At a recent event, panelists discussed why property owners sell and how Section 1031 provides options that those entering retirement should know about.
Financial professionals often work with clients who own real estate. This can include smaller, actively-managed rental properties as well as partial ownership of larger properties through trusts, partnerships, or tenancy-in-common structures.
As clients age, financial planners will need to discuss potentially selling these properties when the management responsibilities get in the way of retirement plans. Though a taxable sale may be right for some, others can benefit greatly from continued income through passive investments, which also offer benefits in estate planning.
By not fully explaining how a 1031 exchange can involve diversified and passively-managed properties, financial professionals may cause their clients to miss out on opportunities. At a recent event, JTC gathered together a group of experts to explain what investors and financial planners need to understand about 1031.
Explaining the benefits of 1031 to financial professionals
The webinar, “1031 in 2024: Building Generational Wealth Through Tax Deferral,” featured a panel of experts discussing 1031 exchanges, Delaware Statutory Trusts, and the transitional period investors face upon entering retirement. They also answered questions from attendees, including some property owners who weren’t sure whether their investments would qualify for a 1031 exchange.
Section 1031 is a portion of the tax code that applies to property held for business of investment use. This can include single-unit rental homes, multifamily apartment complexes, warehouses, retail stores, farmland, and many other types of property. According to Louis Reynolds, CEO of Synergistic Exchange Solutions, property owners who sell often don’t exchange into a new investment property.
“The vast majority of those individuals who sell investment property pay the taxes,” he said, adding that these taxes can be a major deterrent from selling, even when market conditions seem right.
“The #1 reason they do not list and sell is because of the taxation,” said Reynolds. “The good news is that for the last 102 years, in the United States, we have had the option to use a 1031 exchange.”
A 1031 exchange allows property owners to defer taxes on the sale of business use or investment property if they acquire another business or investment property within the bounds of 1031 rules. This allows them to put more invested capital toward the purchase of the new property so they can continue to build wealth.
“Deferring those taxes really operates like an interest-free loan from the government,” said Justin Amos, National Sales Manager and Account Executive at JTC.
“It really promotes the highest and best use of a property,” said Shanaé Mabrie, Director – Client Services – Fund Services at JTC, who noted that 1031 provides benefits for the U.S. economy as well as for investors.
Amos walked through some of the types of properties that can qualify, including those that can partially qualify for 1031, such as home-based businesses or multi-family properties with an owner’s unit – in both those cases, the portion of the property used for business can qualify for 1031 while the portion used as a primary residence can qualify for a Section 121 exemption.
One attendee asked about converting a property formerly used as a primary residence into an investment property, something that is possible with the right planning.
Amos highlighted a valuable tool often overlooked by owners of a highly-appreciated primary residence. While one might enjoy the benefits of property appreciation, it could lead to future tax exposure if the gain exceeds the amount that can be sheltered using the Primary Residence Exclusion. In such cases, a savvy property owner may choose to convert their residence into a rental property for two years prior to selling. Revenue Procedure 2005-14 allows for them to exclude and defer capital gain simultaneously. If they lived in the property for two of the five years preceding the sale, they are eligible to shelter up to $250,000 if they are single or up to $500,000 tax-free if they are married filing jointly. The owner can defer the remaining gain by structuring the sale as a 1031 exchange and reinvest into another investment or business use property.
But as the panelists warned, these tax scenarios can be complicated, so getting the right advice is crucial.
“The most important thing is to be asking the questions to your respective advisors,” said Amos.
“Make sure you’re getting really good, competent answers,” said Reynolds.
How 1031 can factor into the decision to sell upon entering retirement
Reynolds outlined some of the current trends affecting the 1031 market, one of the most notable being the generational shift that is happening due to the Baby Boomer generation entering retirement age, as this generation owns “about 80% of the investment property in the United States,” according to Reynolds. As these property owners get older, actively managing properties becomes less appealing.
“Oftentimes, those individual owners are still doing a substantial amount of the management work,” said Reynolds. “A lot of landlords just come to the place where they’re done with managing tenants.”
Those entering retirement age also may want to move to be near their families, to a state with different taxation, or to fulfill a lifelong dream. For these investors, accepting the burden of capital gains taxes is often seen as a required part of the retirement process.
“The vast majority of individuals pay the taxes,” said Reynolds. “The reason why the vast majority of people who sell their property pay the taxes is just simply because they don’t know their options.”
He discussed the options for those who wish to sell their actively-managed properties but don’t want to purchase another actively-managed property. Options discussed included Opportunity Zones and Delaware Statutory Trusts (DSTs).
“Never have there been as many options for individuals to defer and potentially even eliminate their taxation as there are today,” he said.
Anthony Calderone, SVP at Inland Securities Corp., discussed some of the advantages of DSTs, including that they are professionally managed, allow for fractional ownership of large-scale commercial real estate, aren’t concentrated in one area, and that a DST interest qualifies as a 1031 replacement property, meaning investors can exchange into or out of the DST.
DSTs allow diversification both through the properties owned by each DST and the number of DSTs one can invest in thanks to the low minimum investment, which is why Calderone said they are often thought of as “the mutual fund of real estate.”
DSTs are available at various loan-to-value ratios, and there are DSTs focused on specific sectors like student housing, senior housing, self-storage, and others. A DST can be a good backup option for exchangers because the properties have already been vetted, making the process of selection and closing much quicker.
“I do get calls on Day 45 all the time,” said Calderone. “That 45-day identification period sneaks up on folks.”
On the downside, Calderone noted that DSTs are “rather illiquid investments. They are investments that have 5-to-7-year timelines, on average, until the next real estate decision is made.”
That lack of liquidity can be a bad thing for those who may want to sell earlier, but for those thinking about holding for the rest of their lives, DSTs provide some surprising advantages.
Swap ‘till you drop: holding DST interests until death
Though many exchanges are eventually followed by a taxable sale, it is possible to continue exchanging until one passes away, at which time the investor’s heirs could receive a step up in basis, essentially eliminating a large portion of the taxes on the capital gains from the eventual property sale under the tax law. And with DSTs, this process can become even easier.
“Section 1031 allows you to have another option as it relates to either diversifying or going into something more passive so that your heirs do have the ability to inherit something that’s a little bit more easily managed, and perhaps a bit more diversified as well,” said Calderone.
For some property owners, willing a single property to multiple descendants can be the cause of arguments and strife within a family. But a DST is easier to divide up among heirs because shares can be naturally split, allowing each heir to choose whether to cash out or perform another exchange when the DST properties are sold.
That’s why Reynolds said he believes fractional ownership through a DST “makes tax planning, estate planning on the back end much cleaner, much simpler.” Financial planners with clients who are thinking about estate planning should mention the option of a DST both so clients can avoid paying taxes that may be eliminated through the step up in basis and because DST interests may be easier on those who inherit them.
When to talk to clients about 1031
If you’re a financial professional, there’s a good chance that your clients either have never performed a 1031 exchange or haven’t in a long time. That’s why they need to know about the replacement property options discussed here, as well as when they need to be thinking about an exchange and what requirements they’ll face.
“It’s definitely important to be speaking with a Qualified Intermediary as early as possible,” said Amos, who stressed that property owners need to prepare for “Day Zero,” because the exchange must be decided upon before the relinquished property is sold.
“An exchange cannot be established retroactively,” said Mabrie.
An experienced Qualified Intermediary can help property owners follow through on their preferred exchange method and replacement properties, and JTC has experience with newer or more complicated exchange types that other service providers may not be as familiar with.
“Even though it’s been in the US tax code for well over 100 years, the 1031 exchange space is still an unregulated industry,” said Amos. Financial planners need to recommend quality QIs to their clients, and JTC offers a wide range of benefits that have made us an industry leader in 1031. With our Exchange Manager online portal, clients and partners can log in from anywhere, 24/7, to track each exchange and view progress.
JTC also offers the highest level of security for exchanges and a team with extensive 1031 experience, allowing us to support institutional clients with complex exchanges. When you recommend JTC to your clients, you’re protecting your own reputation by ensuring they get the help they need.
