For some real estate investors, a 1031 exchange can be a powerful financial planning tool. But before you start the paperwork, take a holistic look at your client’s situation. Their needs, goals and finances will help determine if selling a property and then doing a 1031 exchange is right for them.
“Real estate should be treated like any other asset,” says Rob Johnson, head of wealth management for real estate wealth management firm Realized. “What’s the risk? What’s the reward? Only after determining that the reward outweighs the risk,” Johnson says, “advisors and clients should move forward with a 1031 exchange.
Assess your client’s life stage and retirement plans
Your client’s unique needs and goals should drive every financial decision, and a real estate sale for a 1031 exchange is no different. Here are some factors to consider when deciding if a 1031 exchange is right for your customers.
Stage of life. Where is your client in his life? Are they just starting a family, working long hours, changing careers, moving house? Ask them how they see real estate ownership fitting into their daily lives in the context of other demands on their time. If they prefer to focus on something other than the responsibilities of direct real estate ownership, they may want to explore other investment structures. Their state of health also deserves to be examined closely. If they become less mobile, property management may be more difficult.
Role of real estate investment. Do they view their investment property primarily as an income generator or a growth investment? Their views may change as they move from accumulating to harvesting wealth.
Retirement goals. Go through the details of what your client plans for retirement. If they plan to move to another state, split their time with distant relatives, travel the world, or switch to a snowbird schedule, property management may become more difficult. On the other hand, a client who views owner duties as a pleasant way to occupy themselves during retirement may appreciate direct ownership.
Assess the financial situation as a whole
Whatever your client’s goals are for their property, their real estate holdings should always be considered in the context of their larger investment portfolio. When looking at the income a property generates, compare the return on that investment with the returns on their other assets. “Unless the advisor gives the client a holistic view of which assets are generating the return they expect, something could go unnoticed,” Johnson says.
Another comparison will also create perspective: the value of your client’s direct real estate holdings as part of their total portfolio or net worth. Calculating this will help them judge whether their current holdings make them vulnerable to concentration risk, especially when holdings are a single property or multiple properties in close proximity.
The physical location of your client’s real estate assets can also have financial implications. Property taxes in a high-tax state can eat away at investment income, and the outlook for the real estate market can vary significantly from state to state or region. Does direct ownership prevent them from owning more desirable properties? If so, it’s worth considering a sale or trade.
Consider a sale
Together, you and your client may realize that it’s time to sell your current real estate, even if real estate has an ongoing role to play in your client’s estate plan.
The biggest potential challenge with a sale is the tax implications. For some clients, the capital gains tax bill might be enough to deter them from selling, even if they would rather part with the property. But if they know a strategy for making capital work, maintaining desired portfolio exposure, and retaining real estate’s income potential, the choice may be easier to make.
Watching a 1031 exchange
For customers who meet the above criteria, consider suggesting a 1031 exchange. Qualifying transactions may allow a customer to defer capital gains tax and keep the sale proceeds for them. Of course, suitability, transaction timing, and related fees must also be assessed to ensure that this type of exchange will work for a particular client, but it can be a very useful tool.
One way investors can use a 1031 exchange is to relinquish directly held property and acquire shares in a Delaware Statutory Trust (DST) or tenant-in-common (TIC) agreement. Changing the ownership structure can work well for clients who want to retain a real estate position but don’t want the responsibilities or risks of direct ownership.
The flexibility of a 1031 exchange can provide clients and their advisors with an effective wealth planning tool. As with all wealth planning activities, it should be considered in the context of a client’s overall wealth picture. Those choosing to proceed will want to consider the ideal ownership structure for the acquired property, determine the timing, and find a strong partner who has the expertise to help manage the exchange transaction. Completing the transaction with the right support can make a smart decision feel like an even better decision.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.