As a high-net-worth investor (HNWI), managing your real estate portfolio goes beyond acquiring new assets. You also have to consider other aspects like tax exposure, wealth preservation, and long-term flexibility. One strategy designed to help address these considerations is the 1031 exchange. Also called the like-kind exchange, this strategy can potentially allow you to defer capital gains taxes, diversify your portfolio, and even enjoy passive income.
What are the specific features offered by the like-kind exchange? In this article, Realized 1031 has shared 1031 exchange solutions for high-net-worth investors, highlighting their potential role in sophisticated financial planning.
Refresher on 1031 Exchanges
Named after Section 1031 of the Revenue Code, the like-kind exchange is a tax-advantaged strategy that allows an investor to swap two like-kind properties. These properties must be similar. In particular, the similarity must be the fact that both have been held for business or investment use. This transaction isn’t an official sale, which allows investors to defer capital gains taxes until a taxable event occurs.
A traditional or forward 1031 exchange offers this tax advantage. However, there are additional variations to conduct a like-kind swap that HNWIs can leverage. Here are some of these other strategies.
Delaware Statutory Trusts (DSTs)
A DST is an investment vehicle where you purchase fractional interests in a trust that owns a property. Under IRS Revenue Ruling 2004-86, DST interests qualify for completing 1031 exchanges, enabling investors to defer capital gains taxes by reinvesting proceeds from property sales into DSTs.
Since DSTs allow investors to pool funds, the trust can purchase institutional-grade assets like large commercial buildings, medical centers, and industrial parks. This pooling approach provides investors access to assets typically beyond individual investment capacities, offering potential for ongoing income with minimal active management responsibilities.
DSTs also offer additional advantages like the following.
- Diversification: You can allocate proceeds across multiple DSTs in different sectors and geographic locations, thereby reducing exposure to any single asset or market.
- Enables timely execution within regulatory frameworks: 1031 exchanges have strict deadlines set by the IRS. DSTs allow you to comply with these time frames since they are pre-packaged assets.
- Estate Planning Benefits: Fractional DST interests can simplify estate planning processes, as these interests may be more readily allocated among multiple heirs compared to direct ownership of real estate.
Potential risks of DST investments include:
- Market Volatility: Real estate markets can fluctuate, affecting property values and returns.
- Property-specific Performance: Individual properties may underperform due to location, tenant quality, or other factors.
- Limited Liquidity: DST interests are generally not liquid, potentially making it difficult for investors to quickly sell their interests if needed.
- Management Dependence: The success of DST investments relies significantly on the effectiveness and expertise of the DST management team.
Portfolio Diversification Through Multiple Asset Classes
While DSTs offer numerous benefits, the passive involvement may not be suitable for some investors. Thankfully, 1031 exchanges still allow you to own several asset classes directly, thanks to the 200% rule. This provision enables identification of multiple replacement properties, provided their combined value remains within 200% of the relinquished asset's value.
Aside from being able to maintain direct ownership of the assets, this 1031 exchange feature allows you to diversify into new sectors or asset classes, potentially mitigating exposure to market fluctuations and offering exposure to emerging or developing markets. You can strategically allocate their proceeds among multiple properties to meet specific investment goals.
1031 Exchanges for Estate Planning
Many high-net-worth individuals leverage 1031 exchanges to achieve estate planning objectives. Key estate planning benefits of a 1031 exchange include:
- Step-up in Basis: When an investor passes away, heirs inherit the property at a “stepped-up” basis. The asset’s current fair market value becomes its new cost basis, effectively wiping out deferred capital gains taxes.
- Simplified Asset Transfer: As we mentioned, DSTs allow for the easy transfer of fractional interests without the need to sell the underlying property.
- Trust Structures: 1031 assets can be held within revocable or irrevocable trusts, providing ongoing control and potential tax efficiencies for future generations.
Wrapping Up: Like-kind Exchange Solutions for HNWIs
1031 exchanges are more than just tax-deferral strategies for investors. There are other like-kind exchange solutions for high net worth individuals stemming from the nature of the transaction itself. Solutions like DSTs offer a passive ownership structure, while diversified real estate investments support can be used to pursue long-term investment strategies.. When implemented with careful consideration, these tools may help align income objectives with estate planning needs. Understanding how like-kind exchanges work is an important step in evaluating whether these strategies are appropriate for preserving capital, generating income, and planning for future financial goals.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/
