Direct real estate owners, often high net worth entrepreneurs, face obstacles to tax-efficient asset reallocation. Recently increased capital gains tax rates, and depreciation recapture exact a large toll on the proceeds of sale. The following brief provides strategies for tax-efficient asset reallocation for the real estate entrepreneur.
Entrepreneurs often accumulate wealth through a concentrated investment in the asset class of their specialization. Business entrepreneurs typically accumulate a concentrated stock position, either closely held or, in the event of an IPO, in publicly traded stock. Real estate entrepreneurs tend to accumulate concentrated positions in direct real estate investments.
At some point the entrepreneur may be persuaded to diversify – and will need to rebalance assets. Often this occurs when the entrepreneur is ready to take a more passive role in the venture and begins to focus more on retirement, philanthropy, and estate planning. Diversification may also be prompted by a desire for liquidity and risk reduction; for example, the real estate investor may want to reduce or eliminate recourse obligations and personal guarantees.
The investor with a concentrated stock position will learn about exchange funds and various derivative strategies to create reduced exposure to the one asset and a broader exposure to the investable market while minimizing the risk and cost of capital gains. The purpose of this brief is to discuss the alternatives for the real estate entrepreneur who faces additional transaction costs and tax liabilities on the sale of direct real estate investments.
Sell Property and Pay Taxes
The most straightforward approach to reducing exposure to real estate and generating liquidity is to sell the property and to pay all taxes due. If one is selling land in a tax-free state the effective capital gains tax rate will be 23.8% – and that may be palatable. If, however, the property includes depreciated building improvements (subject to depreciation recapture at 25%) and there are state and local capital gains taxes due then the total effective capital gains tax rate may be north of 30%. In NY and CA the rate may easily reach 40%.
When the higher tax rates are applied to properties with a low tax basis, and lacking other alternatives, many investors will decide not to sell.
Finance Existing Property
If liquidity and diversification are the only concerns, the simplest approach is for the real estate owner to leverage the property and extract cash tax-free. Available financing will be a function of: the strength and predictability of property cash flows; real estate fundamentals such as property location, type, and demographics; and the credit-worthiness of the property owner/borrower. Financing can be recourse (the borrower is fully responsible for repayment) or non-recourse (repayment obligations are limited by the property cash flows and collateral). The amount that can be borrowed and the interest rate on the note will vary accordingly.
If, however, there are corresponding goals of risk-reduction and the attainment of more passive ownership, then other options need to be explored.
Sale Leaseback
A business owner who owns real estate used to operate a business may choose to raise cash by selling and leasing back the property. She could sell the land and the building, just the land, or just the building – depending on the level of operating control desired, the amount of liquidity needed, and longer-term plans. She may choose to pay taxes or utilize one of the tax deferral strategies to be discussed.
UpREIT (Section 721 Tax Free Exchange)
One alternative for the real estate investor is to contribute the property to a Real Estate Investment Trust (UpREIT) in exchange for REIT shares, thereby diversifying ownership from one property to a portfolio of properties. This is analogous to the Exchange Fund option for stock investors; the investor takes an interest in a security that is tradable in the market. The process has a couple of steps. First, the investor contributes the property to the umbrella partnership owning the REIT in exchange for operating partnership units in the REIT, with its entire portfolio of holdings. Because a sale of the contributed property by the REIT will trigger a capital gain for the contributor, a deal is struck regarding a period of time the partnership will refrain from selling the contributed property, or if it does, indemnify the contributor from the tax consequences of selling the contributed asset. The investor diversifies within the real estate sector and defers a capital gain for, typically, up to seven years.
The UpREIT strategy is very useful, but it has two major disadvantages: limited diversification and loss of control over a future tax liability after the period of indemnification. Once the indemnification period expires, a sale of the contributed asset by the REIT, with no required consent from the investor, will trigger a capital gain tax for the investor. With current blended capital gains tax rates between 30% and 40% (depending on amount of depreciation recapture, and state and local rates) this can be a scary liability to manage.
Hedge Exposure
Another approach is to hedge the investment return risk of a concentrated real estate position by short-selling public REITS or REOCs (Real Estate Operating Companies). However, costs and timing issues make this prohibitive for most.
Foundation or Donor-Advised Fund
If charitable giving is a major component of the real estate sale objective, the investor may also gift the property to either a foundation or a donor-advised fund. The foundation is generally the most flexible for gifting illiquid assets, but there are donor-advised funds that will accept privately held stock and real estate. The gifting of the property is not a taxable event and may also generate a tax deduction. Additionally, the asset may grow in value, tax-free, and enhance the philanthropic mission.
Section 1031 Tax Free Exchange
A very tax-efficient solution to the over-concentration of wealth in direct real estate is to sell and utilize a tax-deferred exchange. The rules of the deferred exchange (Section 1031 of the Internal Revenue Code) require the seller to buy replacement property of equal or greater size to the adjusted sales price of the relinquished property. Additionally, all cash proceeds from sale must be held by a qualified intermediary and reinvested in the replacement property. If the goal is passive ownership and safety, then suitable replacement property could be commercial real estate subject to a long term lease to a credit tenant (investment grade). This property can deliver a safe coupon and can be efficiently leveraged with nonrecourse debt underwritten to the credit of the tenant; it is very much like a bond –with the added security of real property.
A preferred property will combine the best of credit tenancy and real estate fundamentals. The lease will have regular increases to match inflation and it will be NNN – such that the tenant is responsible for all property maintenance and repair. Additionally, the term of the lease will be long enough to defer the gain for an extended period of time, and potentially until it passes into the investor’s estate.
In summary, the real estate investor sells the operating property and defers the built-in capital gain with a Section 1031 exchange into passive, bond-like replacement property. A new, nonrecourse loan will provide proceeds for asset diversification, and the equity that remains invested in the real estate produces a safe return for 15-20 years. The investor has complete control of his tax destiny and retains economic alternatives to sell, leverage, or reposition the asset in the future.
Conclusion
Traditional investment theory postulates that taxes should not drive investment decisions. However, investors with concentrated wealth in real estate face unique challenges. The combination of higher transaction costs and taxes due on a property with a low tax basis may make selling the investment an unattractive alternative. As explained in this brief, there are several tax-efficient approaches to creating liquidity and diversification – each with its own opportunities and challenges. At the end of the day, the
investor should plan comprehensively and then pursue the strategy most consistent with retirement, philanthropy, estate, and tax planning objectives.
James R. McCartney is a Managing Director at Net Lease Capital Advisors and holds the Chartered Financial Analyst (CFA) designation.
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