In uncertain financial times such as these, someone who is fortunate enough to have a buyer for one’s investment property, is faced with an important decision to make. The choice to be made, prior to the sale of your real property, comes down to,cash-out and pay taxes, or exchange into another property, and defer taxes. This is no small decision, as a significant portion of your proceeds from the sale could be lost to taxes, if you do not plan ahead.
Anyone who has owned investment real estate, whether a student rental, a small apartment building, an office building or a strip retail center, knows that two of the most demanding aspects of being a landlord it dealing with tenants and maintaining property. For many, being a real estate investor appears a Catch-22: you want out, but to get out you must give away the fruits of what you have worked so hard to build. Compounding the difficulty of this decision is forecasting whether commercial real estate has bottomed and whether you expect marginal tax rates to increase or stay where they are.
1031 Exchange. The IRS Code allows you to exchange one real estate investment asset for another while deferring the gain and depreciation recapture on the sale of the first property. With 15% federal capital gains tax, plus state taxes (4.63% in Colorado), plus the recapture of depreciation at your ordinary income tax rate, the potential for deferring taxes is huge……particularly if you have held the property for many years. On the sale of an investment property that has been held long enough to generate significant appreciation while a significant amount of depreciation has been taken, it is not unusual for 30% to 40% of the proceeds from the sale to be paid in taxes if the seller does not 1031 exchange into another property.
The IRS Code says properties eligible for a tax-deferred exchange must be like-kind. For real estate held for investment, that gives you a lot of latitude. An apartment building you own out-of-state can be exchanged for an office building in your state of residence. Raw land can be exchanged for a fully-developed building. Your 100% ownership in the building you are selling can be divided into two or three properties to create diversification. As long as the exchange is done properly the options for tax-deferred investments are limitless.
Replacement Property. Locating and securing your 1031 replacement property must be done swiftly, skillfully and knowledgeably. The replacement property must be identified in-writing within 45 days of the sale of your relinquished property, and then the closing on the purchase of the second property must occur within 180 days of the sale of the relinquished property. The process of selecting your replacement property should begin as soon as you know you have a solid buyer for your replacement property. You do not want to wait until day 44 to begin looking, or you are likely to come up empty handed.
If you are looking to let go of the hassles associated with being a landlord, then you should focus search on Net-Leased properties. Such properties can be purchased as fractional interests (also known as Tenant-In-Common (TIC) interests) or as ‘whole’ properties. Fractional interests are available in retail centers, multi-family housing, and smaller medical buildings, such as the one picture above. Generally, you will need a minimum of $50,000 in cash to purchase a fractional interest such as this.
‘Whole’ Net-Leased properties are often the separately-owned pad sites of larger retail centers. It could be the real estate for a Family Dollar, a Big-O Tire Store, Good Times Restaurant or a Starbucks. One of the classic Absolute-Net-Leased properties for the larger buyer is the real estate housing a Walgreens pharmacy. In general, you will need $500,000 or more in cash to purchase a quality ‘whole’ Absolute-Net-Leased property.
Obtaining Expertise. Your analysis of whether to sell or exchange begins with an assessment of your tax liability by your tax accountant and/or financial planner. If you decide to investigate a 1031 Exchange, two essential members of your team are, (1) an investment real estate broker who can provide you with and help you evaluate your replacement property options, and (2) a top-notch Exchange Qualified Intermediary, QI for short. With the right expertise, you can get a clear picture of your tax consequences, and if choose the 1031 route, you can preserve your hard-earned equity for yourself and your heirs.
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