The flip side to any liquidity event is the tax liability triggered from selling something you own that has appreciated in value.
While there may be ways to defer taxation on the sale of a business, commonly available tax deferral options for a liquidity event from the sale of real estate are typically referred to as a 1031 exchange. Let’s jump in with a few examples and basics relating to a 1031.
Some Basics of a 1031 Exchange
Section 1031 of the US Internal Revenue code allows taxpayers to defer recognition of capital gains on the non-simultaneous sale and purchase of real estate.
There are many conditions you must meet for a 1031 exchange to be accepted:
- The taxpayer must identify the replacement property within 45 days of closing of the initial property.
- The acquisition of the replacement property must close within 180 days of closing of the initial property.
- A qualified intermediary must hold the funds until the acquisition of the replacement property closes. You cannot at any point of time between closing on the sale of the first property and closing on the purchase of the second property be in receipt of the proceeds.
Done correctly, a 1031 exchange essentially allows a real estate investor to parlay the proceeds of one property sale into another deal without triggering taxation on gains. While on paper this appears to be a strong consideration for tax-efficient long-term compounding, there are several downside risks:
- It may be difficult to find an attractive opportunity within the time window.
- Multiples rules and regulations may be difficult to follow/meet.
- Less flexibility with the funds – you are limited to reinvesting the proceeds into acquiring another property.
- Your tax basis in the replacement property is reduced to the amount of the initial property.
- Capital tax rates may be higher in the future.
- Market conditions may make a new real estate investment less attractive based on your real estate investment strategy.
1031 exchanges are not a “magic bullet” for your personal tax planning but are a strong consideration for investors interested in realizing the gains accrued from one property and parlaying the equity into another attractive real estate opportunity.
Let’s say 10 years ago, you invested $900,000 into a commercial real estate asset originally acquired for $3,000,000(70% leverage), resulting in original debt of $2,100,000 (30-year amortization at 4.5%). Today, you are entertaining a sale of the building for $6,000,000. You currently have approximately $1,677,000 of debt on the asset remaining. Your cost basis, assuming 27.5-year straight line depreciation on a multifamily asset, is approximately $1,900,000.
This event typically presents you with three main options: pay the taxes due on the investment exit and take cash in hand to diversify into other assets, “trade”the funds into a “typical triple net” 1031 exchange at a 6% cap rate (10% IRR) deal, or source an, often difficult to find, opportune “best case trade” at 6.5% cap rate with 14% IRR. Let’s review each scenario below.
Find a “typical triple net” 1031 exchange asset. We’ve used the typical parameters of a 6% cap purchase and 9% IRR return in this example.
Find a “best case trade” 1031 exchange asset. We’ve used the typical parameters of a 6.5% cap purchase and 14% IRR return in this example.
Pay the tax, and get diversified into other assets. We’ve used the parameters of our latest Private Real Estate Fund, “Fund III” which provides an efficient 8% preferred rate of return and targets net 13-15% IRR returns to investors***. This gets an investor diversified, eliminates the tax burden, and allows you to do as you please with your monies going forward.
Considerations for 1031 vs. Paying the Tax
As you can see detailed above, there are many implications to weighing your 1031 vs. paying tax options from the sale of a real estate asset. In our assumptions above, we take into consideration the realities of how hard it is to find a great 1031 asset. Many times, investors making 1031s can end up in triple net lease deals which likely yield 9-10% total IRR return. In some fact patterns, paying the tax, eliminating the “tail from wagging the dog” in decision making, and diversifying into other assets might be a consideration. Look at the above, for example. In this scenario, if you paid the tax and invested your proceeds into our latest diversified fund (targeted to be in 20-25 assets), if liquidated in 5 years you’d be very near the after-tax cash year 5 value as a 1031 into a 9.5% IRR asset. Plus, you’d not have a tax bill to worry about or another 1031 to complete. Nothing is perfect in these scenarios, but we wanted to point out items to consider with your tax advisor/CPA.
With The Help of Tax Professionals, Build A Tax Efficient Strategy
Sophisticated tax planning is not a “DIY” activity. Like the other aspects of your wealth preservation plan, you should leverage your personal “board of directors” (CPAs, attorneys) to help you build a tax-efficient strategy aligned with your objectives.
You need a team to be there to answer the many tax-related questions that inevitably spring up during the planning and executing of your wealth preservation strategy:
- Are your investments tax advantageous?
- How does one investment impact another?
- Can depreciation deductions within a passive investment offset taxable income of another passive investment?
These questions and more are best answered by tax professionals who have the understanding and insight to best utilize the potential benefits allowed by the internal revenue code.
Focus First on Smart Investments, Then Focus on Tax Implications
Tax efficiency is an important aspect of your wealth preservation plan, but always remember the number one priority is to make smart investments. Letting the proverbial “tax tail wag the dog” leaves you open to the risk of making less attractive investments over the long haul as opposed to paying the taxes due and making stronger investments with the after-tax proceeds.
Need Help Building Your Tax Planning Team?
MLG Capital is more than happy to leverage 33+ years of existing relationships and provide references for tax professionals who specialize in tax planning strategies for high net worth investors. In addition, we’d love to have a conversation with your personal advisors to see if our strategies fit within your objectives both in the near term, and long-term, as well as bring planning expertise to the table.
*In order to make the comparisons more relevant, we made the assumption that fund level operating income equals accrued pref distributions plus debt payments assuming 65% leverage, a 4.50% interest rate and a 30 year term.
**The numbers reflect a 31.5 year depreciable life, based on an anticipated asset allocation of 65% residential and 35% commercial. This does not consider the benefit of any accelerated depreciation from cost segregation studies.
***The numbers assume that the fund will be current on its 8% yield. Although investors always accrue an 8% return, our fund is not always paying 8%. Review the MLG Private Fund III LLC Confidential Private Placement Memorandum, Supplement and Subscription documents for full details.