When visiting with someone about selling, I generally ask “What will you do with the proceeds and have you visited with a CPA about tax consequences?” Tax implications can be very significant when selling real estate. Traditionally, most sellers receive proceeds by cashing out, a 1031 exchange, or owner financing. I recently read about another option called a deferred sales trust.
Cashing out immediately creates a tax liability on any capital gains. A large sale could also trigger higher federal taxes due to the “alternative minimum tax.” If a seller is keen on liquidating the asset immediately, cashing out is generally the option used.
A 1031 exchange can be used to sell one property and purchase another property without paying taxes on any capital gains. The process can be done as many times without paying taxes until cashing out. The dilemma with a 1031 can be identifying and buying a property within the required time frame. A replacement property must be identified within 45 days and closed within 180 days after transferring the original property. Failure to find a replacement property will cause the capital gains to be taxed immediately.
Owner financing can be an excellent option for someone looking to liquidate over time. This option provides an income stream and interest income on principal not yet paid. The major problem with this route is that the buyer could pay off the note early and cause the seller to lose the income stream. In addition the payoff might trigger a large tax liability similar to cashing out.
Another option I recently read about may be a deferred sales trust (DST). This option would be similar to owner financing or an installment sale. DST will provide an income stream based upon the trust agreement. A portion of the annual proceeds will be taxed as capital gains and the rest will be considered income. DST can be used if a 1031 exchange fails, but it must be in existence before a purchase/sale agreement is signed.
Of course the best way to begin the selling process is to visit with your CPA about financial and tax implications while your attorney can make sure you are able to have a clean sale. Exiting real property with the least tax consequence will depend on several factors. It is best to understand your tax consequences from a real estate transaction upfront instead of finding out afterwards!
By Jeffrey Hignight, Farm Manager and Real Estate Broker at Glaub Farm Management. Serving Landowners in Arkansas, Mississippi, Missouri, and Tennessee.