A family that is selling a farm or ranch can use the IRC Section 1031 Exchange, the IRC Section 664 Charitable Remainder Trust, and the IRC Section 121 Principal Residence Exclusion to save taxes on the sale.
Using one or more of these strategies enables a family to reinvest more money from the sale, which may enable them to generate more income for retirement. While it is important to seek out the assistance of qualified professionals to help you use these financial tools, it is equally important to obtain professional advice on how to invest the sale proceeds.
Investing cash proceeds
Here are some suggestions for investing cash sale proceeds:
• Work with an independent, fee-only registered investment advisor. As opposed to a broker or sales agent, this type of advisor has a fiduciary duty to act in your best interest. They don’t receive sales commissions and thus are not subject to the conflicts of interest other “advisors” face;
• Use low-cost, index mutual funds or exchange traded funds. These types of funds have internal operating expenses called expense ratios that are a fraction of the cost of actively managed funds. Research has shown that it is extremely difficult to outperform the market using actively managed funds;
• Diversify among multiple asset classes. Invest in small, midsize and large stock index funds and REITs both in the U.S. and all over the world. Additionally, invest in short to mid-term, high credit quality bond funds;
• Invest in accordance with your risk tolerance. Determine how much loss you are willing to tolerate (if any) in a given year and then match your portfolio to your risk level. The higher your risk tolerance, the higher percentage of stock and real estate funds you own. The lower your risk tolerance, the higher percentage of bond funds you own; and
• Buy and hold. Once you come up with the proper portfolio, resist the urge to constantly change it. One of the biggest mistakes many investors make is that they change their strategy too often. All asset classes go up and down; one year’s worst performing asset class is often the next year’s best performer.
Investing in a charitable remainder trust
A charitable remainder trust (CRT) can be used to save taxes on the sale of a ranch. When one uses a CRT for selling their property, the full sales proceeds, undiluted by taxes, are invested within the trust for the benefit of the donors. One can invest in many different types of assets within the trust. Most often, a CRT is invested in a diversified portfolio of mutual funds and/or exchange traded funds.
Investing 1031 exchange proceeds
In order to defer taxes on the sale of appreciated land with a 1031 exchange, an investor must exchange into other real estate. This is not limited to land. A family selling land may exchange into rental houses, office buildings, apartment complexes, storage facilities, retail strip malls and Delaware Statutory Trusts (DSTs). These types of properties often have cash flow returns that are three to four times higher than land.
Investing in commercial real estate is complex and therefore, you should seek the assistance of a commercial real estate agent. This person can help you identify and evaluate potential replacement properties for your exchange. With that said, it may be helpful for you to understand some of the basics of investing in commercial property.
When it comes to investing in cash flow real estate, one is not so much interested in buying the property but rather in buying the income stream. There are many types of income producing real estate investments, each with their own unique pros and cons.
Here are four common methods for valuing real estate investments.
• Capitalization rate (cap rate)—Cap rate is the most widely used method for valuing income producing real estate. The cap rate of a property is calculated by dividing the net operating income by the cost of the property.
• Price per square foot—This is determined by dividing the cost of the property by the square footage of the property. Knowing the price per square foot is an easy way to compare the pricing of other properties to each other.
• Gross multiplier—This method is arrived at by dividing the gross operating income by the cost of the property.
• Cash on cash—The cash on cash return of a property is simply valued by dividing the cash flow before taxes of the property by the cash invested. — Chris Nolt, WLJ correspondent
(Chris Nolt is an independent, fee-only registered investment advisor and the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC.)
