The following article was written exclusively for SoCal Real Estate:
Managing Financial Advisor
Carey & Hanna
Real estate prices in Southern California have been a sensitive topic for the last decade. While residential and commercial rents have increased substantially, they have not accelerated at the same rate as property values have appreciated.
Cap rates in some areas, such as the Los Angeles metro area, have fallen into the 2 percent to 3 percent percent range, meaning investors who once received a competitive income stream from real estate assets in their portfolios are now only realizing about half of their property’s net income return potential. These investors, with what we call “trapped equity,” are prime candidates for a 1031 property exchange.
Although the recent revision of the tax code eliminated 1031s for most other classes of property, including fine art and collectible cars, real estate remains a protected asset class. As long as the proceeds are put into another real estate deal, investors can still use 1031s to reduce or defer or potentially, even eliminate, current tax liabilities.
When it comes to identifying properties to exchange, there are a few considerations. Most investors seeking to execute a 1031 are looking for a high rate of stable income, fewer maintenance headaches, and lower taxes. Achieving those three goals is especially challenging of late for those clients who wish to reinvest their proceeds in California. As a financial advisor who assesses tax situations throughout the year, I’ve worked with many clients who own great properties but struggle to find local properties that meet their income criteria for a 1031 replacement/purchase. Some of those clients opted to move their investment out-of-state to somewhere with lower taxes or possibly no income tax at all.
Some investors still would rather invest locally, regardless of the more limited income opportunities. For those investors, we have used a Delaware Statutory Trust (DST) as a great tool to fill gaps. Many investors, particularly those for whom real estate is not their primary business, choose to work with a tax professional and financial advisor like myself to understand the details.
Let’s say a client is able to sell an existing commercial property for $5 million and finds another to buy that fits all their requirements for $4.25 million. If they don’t do something with that $750,000 (boot), they could owe taxes on that entire amount, which in many cases negates the benefits of a 1031. To avoid that tax liability, they can still buy the $4.25 million subject property but fill in the equity gap with a suitable DST and end up with no current tax owed.
Another thing that investors need to be cognizant of is how the IRS looks at real estate debt when it comes time to make an exchange. Many real estate investments have mortgages and although mortgage debt can make the exchange more complicated, it is in no way a barrier to a 1031. In order to have a “balanced” property exchange, clients need to replace the “value” of the mortgage debt on the property they are relinquishing. In other words, if the new property has lower mortgage debt than the one the client is exchanging, that difference will be considered boot, just as if that amount had been delivered in cash and that entire amount is subject to tax.
To solve this problem, let take a slightly different example. An owner of a $5 million property with $1 million in outstanding mortgage debt nets $4 million in escrow. For a variety of reasons, the buyer doesn’t want/can’t get a new mortgage and finds a great $3.75 million replacement property to buy all cash. However, if the buyer ignores the $1 million mortgage they just paid off, taxes would likely be due on that $1 million. Here, they can use special highly-level DSTs to purchase property with $1 million of debt with only about $250,000 in cash, leaving the $3.75 million for the purchase of a replacement property all-cash improving cash flow and avoided the huge tax hit on the $1 million boot with which they otherwise would have dealt.
These days, many of our clients have found that the best solution for maximizing their real estate holdings is to initiate a 1031 exchange and invest the entirety of their proceeds in several DSTs. This can be an especially attractive option for older clients who have significant holdings but no longer want to be bothered with actively managing real estate. DSTs can also be split evenly among children, but you can’t cleanly split a piece of property. Working with a knowledgeable advisor can help them find the right properties to maximize their income stream while still deferring taxes.