Consult Your Crystal Ball and Read Your Tea Leaves

Tax Planning for Real Estate Sales at the End of 2010

I write this just before Congress returns for a short lame-duck session before adjourning for the Christmas holidays. That’s not much time to address all of the issues that were postponed in the frenzy leading up to the elections. The purpose of this article is to try and give you some guidance on what to expect and how best to plan for your year-end real estate transactions.

First some background: the Bush tax cuts expire at midnight on December 31. If the cuts aren't extended, the capital gain rate will automatically increase from 15% to 20% on January 1st. Tax brackets, especially the top brackets, will also be increased. For the tax brackets and the capital gain rates to stay the same, Congress will have to take some action.

Not surprisingly, there is not total agreement on what to do. The Republicans, who have the wind at their back in the House, want an extension of the Bush cuts for at least a year or two, arguing that to raise taxes now would be crippling to the already fragile real estate market. Obama has stated for the past several months that the Bush cuts should only be extended for the middle and lower economic classes, and that anyone earning over $250,000 should pay the higher rates. Of course, if you have a job or any other source of taxable income, it doesn't take much of a gain to push you up into that higher bracket. 

So, what's going to happen and how do you plan for it? First remember: if there isn't agreement between the House, the Senate and the White House before the end of the year, the tax rates automatically go up. This means that there has to be some middle ground that everyone can agree on; Democrats and Republicans will have to cooperate. 

So, what should your strategy be if you have a closing set for December or January? If your closing happens in December, your primary objective is to make sure that the closing actually takes place in December. Sometimes this is harder than it seems; we have the Thanksgiving holiday, followed shortly by Hanukkah, and then Christmas and New Years at the end of the month. People seem to be in some form of holiday mood all month long and business often takes a back seat. You should assume that you're going to have to push everyone: the title company, the buyer's lender, inspectors, appraisers, etc. Bottom line is that you absolutely have to get the sale closed in December if you don't want to worry about what Congress does. 

Should you do an exchange or pay the tax? There are two lines of thought on this one. Yes, I agree that taxes are not going to be this low again, at least not in my lifetime, so there is some logic to paying the tax now. On the other hand, by the time you factor in depreciation recapture and state taxes on the gain, you'll pay a minimum of 20% tax on the gain, and maybe as high as 30% tax. If you have a gain of only $100,000 this means you'd write a check for $20,000 to $30,000. Your CPA may tell you that it's a smart thing to do, but it's still hard to write the check. And if the cuts get extended for two or three years, you will have wasted a bunch of money. 

What if your closing is set for January or early February? If Congress passes an extension of the Bush tax cuts, then you have no worries--the tax will be the same as if you closed in December. But what if it looks like they won’t get an extension passed before the end of the year? 

Without an official extension, there is no assurance that they will actually pass it when the new Congress is seated in January. If it were my transaction I would do everything in my power to have a formal closing in December, with a small amount of the purchase price paid then, and the balance of the proceeds paid in January when the closing would have happened. This is called an "installment sale," and while the default treatment is that the gain is taxable when the proceeds are received, there is an option where you can elect out of installment sale treatment, and throw the gain back into the year of the sale--in other words 2010. 

While monitoring Congress and perhaps having to force a January closing into December seems like a real hassle, so is paying a bunch of tax that you could have avoided.