Taxes are a critical issue when it comes to selling your apartment property, but it is one that most apartment building owners rarely consider until it comes time to sell. This can cause some difficulties when trying to make a deal and agree on a fair price, so owners should consider the tax implications of a sale of their real estate long before they decide its time to sell.
In owning apartment building, taxes arise in two forms: the recapture of depreciation taken, and the capital gain. Recapture of depreciation occurs after a apartment building owner uses the capital depreciation of his or her asset as an expense to reduce his or her income taxes. When they do this, the amount of depreciation is subtracted from the original cost of the building, and the amount that remains is the depreciated capital cost or UCC. When a apartment building is sold, the building’s original cost less UCC is fully taxable to a vendor at income tax rates. This can be a painful surprise to anybody who isn’t expecting to pay such a tax. Building owners should remember that using depreciation doesn’t eliminate income tax; it only defers it, and this decision can come back to haunt them when the time comes to sell.
The other major tax that vendors will have to deal with when they sell is a Capital Gains Tax. This occurs when apartment properties increase in value over time. When they sell, the difference between the value of their property at the time of sale, and its original cost, will be taxable at capital gains rates. Vendors need to be aware when they sell their property, that they will be taxed on the full increase in its value. This can be a significant portion of a vendors net proceeds, especially if a vendor has a large mortgage, perhaps due to refinancing of their property over time. While capital gains tax rates are lower than income tax rates, they can still be a painful surprise to any vendor who isn’t prepared.
And the taxman will get you in the end. On the passing of a 2nd spouse, an owner’s estate will face a deemed disposition of all of its assets. This means the estate will be deemed to have sold everything, and all taxes inherent in the assets will be due, including both recapture and capital gain on any property held by the estate. Unless you have set aside money or have otherwise planned for this event, your children or grandchildren may end up on the hook for the tax bill. They may be forced to sell your asset at less than what it’s worth or assume further mortgages. It is therefore that much more important that building owners deal with their tax issues while they are alive, and not leave the burden for their loved ones.
The Long-Term Lease
With careful planning, there are ways to limit or defer the taxes owed on the sale of your apartment properties. One option could be to negotiate a long-term lease. Here, rather than selling a property, a vendor leases the rights to it for a per-set term — up to 99 years. In this arrangement, the vendor gets a guaranteed income stream over the course of the lease, and as a sale did not occur, recapture and capital gains taxes are deferred. This is not a popular option however, as buyers do not get full ownership of the property, and vendors do not receive full proceeds of a sale. Share Sale Another option to minimize taxes is to, instead of selling a property, sell shares in a company that owns the property.
Most owners hold their property in corporations, and a sale of shares rather than the property itself converts the recapture tax to a capital gains tax. However, share buyers know that they will be on the hook for the low cost base in the assets, and that they may have very little ability to depreciate the asset further. As a result, a buyer will demand a discount for the embedded tax in the asset.
Apartment Share Swap
If selling shares isn’t favored, why not exchange shares instead? This is handy if you are dealing with a large public company. Rather than paying cash, a corporate buyer will offer shares equal in value to your property’s equity, effectively exchanging your property for portions of other properties in the buyer’s portfolio. Selling those shares at a later date will still leave you liable for capital gains, however it provides for a deferral. The biggest risk here is losing control of your money and possible volatility in the value of the newly acquired public shares.
Other strategies range from the simple to the sophisticated. Expert advice is needed to minimize your taxes.
Strategies to Minimize Taxes on Sale or Inter-Generational Transfer
After doing a number of apartments transactions, we’ve seen the following:
- Owners struggle with an inter-generational transfer to their children and grandchildren because of taxes payable.
- Taxes are often the number one issue preventing a sale.
- Owners don’t have a clear understanding of the tax consequences of a sale or an inter-generational transfer.
- Owners and their ad visors need help in understanding simple and sophisticated tax advice.
At SVN Rock Advisors Inc., we can help you make sure you get the maximum net after-tax proceeds possible.
Please contact SVN Rock Advisors Inc. for a confidential discussion on tax strategy.