| A delightful couple owned a piece of rental real estate for over 30 years. The desire to be free of being a landlord and to have a significant portion of their wealth in one piece of real estate led the clients to sell the property. Over the years, the clients had used debt on the property to fund various projects and expenditures. The property, therefore, was fully depreciated but remained tied to a significant mortgage. Being fully depreciated, in addition to seeing a nice price appreciation, meant that there would be a large tax bill upon the sale of the property. The clients sought advice on what their best option would be.
We identified several options:
1. Pay the tax.
2. Complete a 1031 Exchange into another local piece of real estate.
3. Complete a 1031 exchange or to multiple Deferred Sales Trusts (DST), in which each held one leveraged property.
4. Complete a 1031 exchange program resulting in owning a Real Estate Investment Trust (REIT) after two years.
Each option had various advantages and disadvantages, which we discussed with the client.
Pay The Piper
The outright sale and payment of the taxes would have given the clients maximum flexibility in their future investments. However, due to the property’s debt, the clients would have had approximately 65% of the sale proceeds go to the Federal and State governments to pay the Capital Gain and Depreciation Recapture taxes. Being left with about one-third of the sale proceeds would have prevented the clients from enjoying the lifestyle they have been accustomed to enjoying.
1031 Exchange
A 1031 exchange is a transaction in which the IRS allows real estate investors to liquidate one investment and reinvest the proceeds into another investment. By completing the 1031 exchange, the investor can continue to defer the taxes due. Then at death, these investments could qualify for a step-up basis, resulting in the surviving spouse or the heirs having little to no tax owing—any sale proceeds not reinvested through the 1031 exchange become taxable. Therefore, in our client’s case, the debt on the property also had to be considered.
Due to the property’s value, the local real estate market offered limited options. Additionally, the required deadlines set by the IRS made this option difficult, as local properties were not targeted before the sale. Finally, a local property would not fulfill the goal of exiting the role of landlord.
The option of investing in individual DSTs accomplished the deferral of taxes in addition to generating income from dividends. However, the selection of properties was once again challenged by the debt held on the property because specific DSTs had to be selected to cover all the equity and debt of the property. In addition, the individual DSTs are illiquid investments that the investment manager will eventually sell, forcing another 1031 exchange or the tax to become due at some future date. Finally, the individual DSTs also carried the risk of having a significant portion of the client’s net worth tied to one piece of property.
The final and preferred option was a multi-step process that resulted in the clients owning shares in a multi-billion-dollar REIT that held properties across the US and spread over various sectors and industries. This option resulted in lower dividend yields and a lack of liquidity for the first two years. However, beginning in year three, liquidity and dividend yields improved more income from the dividends, and they could partially liquidate REIT shares. The sale of the shares of the REIT would result in a portion of the deferred capital gain being realized, but the tax would be significantly lower because not all gains were realized in one year.
At AEGIS Financial, we are not swayed by product commissions or incentives. Instead, our interest is in finding the right solution to your problems. By laying out various options and educating them on the advantages and disadvantages of each option, we were able to help our clients defer a significant tax bill while providing the income to fund their retirement. |
