"We see a lot of that here," says Paul Auslander, chairman and CEO of American Financial Advisors in Orlando, Fla. "Many people in that situation are interested in a tax-deferred exchange, rather than paying tax on a sale." That, in turn, may draw more attention to property exchanges spelled out under Section 1031 of the tax code.
Even though property values have plunged in many areas from their 2006 peaks, selling may still trigger a huge tax bill. Investment properties are depreciated each year for tax purposes - so long-held real estate might have scant basis, or none at all. Most or all of the sales proceeds may be subject to income tax, and prior depreciation might be recaptured at a relatively high tax rate.
"The tax bill can be surprising," says William Jordan, who heads a wealth management firm in Laguna Hills, Calif.
Here's how a so-called 1031 exchange might work: A retiring investor from Las Vegas sells his strip shopping center and lets an unrelated intermediary hold the proceeds. Then the seller arranges for the intermediary to buy a medical office for the investor in Dallas, using the money held from the previous sale. The double transactions let the investor avoid paying tax now; he might be able to hold the replacement property until he dies and the income tax obligation vanishes.
"Deferring taxes by using a tax-free exchange allows 100% of the dollars to be reinvested," says Rob Studin, executive director of financial advisory services at Lincoln Financial Advisors in Birmingham, Ala. "Assuming some basis, an investor who sells and doesn't exchange might have 85% to 90% to reinvest after tax."
Clients considering a 1031 exchange should consider many factors, from existing diversification to life expectancy, as well as taxes. But psychologically, the weakened real estate market may be the most important issue.
"First, investors must be comfortable selling now," says Chet Ju, co-owner (with his wife Shirley) of 1031 Investment Solutions in Natick, Mass. "Property values are down and a lot of investors don't want to sell at today's prices."
The flip side, of course, is that today's seller also can be today's buyer, finding good value in a depressed real estate market. "The real estate market is better now, so there are opportunities for investors," Jordan says. "I told folks to get out of real estate in 2006, but now I'm a buyer, not a seller."
Beyond soft property prices, Studin says planners need to go back to basics: "Does the client have sufficient liquidity? Because real estate is almost always a long-term investment. How big is the taxable gain in relation to the property? If it is a very low basis property, gravitating to an exchange makes more sense. Diversification is also an issue," he adds. "If the client is overly heavy in real estate, taking the tax hit to create some negative correlation may be appropriate."
If a client is older or in bad health, deferring a gain via an exchange may make sense in order to pass along to heirs the higher basis value, according to Studin. If that Las Vegas investor has a short life expectancy, he might defer the gain via an exchange to a Texas property. At his death, assuming current tax law still applies, he can leave the Texas property to his children, who'll get the property's date-of-death value as their basis, avoiding deferred income tax. (Estate tax will still apply.)
FOCUS ON ECONOMICS
But ultimately, Studin says, the most important issue is whether the deals actually make financial sense. "If the economics are good, then it makes even more sense if I have extra dollars to invest, because I don't have to pay taxes now. ... The tax deferral is a great bonus." Taxes shouldn't be that much of a consideration, however, if clients don't find the right reinvestment property.
Studin tells of one client, age 83, who recently had an office building seized by her state under eminent domain. "She received $2 million for it," he says, "of which $1.4 million to $1.5 million will be taxable, because she had some basis in the property. The tax will be a significant amount so she'd like to defer it. At her age, there's a good chance her heirs will be able to inherit with a basis step-up."