The White House wish list for tax law changes includes the elimination of both 1031 Exchanges and the step-up in cost basis at death. Potentially, these are major speed bumps in what had been a friction free zone.
Real estate represents one of the three major sources of wealth for billionaires featured in Forbes Magazine. Real estate paves the way into the “Three Comma Club” via pure economics, resulting from rising rental income and capital growth, both enhanced through leverage.
However, tax regulations have played a key role in wealth development. Depreciation is an accounting concept (not cash flow) that provides annual deductions, reducing the tax on rental income. Gains on real estate sales can be deferred without limit via 1031 exchanges. Meaning, you can arguably buy and sell properties throughout your life, accumulating greater wealth with each transaction and yet you would not necessarily pay income tax on these gains. Under current law, when the taxpayer passes away, their decedents receive a “step-up” in cost basis equal to the fair market value of the property. A lifetime of taxation on deferred gains simply goes away. Heirs receive the property and can sell without any income tax consequences or can continue to own the property with reset depreciation allowances. This lack of friction pays off, especially over long time periods.
But tax talk is cheap. History is replete with trial balloons that never floated. Recent proposals from the White House are only the opening salvo in a long negotiation and we are explicitly not endorsing any significant financial moves today based on laws that may or may not be adopted. However, it is good to “aim high with your steering” and be prepared for any potential curve in the road.
Economics: Does your existing property make economic sense? Are you receiving sufficiently high rents to produce a reasonable return on your equity? How are the leases on your property structured? Apartments typically roll over frequently, but office or industrial space may be subject to longer term commitments. When leases expire the owner/landlord typically faces both risk and the potential for higher rents. What is the cost to re-tenant the property and is that within your risk profile? Is new construction coming into your area that increases the risk of losing tenants? Do you want to hold the property indefinitely?
Debt: Do you have debt on your property? If so, is the rate fixed or variable and when will it mature? Did you go into the property with the intention of selling before facing the need to refinance? Do you have recourse obligations?
Management: Are you personally managing the property or are you employing third party management? If you plan to hold properties long enough to receive a “step-up” event, which of your heirs will be responsible for managing? Do they have the aptitude, the appetite?
Liquidate and pay taxes: This option is the simplest and cleanest but subjects the owner to long term capital gains taxes as well as recapture of previously taken depreciation. Taxes are a major source of friction. On the other hand, cash is flexible, and can be reinvested in any asset class, used to pay down debt, or be given away.
1031 Exchange: If you would like to sell your existing property and defer income taxes via the exchange, you should consult with your C.P.A. and/or tax attorney for feedback on the likelihood and/or timing of any elimination that could result from enactment of the Administration’s tax proposals. It is conceivable you might want to move on any such strategy sooner rather than later. Rules generally require a like-kind investment into property with equal or greater value and debt, and time constraints can create pressure.
Charitable Trusts: Instead of deferring taxes through an exchange, contribute the property to a Charitable Trust. The Trust could sell the property and avoid taxes altogether. The taxpayer can receive an immediate income tax deduction and a stream of cash flow for life.
Qualified Opportunity Zone (QOF): These vehicles were created at the end of 2017 as part of the Jobs Act. Taxpayers can defer taxes in the current year by contributing the gain portion of a sale into a QOF. The taxable income that would have been recognized in 2021 is deferred to 2026. If the QOF is held at least 5 years, the taxable income reported is only 90% of the actual gain. If the QOF property is held for at least 10 years, it can be liquidated with zero federal income taxes. One advantage over the 1031 Exchange is the ability to put your cost basis immediately into your pocket and invest only the gain portion. The potential for tax-free gains, albeit in 10+ years, is virtually unique in today’s world, and would be more like a unicorn if the 1031 Exchange is eliminated.
Every property is unique and, each investor has their own personal goals and constraints. Deciding whether to sell a property and how to handle the taxes are questions best answered through a detailed analysis. We present the menu above so you can consider all your options.