Pat Hune, Broker, 1st Southwest Realty, and Various Sources, May 2018
If you own a rental property, you are probably sick and tired of dealing with repairs, turnover and tenant issues. Even if you have a great property manager, like 1stSouthwest Realty, rentals can still be a hassle. If you are thinking about selling, have held the asset for more than one year and you will make money then congratulations! This is great news! The bad news is the IRS will want their share of your good fortune in the form of taxes on the capital gain and depreciation recapture.
How much will you owe? The long-term capital gains tax (defined as assets held for more than one year) is based on your tax bracket. A 0% long-term capital gains tax rate applies to individuals in the two lowest (10% and 15%) marginal tax brackets. Well gee. I guess the IRS is giving the people at the poverty level a break. How likely is it these folks, who are just scraping by, will have a capital gain? In my experience this is not very likely which is probably why the IRS did this.
The next four brackets — 25%, 28%, 33%, and 35% — pay 15%. There is a 20% long-term capital gains tax rate for taxpayers in the highest (39.6%) tax bracket. But wait! There’s more. Certain high-income taxpayers pay an additional 3.8% net investment income tax. (Gotta love the IRS. And don’t get me started on what the government does with all this money. Also these rules can change at anytime with no notice from the IRS. The nerve! Remember Congress writes the tax code. So when it comes time to elect your congressperson be sure to ask them if they are committed to simplifying the tax code. It is more than 3.7 million words long!)
Depreciation is a great tax write off until you sell the property.
The longer you have held the property the more depreciation will be recaptured. Depending on the value and if the property has been held for more than around seven years you will be crying big crocodile tears.
Why? You have benefited from the depreciation expense by lowering your taxable ordinary income year after year against your rental income. The good people at the IRS figure they might as well get some of the money back when you sell of the property.
How much? Up to 25% of the “recaptured” portion. To quote Nicholas Aiola, CPA, from New York, NY, “That’s like someone inviting you to a dinner party and giving you a nice meal and wine only to ask for 25% of the cost on your way out. But what if you refused the food and wine? It doesn’t matter! You still have to pay up to 25%. And you wonder why no one goes to the IRS’s dinner parties. . .”
Residential rentals are depreciated over 27.5 years and land is not depreciated. If your depreciation basis is $275,000 and you have held a residential property as a rental for 3 years, your yearly depreciation is $10,000. $10,000 x 3 years = $30,000 x 25% = $7,500 you will owe in taxes. This is a pared down example. The formula is much more complicated because nothing the IRS ever does is simple or easy.
In case you were one of the many unfortunate souls who invested at the wrong time in say 2005 or 2006 you still have to pay tax on the depreciation recaptured when you sell. Say what? Talk about the IRS pouring salt into your wounds! You are losing money and have to pay tax. Another stunning fact is if you did not take the depreciation write off you still have to pay tax on the recapture.
One way to defer the tax on all this mess is to do a 1031 exchange. Before putting the property on the market you should meet with your accountant and a 1031 Exchange expert to determine your potential tax liability.
What is a 1031 Exchange? (Ok if you already know all this skip down to the juicy stuff at the bottom where it says “I am over being a landlord. I highlighted this section in green.”)
The term 1031 Exchange (aka a “Starker exchange” or a “Like Kind exchange”) is defined under section 1031 of the IRS Code. To put it simply, a 1031 exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold. A “like-kind property” is purchased with the profit gained by the sale of the first property. And no you cannot buy a property you will immediately use as your personal residence.
The 1031 Exchange Rules require both the purchase price and the new loan amount be the same or higher on the replacement property. There are four types of exchanges but this article will focus on a delayed exchange, as it is the most common. A delayed exchange means once you have completed the sale of the investment property you have forty-five (45) days to identify and one hundred and eighty (180) days to complete the purchase of the replacement property. The money has to be placed with an intermediary called an exchange agent. The money cannot go directly to you. Consult with a 1031 Exchange specialist to make sure you are in compliance with the IRS rules.
I found a sweet condo in Lake Tahoe, NV. It would be a perfect retirement home for me. Are you sure I can’t buy this and make it my personal residence in the future?
Yes you can but only if I get to visit. Seriously you can convert a rental into your personal residence but there are a bunch of rules. The property must be held for 24 months, must be rented out at market rate for no less than 14 days per year and you cannot use the property for personal use for more than 14 days or 10% of the total days it was rented.
So does this mean I can eventually avoid paying taxes and get a retirement home at the same time?
Yes if you are willing to wait. You have to hold the property for two years as a rental, then move into the property and live in it for at least five more years. There is a capital gains exemption on the sale of a personal residence of $250,000 for a single person and $500,000 for married people. Hopefully you are in a high tax bracket and can realize a significant savings on capital gains. Again the IRS has made this as complicated as possible and can change at any time without warning. Before buying a property you want to move into check with your accountant and a 1031 exchange expert to make sure you follow the rules or it could cost you big time.
What types of properties qualify for a 1031 Exchange?
You can exchange multiple properties for a larger one and vice versa as long as the new properties are like the original properties. Both properties must be in the United States. The net market value and the equity of the old property you sell must be the same or greater than the shiny new replacement property. Let’s say you have a property worth two million dollars and a mortgage of five hundred thousand (we should all be so lucky). The replacement property has to have a total value of $2 million.
Do I have to invest all of the gain in the replacement property?
The short answer is yes if you want to avoid paying any taxes. If you receive money (called Boot) you will pay capital gains taxes on this money. Using the above example if the replacement property is worth $1.5 million then you would pay taxes on the $500K. (This is a simplified explanation, as I wanted to keep this article short. Well too late for that.) However paying taxes on a $500K gain is a problem I would like to have.
Will I still have to pay taxes when I eventually sell and do not want to do another 1031 exchange?
Oh yes indeedy. The IRS has just been patiently waiting for this day to arrive. The 1031 exchange defers the taxes i.e. pushes out when you will have to pay. Hopefully when you are ready to get completely out of your investment your tax bracket will be lower which means your tax bracket for the long-term capital gain will be lower. Well wait a minute. Did I say hopefully your income would have dropped to put you at the poverty level tax bracket? What was I thinking? Yes you would pay less in taxes but you sure will need the money. But I digress.
I am over being a landlord. Surely there is another way to invest my gain to defer the taxes?
Yes. If you have at least $100,000 of gain to invest you can put your money into a Delaware Statutory Trust (DST). A DST is a business trust formed under Delaware law. The DST provides owners with a passive fractional ownership rather than owning a whole property. Essentially you sit back, relax, go fishing, watch the ball game or whatever and wait for the check from the DST to appear in your bank account. No more hassling with unexpected expenses like replacing HVAC units, plumbing or roofs.
What types of properties does the DST hold?
The properties include multi-family, self-storage, senior housing, retail and healthcare properties. Typically the assets are newer, have at least 10 years left on the lease and are occupied by NYSE tenants. You can see some examples here.
What are the benefits of a DST?
Well there is the obvious one of delaying when you give the IRS your hard earned money.
Diversification – You can invest all or a portion of your proceeds in real estate assets that are in place. Rather than putting all your eggs in one real estate market basket you can select different property types and geographical locations. How many people rushed into the Phoenix market right before the crash and bought a bunch of properties believing the run up would continue? A lot. In January 2011, considered the bottom of the market, there were 42,881 active listings. In March 2018 there were 4,053 active listings.
Professionally Managed – Ownership is in institutional quality real estate assets and is managed by professional real estate companies. The operating manager, aka Sponsor, takes care of all of the decisions. (Not to be confused with the Sponsor that helps you at AA.) Let’s face it. Not everybody is great at managing rental properties.
Regular Income – Income from the investment is paid monthly and is passive.
Replacement of Debt, if applicable, can be accomplished as financing is pre-arranged and is non-recourse to the investors. Mortgage Boot is not a kick in the butt though it sounds like it could be. Boot occurs when the Exchanger does not acquire or replace debt that is equal to or greater than the debt that was paid off and is therefore “relieved” of the debt. Therefore, the debt relief portion is taxable, unless offset by adding equivalent cash to the transaction.
The DST works well for estate planning and achieving philanthropic objectives. Investors can instruct the Trustee to send monthly income to a non-profit which can be used as a reduction on the exchangers tax liability. These specific benefits should be discussed with your tax attorney and or CPA to determine its application in your particular situation.
Can my investment lose value?
Yes just like any investment. Unlike Bernie Madoff, who claimed all of his 4,800 clients were making money every year while bilking them out of an estimated $64.8 billion, there is no sure thing when investing. Just like the real estate you are invested in now it may be worth more or less than it was when you purchased it.
How much has been invested in DST and what has been the return?
In 2017, approximately $1.7 B of equity was invested in DST’s. Because of the variety of properties that DST’s invest in the returns, like the gas mileage on your car, will vary.
Who manages the properties?
The money is invested in real estate. The manager of the real estate assets is called a Sponsor. The Sponsor is responsible for finding the investment property, doing the due diligence to try to make sure it is not a dud, structuring and financing debt (if applicable). After the property is purchased the Sponsor handles the property and program management and liquidation of the trust assets through a Master Operating Lease with the Trust.
How trust worthy are the Sponsors that manage the properties?
The Sponsors go through an extensive background check. They have to have a proven track record of managing the specific type of asset before they are assigned the responsibility. The key is to find an experienced Registered Representative, i.e. someone with experience in the real estate capital market industry, to vet the Sponsors.
What if I want to sell my interest in the DST?
The chances of selling your DST interest are slim and none. It is not like shares of publicly traded stock, which are easily sold on E-Trade with a couple clicks. When you invest in real property individually, like a fourplex or apartment building, it is not easily liquidated. However it is somewhat easier than a DST thanks to real estate databases like the Multiple Listing Service, LoopNet and CoSTAR.
Let’s use that pesky timeshare you bought after too many Margaritas when you were in Cancun, Mexico. It seemed like a good idea at the time. Five years later, after paying the yearly maintenance and some special assessments for a property you have not seen since the alcoholic induced purchase, you are ready to get out. DST’s, like timeshares, have no established market making it difficult to sell your interest. And like timeshares the buyer will probably not give you full value unless there have been astonishing returns. And if there were astonishing returns why would you sell? If you want to sell it is up to you to find an interested buyer, pay the commissions, escrow fees, etc. to liquidate your interest in the property. Basically you are in a DST until the Sponsor decides to liquidate.
So the Sponsor can decide to liquidate the DST?
Yep. For example you buy into a new apartment complex for $500K. A few years later you get a letter from the Sponsor saying the property is going to be sold for a nice profit and your share will be $750K. Whoo Hoo! You have a choice of taking the money and paying the taxes, 1031 exchange into something else or take a portion (pay the taxes) and reinvest a portion. At this point you can take your money out of the DST and 1031 exchange back into regular real estate. But you have to sell. Think of it like the Musketeers. All for one and one for all. Generally this will happen in about 10 years since the Sponsor looks for properties with 10 years left on the lease.
How do I get started investing in a DST?
Talk to an expert. There are many DST experts and advisors so make sure you find someone with a lot of experience. Look got someone like Dan Mercer Sr.. Dan is a Registered Representative with over 40 years experience in real estate capital markets industry. You can contact Dan at 602-315-0884 or [email protected]