Benefits of Capital Gains deferral

[mothakapalli]

I'm negotiating a seller financing deal for purchasing a property. The sellers are an older couple. They have requested me to outline for them examples of the benefits of deferring Capital Gains. For example, if we negotiate a Seller Financed 30 year amortized loan, they would recognize their Capital Gains over 30 years. However, if they opt for the more traditional cash-out sale of the property, their taxes on Capital Gains would be due immediately.

Based on my research, there are two benefits of deferring Capital Gains:

1. Recognizing the Capital Gains over a period of time allows the opportunity for offsetting future Capital Losses against the gain. Eg. If you pay all your Capital Gains this year and then have Capital Losses next year, you’re out of luck. But if you “carry over” the gains to future years, you can apply losses whenever you incur them.

2. If they are able to adjust their AGI to bring it down low enough, then they can exempt themselves from paying any Capital Gains altogether. I think the tax bracket that allows this is 15% (or is it 10%?). For example,

a. Assume a financed amount of 400K all of which is Capital Gains
b. Assume the property has net income of $1200/mo, which is $14400/yr.
c. Assume that this disqualifies them by putting them over the highest allowable AGI for zero Capital Gains
d. Now, if they sold me the property outright, they would immediately owe the maximum Long-term Capital Gains of 15%
e. However, if they seller financed it to me at 1% interest per anum, they would only have to recognize $4000/yr in income.
f. If that $10,400/yr AGI drop allows them to get into the right tax bracket, then they could end up with a zero Capital Gains tax liability

Anything incorrect about what I’m saying? Can anyone think of any other benefits to deferring Capital Gains that I haven't thought of? Also, for older couples, are there any tax breaks (related or unrelated to this transaction) that might be worth mentioning?
I would appreciate any input from tax whizzes on this forum.

[Desi]

The excerpt below is from this link - http://www.irs.gov/publications/p523/ar02.html#en_US_2010_publink1000200711

Maximum Exclusion


You can exclude up to $250,000 of the gain on the sale of your main home if all of the following are true.

You meet the ownership test.

You meet the use test.

During the 2-year period ending on the date of the sale, you did not exclude gain from the sale of another home.

If you and another person owned the home jointly but file separate returns, each of you can exclude up to $250,000 of gain from the sale of your interest in the home if each of you meets the three conditions just listed.
You may be able to exclude up to $500,000 of the gain on the sale of your main home if you are married and file a joint return and meet the requirements listed in the discussion of the special rules for joint returns, later, under Married Persons .

[samv]

OP

[1] I am not even sure if IRS allows what your are proposing (recognizing capital gain over time.). Having said that I am not very knowledgeable here, but please check if IRS even allows it. Otherwise the whole point is moot.

[2] Even if IRS allows it,
- If your seller is owner occupier of the house (for 2 of the last 5 years), then as Desi pointed out in post #2, most of their capital gain will be tax free anyway! so why bother?
- If your sellers are selling you their rental property, then a lot of their capital gain will be composed of depreciation. According to IRS, depreciation needs to be recaptured at some high rate (25%?) so defering it does not really lower the rate. In this situation, your sellers are better served by considering a 1031 exchange if possible.

[mothakapalli]

Thanks for your Response Desi. I realize I forgot to mention a critical point: the property is not their primary home, so unfortunately they would not qualify for the exclusions. Assuming cap gains is due, do you have any further ideas in the scenario I described?

Thanks again for your response.

[Desi]

Thanks for your Response Desi. I realize I forgot to mention a critical point: the property is not their primary home, so unfortunately they would not qualify for the exclusions. Assuming cap gains is due, do you have any further ideas in the scenario I described?

Thanks again for your response.

No, I do not have any suggestions. I have read on some internet links that seller financing helps in reduce cap gains, but never went into detail of examining it. Perhaps there may be some estoteric structure that I do not know or understand but I am apprehensive about it.

I would think that a sale is a sale and taxable once the sale is good and title transferred. The money extended to you is a loan with interest rate defined and not a deferred sale, so I would tread carefully.