As we all know from reading the headlines, real estate in the Puget Sound region has appreciated significantly over the past few years. As a result, many people have much of their investment assets tied up in this real estate - whether it's a rental home, apartment house or commercial property.
But what happens when these investors no longer want to manage their property? When they get to a point in their lives when they no longer want to deal with what I call the three Ts - tenants, toilets and trash? And, when it comes time to sell, how can investors avoid the fourth T - taxes?
There is a way for investors to take their real estate holdings, defer taxes and still earn an income stream from the appreciated real estate. A way for these investors to trade in their rental residences - with rents that don't always keep up with the rising value of real estate - for a larger, institutional-quality real estate option that until recently was only available to very wealthy investors. And, there is a way to do this without paying taxes on the real estate sale.
One option is through a Tenancy-in-Common 1031 exchange. Many real estate investors already know that a 1031 exchange allows individuals who hold real estate to sell their property and buy other investment real estate and defer their taxes. There are very specific Internal Revenue Service rules that must be followed, and investors must use the services of a qualified intermediary, or 1031 exchange facilitator.
But the benefits are worth the hassle - if investors are careful. These 1031 exchanges apply to most types of investment real estate, including apartments, retail centers, office buildings, warehouses and agricultural property. The investment properties can be sold and the proceeds reinvested tax-deferred into any other type of qualified investment real estate.
Over the past four years, Tenancy-in-Common (TIC) exchanges have become the fastest growing option for 1031 exchange investors seeking suitable replacement property. That's because the IRS in 2002 released procedures outlining how to properly execute a TIC exchange. This eliminated much of the uncertainty about whether a transaction would qualify for the favorable tax treatment offered in Section 1031 of the IRS code.
A TIC exchange enables an investor to buy a piece of an institutional-grade commercial property and earn income off of the property. For example, an investor with as little as $100,000 to reinvest in a replacement property can buy part of a multi-million-dollar piece of real estate. They can diversify their original holdings in a single piece of property by investing in up to three separate TIC properties.
Here's how this works: I have a client (CMF1) who owned and managed two Seattle-area rental homes. The combined annual rental income for the two homes was $21,600. The annual combined real estate taxes and homeowner's insurance was $7,100. Therefore, the annual net profit on the two homes was $14,500.
Using the net proceeds from selling the rental homes (CMF2), the client converted into a TIC ownership of two warehouse/manufacturing centers in two different regions of the country. He no longer had property management headaches - plus he more than doubled his annual net income to $30,000 a year. Not all investors get such economic results from a TIC exchange. The new properties - like the rental homes - also offer the same depreciation benefits to the client. With the additional income, the client has more money to spend or invest - with the possibility that the properties will also appreciate in value by the time they are sold.
With a Tenancy-in-Common, investors receive a deed for their fractional ownership in the property. They receive their fractional share of the income from the investment - in addition to any potential appreciation on the property when it is sold after a typical term of five or 10 years.
Some properties have a lower income stream that is based on the performance of the property, but offer a greater opportunity to share in any appreciation when the property is sold. Some TIC sponsors offer a master lease, in which the sponsor accepts the income risk of the property and guarantees the investor a specified annual income.
In addition, many people use a TIC property as an estate-planning tool. Through a 1031 exchange, a couple is able to continue to swap out properties (tax deferred) until one spouse dies. In a community-property state such as Washington, the property passes to the surviving spouse at the current fair market value. This step-up in cost basis eliminates any income tax liability and any need for future 1031 exchanges.
These programs aren't for everyone. As with any real estate investment, the assets are not liquid and investors should plan to stay invested until the property is sold. Investors also must be accredited with a minimum net worth of $1 million. And of course, there are the standard real estate risks, including vacancies and the possibility of property devaluation.
There are now dozens of companies across the United States offering Tenant-in-Common replacement properties and billions of dollars of Tenant-in-Common owned properties on the market. The key is finding someone to help the individual investor find the right property to fit his or her needs.
Gary Justice is a principal with Feek Justice Financial in Kirkland. He can be reached at 828-1400 or gjustice@privateconsulting.com.[[In-content Ad]]
