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Commentary & Insights

Insight, Tax Planning

Blending for Results

20 November 2023

By Steven A Weintraub

Bailey’s Irish Cream, launched in 1974, sells two billion bottles per year. Coffee revenues, in the U.S. alone, exceeds $90 billion annually. Two giants, exceedingly successful on their own, blend together to make magic. 

The sale of assets typically triggers capital gains. The Federal government taxes capital gains (at lower rates than ordinary income) and adds a Medicare Surtax (3.8%). California applies ordinary tax treatment to the sale of capital assets. Is it possible to avoid these taxes by blending two different tax rules?

IRC Section 1031

IRC 1031 provides for tax “deferral” on the sale of property held for investment when exchanged for “like kind” replacement property. Deferral should not be confused with tax-free. The taxpayer’s cost basis in the sold asset carries over to the replacement property. Compliance with strict rules is critical and transactions typically include brief time constraints.

IRC Section 121

An individual can sell their principal residence, if held for two of the past five years, and exclude $250,000 of the gain from taxation; the exclusion is $500,000 for couples if married and filing jointly.

Mixing the Drink

Pouring some Bailey’s into a cup of coffee is more art than science and subject to individual tastes. Combining tax codes, by contrast, relies on detail and precision. 

When Appropriate

While we do not pretend to have any hard data concerning people’s drinking habits, casual observation points toward increased popularity during winter nights for coffee and Bailey’s.

Serving up the tax cocktail fits nicely with an older couple, especially those seeking the transition to a retirement home. Here’s how it could play out: Either or both spouses might desire or even require some assistance for their basic living needs. If they have sufficient financial resources to cover both the buy-in (when needed) and the monthly payments (typically high, especially for assisted living and particularly in California), no problem. In some instances, long term care insurance could mitigate the costs. However, this would require both having insurance in place and qualifying for benefits under the terms of the policy. Unfortunately, some families lack both capital and insurance.

Most people do not consider their home as an “investment” because of personal use. However, it is, especially for Californians, an “ace in the hole.” Selling creates capital gains. Strategic planning and patience could produce better results. Reverse mortgages may present another option, but todays’ higher interest rates will chew through equity over time, leaving beneficiaries with a smaller potential inheritance.

Consider, instead, moving out of the primary residence and into the retirement home. Convert the vacant house to a leased property. Rental income should help alleviate the monthly costs of the retirement home.

After two years, sell the home, previously converted into commercial property. The owners first utilize their Section 121 Exclusion that allows up to $500,000 of gains to flow into their pockets, tax-free. Exchange the remaining proceeds, under Section 1031, into an income producing property such as a NNN lease restaurant. Commercial properties typically provide a higher cash flow yield than a personal residence and the NNN lease requires no management.

When either the first or the surviving spouse passes, sell the commercial property. Because of the step-up in cost basis available in most instances, no income taxes would be due.

If a couple lacks the buy-in for a retirement home or a continuous care facility, they should consider taking a $500,000 loan on their residence and paying the loan back upon receipt of the proceeds attributable to IRC Section 121.

We can all toast to that.