Meet Brett and Angel

Brett and Angel have dreams. When we first met them, Angel said, “I have lived in the same house with Brett for more than 30 years, and I want a new kitchen.” Brett said, “I want to travel Europe before I get too old to do it.” Because they weren’t willing to sacrifice those dreams to avoid the IRS, Brett and Angel may have been our favorite case in recent memory.

Nuts and Bolts

How much money is needed to travel Europe and remodel a kitchen? That was the question that needed to be answered. Brett said, “We want to take about $200,000, after taxes, out of our exchange.”

Reviewing their returns showed there were no passive losses or capital losses that would reduce their tax bill. Next we needed to know about the value of and the debt on the property they were selling. If the debt was low in relationship to the sale price, there would be excess basis that we could use cost segregation on. The property was worth about $1,800,000; after selling expenses, the couple would net about $1,700,000. Unfortunately, their debt was near $700,000, leaving a very small amount of excess basis.

After working a long time with Brett and Angel, we discovered couldn’t use any of our traditional ways to get them the cash they wanted without a lot of tax. 

Bad News

Our response to them was, “I don’t see how we can shelter this amount of boot. If you want to take $200,000 cash out of the exchange, you should probably take an extra $120,000 out so you have enough money to pay the tax. In addition, you will have a problem replacing the debt, which creates more boot and tax problems. Are you sure you need $200,000?”

The answer was unequivocal. “Yes, we know we are going to pay a lot of tax. We came to you to make sure we put aside enough money and still get our $200,000.”

So we went forward in planning the exchange. 

Taxes Are Complicated

In a situation like this, there are so many factors that it often takes a while to look at them all and find the best solution. The best solution for them would be to get their dream without having to pay so much tax – but how could we accomplish that? If we can’t shelter their boot, but could we shelter their other income?

Brett and Angel actually have quite a good retirement income in the form of pensions. If we could shelter this income, their tax would be significantly less. After discussing the idea with them Brett and Angel agreed to use the idea to save the additional cash.

Conclusion: Investing in Open Space

The exchange was completed in early 2018. In November of 2018, we talked to Brett and Angel and suggested they invest in a partnership that was going to develop a granite quarry. The possible returns looked good, so they decided to invest $25,000. In December of 2018, the quarry investors voted to conserve the land instead of developing it.

About 40 years ago, Congress passed a law that says if you conserve land through a conservation easement, you can get a very generous tax deduction. Brett and Angel received a $145,000 charitable contribution deduction for their investment. This left them with only the capital gain to pay tax on, which had several positive effects on their tax bill. When your income is low, there is a 0% tax on a portion of capital gains. Tax rates on the rest of the income can be as much as 60% lower than tax rates on the ordinary income. A taxpayer can end up paying almost the same tax on $165 of remaining capital gain as on $100 of ordinary income. 

Here’s the bottom line: Brett and Angel ended up paying about $41,000 more tax for 2018 than they did for 2017. Their income was the same both years, excluding the exchange. Adding the $41,000 in tax to the $25,000 quarry investment, they essentially paid $66,000 on $320,000 of boot. In percentage terms, this is just a little more than 20%. Considering that for California purposes much of the gain was taxed at 9.3%, this was a big win! Brett and Angel were very excited to see such a low tax bill and are now adding some Asian destinations to their travel plans.