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Practice Management

Peripatetic retirees may find tax relief in property exchanges versus outright sale of their real estate holdings.

This Practice Management article is intended for financial advisors only (registered representatives of broker dealers or associated persons of Registered Investment Advisors).
 

The coming wave of baby-boomer retirements is likely to trigger a related shift in the real estate market. As clients retire—and relocate—you may find yourself discussing what to do with a snowbelt investment property held for many years, which a client doesn't want to manage from the sunbelt.

"We see a lot of that here," says Paul Auslander, chairman and CEO of American Financial Advisors in Orlando, Florida. "Many people in that situation are interested in a tax-deferred exchange, rather than paying tax on a sale." That, in turn, may draw more attention to property exchanges spelled out under Section 1031 of the tax code.

Even though property values have plunged in many areas from their 2006 peaks, selling may still trigger a huge tax bill. Investment properties are depreciated each year for tax purposes—so long-held real estate might have scant basis, or none at all. Most or all of the sales proceeds may be subject to income tax, and prior depreciation might be recaptured at a relatively high tax rate.

"The tax bill can be surprising," says William Jordan, who heads a wealth management firm in Laguna Hills, California.

Here's how a so-called 1031 exchange might work: A retiring investor from Las Vegas sells his strip shopping center and lets an unrelated intermediary hold the proceeds. Then the seller arranges for the intermediary to buy a medical office for the investor in Dallas, using the money held from the previous sale. The double transactions let the investor avoid paying tax now; he might be able to hold the replacement property until he dies and the income tax obligation vanishes.

"Deferring taxes by using a tax-free exchange allows 100% of the dollars to be reinvested," says Rob Studin, executive director of financial advisory services at Lincoln Financial Advisors in Birmingham, Ala. "Assuming some basis, an investor who sells and doesn't exchange might have 85% to 90% to reinvest after tax."

Key Factors
Clients considering a 1031 exchange should consider many factors—from existing diversification to life expectancy, as well as taxes. But psychologically, the weakened real estate market may be the most important issue.

"First, investors must be comfortable selling now," says Chet Ju, co-owner (with his wife Shirley) of 1031 Investment Solutions in Natick, Massachusetts. "Property values are down and a lot of investors don't want to sell at today's prices."

The flip side, of course, is that today's seller also can be today's buyer, finding good value in a depressed real estate market. "The real estate market is better now, so there are opportunities for investors," Jordan says. "I told folks to get out of real estate in 2006, but now I'm a buyer, not a seller."

Beyond soft property prices, Studin says planners need to go back to basics: "Does the client have sufficient liquidity? Because real estate is almost always a long-term investment. How big is the taxable gain in relation to the property? If it is a very low basis property, gravitating to an exchange makes more sense. Diversification is also an issue," he adds. "If the client is overly heavy in real estate, taking the tax hit to create some negative correlation may be appropriate."

If a client is older or in bad health, deferring a gain via an exchange may make sense in order to pass along to heirs the higher basis value, according to Studin. If that Las Vegas investor has a short life expectancy, he might defer the gain via an exchange to a Texas property. At his death, assuming current tax law still applies, he can leave the Texas property to his children, who'll get the property's date-of-death value as their basis, avoiding deferred income tax. (Estate tax will still apply.)

Focus on Economics
But ultimately, Studin says, the most important issue is whether the deals actually make financial sense. "If the economics are good, then it makes even more sense if I have extra dollars to invest, because I don't have to pay taxes now... The tax deferral is a great bonus." Taxes shouldn't be that much of a consideration, however, if clients don't find the right reinvestment property.

Studin tells of one client, age 83, who recently had an office building seized by her state under eminent domain. "She received $2 million for it," he says, "of which $1.4 million to $1.5 million will be taxable, because she had some basis in the property. The tax will be a significant amount so she'd like to defer it. At her age, there's a good chance her heirs will be able to inherit with a basis step-up."

On the downside, the amount is a significant portion of her net worth, which Studin is reluctant to tie up in a single property. "If we could get diversification and find properties where the economics are favorable, I might suggest it. So far, though, I haven't found anything that works, so I may recommend that she pay the tax."

One other issue that can be a problem for 1031 exchanges: timing. To qualify for tax deferral, a seller must identify replacement properties, in writing, within 45 days of the sale. Up to three possible replacements can be named; more than three can be named if the total value is no more than twice the value of the sold property. Perhaps more difficult, the new property generally must be acquired within 180 days.

"As a backup," Jordan says, "I'd suggest putting a professionally managed deal on the list, if an attractive one is available. Then, if buying a particular replacement property within the time limit isn't possible, the seller can defer the tax by buying into the multi-owner deal."

Teaming Up
Such co-ownership ventures, actually private placement securities, are not just for deadline desperation. "Co-ownership offerings are especially attractive for real estate owners who have held the property for quite a while and no longer want to deal with the so-called Three Ts: tenants and trash and toilets," Ju says. "The owners may be relocating, so they don't want to manage their old properties long distance, but they also don't want to be hands-on managers in their new area."

These deals typically involve one or more high-value, institutional-grade parcels, such as retail space leased to a chain. The deal's sponsor is responsible for property management, and the deals are usually structured so that multiple owners are involved; often they're designed to attract investors pursuing a 1031 exchange. "They usually pay cash flow to investors," Ju says, "often in the 6% to 7.5% range these days." As with any type of sponsored deal, there are costs, so investors might see lower returns than if they dealt with the Three Ts themselves.

Multi-owner exchanges became popular about a decade ago, often with a tenancy-in-common (TIC) structure. Now, Ju says, TICs have been largely replaced by Delaware statutory trusts (DSTs). "The main reason relates to financing," he says. "Banks today don't want to do a credit check on each individual owner, as they had to do with a TIC offering. With a DST, the bank makes one loan, to the entity owning title to the property or properties."

To a property owner, the deals look similar: tax deferral, cash flow and passive management. However, as Ju points out, a DST investor has less control over the properties than in a TIC. "The trustee decides when to sell a property, for example," he says. With the TIC structure, investors have the right to vote on sales and refinancings.

Ju concedes DST interests are illiquid, but says that's true for any property investment. "With a DST, at least, you may have 50 other owners who are familiar with the real estate," he says. "At the right price, one of those owners might be willing to buy an interest from someone who wants cash."


Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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