How Income Property Can Help You Retire
Investment real estate has long been one of the best ways to build wealth in America. It generates income, enjoys tremendous tax advantages and can grow in value.
On the other hand, it also can shrink in value, although there has been a tendency for prices to rise over longer periods, especially here on the west coast.
Advice from a Financial Advisor
There is a problem that most of my clients who have owned properties for decades face. Over time, most owners and landlords want to minimize turnover in tenants. After all, when you have a tenant leave, it usually costs money (paint, repairs, modifications, upgrades, etc.) in addition to losing out on getting the rental income from a tenant that you are counting on for your income.
So, when you find a solid, low maintenance, reliable tenant, there is a tendency to want to keep them happy and paying. In order to keep a great tenant, landlords frequently limit the rental increases to less than market rates.
This strategy rewards the loyalty of the tenant for their length of tenancy and makes it harder for the tenant to justify increasing costs by moving.
The unfortunate byproduct, especially in many parts of the west coast, is that property values have increased more rapidly than rents. When this happens, your cash flow as a percentage of the property’s value goes down.
I have seen many people over the last 20 or so years, who are only getting 1-2% free cash flow (net income after expenses). When they tell me they need more income, in the next breath they tell me they can’t sell the property because they will have to pay too much tax if they do!
All of those tax breaks, like depreciation, are “recaptured” upon the sale of the property and will trigger a tax under section 1250, in addition to capital gains taxes on the balance of the profit on sale. Next they will tell me that if they keep the property until they die and pass it on to their heirs, the property will get a “step up in basis” and can then be sold, dramatically reducing the taxes to only the amount above the valuation on the date of death of the owner ( or the alternative valuation date), so they are ‘stuck between a rock and a hard place’, they want more income, but don’t want to deal with new tenants and they don’t want to sell and pay taxes.
Instead of Being Stuck, There are Options
Is there a way out of this dilemma? The short answer is that there are several. The most common, and what we are going to discuss in the rest of the article, is the 1031 exchange (referred to as a “Starker Exchange” or “like kind exchange” by some), which allows someone to sell a property and rollover their cost basis to a new property, postponing the tax on their gain and retaining the ability to get the step up in basis upon death. By exchanging into a new property, the investor has the opportunity to increase their income with the new property.
Other options can be explored through the use of qualified charities, foundations, or donor advised funds. We will not explore those in this discussion. If you want to look into those options, give the office a call and we can discuss them.
The Other Side of Owning Property in Retirement
The other big issue that clients tell me is just the demands of being a landlord. Even if you have a quality management company (hard to find in my experience), if there is an issue like toilets backing up or the refrigerator breaking, the tenant or management company will still have to call you to authorize repairs. This isn’t such a big deal when we are young, but as my clients get into their 70’s, many do not want to be bothered with those calls.
Can Both Issues be Addressed Together?
So, is there a way to avoid paying taxes, pass the property to your heirs while getting the step up in basis, AND avoid the headaches of direct ownership, while increasing income?
While that is a mouthful for one sentence, the answer is YES!
There is a product that, in addition to qualifying for a 1031 exchange, will address the issues of increasing income and reducing the burden of managing property. It is called a “Delaware Statutory Trust” or DST.
This tool is a structure where we use professional managers to manage larger properties and the exchanger owns a fractional interest in the DST that holds the asset. These can be invested in any type of income property.
I have clients who own parts of multi family developments, office buildings, supermarkets, retail centers, self-storage and even medical office buildings. By using this tool, they have been able to invest in strong geographical areas that offer better returns than one might find in our area. In most cases they have diversified beyond the few tenants they currently have to more and stronger tenants to depend on for their income, making the income more stable.
DST’s currently yield anywhere from 4.75% up to 7+% depending on the type of property and its location. They also come in a variety of loan to value scenarios. This is important when doing a 1031 exchange as the new property must have at least the same percentage of debt as the property being sold, otherwise there could be a tax generated.
Additionally, the rules for an exchange are very detailed and about 20% of them fail because the rules were not properly followed. This is why we use a QI (Qualified Intermediary), to facilitate the transaction and make sure it complies with the rules.
Why is This Important Now?
This area has been very strong for a number of years and many real estate investments have done very well over the past 10 years. I talk with a lot of realtors and they tell me that prices seem to have been topping out over the past year and are starting to go down.
This is due to a number of factors. Interest rates have been going up, many of the foreign buyers who were paying cash as recently as a year ago have been pulling back due to trade wars and new capital restrictions that many countries have put in place, and general nervousness about the economy going forward (potential recession in the next couple of years).
This means that the coming year might be the best opportunity to reposition your real estate investments for quite some time.
A Quick Example
Several years ago, a couple was referred to me that owned a small apartment building here in Marin County. They had owned it for nearly 50 years. It was purchased for about $160,000 and thought it was worth about $1.8m. They were coming up short about $40,000 per year for their income and had spent much of their other savings to fill in the gap. We were in a period where lenders were not willing to do cash out second mortgages and the penalty to refinance the first mortgage and take money out of the equity was almost 18%!!
Originally, they wanted to sell and have me invest the proceeds to provide greater income. Well, when we figured out how much they would clear after paying off the mortgage, paying the income taxes on the gain, they would be left with only about 40% of the selling price for investment. This would have given them about the same income they were currently getting from the property, but not increased to provide what they were coming up short every month. By doing an exchange into a portfolio of DST’s, they almost doubled their income, avoided tax (they are earning income from the money they would have sent to the tax man), and greatly reduced their day to day involvement with managing their property.
Avoid a Failed Exchange
Since the exchange rules are very specific under 1031 and you only have 45 days to “identify” the property you will exchange into in order to qualify (45 days!!), there can be concerns about removing contingencies (property inspections, appraisal, financing, etc.), many folks will “identify” a DST as a backup property so that if the desired property doesn’t close on time (180 days) you can use the DST to continue the tax deferral. You can also use the DST to avoid taxable “boot” if the property being purchased was of a lower value than what you sold.
If you are holding a piece of property and any of the above describes you, you may want to consider taking advantage of current valuations and financing options before things get worse and look to sell your property now and move to something more “recession resistant” that pays you more, with fewer headaches for you.
This article has been an overview of a very technical area of financial and retirement planning. If you would like to get more detailed information or explore any of the topics and strategies discussed as it pertains to your individual situation, contact us and we can discuss.
Roger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance and a Certified Paralegal for Estate Planning.