Q: I own a restaurant building that I purchased using a 1031 exchange. I used to own an apartment building. If I sell the restaurant building and have a large capital gain is there any way to avoid paying capital gains tax?

A: One of the best way to defer paying federal income taxes while investing in real estate is by buying and selling properties and using a 1031 tax deferred exchange mechanism.

A 1031 exchange – also known as a Starker exchange – allows you to sell an investment piece of real estate and buy a subsequent piece of real estate of equal or greater value and not pay federal income taxes on the sale.

If you owned the apartment building for a long time before buying the restaurant building, you should have been able to defer a significant amount by using the 1031 exchange to complete the transaction.

If you worked out the details properly for the exchange, you sold the apartment building and then – within 45 days of closing on the sale of the apartment building – you designated the restaurant building as the new property to replace the apartment building. You closed on your purchase of the new restaurant building within 180 days of the sale of the apartment building and for federal income tax purposes, you paid no taxes.

If you had not used the 1031 exchange for the sale of the apartment building, you probably would have had a significant tax liability resulting from its sale

If you now sell the restaurant building, you’ll have to pay federal income taxes on the sale of the building. On your capital gain in the sale you will have to pay federal income taxes at the rate of 15 percent, your applicable state tax, and recapture the depreciation you took over the years.

Let’s assume you bought the apartment building for $100,000 years ago and bought the restaurant building for $500,000. Now you’re selling the restaurant building for $1,000,000.

With these numbers, you’d have a capital gains tax to pay on the difference between the purchase price of the apartment building ($100,000) and the sales price of the restaurant building ($1,000,000).

Over the years, you were entitled to depreciate the cost of the buildings and receive a tax benefit each year that you owned the buildings. When you sell, you’ll have to pay back the depreciation benefit at the rate of 25 percent.

While shelling out that much cash to Uncle Sam might seem steep at first glance, you might first want to consider that today’s capital gains tax rates are the lowest we’ve seen in years. If you sell now and pay the taxes, you may be paying taxes at lower rates today than the rates we may see in the future.

But if you want the cash now but want to minimize the effect on your taxes and don’t want to do another tax deferred 1031 exchange, there may be other options.

If you assume that federal income tax rates will remain about the same, you could sell the property on an installment sale basis. That is to say, you would sell the property over time and receive your money over the next several years. In an installment sale, you pay federal income taxes as you receive the payments from the installment contract buyer.

Another option that some real estate professionals are advising their clients on is a structured settlement through a 1031 tax deferred exchange company. Unlike a traditional 1031 tax deferred exchange, the company would assist you in setting up the sale of the property and transferring the proceeds to a company that would then pay you over time the proceeds from the sale. Those proceeds would be taxed to you in future years at your then applicable tax rate.

You should know, however, that in these structured settlements of real estate sales, some real estate professionals are not convinced of their effectiveness in dealing with the tax issues. That means, some people don’t believe that the IRS will look kindly on what are essentially tax shelters. On the other hand, the companies that are setting up these structural settlements believe that the seller should not have problems with the IRS.

Before you make any move, you should explore the tax ramifications of all of your options with your accountant (provided he or she has substantial experience in real estate transactions deferred exchanges) or your real estate attorney.

June 25, 2008