#2 of 5: Are 1031 Tax Benefits More Important Than Personal Goals?
There’s more to life than just minimizing taxes! 1031s may offer flexibility to achieve a blended compromise when sensible.
Q #2 of 5 Questions to Answer Before Engaging in a 1031 Exchange.
Last week I started a series titled “5 Critical Questions to Answer Before Engaging a 1031 Exchange”. In my first post, I offered tips related to the importance of having well-defined planning objectives to help you make suitable decisions with how 1031s may help. If you haven’t read that yet, you might want to go back and give it a look. A foundational process for evaluating options and desired outcomes can be helpful making other questions much easier to digest!
With that in mind, let’s move on to Question number 2!
What would I do with my property’s sales-proceeds if I wasn’t facing taxes?
Another way of asking this question might be, “Do I still want to be in real estate as an asset class after I sell my investment property?” Or, perhaps, “Am I better served by just being taxed and using the sales proceeds for something other than real estate, like living expenses, college education… or a new boat?”
The idea behind this question is to clear one’s head about real priorities. It’s an exercise in dreaming a bit, which can be valuable to help clarify the order of priorities in our lives. When we envision what we might really want, suddenly our choices and actions become better defined. Once those priorities are fully considered, then it’s important to weigh them through the lens of the possibilities provided by 1031s. That naturally includes the tax benefits and flexible nature of 1031s.
When they make sense, 1031 Exchanges permit substantial tax-deferrals that can be very valuable on appreciated property. Hence, candidates want to make sure they understand those advantages, some of which are indirect to the 1031.
Those includes tax deferrals that may, ultimately, lead to the functional forgiveness of accumulated cap gains for the next generation as part of an estate plan. In that case, it’s important to know that heirs of investment property presently earn a valuable step-up of tax-basis when you die, a benefit that applies generally to most investment assets. A property that may have the legacy tax-benefits of several 1031s from a chain of previously owned properties could, therefore, have that old basis reset to a market value determined as of the owner’s date of death. It could then be sold by heirs any time thereafter using a comparatively friendly tax basis.
That means heirs (rather than the government) get to inherent what would have been paid in taxes if the parent's generation of owners sold that property a few years earlier. Heirs are then free to reinvest the proceeds in whatever asset class they prefer without feeling handcuffed to remain in Real Estate, as is the requirement for 1031 deferrals. Of course, whatever investment real estate they retain or acquire will be eligible for 1031s into the future.
There are other potential tax-benefits related to charitable giving, and so forth, that might also be helpful. Would you prefer your favorite charity receive what you would otherwise pay in taxes if you sold the property? That may be an option to consider. What’s the best way to maintain your deferral until you donate? What’s the easiest property to donate? All questions that can affect how you structure a 1031.
Whatever the case, those are potentially powerful advantages captured in the aphorism “swap until you drop” common to the 1031 industry. But to experience that full advantage also requires the sacrifice that 1031 Exchangers must always continue with some form of like-kind real estate. Is that what you really want? Does that meet your risk or cashflow needs? Or are there other plans you’d prefer for some or all those proceeds, even if that means being taxed on a transaction?
The only answers that make sense are what’s right for your situation. Hence, the importance of Question #1 in our series.
A nice thing about 1031s, however, is that they are not an “all-or-nothing” proposition. That means you can do a partial 1031 to retain some deferrals and allow the remainder to be taxed and used for other goals or more suitable investment strategies.
Likewise, a 1031 deferral doesn’t have to be forever. You could do a full or partial exchange with your present transaction and proportionally defer taxes knowing that sometime in the future from now you’ll need partial liquidity of those proceeds for purposes other than owning real estate. Depending on your timing need, you would then proportionally use a new 1031 as merited.
Of course, you’d have to carefully consider the associated investment risk relative to your goals. For such planning, it’s therefore good to work from a foundation of confidence the direction and outcomes you’re trying to achieve since different types of replacement property may be more suitable than others for achieving your goals.
For example, meeting cashflow objectives might include using passive, professionally managed real estate projects via Delaware Statutory Trusts for some or all of your 1031s. Different DSTs will typically offer various time-horizons, leverage amounts, return projections, and risk profiles for their planned life-cycles. At the projected full cycle, the DST would sell the property it holds for a cash distribution, creating a liquidity-event for investors.(1) Those proceeds would then be eligible for a fresh 1031 Exchange, or whatever else you’d like. Those events are often targeted from three-to-ten-years from when the DST fund closes to new investors, sometimes longer depending on the DST. That would permit an investor to roughly align a projected DST holding-period with their personal goals, subject to risk tolerances.
Other DSTs might be designed to provide a conversion option form their property via a legal structure that’s called a Section-721 UPREIT, as early as two-years into the program. The new asset would be a REIT and would permit incremental sales as needed. This would provide more flexible cashflow potential than having to wait for a full-cycle liquidity event with an ordinary DST, which might be 5-10 years later. It would also avoid the costs, delays, risks, and hassles of having to put directly-owned investment property on the market with hopes of being able to sell it at a fair value in time for needed cashflow.
However, UPREIT liquidity comes with a cost. While conversions into them carry forth the tax-deferral of the original DST, thereafter all distributions are fully taxable and no longer eligible for 1031 Exchange treatment. When portions of an UPREIT are liquidated, previously deferred gains become taxable, and that’s that. Although, any portions not liquidated earn a step up of basis.
An intended UPREIT conversion option is potentially advantageous for those who want eventual liquidity and incremental control when those taxes occur. Keep in mind, that’s compared to the “all at once” tax-event that would occur via a straight sale absent a 1031 Exchange. Hence, some investors find it advantageous to put a predetermined portion of a 1031 into UPREIT conversion DSTs based on their cash-flow-needs projections. The remainder might go into longer-term DSTs that protect potential 1031-eligibility, or into directly-owned property, or just have a portion simply taxed. It could also be any combination of those options via the same 1031.
It’s also important to note that there are never any guarantees that any replacement property, active or passive, will go as planned. Liquidity opportunities can occur earlier than expected or be delayed indefinitely. DSTs are also specifically required to conform with maintaining 1031 eligibility requirements unlike other forms of real estate ownership, which can add to complexity and also affect outcomes.
It’s also critical to fully embrace that, despite how well real estate has done for several decades and how quickly it recovered from prior crisis, there are never any guarantees. COVID-19 is presenting unprecedented stresses to the entire economy, including real estate. There is great uncertainty in terms of rent and lease security and how various sectors may have changed and may be forever reshaped. It’s also causing a vast recalibration in terms of how business and individuals view investment real estate, which cause a new era of recalibrated cap-rates in sectors losing popularity. Should you be looking elsewhere? How much risk should you really be taking relative to the safety of achieving your goals? Are there better options?
With all that in mind, let’s get back to the premise of Question #2: What is it that you really want to achieve after you sell your investment property? Is it retirement? Is it more travel? More time with the family? Moving to a different region? A change of career lifestyle?
What about your legacy planning? How much should go to heirs? What about charity? Is a small family-related Foundation sensible? The possibilities are boundless and unique to each of us, and those answers are what should govern to what degree if and how you might use a 1031 Exchange, all the way down to which replacement property choices are better for different strategies.
As I noted at the start of this article, Question #2 invariably brings us back to the foundational importance of Question #1 covered in the first article in this series. Being organized with valuable information can help quantify your options and aid in forming goals that are both meaningful and more realistically attainable. Having those answers, along with the metrics of what’s required to achieve them, is an enviable position from which to evaluate 1031s.
That’s a lot to cover on your own, especially if you’re under the stress of a looming closing-date or facing deadlines as you decide to complete the 1031 you’ve started. Contact our team of 1031 professionals for a no-obligation consultation or to gain insight to questions you have!
Johannes Ernharth, AIFA® is Mid-Atlantic Regional Director of Asset Strategy, a Private Wealth Management firm whose advisors take a fiduciary-driven, goal-oriented approach to become thought partners with their clients. He specializes in 1031 Exchanges and potential replacement property strategies.
(1) Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
This is for informational purposes only, does not constitute as investment advice, and is legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. There are material risks associated with investing in real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor.
Securities offered through Concorde Investment Services, LLC, member FINRA/SIPC Insurance offered through Asset Strategy Financial Insurance Agency, Inc. (ASFG) Advisory services provided by Asset Strategy Advisors, LLC (ASA), a Registered Investment Advisor. CIS is independent of ASFG and ASA.