How to Create Passive Income & Avoid Capital Gains Tax on the Sale of Real Estate

Before we get into sharing all the tips and tricks you need to know about avoiding capital gains tax on the sale of real estate, let me start by sharing this link to a podcast we published, along with Greg Smith, a 1031 exchange expert and intermediary, and a top-notch realtor in Rachel Alley of Millennium Group / Keller Williams Capital Partners.

I’ll try to cover the majority of what we discussed on the podcast, but be sure to check it out as a means of getting some additional information on this topic.

Also, before you start, it is CRUCIAL that you read this article to the very end. In order to provide the best education, I needed to write this article and teach each topic in a certain order, just so it would all make sense.

Point being, know that THE BEST SECRET IS TOWARD THE END!

…but unless you’re a tax professional, you might struggle to understand the concepts if you don’t read everything in order.

Alright – let’s start with a little prerequisite to understanding the not-so-well-known tax strategies I’m going to share with you today. There are two types of real estate investors:

• Active Investors
• Passive Investors

“Active” refers to people who physically own residential or commercial property. They might own property in Qualified Opportunity Zones (QOZs). Some investors might take care of all property management duties themselves, while others hire companies to do the work for them. In either case, these investors play a very active role in the management, financials, tenants, and upkeep of the real estate in question.

“Passive” refers to people who believe real estate is a great investment, but they don’t want all the hassles that comes along with being an active investor. These individuals might own traded real estate (also known as traded Real Estate Investment Trusts or REITs for short). Some invest in private, non-traded real estate or QOZs as a passive investor. Then, there are others called Delaware Statutory Trusts (DSTs).

Today, I’m focusing on “active” investors and DSTs, but we’ll still dabble a bit in the passive category toward the very end of this article.

It should go without saying that real estate is a great investment. I often share that of our wealthiest clients, I don’t know too many of them who don’t own residential or commercial investment property.

Real estate is a great compliment and diversifier to a retirement plan at work. If you keep the real estate until you die, it passes on to your family tax-free (due to a “step-up” in cost basis at death).

The biggest problem for most people who own real estate is this: If you sell it while you’re living, there can be a large capital gains tax owed on the property (or portfolio of properties).

Another issue that often arises has to do with passing the real estate down to the next generation. Sure, it’s tax-free due to the step-up in cost basis, but oftentimes, the kids don’t have any interest in owning, managing, or dealing with the financials involved with managing real estate.

Said another way, they don’t want to deal with “The Terrible T’s”:

1. Toilets
2. Tenants
3. Trash

So, if real estate is a great investment, we don’t want to pay capital gains tax, but the kids don’t want the hassle of being active real estate investors, what should we do?

Well, there’s another option – it’s called a 1031 tax-free exchange.

You’re probably thinking, “Oh, I’ve already heard of this – why am I wasting my time with this article?!”

Hold on… sit tight. There’s more to share than simple, “boring” 1031 like-kind exchanges, but let’s start there for those reading who aren’t familiar with the concept.

Let’s say you buy a residential or commercial property for $500,000 and years later, you decide you want to sell it. Unless it’s your primary residence (that’s another topic for another day), you would owe income tax on the amount of money you made, above the purchase price (AKA: “Cost Basis”).

So, in this example, if you sold the property 15 years later for $1,000,000, you would owe tax on the $500,000 gain.

Naturally, investors want to avoid this tax, and the most commonly known way to do just that, is through a 1031 like-kind exchange, and this is how it works…

When selling a property, you find another “like-kind” property to invest in. What’s “like-kind” mean? Well, if you’re selling a piece of real estate, you would want to find another piece of real estate, which includes commercial property, single-family homes, duplexes, apartment buildings, industrial property, retail property, or land (just to name a few).

In addition, this could be one property or a portfolio of several properties – it doesn’t really matter. However, as long as you reinvest the proceeds from the sale of your original property into the new one(s), you can avoid up to (or all of) the taxes you otherwise would’ve paid if you simply took the cash.

In order to avoid the entire tax bill, the investor must:

1. Purchase property of equal or greater value,
2. Reinvest all the net proceeds from the sale of the relinquished property,
3. If debt (i.e., a mortgage) exists on the property being sold, that debt must be replaced in the transaction with a new loan of equal value, by injecting equity from outside the exchange, or a combination of the two, and
4. The investor cannot receive anything in the exchange, other than the like-kind property.

If you find a like-kind property, but the total value does not fully replace the value of the relinquished property, at least a portion of the proceeds will be taxable.

Another crucial step in this process is to understand the time limits involved in a 1031 exchange:

The 45 Day Rule:

The Exchanger must identify the potential replacement property or properties within the first 45 days of the 180-day Exchange Period.

The 180 Day Rule:

The Exchanger must acquire the replacement property or properties within the earlier of:

a) 180 days, or

b) The date the Exchanger must file the tax return (including extensions) for the year of the transfer of the relinquished property.

Keep in mind – there are no extensions for the deadlines and the days I’m referring to above are calendar days, including Saturdays, Sundays, and holidays (not business days), and the time limits begin to run on the date the Exchanger transfers the relinquished property to the buyer.

So, you can probably imagine, it is NOT advisable to wait until you’ve sold a property to start the process of initiating a 1031 exchange! Rather, you want to have your eyes out to identify a potential exchange candidate (property) before the relinquished property is sold, otherwise you can find yourself in a race against time.

THE BIG SECRET – as promised!

This has all been great…

Now we know how to avoid paying taxes on the sale of our real estate, we can buy new property, upgrade, change the location where we own property, continue to manage it until we die, at which point the value will “step-up” at the date of death, and it’ll then pass onto our beneficiaries tax-free.

BUT… what if we don’t want to manage a real estate portfolio anymore? What if we don’t feel like we’re “retired” because we’re always faced with the receivables, bills, and financials throughout the year, not to mention the prep work required for tax time, come April 15th.

What if we don’t want to deal with “The Terrible T’s” any longer (again, that’s the hassle related to Toilets, Tenants, and Trash), but we do want to avoid tax and allow our family and beneficiaries to receive their inheritance, tax-free?

I’ve got great news – there is a way – it’s called a Delaware Statutory Trust (DST) 1031 Exchange into a passive portfolio.

What’s a DST? Well… it’s a passive investment where a large, institutional real estate company allows contributions of money into the investment from several real estate investors who are interested in passive real estate, and they purchase property with the funds that have been collected from all the investors.

The company sponsoring the DST does all the management, financials, receivables, and deals with “The Terrible T’s,” while you sit back and collect your “rent checks” (via quarterly or monthly distributions), all while enjoying your partial ownership and equity in the property. It’s like owning real estate, but without all the physical hassles that come along with managing the property yourself.

There are several companies that offer DSTs, and many choices of “sectors” one can choose for their 1031 proceeds. For instance, you can do a 1031 exchange from a property you sell and purchase property in any of the following sectors:

• Hospitality
• Multifamily Housing
• Retail
• Student Housing
• Health Care
• Self Storage
• Industrial / Warehouse
• Office

This is how it works…

When you decide to sell your commercial or residential real estate, instead of looking for a local, physical property or portfolio of properties, you pick out a DST (or multiple DSTs) that makes sense for you.

From there, you implement a 1031 exchange from the sale of your physical property that you previously managed, into the DST, and you can then avoid all taxes you would’ve otherwise had to pay.

Furthermore, you continue to get income from the DST, just like you would from real estate you own and manage yourself… but without the “management” headaches.

Eventually, the DST will be sold at some point in the future, and you’ll have a choice, once again, to either:

A. Sell the property outright and pay the capital gains tax, or

B. Implement another 1031 Exchange into another DST, avoiding the tax once again.

So, you can continue to defer the tax burden until your last day on earth, and the kicker?

When you die, your beneficiaries still benefit from the step-up in cost basis, rendering the sale of the DST tax-free on/after the date of death.

To elaborate, let’s say you bought a property for $500,000, sold it 15 years later for $1,000,000, and did a 1031 Exchange into a DST at $1,000,000, avoiding all capital gains tax.

Now, let’s say the DST is liquidated by the institutional sponsor, and you decide to defer the taxes again. So, this time, let’s say it’s been another 10 years, and your investment is worth $1,250,000. You do another 1031 Exchange into another DST and start collecting your income checks.

If you were to pass away 5 years later and you still own the DST (let’s say it’s worth $1,350,000), your beneficiaries inherit the asset, and it can then be sold without any taxes owed, because your original cost basis (of $500,000) “steps-up” to the date-of-death value on the day of your passing, which in this case is $1,350,000.

So, the only way your heirs would pay taxes would be if they held it for a few more years instead of selling it. Let’s say they hold it for 5 years and it’s liquidated for $1,450,000. They would owe capital gains tax on $100,000 (the difference between $1,450,000 and the date-of-death market value of $1,350,000).

Think about it – in this example, you paid $500k for a property, collected rent for 15 years, passed on the management to a total of two DSTs over the course of the following 15 years, and the only tax you’ve paid is a partial tax on any applicable monthly or quarterly distributions.

What’s not to like?!

So, if you or someone you know owns commercial or residential real estate – they’d like to sell someday, but they don’t want to deal with “The Terrible T’s” any longer, and they certainly don’t want to pay tax on the sale of their properties – please feel free to reach out to us and set up an introduction call so that we can discuss your situation further.

As it stands, tax laws are not changing for 2023, so take advantage of these strategies while they still last…

‘till next time!

Adam