With the recent dramatic run-up in real estate prices, many investors are selling their properties to take advantage. Other investors routinely sell rental properties to get out from under the burden of operating and managing property.
The recent reduction in federal capital gains taxes from 20 percent to 15 percent makes such sales a little more attractive than in prior years. However, many investors do not wish to get out of real estate entirely. Others would like to keep their money working without paying capital gains taxes.
The standard solution to both of these objectives is the 1031 exchange. A 1031 exchange allows a seller of a capital asset to buy a replacement asset of a similar type without paying capital gains taxes. The cost basis of the sold asset is transferred to the new asset.
The new asset continues to generate income and gains, and tax is only paid upon the eventual liquidation of the final asset held. This deferral process can allow an investor to accumulate wealth more rapidly, even at the same rate of return as an investor not using this tactic.
Before contemplating such an exchange, you should first know that the replacement asset must meet certain IRS qualifications. Generally speaking, the exchange of one commercial or rental property for another will qualify. There are other rules about how to handle debt and equity, but an investor seeking to accomplish a rollover can generally make one work.
The tough part about 1031 exchanges is finding a new property. You have 45 days from the sale of the old property to identify the new one, or a few potential new ones. You have 180 days to actually close the sale of the new property. Talk to your tax or legal adviser for all the details.
An investor seeking to find an attractive replacement property is in a quandary. If the investor sold a property because they were tired of managing it, why would they want to buy another? They would merely exchange one headache for another.
Another investor might have sold because she thought the market was too high, and that rental income was too low relative to the building’s value. That investor will have a tough time finding a better yielding building somewhere else locally.
A potential solution to both of these problems is growing in popularity. Investors can buy a share of a larger property from a syndicator or sponsor. The sponsor arranges for the purchase of a property that is built and leased. Investors each buy a tenant-in-common interest in the property, or TIC. That is, each investor owns a fixed percentage of the whole building. The investor actually receives a deed for their TIC share of the building.
The program sponsor operates the building and pays out the net cash flow to the investors each month. The tenant-in-common offerings I have reviewed show cash flow projections yielding seven to nine percent. If the building is ever sold, the investor will receive a proportionate share of the net proceeds. Depreciation benefits can pass through to certain types of investors.
These TIC real estate investments can satisfy four basic needs:
1. They can allow an investor to avoid paying capital gains taxes while still disposing of an unwanted asset.
2. The right TIC deal can provide a stable stream of monthly income.
3. They allow an investor to remain in a real estate investment, but get out from under all of the management responsibilities.
4. Finally, they can allow an investor unsatisfied with local real estate opportunities to invest in other markets across the country.
TIC real estate investments have a few drawbacks. They generally will not pay as high a total return over the holding period as a direct real estate investment. This is the price one pays for the simplicity involved. Another drawback is the uncertain liquidity of the investment. While the TIC interests are freely transferable, there is no well-established national marketplace for the resale of shares. An investor needing to liquidate such holdings might have to suffer a long and inefficient sale process.
I am always cautious to not let the tax tail wag the investment dog. I would not suggest a TIC investment simply to avoid taxes. But, given the rather depressed potential for returns on bonds, commercial real estate continues to look at least as attractive as stocks. A 1031 exchange accomplished by way of a tenant-in-common deal can be a very attractive alternative for many investors.
As always, please see your adviser before making any of these investments. And please – please – read the entire prospectus. Every deal I have reviewed is different, and there are sneaky little time bombs lurking in some of them.
Rick Ashburn is a chartered financial analyst and certified financial planner, and is president of Richard Ashburn Investment Counsel in La Jolla. Write to him at firstname.lastname@example.org or 1224 Prospect St., Suite 130, La Jolla, 92037.