Like most advisors, you probably have clients who own investment real estate. These real estate properties may make up a significant percentage of their net worth. However, these held-away assets are often excluded from the investment planning process.
Over the years, active investment and management of real estate or investment properties has proven an effective strategy for growing long-term wealth. However, part of this growth often comes from the time and energy an owner invests in their projects. As owners age, what were once the "crown jewels" of their savings can become an albatross, preventing them from living in the style they had planned for in retirement. In other cases, the equity trapped in a property may be needed to fund their lifestyle as they transition from a wealth accumulation to a wealth distribution.
For those ready to turn in their landlord keys but are not willing to pay a large tax bill, and who want to pursue passive income in retirement, there are opportunities. Passive real estate investors typically receive income from their investment but do not have the same level of involvement in the day-to-day management of the property as they do with direct real estate ownership. Opportunities can include real estate investment trusts (REITs), purchasing shares in a real estate crowdfunding platform, becoming a limited partner in a real estate development project, or placing equity into an investment such as a Delaware Statutory Trust (DST).
Diversification and concentration risk
By owning similar property types within a small geographic region, real estate investors often unknowingly subject themselves to significant concentration risk. Yet diversifying a real estate portfolio can be challenging. True diversification in real estate investing refers to spreading investments across different property types, sponsors, tenants and geographic regions. Managing concentration risk is also important, and a very difficult process in real estate due to the large and chunky nature of the asset class.
By leveraging passive real estate investment vehicles that offer fractional ownership of multiple property types across several states, advisors can bring traditional wealth management and diversification strategies to their clients who own direct real estate.
What's next when your clients decide to sell?
Clients who have held onto highly appreciated real estate could be facing a large tax bill if they decide to outright sell their investment. Fortunately for investors, there are options to help with deferring their capital gains taxes to keep more of their proceeds working for them.
One of the main benefits of capital gains deferral is that it allows individuals to lock in the appreciation of their assets without having to pay taxes on the gains right away. This can help to grow their wealth and increase their overall returns on investment.
Options advisors might consider to help clients defer capital gains taxes include:
- 1031 Exchange: This allows an individual to sell a property and use the proceeds to purchase a similar property, deferring the capital gains taxes
- Deferred sales trust: This allows an individual to sell a property and defer capital gains taxes by investing the proceeds into the trust and receiving payments from the trust over a period of time
- Investing in Opportunity Zones: Investing the proceeds from the sale of a property in an Opportunity Zone can also help to defer capital gains taxes
It is important to note that these methods have certain rules and requirements that need to be met, and it is best to consult with a tax professional to ensure compliance and to understand any potential tax implications.
Let's take a look at the 1031 Exchange. If your client is preparing for retirement and looking to get out of the active landlord business, then using a 1031 Exchange to sell their investment property only to purchase another direct property may not be effective. However, an alternative they may consider is using Delaware Statutory Trusts as replacement properties.
Why choose a DST?
Many DSTs hold properties such as apartment complexes, student housing and hotels, which offer more potential for rental rate increases than direct properties. These property types can adjust leases/rates on a semiannual, monthly, or even daily basis vs. the longer-term contract length of other property types. Because of their flexibility and size, a DST can be tailored to meet the monetary needs of a 1031 exchange.
