While the sale of business real estate can generate immediate cash to meet obligations, such as a divorce settlement, the sale of real property often comes with a price in the form of tax liabilities from capital gains, depreciation recapture tax and alternative minimum tax. These taxes can take a significant bite out of both current and future income from divesting from a property.
Fortunately, Section 1031 of the Internal Revenue Code provides an alternative strategy for deferring the taxes that may arise from the sale of a property. By exchanging a relinquished property for “like-kind” real estate, property owners may defer their federal taxes and use the majority (and, at times, all) of the proceeds for the purchase of replacement property.
“Like-kind” property can include wholly-owned assets, such as vacant land, commercial property (including commercial rental property), industrial property, 30-year or more leasehold interests (even in mineral rights or oil and gas wells), farmland, residential rental property or a doctor’s own office. It can also be applied to fractional ownership, such as a tenant-in-common ownership interest in an investment property, or a beneficial interest in a Delaware Statutory Trust, or “DST.”
Revenue Ruling 2004-86 defines a DST as a Fixed Investment Trust, with a series of attributes that cannot be changed once the trust is established. A properly-created DST can be considered “like-kind” real estate in a Section 1031 exchange. This can then be used to assist a client in moving from the sale of an investment or business property interest that needs to be relinquished in a divorce to ownership in privately held, rent producing, real estate while avoiding the capital gains bite. It can be a BIG bite – up to 20 percent or more of all the growth in value of the property, before considering the state tax costs.
A 1031 exchange generally cannot apply to a primary residence, vacation or second home. However, vacation and second homes can sometimes qualify under safe harbor if they are deemed either a “relinquished property” or a “replacement property.” Both the relinquished and the replacement properties must have been held for investment purposes or for productive use in a trade or business to qualify for a 1031 exchange. In many cases, these assets can be characterized as non-qualifying so they will qualify for 1031 exchange status, saving the owner the pain of the capital gain costs.
In a 1031 exchange, the seller cannot receive or control the net sale proceeds – the proceeds must be deposited with a Qualified Intermediary (QI) – a company that is in the full-time business of facilitating Section 1031 exchanges. The QI enters into a written agreement with the taxpayer where the QI transfers the relinquished property to the buyer, and transfers the replacement property to the taxpayer pursuant to an exchange agreement. Capital gains taxes are then deferred, as the QI holds the proceeds from the sale of the relinquished property in a trust or escrow account to ensure the taxpayer never has actual or constructive receipt of the sale proceeds. The client, working with a qualified wealth advisor, may also pay most or all of the wealth advisor’s fees from within the 1031 exchange, saving ready cash for other needs and making these fees a pre-tax payment. This often saves the high wage earner approximately 40%, or 40 cents on each dollar spent.
How would this work for a divorce settlement? Let’s consider a hypothetical example where, following divorce proceedings, the husband owed the wife a $2 million settlement. Instead of fulfilling the settlement in a lump sum cash payment, which may not be available, or spousal support payments, the husband offers to deed his wife one or more of their investment properties worth $2.1 million. We will also assume that the couple’s tax basis in the asset(s) is $300,000.
The wife may choose to accept the property, manage the property and defer the gains for a number of years. However, some spouses may feel ill equipped to handle the responsibilities of property management or bear the risks associated with the concentration of their settlement in investment property.
While this transaction would appear to offer the wife additional value over the agreed upon divorce settlement, it would also carry with it a hidden deferred tax liability. If the wife sells the property for access to the funds on the open market, she may owe approximately $360,000 or more in federal taxes, leaving her with only $1.74 million in cash.
To negate the immediate tax impact, as well as the challenge that her management of investment property may imply, a 1031 exchange on the real property could benefit the wife’s financial plan, positively enhance her lifestyle and improve her legacy.
The wife could take the investment property in her name via the deeding process; then, using a qualified 1031 intermediary, follow the 1031 process to sell the property and purchase a professionally managed syndicated replacement property or a portfolio of professionally managed properties that have been structured as a 1031 utilizing a Delaware Statutory Trust (DST). Many of these syndicated assets yield annual cash distributions of approximately 6 to 7 percent ($126,000 to $147,000 on $2,100,000). The spouse would retain her interest in real property, with its inherent risks and benefits and would pay no tax on the exchange of her assets into the DST.
This process is simplified by buying and holding the replacement real estate properties in the DST. The DST structure also allows for estate planning transfers of fractional interests to children or charities as well as a step-up in tax basis on the properties in the DST at her passing, giving the family permanent relief from taxation on the capital gains.
Whether in a divorce situation or for general financial planning purposes, the DST asset can help individuals avoid large capital gains taxes, benefit from professional management, achieve estate and gift planning flexibility and often improve cash flow.
A $2.1 million dollar settlement delivering annual cash flow of $126,000 to $147,000 looks much better for the client and the attorney than a $1.7 million dollar settlement and a $360,000 IRS bill.
For more information about how 1031 exchanges work, visit our website at www.ldloweplan.com.
LD Lowe Wealth Advisory is a SEC Registered Investment Advisor. Registration does not imply any certain level of skill or training. LD Lowe encourages investors to review the training, tenure and track record of a potential advisor.