What is a 1031 Exchange?
Real estate income property is a wonderful asset for many folks. It has been a resource that has provided the foundation to building wealth for decades. After all, it can produce income, tax benefits and appreciation. That is quite a triple threat!
Please read to the end of this post as I have a time sensitive offer for my readers at the end.
Why Doesn’t Everyone Invest in Income Producing Property?
If it does all those things, why doesn’t everyone do it? First and foremost, to succeed in real estate investing, it helps to be actively involved. That means all the stuff that landlords do; maintain property, rent the property, evict tenants, repairs, crisis phone calls, pay taxes, keep insurance up to date, etc.
Most people today don’t have the time or the inclination to be that involved in their portfolio, so they use assets like stocks, bonds, etf’s and mutual funds since they are easy to buy and sell, and don’t require a lot of maintenance on the part of the owner.
So, Rents Produce Income, What is the Problem?
Yes, as long as tenants pay, rents will produce income. For most long-term real estate investors, their biggest headache is re renting a property. Not only do you receive no income while the property is vacant, you usually have to put money in for repairs and maintenance to prepare the space to be re rented.
The other big headache is that until they move in, you may not find out if the tenant is going to be a good one or a nightmare! As a result of this annoying reality, many landlords will not raise rents to market rates when they find a good paying, low maintenance tenant. Its that old “the devil you know is better than the devil you don’t know”.
This means that for many, especially here in the bay area, rents have not gone up as much as property values have. This means that your cash flow is lower than it should be. Lately I have seen many properties only providing a net cash flow (after taxes and all other expenses) of 1-3% on their equity!!
Besides that, most of my clients who have owned income property for decades get tired of being a landlord. They get tired of dealing with tenant complaints, taxes, maintenance and repairs. They just want to enjoy their life and live off the wealth they have built. Whether it is travel, volunteer work, learning new skills or just hanging out with friends and family, most of them no longer want to devote time to property management.
Now you are probably thinking: “I can just hire a management company to take care of it”. While conceptually true, the reality can be far different. It is very hard to find a competent, caring, responsible and honest management company (just ask your friends and family members who have tried).
If you are lucky enough to find one, just remember, you will need to pay them, further reducing the cash flow you will get from the property. And even having this buffer in place, if anything big happens like losing a tenant or having a repair that costs more than a minimal amount, the management company will need to contact you and there you go, back in the thick of it.
So Why Not Just Sell?
If someone approaching or in retirement isn’t getting enough income from their property to live the life they want and they are tired of dealing with the property management part, why don’t they just sell?
Well, if you sell a property you have owned for a long time, there will likely be significant taxes to pay. If the property has appreciated, there will be capital gains taxes to pay.
Here in California, between state and federal taxes, that can range to over 30%. There is also another tax, it is called depreciation recapture. While you own the property, you must take depreciation deductions against the income from the property. That depreciation deduction reduces your cost basis and if you own it long enough, eventually the cost basis will be ZERO!
That means when you sell it, all the proceed above that reduced cost basis is taxable. The amount that came from depreciation is taxed at a rate even higher than capital gains!!
The flip side is that when the owner of the property dies, the depreciation and gain are wiped out for tax purposes and the “cost basis” is “stepped up” to the market value at the time of death (or the alternate valuation date). So if your heirs sell, they will only pay tax on the amount above the value when they died. This fact alone has many people making sacrifices so that the kids will get the ‘step up.’
The Good News is, There are Options That Address All of These Issues
Income property investors do have an option to do a tax deferred exchange, which works a lot like rolling over your IRA or 401k, you move to a new investment, but defer the tax. Like a rollover, you must follow some very specific rules when making this move, or you could inadvertently have your transaction DISQUALIFIED, which could result in a huge tax bill!
The exchange opportunity is called a 1031 exchange. As I wrote in a previous post, this exchange defers taxes and the new property will have the same cost basis as the old one, unless you buy a more expensive property, and will also get an increase in cost basis upon death of the owner.
Well that addresses the tax issue, but what about the low cash flow and management headaches?
Well you can address both issues by using a tool called a ‘Delaware Statutory Trust’ (DST). This tool allows the investor to exchange into a property that is usually much larger and more profitable for the owner. They can even diversify into a variety of real estate classes to diversify risk, both by type of property and locations.
The investor enjoys professional management and free cash flow of 5-6% or more today based on the type of real estate being purchased. Today we have things like multifamily, self-storage, medical office, necessity based retail, and even health care hospitality.
These are recession resistant categories, there are others that might pay more, but could be vulnerable during a recession. The types of properties mentioned above should perform better in a recession than something like retail or office buildings that can increase vacancies if the economy slows.
Free 1031 Exchange Workshop in San Rafael
I will be hosting a workshop on May 7 in San Rafael. We will be teaching about developments in 1031 exchange strategies, especially considering the changes in the tax code from December 2017, and how you can use the tool of a DST to avoid boot in an exchange, increase retirement income and circumvent taxes.
The workshop is free and will go from 11:30 until 1:00pm. We will have a guest speaker who is an expert in this area and we will be serving lunch!
If you have a direct investment in income property or have friends who do, this workshop will provide you with knowledge about options available to help you achieve retirement goals, so you can make better decisions. The program is focused on education around 1031 so you will have more confidence in understanding your options.
We look forward to seeing you there and helping you understand options for you to Retire Happy!
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.