,

How to Use Real Estate Exchanges to Improve Your Retirement Happiness!

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.

rental -income-property

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.

home-for-sale

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.’

tax-issues-retirment

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.

There is only seating for 25 so you need to RSVP in advance so we can save your place. You can RSVP by calling 415-331-9030 or send an email automatically by clicking here.

We look forward to seeing you there and helping you understand options for you to Retire Happy!

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.

investment-property

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.

investment-options

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.

couple-retired-hands

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.

Conclusion

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.