"I would love to sell all my real estate to take advantage of today’s high prices, but I don’t want to pay Uncle Sam a fortune in taxes." That’s what a widower homeowner and investor, who I estimate is in his 70’s, told me a few weeks ago.

Since our conversation, I’ve been wondering if he realizes all the tax-saving choices he has to totally avoid or at least minimize his capital gain taxes if he decides to sell his house and/or investment properties which he has owned for many years. Although it has been at least three years since his wife died, my friend often mentions her in our conversations. Because they owned their properties together, I hope he understands the major benefits of his new "stepped-up basis" for his properties after she passed on. Maybe his capital gains tax won’t be very substantial after all!

That’s why I decided it would be beneficial to briefly discuss in one place virtually all the major tax avoidance methods which home sellers and investors need to understand. In addition to the well-known methods, we’ll look at some virtually unknown tax-avoidance methods which can save both capital gains taxes and estate taxes. Of course, this special report is no substitute for consulting your personal tax adviser to apply these tax-saving techniques to your personal situation. Let’s get started.

WHAT IS THE DIFFERENCE BETWEEN ORDINARY INCOME AND CAPITAL GAINS? We’re all familiar with federal income taxes on earnings received from job wages, interest, dividends, and other fully-taxed sources. This is usually called " ordinary taxable income." It is generally taxed at the highest tax rates, based on a sliding scale – the higher the total ordinary taxable income, the higher the tax rate.

Unless you receive very little or no taxable ordinary income, allowable itemized deductions can significantly reduce the income tax on your ordinary income. Deduction examples include home mortgage interest, residence property taxes, charitable donations, casualty losses, moving expenses, and home business deductions. More details are in my special report "2005 Realty Tax Tips: Eight Chapters of Tax Savings for Homeowners and Realty Investors."

In addition to the federal income tax, all states except Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming have a state income tax. However, New Hampshire and Tennessee tax only dividend and interest income. State income tax rates are generally much lower than the federal income tax rates, but California, Hawaii, Minnesota, New York, North Carolina, and Wisconsin have the highest state income tax rates.

However, federal long-term capital gains, taxed at a much lower tax rate than ordinary income, are earned from profitable sales of capital assets, such as common stocks, bonds, and real estate, held over 12 months. If the capital investment asset was owned less than 12 months before sale, its short-term profitable sale is usually taxed the same as ordinary income.

Currently, the federal capital gain tax rate is 15%, except a special 25% federal tax rate applies to "recaptured" (that means "taxed") depreciation which was deducted in a prior tax year. Most states also tax capital gain profits, but their tax rules are not always the same as the federal capital gain tax rules. States without capital gains taxes on the sale of capital assets include Alaska, Florida, Nevada, New Hampshire, New Mexico, South Dakota, Tennessee, Texas, Washington, and Wyoming.

HOW TO KNOW YOUR "ADJUSTED COST BASIS." The starting point for avoiding long-term capital gains tax on the profitable sale of your personal residence and investment real estate is its adjusted cost basis. This number is needed because it must be subtracted from the property seller’s "adjusted sales price" to arrive at the long-term capital gain when the property is sold. Most property owners think their adjusted cost basis is their purchase price. As we will see, that is often wrong!

1 – The basic "adjusted cost basis" rule. The starting point is usually (a) the property purchase price, plus (b) any purchase expenses which were not tax deductible at the time of purchase.

EXAMPLE: If you bought your personal residence for $200,000, paid $2,000 in tax-deductible loan fee points to obtain your home acquisition mortgage, and paid $5,000 in various non-deductible closing costs such as transfer fees, attorney or escrow charges, and title fees, your home’s adjusted cost basis is $205,000. The $2,000 mortgage loan fee points qualify as an itemized income tax deduction in the year of home purchase. Each "point" equals 1% of the amount borrowed. But the mortgage amount doesn’t matter for determining the adjusted cost basis.

2 – Subtract any "rollover" deferred capital gain from principal residence sales before May 7, 1997. If you used the old now-repealed Internal Revenue Code 1034 "rollover residence replacement rule" before May 7, 1997, don’t forget to subtract from your home’s adjusted cost basis, as explained above, the amount of any deferred capital gain from the sale of your prior principal residence(s). You might even have deferred "rollover" capital gains from more than one principal residence sales before new IRC 121 replaced the old rule. The new IRC 121 exemption, discussed below, includes these "rollover deferred capital gains.

3 – If real estate was acquired in an Internal Revenue Code 1031 tax-deferred exchange, subtract the amount of the tax-deferred capital gain profit from the acquisition cost. Although your tax adviser will calculate your exact adjusted cost basis for property acquired in an IRC 1031 tax-deferred exchange, such as a rental house or an apartment building, a quick shorthand method to estimate your adjusted cost basis of the acquired property is to use your purchase price and then subtract your deferred capital gain resulting from the old exchanged property.

EXAMPLE: Using an IRC 1031 tax-deferred exchange, suppose you had a $100,000 capital gain on the sale of a rental house which you traded for a $600,000 warehouse. From your $600,000 warehouse purchase price, subtract the $100,000 deferred capital gain to arrive at a $500,000 estimated adjusted cost basis for the warehouse. Of course, be sure to add any non-deductible acquisition costs to arrive at the warehouse’s full adjusted cost basis.

4 – Add the total costs of capital improvements made during property ownership. Most homeowners and property investors fail to keep accurate records of their total capital improvements added during ownership. Be sure to add the cost of capital improvements to your property’s adjusted cost basis. To illustrate, if you paid a contractor to build a new $5,000 deck, or had new landscaping installed for $10,000, those are capital improvement costs to be added to your cost basis. However, if you did the labor yourself, then only the costs of the materials qualify as capital improvements. Your labor is valued by Uncle Sam at zero!

EXAMPLE: If you had a new roof installed on your house for $10,000, add that $10,000 to your home’s adjusted cost basis. However, if you just repaired your leaking roof at a cost of $1,000, that’s a personal expense without any tax significance because repair costs on a personal residence are neither tax deductible nor are they capital improvements. However, repair costs on an investment property are tax deductible expenses in the tax year paid.

5 – Subtract total property depreciation deducted on your income tax returns. If you rented all or part of your real estate during ownership years, you should have deducted depreciation on your income tax returns. To illustrate, if you rented your house to tenants for a year while you were in Europe, you probably deducted depreciation on your Schedule E of your income tax returns for those 12 months. That’s the same place you reported the rental income. Or, if the property was always a rental during your ownership, then you had many years of annual tax-saving depreciation deductions. Add the total depreciation deducted on your tax returns and then subtract the total depreciation from the property’s adjusted cost basis.

Depreciation tax deductions must be subtracted to arrive at your home’s adjusted cost basis. Most investment property owners are very familiar with the depreciation deduction which is a major tax benefit of owning depreciable real estate, but it also reduces their property’s adjusted cost basis.

HOW TO KNOW YOUR "ADJUSTED SALES PRICE." After estimating your home or investment property "adjusted cost basis," if you are thinking of selling that property, it pays to estimate its adjusted sales price. Briefly, that is the gross sales price, minus non-deductible selling expenses such as the real estate sales commission, transfer taxes, and attorney or escrow fee. Such sales expenses aren’t deductible, but they are subtractible from the gross sales price.

Your long-term capital gain is the difference between the adjusted sales price and the adjusted cost basis. This capital gain amount may be eligible for either full or partial tax exemption, or tax deferral, depending on the type of property (principal residence or other property).

HOW TO AVOID PAYING TAX ON YOUR CAPITAL GAIN. Armed with your estimated "adjusted sales price" from which you subtract your "adjusted cost basis" to arrive at the estimated long-term capital gain if you sell the property, it’s time to consider how to avoid paying capital gain tax on that sale profit.

METHOD #1 – IF YOU INHERITED PROPERTY, DON’T FORGET YOUR "STEPPED-UP BASIS." This is a major tax benefit of inheriting property which most homeowners and investors don’t fully understand. Obviously, the higher a homeowner’s or investor’s adjusted cost basis in their real estate, the lower the potential capital gain when that asset is sold. "Stepped-up basis," available only to heirs who inherited real estate and other assets, is an often overlooked method of maximizing the adjusted cost basis for an inherited property.

FIRST RULE: Any capital gain the deceased owner would have incurred upon selling a property before his or her death is forgiven or forgotten by Uncle Sam! This is a major reason why property owners usually should NOT make a taxable sale of their capital assets if they know they are expected to die soon. Unless the property must be sold by the terminally ill owner to pay bills, or for other valid reasons, it is usually best not to sell and to thereby save the capital gain tax.

SECOND RULE: A person who receives title to a property as a gift from a property owner before death takes over that donor’s old (usually very low) adjusted cost basis and does not receive a new stepped-up basis which only applies to inherited property.

THIRD RULE: The person who inherits a property after the decedent’s death does not take over the decedent’s adjusted cost basis but, instead, receives it with a new "stepped-up basis." This rule also applies to a surviving joint tenant or tenant by the entireties who receives ownership as a surviving co-owner.

The new stepped-up basis for inherited assets is usually the property’s fair market value on the date of the deceased owner’s death.Or, if the deceased’s estate used an alternate valuation date several months later, that value becomes the heir’s new stepped-up basis. Special valuation rules often apply to farms and closely-held businesses, or if a qualified conservation easement is involved.

Heirs should have inherited property appraised shortly after receiving title to establish their new stepped-up basis. If you inherited property many years ago and have no evidence of your stepped-up basis, hire an experienced licensed appraiser to appraise the property’s fair market value as of the date you received title. Such an appraiser is often expensive, but it is well worth the cost because the appraisal establishes your stepped-up basis to save future capital gains taxes when you decide to sell or trade the inherited property.

If the deceased’s non-exempt total net estate exceeds the federal estate tax exemption below, the estate will have paid any federal estate tax due on the inherited property before title is transferred to the heir. Surviving spouses should be aware that all assets left to a surviving spouse by the deceased spouse are free of federal estate tax under the marital exemption, regardless of total estate value. Here are the federal estate tax exemptions for decedents dying in:

2004 -- $1.5 million

2005 -- $1.5 million

2006 -- $2 million

2007 -- $2 million

2008 -- $2 million

2009 -- $3.5 million

2010 -- UNLIMITED

2011 -- $1 million

Congress is expected to "adjust" the federal estate tax exemption for decedents dying in 2011 and thereafter. Under current estate tax law, if you want to leave a huge estate to your heirs completely free of federal estate tax, the obvious year to die is 2010!

When an heir receives property title by survivorship or by inheritance, the heir’s adjusted cost basis is stepped-up to market value on the date of death (or alternate valuation date used by the estate). That’s usually not a problem. However, if a property owner instead gave away title to their property before death as a lifetime gift, then the donee takes over the donor’s (often very low) adjusted cost basis.

EXAMPLE: A friend or relative knows he or she is dying of a terminal disease. That person wants you to own their home which is now worth $400,000 but cost the owner only $100,000 many years ago. Before death, that owner gives you a quit claim deed to the home. As the donee, you therefore take over the donor’s low $100,000 adjusted cost basis. However, if the owner had instead willed the home to you, or left it to you in his or her living trust, you would receive a $400,000 stepped-up basis. Then if you sell it for $400,000, you would not owe any capital gain tax. However, if you received the home as a pre-death gift, your basis will be the donor’s low $100,000 basis so if you then sell the house for $400,000 you will have a $300,000 capital gain.

For this reason, I frequently say it is better to inherit real estate and other capital assets with a new stepped-up market value basis than to receive title as a gift before death. To avoid probate costs and delays, yet give the heir a new stepped-up basis, a savvy property owner should deed the title to their home and other real estate before death into their revocable living trust which will then distribute it after death.

When the principal or trustor dies, their living trust then becomes irrevocable. The living trust assets are then distributed after death without probate by the named successor trustee. If the living trust specified you are to receive title to the home, the successor trustee then distributes the living trust assets without probate to whomever is named in the living trust.

Probate costs and delays are thereby avoided and the new owner also receives a new stepped-up basis of market value on the date of the decedent’s death. More details are in my special report "Living Trust Pros and Cons for Avoiding Probate Costs and Delays for Your Heirs."

SPECIAL SITUATION: TENANTS IN COMMON CO-OWNERS. When a property is owned by two (or more) tenants in common, after one tenant in common dies, their property share passes to whomever they named in their will to receive it. This heir will receive a new stepped-up basis on the inherited portion of the property.

Title does not automatically go to the surviving tenant(s) in common – unless that person was named to receive it in the deceased tenant in common’s will. If the deceased tenant in common’s will named an existing tenant in common co-owner to receive the deceased’s title, that person then has a new stepped-up basis for the inherited share but not for the already-owned tenant in common share.

In most states, the will of the deceased tenant in common co-owner must be probated in the local probate court, thus adding delays and expenses. For this reason, it is usually best for a tenant in common to hold their property share in their revocable living trust – to avoid probate and to allow flexibility to change the names of the living trust heirs.

SPECIAL SITUATION: JOINT TENANCY WITH RIGHT OF SURVIVORSHIP (JTWRS). When a JTWRS dies, the surviving JTWRS(s) automatically acquires the share of the deceased JTWRS without probate. In most states, the surviving JTWRS need only record a certified copy of the death certificate and an affidavit of survivorship to clear the deceased joint tenant’s name off the property title.

The obvious JTWRS big advantage is probate avoidance. Even if the deceased joint tenant’s will left their share to someone else, a will has no effect on joint tenancy property which automatically goes to the surviving joint tenant(s).

The surviving joint tenant(s) receive a new stepped-up basis on the deceased joint tenant’s property share (but not on the original share already owned by the surviving joint tenant(s)). However, if the joint tenants are husband and wife in a community property state, under IRS Revenue Ruling 89-98 it is possible for the surviving joint tenant spouse to obtain a new stepped-up basis on the property’s entire value. Please consult your personal tax adviser for details.

SPECIAL SITUATION: TENANCY BY THE ENTIRETIES. This is a special form of joint tenancy with right of survivorship allowed only between husband and wife in these states: Alaska, Arkansas, Delaware, Florida, Hawaii, Indiana, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, Missouri, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Tennessee, Vermont, Virginia, Wyoming, and the District of Columbia.

Tenancy by the entireties requires the signatures of both spouses to convey title held by this method. Unlike joint tenancy, one spouse alone cannot change the title holding method. But in most states, when two or more individuals own JTWRS property, one joint tenant can convey their share without the permission of the other joint tenant(s). This can result in the breaking up of a JTWRS (thus creating a tenancy in common) and the surviving JTWRS might not even be aware what happened. But that result cannot happen with a tenancy by the entireties which requires the signatures of both spouses to convey title.

SPECIAL SITUATION: COMMUNITY PROPERTY. In the community property states of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin, husband and wife can hold title to their real estate and other capital assets as community property. Each spouse’s half of the community property asset can be passed by will to whomever they want – community property title does not automatically go to the surviving spouse (unless the deceased spouse left no will).

The major advantage of community property, when a deceased spouse leaves his or her half of the community asset to the surviving spouse by will, is that surviving spouse receives a new stepped-up basis on the property’s entire market value (not just the 50% received from the deceased spouse). For this reason, in community property states, it is usually very advantageous for husband and wife to hold title to their real estate as community property.

Spouses in community property states should consult an experienced real estate attorney about the best way to title their real estate. To illustrate, California recently enacted a new statute allowing a husband and wife to hold title as "Community property with right of survivorship." That means the surviving spouse automatically receives the deceased spouse’s 50% of the property without probate (the same as JTWRS) and a spouse’s will cannot change the survivorship result. The stepped-up community property basis benefit, of course, applies for the surviving spouse.

METHOD #2 – THE $250,000 AND $500,000 PRINCIPAL RESIDENCE SALE TAX EXEMPTIONS. Most homeowners are aware of the very generous tax exemptions of Internal Revenue Code 121, enacted by Congress in 1997 to repeal the old (a) $125,000 tax exemption for senior citizen home sellers over 55, and (b) the "rollover residence replacement rule" which required buying a replacement principal residence of equal or greater cost to qualify for tax deferral. Those old tax breaks were repealed!

Instead, IRC 121 now entitles principal residence sellers to a $250,000 tax exemption (up to $500,000 for a qualified married couple filing a joint tax return in the year of home sale). To qualify, the principal residence seller(s) must have owned and occupied their primary dwelling an "aggregate" 24 of the 60 months before its sale.

In the case of a married couple, title to the principal residence can be held in the name of one spouse alone, or in the name of both spouses, but both spouses must meet the 24 out of last 60 month occupancy test to qualify for the full $500,000 exemption. However, it is usually best to have title held in the names of both spouses so a surviving spouse can get the stepped-up basis inheritance benefits. If the name of the deceased spouse was not on the title, the surviving spouse didn’t inherit anything so the stepped-up basis rules don’t apply.

Partial exemptions after less than 24 months of principal residence occupancy are available if the principal residence sale is due to (a) health reasons, (b) change of employment location qualifying for the moving expense tax deduction, or (c) "unforeseen circumstances" explained in the IRS regulations. Details on this generous tax break are in my special report "Everything Homeowners Need to Know About the New $250,000/$500,000 Home Sale Tax Exemption Rules."

METHOD #3 – INTERNAL REVENUE CODE 1031 TAX-DEFERRED EXCHANGE OF REAL ESTATE HELD FOR INVESTMENT OR USE IN A TRADE OR BUSINESS. The major method of avoiding capital gains tax when selling property held for investment or used in a trade or business, such as apartments, rental houses, warehouses, shopping centers, vacant land, and office buildings, is to make an IRC 1031 tax-deferred "like kind" exchange for another qualifying property.

The general rule is to make a tax-deferred exchange, you must trade equal or up in both market value and equity. That means if any cash is taken out of the trade, called "boot" or unlike kind personal property, that boot is taxable to the exchanger. However, the balance of the exchange remains tax-deferred.

Today, most tax-deferred exchanges are made under IRC 1031(a)(3). They are known as Starker delayed exchanges. After the sale of the old property, the Starker exchanger has 45 days to designate the qualifying replacement property of equal or greater cost and equity (known as the "up leg" in the exchange). Meanwhile, the sales proceeds must be held by a qualified third-party intermediary accommodator beyond the "constructive receipt" of the exchanger. Details are in my special report "How the New Tax-Deferred Real Estate Exchange Rules Can Make You Very Wealthy."

However, the possible disadvantage of tax-deferred exchanges is the investor will be acquiring more rental or investment property. Personal residences and "dealer property," such as a home builder’s inventory of new houses, are not eligible for tax-deferred exchanges.

To overcome this disadvantage, many long-time investors are making IRC 1031 tax-deferred exchanges for their ultimate dream homes. Since personal residences are not eligible for exchanges, the dream home must be a rental at the time of the exchange. Most tax advisers suggest renting the acquired property at least six to 12 months before making a tax-free conversion to the owner’s personal residence.

However, effective October 22, 2004, Congress said a personal residence acquired in an IRC 1031 tax-deferred exchange via this conversion route cannot use the generous IRC 121 principal residence sale $250,000 or $500,000 exemption until after the residence has been owned at least 60 months. But the homeowner is only required to occupy it for 24 of those 60 months as their principal residence.

METHOD #4 – INSTALLMENT SALES. Home sellers and realty investors often forget about this method of selling real estate without paying capital gains taxes (or at least deferring those taxes far into the future, or maybe never!). When a personal residence or investment property is owned free and clear without any mortgage, the seller is in an ideal situation to sell and carry back the mortgage financing for the buyer.

Offering easy financing is a great way for a property seller to get top dollar for the property. Equally important, the seller will then receive installment sale income. If the seller doesn’t want to pay any capital gains taxes on the installment sale (which must be spread out with payments received in at least two tax years), secured by a first or second mortgage on the property sold, the installment sale promissory note can be structured to be "interest only" payments from the buyer to the seller. That’s good for the buyer who makes minimal tax-deductible monthly payments to the seller. Of course, the interest income received is taxable as ordinary income to the seller-mortgage holder.

If there are no principal payments made to the installment sale seller (except a minimal $1 in the year of the property sale, plus the principal balance due in a future year), all the seller’s principal remains busy earning interest income with no work on the investor’s part (except depositing the monthly interest checks).

In today’s low interest rate economy, a property seller can easily earn 5% to 6% or higher interest income on installment sales with the security of a mortgage or deed of trust on the property sold. If the buyer doesn’t make the monthly payments, the seller can foreclose and either get paid in full at the foreclosure sale or get the property back to resell for a second profit.

If the property seller dies while still holding the installment sale mortgage on which there were no or few principal payments made, the capital gains tax which would have been due is forgiven by Uncle Sam. Of course, the installment sale mortgage becomes an asset in the estate of the deceased mortgage holder who avoided paying capital gains tax.

METHOD #5 – TAX-FREE INVESTING WITHIN YOUR ROTH I.R.A. A great way to create tax-free income during realty ownership without capital gains tax when selling a property is to invest in real estate within your Roth IRA. If you have a regular IRA, or another retirement plan such as a 401(k) or 403(b), you can often "rollover" those assets, paying the tax, into your Roth IRA where you can buy investment real estate within your tax-free Roth IRA.

To do this, the Roth IRA must be set up to be self-directed with a trustee who allows real estate investments. For more information, good websites include www.entrustadmin.com (Entrust Administration), www.Sterling-trust.com (Sterling Trust Services), and www.midoh.com (Mid Ohio Securities). Entrust has an extensive website with lots of valuable information.

METHOD #6 – PRIVATE ANNUITY TRUSTS. This is a rather sophisticated tax and estate planning device which definitely requires the assistance of an experienced trust attorney. The basic idea is to create a private annuity trust which will be funded with assets, such as appreciated real estate, which is then exchanged tax-deferred for a private annuity contract to pay income to the investor. If you don’t need immediate income, the annuity income can be deferred to age 70½.

No tax will be due until income is received, such as from a commercial annuity purchased with proceeds from the sale of the appreciated real estate. In addition to the income advantage, a private annuity trust reduces the investor’s taxable estate and no tax is due upon transfer of the property into the trust because the tax is deferred, similar to an installment sale. For more information, a good website is www.PrivateAnnuityTrusts.com.

METHOD #7 – CHARITABLE REMAINDER TRUSTS. Another method of deferring and eliminating capital gains tax is to create a charitable remainder trust to support a favorite worthwhile charity. Not all charities have established procedures to accept real estate donations which usually provide lifetime use and/or income to the donor. Most large universities and major charitable organizations, such as the Salvation Army and the American Cancer Society, welcome charitable remainder trust donations. The possible disadvantage is it is an irrevocable trust so once the asset is donated, the donor can’t revoke the donation due to changed personal circumstances.

SUMMARY. These seven significant methods are excellent ways for avoiding payment of capital gains tax when disposing of your personal residence and/or investment real estate. Depending on your wishes, you can also create tax-free or taxable income for yourself and your family. Or you can donate your real estate assets to a favorite charity while enjoying property benefits and income during your lifetime. For full details on avoiding capital gains taxes when selling your home or investment property, please consult your personal tax adviser.

COPYRIGHT 2005 BY ROBERT J. BRUSS

This publication is intended to provide scant and authoritative information. It is sold with the understanding the publisher is not engaged in rendering legal services to readers. If legal or other expert assistance is required, services of a real estate attorney or other professional should be obtained.