social Security benefits. Our office can help you evaluate possible strategies for reducing this tax.
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TAX CALENDAR
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DECEMBER 2011
December 15
Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in November if the monthly rule applies.
Corporations. Deposit the fourth installment of estimated income tax for 2011.
JANUARY 2012
January 17
Individuals. Make a payment of your estimated tax for 2011 if you did not pay your income tax for the year through withholding (or did not pay enough in tax that way). Use Form 1040-ES. This is the final installment date for 2011 estimated tax. However, you don’t have to make this payment if you file your 2011 return and pay any tax due by January 31, 2011.
Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in December if the monthly rule applies.
January 31
All businesses. Give annual information statements (Forms 1099) to recipients of certain payments you made during 2011. Payments that are covered include: (1) compensation for workers who are not considered employees, (2) dividends and other
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corporate distributions, (3) interest, (4) amounts paid in real estate transactions, (5) rents, (6) royalties, (7) amounts paid in broker and barter exchange transactions, (8) payments to attorneys, (9) profit-sharing distributions, (10) retirement plan distributions, (11) original issue discounts, (12) prizes and awards, (13) medical and health care payments, (14) debt cancellations (treated as payment to debtor), (15) payments of Indian gaming profits to tribal members, and (16) cash payments over $10,000. There are different forms for different types of payments.
Employers. Give your employees their copies of Form W-2 for 2011.
For nonpayroll taxes, file Form 945 to report income tax withheld for 2011 on all nonpayroll items, such as backup withholding and withholding on pensions, annuities, and IRAs.
For Social Security, Medicare, and withheld income tax, file Form 941 for the fourth quarter of 2011. Deposit or pay any undeposited tax under the accuracy of deposit rules. If your tax liability is less than $2,500, you can pay it with the return. If you deposited the tax for the quarter in full and on time, you have until February 10 to file the return.
For federal unemployment tax, file Form 940 (or 940-EZ) for 2011. If your undeposited tax is $500 or less, you can either pay it with your return or deposit it. If it is more than $500, you must deposit it. However, if you already deposited the tax for the year in full and on time, you have until February 10 to file the return.
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