In the past few years, land values in our area have exploded – it’s no wonder that individuals and families are looking to profit from the current boom. The question is… “Can you sell, make a profit, and not have a huge tax burden?” The answer is “Yes!”

Typically, by selling your investment property (ranch, farm, rent house, land, etc.), you may trigger federal capital gains tax and also recapture previously claimed depreciation, which causes you to pay income taxes. These taxes make it extremely difficult for you to trade up in real estate value and increase your cash flow and net worth.  Fortunately, there are a number of options offered within the Internal Revenue Service tax codes as well as other means to ease this tax burden. Many of these options are extremely complicated and the cookie cutter approach simply won’t work. However, I feel it is important for individuals and families who find themselves in this position to be aware of these options. Following are two of the most common available to you today:

The first and most commonly known option is a “like-kind” exchange, also known as a 1031 exchange. In 1031 exchanges, real-estate owners defer capital-gains tax on the sale of real property by purchasing real property of equal or greater value, according to rules set by the Internal Revenue Service.  The following is one example of how a 1031 exchange might work:

George and Lucy want to sell their 1,000-acre ranch for $2 million. After the sale, they discover they will owe Uncle Sam $225,000 from capital gains. So they go to their advisor for help. George and Lucy explain that they would like to retire in the next few years and do not want to hassle with another ranch, farm, or rent properties and tenants (typical examples of a 1031 exchange). They would like to sit back and enjoy life. Their advisor talks with them about a 1031 exchange into a qualified replacement property or properties to defer 100 percent of the tax from the sale of their ranch. There are real estate companies that partner with investors like George and Lucy to buy institutional grade properties like shopping centers or pharmacies. These are income-producing properties that are generally held for 5 to 7 years and sold at an increased value. These real estate investments are generally called Tenants in Common programs (TICs). George and Lucy like the idea of “mailbox money” and the ability to sit back while their assets grow in value, so they decide they are going to sell their ranch and exchange it for a TIC. However, the decision to implement a 1031 exchange is only the first step.

When and if you decide a 1031 exchange is right for you, it is important to let your advisor know long before the sale of the investment property in order to properly meet the requirements. The exchange process can be very complicated, requiring intimate understanding of the tax code and related law. And the exchange must be done with qualifying properties. The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents, or else all the proceeds will become taxable. Within 45 days of selling the relinquished property, you must identify other replacement properties. Within 180 days, the investment property must be replaced, even if the date falls on a Saturday or Sunday.

The second option involves alternative investments to minimize the tax. Oil and Natural gas from domestic reserves helps to make our country more energy self-sufficient by reducing our dependence on foreign imports. In light of this, Congress has provided tax incentives to stimulate domestic natural gas and oil production financed by private sources. Section 263 of the tax code allows investors to deduct 100 percent of the intangible expenditures of drilling, which is usually 65 to 80 percent of the well, during the year the investment was made. Additionally, tangible drilling costs are 100 percent tax deductible and may be deducted as depreciation over a seven-year period. The following is a scenario of using oil & gas investments to minimize tax.

George and Lucy think some more and decide that they still like the idea of mailbox money and the ability to sit back while their assets grow, but want to have more flexibility with their money and feel it is important to own other investments as well. Their advisor discusses using a diversified portfolio tailored to their unique situation and using oil & gas investments to offset some of the tax created by the sale of their ranch. A $100,000 investment could yield up to $75,000 in tax deductions during the year of the investment. George and Lucy like this idea.

You’ve heard me say it before-most people don’t plan to fail; they just fail to plan. And just like retirement, most people only get 1 chance to do it right. There is immense complexity involved in real estate transactions that most individuals are not aware of. Whichever path you choose to follow, you must keep in mind that these – like most – investments involve risk and may not be suitable for all investors.  Tax laws could change which could impact the features of these investments. Therefore, I encourage you to ask questions and consider all of your options. Otherwise, you could be jumping into the deep-end of the pool without a lifejacket and be dog paddling for years.