. This article will briefly explain how each strategy works and the pros and cons of each strategy.
1031 Exchange
The 1031 exchange allows a person to sell appreciated real estate and defer taxes on the sale. To execute a 1031 exchange, you must identify in writing the property or properties you wish to exchange into within 45 days of closing on the sale of your relinquished property. You must also close on the sale of your replacement property within 180 days of closing on the sale of your relinquished property.
Besides saving the taxes, a 1031 exchange allows you to potentially generate more income and build more wealth. For example, if you save $400,000 of capital gain taxes by doing a 1031 exchange, that allows you to purchase $400,000 more of real estate. Assuming a 7 percent annual cash flow return, you would generate an additional $28,000 per year of income by doing the exchange. Additionally, if your real estate appreciates in value by 2 percent per year, that $400,000 would grow to $538,000 over 15 years.
Another advantage associated with a 1031 exchange is that real estate receives a stepped-up cost basis on death. When a person dies, an appraisal is done on the property and the fair market value as of the date of death becomes the new (stepped-up) cost basis. If you hold onto property until you die, your heirs could sell the property after your death for the full market value and not owe any capital gain taxes.
Therefore, under current tax law, you may not only be able to defer taxes with a 1031 exchange, you may be able to avoid them entirely. There is no limit on the number of 1031 exchanges you can do during your lifetime which is why we often advocate that you swap until you drop.
Some disadvantages of a 1031 exchange are:
• Identifying the right property within 45 days can often be challenging. You don’t have the luxury of waiting around until you find the right deal;
• Matching up the equity of your replacement property with your relinquished property can be challenging and if you don’t stay equal or go up in equity, you will end up paying taxes on the cash you take out;
• To defer 100 percent of capital gain taxes, you must not only go up or stay equal in equity, you must also replace all of your debt on your relinquished property. Many people desire to pay off debt when they sell their ranch but any debt that is paid off on the relinquished property is referred to as debt relief boot which is taxable;
• Real estate is often a labor-intensive investment. Many people don’t want anything to do with managing investment property when they retire. While a property management company can relieve you of much of this burden, you often need to oversee your management company and there are always issues that can come up when owning real estate, especially real estate that has tenants; and
• Lack of diversification. The net worth of the typical rancher is made up almost entirely by the value of their land. When selling their land, it is often very difficult to diversify into enough properties to be effectively diversified. Not only do the time constraints of the 45-day ID period make it difficult, the minimum amount of money it takes to purchase a quality investment property is high relative to other investment options. Consequently, families often exchange into one or two properties, subjecting their financial future to success of those properties.
Charitable remainder trust
A charitable remainder trust (CRT) is another strategy for deferring tax on the sale of appreciated property. When property is sold through a CRT, the full, undiluted sales proceeds of the sale are invested in the trust. People who sell their property through a CRT are called the donors and they receive annual payments from the investments in the trust for either their lifetimes or for a term of years.
While a CRT can be more complex than a 1031 exchange, it does offer several advantages.
One advantage it offers is that in addition to real estate, one can sell livestock, crops, machinery and equipment through a CRT, deferring capital gain and ordinary income tax.
Similar to a 1031 exchange, by deferring taxes on the sale, the full sales proceeds may be invested. This allows donors to generate more annual income since they have more money invested for their benefit. Another advantage is that donors receive a charitable deduction for their gift to the trust.
Another advantage of a CRT, is that it allows a person to invest in a diversified investment portfolio, reducing the risk of having all your eggs in one basket which is often the case with a 1031 exchange. Additionally, the investments in a CRT are typically a portfolio of mutual funds and/or exchange traded funds, making this a truly passive source of income for the donors.
A disadvantage of the CRT is that the money left in the trust after you die or after the term of the trust has expired goes to charity rather than your heirs.
If you are selling appreciated property, it is wise to explore tax-saving options and to speak with someone who is knowledgeable about both the 1031 exchange and the CRT. Compare the pros and cons of each and make sure you do your due diligence on the investments used for with each strategy. It is worth noting that it may be possible to sell part of a property with a 1031 exchange and part with a CRT. — Chris Nolt, WLJ correspondent
(Chris Nolt is the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC.)
