By Stephen W. Bedikian, Associate Wealth Advisor
Key Takeaways
- A 1031 exchange defers capital gains taxes, but it doesn’t eliminate them. Over time, investors can accumulate significant embedded tax liability.
- Direct real estate ownership can often become less appealing in retirement. Management responsibilities and concentration risk may no longer align with lifestyle goals.
- Indirect 1031 strategies can provide diversification. Structures like DSTs and UPREIT transactions can help investors to transition into more passive real estate exposure, but deferred taxes remain.
- Tax-aware equity strategies can generate capital losses. Direct Indexing and Enhanced Direct Indexing (EDI) intentionally harvest losses that may help offset gains from real estate sales.
- Coordinating real estate and portfolio strategy helps create flexibility. A combined approach can help investors reduce management burden, improve diversification, and manage future tax exposure.
What is a 1031 Exchange and How Does It Work?
1031 exchanges allow direct real estate property investors to roll their capital gains from a real estate property they’re selling into one they’re buying—and defer paying capital gains taxes that would otherwise be taxable immediately. This process can be repeated over and over again.
Many successful direct real estate investors use 1031 exchanges throughout their careers, which can potentially lead to large, deferred capital gains. This is an enviable problem—but it can still sting when the tax bill comes due.
How Direct Real Estate Investing Differs From Passive Investing
Direct investors take a very different path from the passive real estate investor who buys publicly traded REIT stocks or privately held REIT interests. Direct owners can be successful: they’ve engaged in the active management of their properties and given their operations the time and attention required for successful property management. But by the time they’re in their 60s or 70s, they may no longer wish to carry the management burden of direct real estate ownership. Retirement and the golf course beckon!
Three Options for Direct Real Estate Investors
If you’re in this position, you have several options to consider:
- Continue ownership of the real estate properties until your death. At that time, the cost basis of your assets will be stepped up to current fair market value and your heirs can inherit and potentially sell the properties without facing a large capital gains tax bill. For many, this option doesn’t fit well with a worry-free retirement lifestyle, since hiring a property management company often comes with its own set of headaches. And sometimes, the investor’s children—the next generation of potential managers—make it clear that they have no interest in inheriting or managing a real estate portfolio.
- Execute an Indirect 1031 Exchange into a REIT. A 1031 exchange can’t be done directly because REIT shares are a security and thus personal property, not real property. Instead, the exchange is done indirectly through a Delaware Statutory Trust (DST). Often, the interest in the trust is structured to a future roll up into a REIT through a Section 721 Umbrella Partnership REIT (UPREIT) structure. There is cost and complexity associated with this option. Usually there is also a two-year holding period, and when it’s completed, you have diversified your property interest into REIT shares. But any deferred tax liability will still be payable when you sell your shares. And if a significant amount of your net worth was concentrated in real estate, that won’t change after the process is completed. You’ll just own a fractional interest in a more diversified real estate portfolio.
- Implement a tax-aware equity investment strategy like Enhanced Direct Indexing (EDI) designed to generate capital tax losses to help offset gains in your real estate portfolio. A mistake real estate investors can make is putting their investment portfolio into one mental bucket and their real estate investments into another. However, both produce taxable capital gains and losses. A tax-aware investment strategy seeks to intentionally generate taxable capital losses that can be used to partially or fully offset the potential tax liability associated with the deferred capital gains generated by 1031 real estate exchanges.
How do tax-aware indexing strategies work?
Most investors are familiar with passive investment strategies that involve buying an ETF that tracks an index like the S&P 500. The investor owns shares in an ETF, which holds shares of all the companies in a specific index; most ETFs weight allocations are based on market capitalization.
The objective is to match the return of the index (less fees), not beat it. Even in years when the overall index experiences significant gains, the prices of the individual stocks constituting the index can experience high volatility throughout the year.
Direct Indexing Strategies
A Direct Indexing strategy seeks to take advantage of that single-stock volatility by holding most or all of the stocks constituting the index individually in a separately managed account and selling those stocks that decline in price during the year to intentionally realize taxable losses. Shares can be bought back after 31 days and avoid the wash sale rule.
The objective of the strategy is to match the overall performance of the index subject to a degree of tracking error while simultaneously producing capital losses. Those losses can be used by the investor to help offset capital gains in other parts of their portfolio—or on real estate investments, including their primary residence.
Enhanced Direct Indexing Strategies (EDI)
An Enhanced Direct Indexing (EDI) strategy uses margin to add equal long and short extensions to the investor’s account. Thus, for example, an account can be long 150% and short 50%, so the extensions are overall market neutral. These extensions aim to enhance the ability of the manager to realize taxable losses while still tracking the target index (subject to a defined tracking error).
Developing a strategic plan for highly appreciated real estate assets
Options 2 & 3 can be implemented simultaneously if an investor has both a significant taxable portfolio as well as highly appreciated real estate holdings. The 1031 exchange real estate can be converted into REIT shares via a DST to help achieve real estate property diversification, while the EDI strategy seeks to generate taxable capital losses to help offset future realized capital gains.
If you own highly appreciated commercial or residential real estate with a large capital gain and associated embedded tax liability, talk with us. We can advise you on whether an EDI account may be a good fit for you. Reach out to us to learn about your options.
Disclosure:
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser with its principal place of business in Long Beach, California. HH may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of HH, please contact HH or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com.
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