Thinking About Selling a Rental House but Don’t Like Paying Tax on the Gain?

If you have owned the house for a long time and have been depreciating it, your adjusted cost basis may be quite low. While the top federal tax rate on long-term capital gain in securities and undepreciated real estate is 15%, the gain attributed to the depreciation you have taken could be taxed at the 25% federal rate. This could significantly reduce the net proceeds you have to reinvest.

With a charitable remainder trust, you can avoid taxation of the gain when the property is sold and receive income for life from the entire proceeds.

Example: Roger and Nancy, aged 69 and 68 respectively, purchased a rental house for $150,000 nearly 20 years ago, but now they would like to be relieved of the responsibility of keeping it rented and maintained. Although the property has declined in value since 2008, it appreciated significantly during the early years of their ownership and is now worth about $300,000. However, their adjusted cost basis is only $80,000 because they have reported $70,000 of depreciation on their tax returns. If they sold the property and netted $300,000 after selling costs, they would pay approximately $45,000 in federal tax, not counting any state tax that might apply.

Instead of selling their house, they contribute it to a charitable remainder unitrust with a 5% payout rate. They are not taxed on the gain when they transfer the property, and the trust is not taxed on the gain when the property is sold. Thus, the entire $300,000 of net proceeds can be reinvested to generate income for them. During the first full year after the sale of the house they would receive $15,000. In subsequent years they would receive 5% of the value of the trust assets as of the beginning of the year. If the trust assets grow in value, their income will increase correspondingly. Prior to the sale of the property, they would receive payments that would approximate the net rental income to which they are accustomed.

In addition to the tax savings on the capital gain, Roger and Nancy receive an income-tax charitable deduction of $115,791, which will reduce the taxes they pay on their total income. The payments from the unitrust will probably be taxed partly as ordinary income and partly as capital gain, and some may be tax-free. This is preferable to having all of the net rents taxed as ordinary income, which is presently the case.

At the end of the life of the survivor of Roger and Nancy, we would receive the remaining assets, which would be used for the purpose Roger and Nancy had designated. One possibility would be an endowment named for them. In summary, they will have arranged a meaningful gift, saved taxes, ensured life income, and relieved themselves of the burden of managing the property.

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