At Realized, we believe that tax planning in real estate is about seeking opportunities that can help ensure that the amount of money you make remains money you keep. In our final post in this series, we’ll cover an additional tactic to consider when seeking ways to increase your after-tax cash flow: leverage tax-deferred real estate exchanges.
So far, we’ve explored how increasing your cost basis and using depreciation can potentially provide some tax advantaged strategies designed to help keep more of your wealth in your pocket. There is one additional tactic that is worth considering: leveraging tax-deferring real estate exchanges.
Tax Shelter Strategy: Real Estate Exchanges
The final suggestion on leveraging tax planning to your advantage is determining how to shelter income and capital gains at the time of sale. (Or, when the depreciation runs out at 27.5 years.) A real estate exchange can provide an opportunity to keep more of the money you’ve earned on previous properties working for you.
To show how exchanges can be beneficial, let’s use the following example:
Initial cost basis ($85k gain)
Increased cost basis ($55k gain)
$20,000 depreciation
x 25% recapture rate
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$5,000 owed
$65,000 remaining amount
x 15% standard long-term capital gain rate
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$9,750 owed
Total tax due = $14,750
$20,000 depreciation
x 25% recapture rate
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$5,000 owed
$35,000 remaining amount
x 15% standard long-term capital gain rate
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$5,150 owed
Total tax due = $10,150
1031 Exchange
In this example, the $10,150 tax bill that’s generated by capital gains and depreciation recapture isn’t a given -- it can also be deferred by using a 1031 Exchange. Found in Section 1031 of the U.S. Internal Revenue Code, this type of exchange allows investors to postpone paying capital gains taxes as long as the money from the sale is reinvested in a similar property, also called a replacement property or a like-kind property.
The exchange gives investors a lot of flexibility when choosing a replacement property, and it provides an alternative for real estate investors seeking to keep both their money and getting a new rental property. Finding that replacement isn’t always as easy as it sounds, though, especially if a down market or other factors make finding a like-kind property challenging.
One potential investment strategy when using 1031 exchanges is for investors to exchange their capital gains into a Delaware Statutory Trust, or DST. Investors who join a DST become a beneficiary of the trust, which provides real estate investments owned by the trust without the labor-intensive management that comes with being a property manager.
721 UPREIT Exchange
One disadvantage of the 1031 Exchange is the level of involvement it requires with the replacement property. For investors who want to reinvest, but are focused more on diversifying their portfolio or having access to liquid cash, the 721 UPREIT exchange is a way to keep any capital gains tax-sheltered by investing in operating partnership (OP) units.
This type of investment gives a real estate investor access to some of their cash if they need it down the road simply by converting their OP units into REIT shares that can be sold. It can provide an option if access to cash is essential, but a downside to this type of exchange is that it creates a taxable event.
Strategic tax planning can have an effect on the overall real estate investment returns. We believe a financial team should be able to help ensure investors are considering all available real estate investment tax benefits.
