HOW NOT TO TAX YOUR CHILDREN AND OTHER STRATEGIES FOR SELLING YOUR APARTMENT BUILDING
Tax issues are a major reason why apartment building deals fall through. Two things you can’t avoid in life are death and taxes, but these are things that many apartment owners rarely consider when they consider the future of their asset. Taxes can also be a harsh sting to greet children inheriting an apartment property once you’re gone. To avoid these problems, it’s important to consider your building’s tax implications now, even if you aren’t planning to sell.
For apartment building owners looking at selling their properties, taxes come in two forms: recapture taxes, and capital gain taxes. Recapture taxes claw back the depreciation that a apartment building owner claims on his or her capital asset as a building expense against income taxes. When a building is sold, the amount of depreciation is subtracted from the original cost of the building, leaving the remaining amount as the undepreciated capital cost, or UCC. Recapture taxes are payable at income tax rates on the portion of the building’s original cost minus its UCC, so the more you depreciate your depreciate your capital asset, the higher your recapture taxes.
Recapture taxes can be a painful surprise to anybody who isn’t expecting to pay such a tax. Building owners have plenty of incentive every April to use depreciation to reduce their income taxes, but this only defers those taxes, not eliminates them. If they have to suddenly sell their building, these taxes come due in one lump sum.
Capital gains taxes are better known, especially in centres where properties have seen considerable appreciation in value. When a property’s value increase over time, the difference between the current value of that property versus its original value of that property becomes taxable at capital gains rates once a property is sold. This tax can represent a significant portion of a seller’s net proceeds, especially if a vendor has maintained a large mortgage, possibly through refinancing their properties over time. Capital gains tax rates are lower than income tax rates, but these can still be a painful surprise to a seller who isn’t prepared for them.
Many apartment building owners aren’t prepared for these taxes because they don’t expect to sell their properties. However, many buildings are placed on the market by sellers who weren’t originally expecting to sell them. Financial conditions change, and some sellers need to sell in a hurry, only to discover that recapture taxes and capital gains taxes complicate matters terribly.
Even if a building owner doesn’t sell his or her apartment building, the taxman will get his due in the end. On the passing of the owner and the owner’s spouse, an owner’s estate will face a deemed disposition of all its assets before it is passed onto the owner’s children. This means that, in the eyes of the government, the owner’s estate will be deemed to have sold everything, and all taxes owed on all assets will come due, including recapture and capital gains taxes. Unless the owner sets aside money or has planned for this event in some other way, the owner’s children or grandchildren will have to foot the bill, possibly forcing them to assume further mortgages, or sell the owner’s asset at less than what it’s worth.
These taxes can be limited or deferred through careful planning, however. Options include leasing your properties rather than selling them, putting together a share sale or a share swap, and more.
Leasing a property involves giving the rights of a property to a buyer for a pre-set term (up to 99 years) in exchange for a guaranteed income stream over the course of the lease. Since a sale did not occur, recapture and capital gains taxes aren’t payable. This option isn’t for everyone, however, since buyers don’t get full ownership of the property, and sellers don’t receive the full proceeds of a sale.
In a share sale, a seller transfers a property to a buyer not by selling the property, but by selling shares in a company that owns that property. By holding a apartment building in a corporation, a sale of shares converts the recapture tax to a capital gains tax, reducing the burden. This disadvantage of this arrangement is that the buyer is less able to benefit from the capital expense of depreciation once he acquires the property, and they will likely demand a discount in the sale price to reflect this.
If a seller or a buyer doesn’t want to sell shares, an alternative is exchanging shares instead. This is especially handy if one is dealing with a large public company. Rather than paying cash, a corporate buyer instead offers shares equal to a property’s equity, effectively exchanging that property for portions of other properties in the buyer’s portfolio. Selling those shares at a later date still incurs capital gains tax, but the payday is deferred. The risk of this strategy is the possible volatility of the value of the newly acquired public shares.
These are just some of the strategies a apartment building owner can use to protect themselves and their children from an unexpected tax bill. It’s important to discuss things with a broker with experience in the apartment industry. They can help building owners navigate the maze of tax regulations to ensure that no surprises lie in wait.