Exit Strategies for the 1031 Exchanger

Read comments | Add comment / Rate this Article

Article by: Sun 1031

Many real estate investors have come to appreciate the power of compounding tax dollars through 1031 exchange to maximize growth in their real estate investment portfolios. As these exchangors work their way through the real estate investor lifecycle, they utilize the tax benefits of IRC 1031 to first accumulate a portfolio of larger more valuable properties, with the final phase of this investment cycle being geared more and more toward exchanging into “income producing properties” to provide and/or supplement their retirement income. Throughout this lifecycle savvy investors continue to exchange their equity forward, deferring the capital gains taxes while also reducing their cost basis by depreciating the property to maximize cash flow. The end result for many successful investors is a large portfolio of real estate in which they have accumulated substantial capital gains. Add to that the 25% recapture rate for the depreciation taken and these investors are faced with the same perplexing question.

“How does a successful real estate investor ever retire from the day to day management burdens of income property ownership, without having their equity substantially reduced by the accumulation of capital gains taxes owed upon liquidating their properties?”

As this is a daunting question, many investors find themselves holding onto labor intensive income properties much longer than they would like, due to a “perceived” lack options. Therefore, it is very important that real estate investors carefully consider their options and devise a plan prior to finding themselves faced with this decision. With this in mind, here are three options available to investors seeking to retire from the management burdens associated with income property ownership.

The first option is to pay the taxes owed, moving the remaining equity into traditional income investments such as certificates of deposit, bonds or annuities. This is the worst possible scenario for most, as the combination of lost investment dollars (the combination of capital gains tax and depreciation recapture are often times in excess of 40% of the equity the investors have worked so hard to build) and the poor returns currently offered by traditional income investments leave the investor with the lowest possible retirement income and little if any upside for the remaining principle they have invested.

The second course of action is a section 202 property reclassification. In this scenario, the investor exchanges into his “dream home” with the intention of eventually occupying the property. After acquiring the home, the exchangor must hold the property for investment (rent the property) for up to 3 years (obtain advice from your tax preparer to determine the appropriate minimum holding period) prior to occupying the home. Then after having occupied the home for at least 2 years as their primary residence (must also have been owned for at least 5 years) the exchangor can sell the home and take an exemption of $250,000 if single or $500,000 if married against the capital gains owed under section 202 of the internal revenue code. This strategy requires careful planning and can be especially difficult to facilitate if the investor owns multiple investment properties. Furthermore, the exchangor will be limited to offsetting a maximum of $250,000 to $500,000 in gains respectively.

The third option is not so much an exit strategy as it is a life long investment strategy, designed to help investors avoid ever having to pay capital gains taxes. To avoid ever paying capital gains taxes savvy investors embrace what is known as the swap-til-you-drop philosophy. This philosophy revolves around the concept of exchanging into investment property that provides a more passive management role for the owner and then passing their investments to their heirs with a stepped up basis. When real estate is inherited, the heirs receive the property at the current property valuation as their cost basis and therefore can sell the property without any of the previously accumulated capital gains taxes being owed.

The most common “passive income” real estate investments include Triple-Net-Lease (NNN) commercial property and Tenant-In-Common (TIC) investment property. In a NNN leased commercial property, the tenant or tenants leasing the property are responsible for all of the expenses related to the ongoing operations, maintenance and taxes for the property. The leases are typically written for longer periods with periodic increases (often called steps or bumps) in rent to offset the effects of inflation on the income produced by the property. The structure of NNN property alleviates much of the management burden associated with ownership and hiring a professional property management company can further reduce the responsibilities and work performed by the owners. When considering NNN property it is important to note that a “single tenant” property is considered to be among the riskiest commercial property investments, due to their dependence upon the single tenant to derive income.

Tenant-In-Common (TIC) investment properties are typically institutional grade commercial real estate, which have been structured for co-ownership by up to 35 investors. In most cases, these properties are structured with NNN leases and professional property management already in place, allowing the investors to enjoy a more passive ownership role. In this structure, each co-owner is issued an individual deed for a percentage of ownership in the entire property based upon their percentage of the equity invested. TIC property owners share in the income, appreciation and costs associated with the property respectively. The co-ownership structure of TIC property provides investors with the same property rights, benefits and risks as a sole property owner (tax-advantaged income, appreciation, depreciation, etc) for a relatively low minimum investment. The low minimum investment requirements provide average investors with the ability to invest in properties that were previously reserved for the very wealthy, as well as an effective means to diversify their real estate portfolios both geographically and across asset classes. Furthermore, in March of 2002 the IRS enacted Revenue Procedure 2002-22 to IRC 1031, which provided guidance on structuring TIC investments to qualify for a 1031 tax deferred exchange. The combination of the tax advantages and benefits offered by these properties has sparked tremendous growth in this segment of the market, with TIC properties rapidly becoming the most popular choice for investors seeking replacement property for their 1031 exchange.

When considering TIC property it is very important to do appropriate due diligence on the property as well as know the answers to the following questions: Has the TIC property been structured to be offered as a security or as real estate? Who is the sponsor company? (Principle investor structuring the TIC offering) What is the sponsor companies commercial real estate experience and track record? What are the costs (and/or hidden costs) necessary to facilitate the investment? With proper due diligence and planning, TIC properties can provide investors with the perfect strategy to both enjoy their retirement and keep all of their hard earned investment dollars working for them to the very end...

This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.

Comments on this article

Comments by Bill
Thorough explaination of the strategies available to investors who want to retire and don\'t want to deal with the \"day to day\" of property oversite.

Add a comment / Rate Article

Name

We never sell your information

Rating

Comments

Please enter the numbers in the textbox, you see here in the image