If you are a real estate investor, you are likely aware of the significant impact of capital gains taxes and depreciation recapture when selling an appreciated property. If you buy and sell multiple properties throughout your lifetime, these taxes have the potential to significantly hamper your long-term wealth-building potential.
For example, if you buy a property for $2 million and later sell it for $3 million, you will be subject to capital gains taxes on the $1 million gain. At a 20% long-term capital gains rate, you would need to pay $200,000 on the sale. Consider how much growth potential that $200,000 could result in if it had been invested in a diversified portfolio rather than sacrificed to the IRS.
Fortunately, there are two strategies that may allow you to defer capital gains tax on the sale of your investment properties, which I will discuss below.
Strategy #1 – 1031 exchange
Section 1031 of the Internal Revenue Code allows real estate investors to defer capital gains and depreciation recapture taxes by exchanging one property for another “like-kind” property. In order to qualify for a tax deferral, a 1031 transaction must be:
- Exchanged for a “like-kind” property –In order to qualify as a 1031 exchange, the two properties must be of the same nature or character. This is a broad definition, which typically allows most types of real estate to be exchanged for one another.
- Held within the United States – Only U.S.-based properties qualify for a 1031 exchange.
- Used for investment or business purposes –Both the relinquished and replacement properties must be used for investment or business purposes. Primary residences and second/vacation homes do not qualify for a 1031 exchange.
- Exchanged for a property or equal or greater value –In order to completely defer taxes, the value of the replacement property must be equal to or greater than the value of the relinquished property.
- Completed within certain timeframes –There are several specific timeframes that must be adhered to in order to qualify for a 1031 exchange.
- 45-day rule – You have 45 days from the date of the relinquished property’s sale to identify a replacement property.
- 180-day rule –You must acquire the replacement property within 180 days of the relinquished property’s sale. This timeframe runs concurrent with the 45-day window to identify a replacement. That means if it takes you 35 days to identify a replacement property, you will have 145 days to acquire that property.
1031 exchange pros
- Tax deferral –The main benefit of completing a real estate exchange is the opportunity to defer taxes that you would have otherwise paid on the sale.
- Wealth accumulation –Deferring taxes on your real estate sale allows you to invest and grow funds that would have otherwise been lost to the IRS. Over time, this practice has the potential to result in significant wealth accumulation.
- Estate planning benefits –1031 exchanges can be used to delay realizing gains on a sale, which in turn can allow you to pass property to your heirs on a stepped-up basis, which may allow those heirs to reduce or fully eliminate the embedded capital gains associated with the asset.
1031 exchange cons
- Complexity –1031 exchanges have strict qualifying rules and deadlines. It is wise to seek the guidance of a qualified financial advisor who can help you avoid potential pitfalls.
- Illiquidity –To fully defer taxes, you must reinvest all proceeds from your real estate sale into another real estate investment, which means these assets will be locked up for a period of time.
Strategy #2 – 721 exchange (UpREIT)
A 721 exchange, also known as an umbrella partnership real estate investment trust (UpREIT), is similar to a 1031 exchange in that it allows a real estate investor to defer capital gains and depreciation recapture taxes on a sale. However, rather than exchanging one property for another, the investor instead exchanges a property for operating partnership (OP) units in the UpREIT. The investor then holds the OP units for a minimum period of time, typically 12 to 24 months. During this timeframe, the investor enjoys the same benefits as if he/she held shares in the REIT, including dividend-like distributions.
UpREIT pros
- Tax deferral –UpREITs allow you to defer capital gains taxes for at least a year, and potentially longer.
- Liquidity –When the 721 exchange period is complete, you can request redemptions from the fund similar to selling shares. Doing so allows the investor to liquidate a portion of the investment rather than the whole. This provides additional liquidity and can help minimize the tax burden by spreading out sales over many years. Additionally, it can be very beneficial for estate planning to have increased liquidity to divide the “stepped-up” shares among heirs, rather than shared ownership in one asset.
- Diversification – With one transaction, an UpREIT allows you to exchange your property for a fractional ownership percentage of a diversified real estate portfolio.
- Passive investing and income –Exchanging your property allows you to take a hands-off approach to real estate investing without needing to worry about managing the challenges and maintenance of owning a property.
- Capital appreciation –The goal of an UpREIT is to provide income and long-term capital appreciation for investors.
- Increased Income – Many real estate investors in high property value states earn low cap rates (yield equivalent = net operating income / market value) because rent inflation can significantly lag the increased market value. The yield investors receive from the UpREIT (currently in the 4%-5% range) can be much higher than low cap rate properties.
UpREIT cons
- Potential for both capital gains and losses –Just like any real estate investment, the value of your ownership in the UpREIT will fluctuate based on market trends and the performance of the underlying real estate assets. Downside volatility can lead to losses, while upswings can lead to capital gains tax liabilities.
- Loss of control –Handing your property over to an UpREIT means you can no longer make decisions as the direct owner of that property.
If you could use some help determining whether a 1031 or 721 exchange makes sense for you, we would love to have a conversation. To learn more, please contact us.
