On paper, they’re millionaires. In practice, they’re stuck.
The properties are worth roughly $3.2 million, but after 25 years of depreciation the adjusted cost basis has been ground down to about $480,000. That means the total taxable gain on a full sale is approximately $2.7 million – and a big chunk of that is depreciation recapture, which is taxed at 25% regardless of their income level.
Add in long-term capital gains (20%), Net Investment Income Tax (3.8%), and Illinois state taxes, and a full liquidation in a single year could easily cost $700,000 or more. That’s not a rounding error. That’s seven years of rental income gone in one tax bill.
So they do what most people in their position do: nothing. They hold on, deal with the headaches, and tell themselves they’ll figure it out next year. Meanwhile, the roofs are aging, the tenants are getting harder to find, and the deferred maintenance list keeps growing.
They’ve looked at the usual options. A 1031 exchange would defer the taxes, but it just means buying more real estate – and more real estate is the last thing they want. They’ve heard about Opportunity Zone investments too, but that still keeps them concentrated in a single asset class with a long hold period and limited liquidity. The whole point of getting out is to actually get out – diversify into something they don’t have to manage and aren’t overexposed to.
- Before they sell a single property, we start investing a portion of their annual cash flow into a separately managed account designed to generate harvestable tax losses
- The strategy holds a diversified portfolio of individual stocks that tracks a broad market index. As individual positions decline, we systematically sell them to realize losses and immediately replace them with similar holdings to maintain market exposure
- Those realized losses get banked and carried forward indefinitely – they become ammunition to offset the capital gains that will come when the properties sell
- The goal is to build a meaningful loss reserve over 2-3 years before the first property sale. The earlier we start, the bigger the offset when we need it
- Meanwhile, the portfolio itself is still invested and growing. The losses are a tax benefit, not an economic one – the account value doesn’t go down just because we’re harvesting
- Depreciation recapture is the most painful part of a real estate exit. It’s taxed at 25% – no preferential rate, no exceptions. On $680K in accumulated depreciation, that’s roughly $170K in tax before they even get to the capital gains
- If they have any charitable intent – and they do (they’ve been writing checks to their church and a few local nonprofits for years) – we can redirect that giving through a donor-advised fund for a significantly better tax result
- Here’s how it works: they contribute appreciated assets (stocks from the SMA or other holdings) to the DAF. They get an immediate income tax deduction at the full fair market value of the contribution, and they never pay capital gains on the appreciation
- That deduction directly offsets the depreciation recapture income in the year of sale. Instead of writing a $170K check to the IRS for recapture, a well-timed DAF contribution can meaningfully reduce that number
- They still control the charitable dollars – the DAF is like a charitable checking account. They can distribute to their church, their nonprofits, or any qualified charity whenever they want. The tax benefit is immediate; the giving happens on their schedule
- This isn’t a new expense. It’s redirecting giving they were already doing into a structure that creates a tax benefit at exactly the right time
- Selling all three properties in a single year would concentrate the entire gain into one tax return – maximizing NIIT exposure and stacking all the depreciation recapture on top of their ordinary income at once. The smarter move is to phase the sales across 2-3 tax years
- For each property, we evaluate whether a traditional sale or an installment sale makes more sense. An installment sale lets them receive the proceeds over time and recognize the gain proportionally as payments come in
- The townhomes might sell to a local investor for cash and close in year one. The first apartment building might sell via installment note in year two, spreading that gain across 5-7 years. The second apartment building sells in year three
- By staggering the sales and using installment treatment where it makes sense, we control how much income hits each year’s return, reduce the depreciation recapture piling onto their ordinary income, and give ourselves more runway to match gains against the harvested losses from Step 01
- Each sale is timed to coordinate with the DAF contributions from Step 02 and the loss harvesting from Step 01. The three strategies work together – not in isolation
- The tax-loss harvesting strategy from Step 01 doesn’t stop when the properties start selling. It keeps running in parallel – generating new losses each year to offset the gains being recognized from the installment payments and outright sales
- As sale proceeds come in, a portion gets reinvested into the SMA, expanding the pool of positions available for harvesting. More positions means more opportunities to realize losses when markets dip
- This creates a compounding effect: the property sales generate gains, but each gain is met with a corresponding batch of harvested losses. Over the full 3-5 year exit window, the cumulative offset can be substantial
- Once the properties are fully sold and the harvesting has done its work, the SMA transitions from a tax-focused strategy to a long-term growth portfolio – replacing the rental income with dividends, interest, and systematic withdrawals from a diversified portfolio they don’t have to manage
- The biggest fear for any landlord exiting is: what replaces the rent checks? $192K a year in net rental income is real money, and they need to know it’s not disappearing
- After the sales are complete, the combined proceeds – minus taxes (significantly reduced by the playbook) – go into a diversified portfolio designed to generate reliable income
- The portfolio blends dividend-paying equities, investment-grade bonds, and alternative income strategies to target a comparable cash flow. The exact mix depends on their spending needs, Social Security timing, and how much they want to keep in growth vs. income
- The key difference: this income shows up in their account every month without a single phone call from a tenant, a property manager invoice, or a surprise $40K roof replacement
- They go from managing 12 units to managing nothing. The portfolio does the work. That’s the whole point
This case study is a fictional example created for illustrative purposes only. It does not constitute investment advice, financial planning advice, tax advice, or a recommendation of any specific strategy or product. Every individual’s financial situation is unique. Please consult a qualified financial advisor before making any financial decisions.