I am going to wrap-up my three part series on the 5 compelling ways real estate can make you wealthy by taking a final look at Pete’s case study. Unfortunately,Pete still has not found a tenant to lease his office building and is being patient while continuing to look at his options.
The last two ways real estate can make you wealthy are tied together: disposition strategies and tax strategies. These strategies can be complicated, so always have a tax professional, exchange professional and real estate broker on your team.
Selling is one disposition strategy, but potentially with significant tax consequences. If Pete were to sell his office building he would have to pay capital gains taxes in excess of a rough estimate of $150,000 on approximately $650,000 of gain.
Another seldom thought of option is to sell and carry financing for the buyer. This may not work in Pete’s case because he still has a small loan, but if he were to pay it off with the down-payment received, it could work. In carrying financing Pete is essentially paying capital gains taxes over the term of the note thereby spreading his tax liability over many years.
One widely-used disposition strategy is the 1031 tax-deferred exchange. The IRS and Franchise Tax Board sees this as not really selling, but exchanging an investment property for another. So, Pete could exchange his office building by selling and purchasing an apartment building.
The type of property exchanged into doesn’t really matter–what matters is that you are exchanging investment real estate for another investment real estate.
There is flexibility in what Pete could exchange into–he could even exchange into two investment properties. But, don’t think this process is simple, there are many other rules to comply with including timing and exchanging into a property that is equal to or more in total purchase price. You also need to have financing equal to or more in loan amount on the replacement property.
Remember in part 2 of this article series, I mentioned that Pete could refinance and purchase a $2.5 million property? He could also perform an exchange and acquire a $3.6 million property. Selling his office building will give him approximately $900,000 in equity to place as a down payment on the replacement property with $2.7 million in debt financing and pay no taxes.
If Pete did not want to be an active real estate investor any longer and still limit his tax liability he could exchange into a Delaware Statutory Trust. A DST is basically crowdfunding for 1031 tax-deferred exchange participants. These can be costly and complicated and not for everyone.
Becoming a millionaire is a process comprised of good decisions and time. Pete is within reach of increasing his net worth, but it will require him either refinancing his office building or performing an exchange and acquiring additional real estate.
Substantial growth occurs when taking risk and using the leverage you have to acquire additional investments. But, there is always the advantage we have of time–well, some of us.
Burt M. Polson, CCIM is a local real estate broker specializing in commercial, luxury estates and wineries. Reach him at 707-254-8000 or [email protected] Sign up for his email newsletter at BurtPolson.com.