Part 3: Using Tax Planning In an Effort to Increase Returns – Real Estate Exchanges

Part 3: Using Tax Planning In an Effort to Increase Returns – Real Estate Exchanges

Posted by on Jul 6, 2021

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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
----------------------------
$5,000 owed

$65,000 remaining amount
x 15% standard long-term capital gain rate
----------------------------
$9,750 owed

Total tax due = $14,750
$20,000 depreciation
x 25% recapture rate
----------------------------
$5,000 owed

$35,000 remaining amount
x 15% standard long-term capital gain rate
----------------------------
$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.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Examples shown are hypothetical and for illustrative purposes only. Actual results may be more or less favorable. No public market currently exists and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment. Costs associated with a real estate transaction may impact investor's returns and may outweigh the tax benefits. The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. Income, cash flow and/or appreciation are not guaranteed. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.  There are risks associated with these types of investments and include but are not limited to the following:  Typically no secondary market exists for the security listed above.  Potential difficulty discerning between routine interest payments and principal repayment.  Redemption price of a REIT may be worth more or less than the original price paid.  Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.  Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.  This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein.  The offering is made only by the Prospectus.

 


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