Real Estate Tax Strategy for the Family Office

Posted Jan 5, 2021


Very affluent families may establish a family office to manage their wealth. These entities usually serve family units with tremendous assets and complex needs. In addition to investment advice, the family office may provide tax and estate planning services and personal support in other areas. Historically, most family offices were not registered as investment advisers due to their private status. After the Dodd-Frank Wall Street Reform and Consumer Protection Act eliminated the exemption for private advisers, the Securities and Exchange Commission adopted a rule that defined family offices and excluded them from regulation under the Investment Advisers Act of 1940.

Not every family office has in-house expertise in real estate. As a result, the investment adviser may need guidance in taking full advantage of the family's opportunities to defer capital gains tax and maximize the funds to continue investing in real estate productively. Suppose the principals (or any of the family clients) want to relinquish a specific property that has appreciated. In that case, the best course might be to consider exchanging it for another investment property via a 1031 transaction. Perhaps the property is a multi-family housing unit that the family office no longer wants to own, or a commercial building that currently does not support the family's goals. If the preference is to continue growing the portfolio, there is a case to be made for using all of the proceeds rather than paying some out in a capital gains tax assessment. 

The family can avoid realizing the capital gain by exchanging the relinquished property for a like-kind replacement. The Section 1031 exchange has precise timeline requirements but some generous property type accommodations. For example, the multi-family housing unit mentioned previously could be exchanged for an office building or a retail property. The relinquished and replacement assets must be investment properties, and the property sold should have been held for two years. Planning is crucial since the taxpayer must formally identify the replacement asset within 45 days of the initial property's sale and complete the entire transaction within 180 days (inclusive of the first 45-day period).

It is helpful to note that direct ownership is not the only option available for the exchange property. If the family investors prefer unified fractional ownership, the purchase of shares in a DST is a feasible option. Delaware Statutory Trusts (DSTs) are trusts which own properties and are financed by the investors. These arrangements are valid for tax purposes as property investments, enabling the investor to defer the realization of capital gains by directing proceeds to the purchase. Further, the investor retains the ability to liquidate the interest in the trust later and reinvest in direct property or some other eligible instrument.

This flexibility provides a means for the affluent family to pursue its wealth accrual goals while designing a real estate investment portfolio with versatility. The family office management team should be careful to utilize a neutral Qualified Intermediary for the exchange to safeguard the tax-deferred nature of the transaction.

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.

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