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A New Approach for Real Estate Diversification

'Like-kind' exchanges may permit clients to defer capital gains taxes.

The forecast for real estate is highly uncertain in the COVID-19 era, with many experts expecting dramatic change in commercial, residential and industrial markets. However, this much is clear: The portfolios of many older Americans contain a respectable amount of investment real estate, and it’s something advisors need to consider as they help clients pivot their holdings toward an appropriate asset mix for retirement.

American households held $6.4 trillion in investment real estate, exclusive of the value of their primary home in 2016, according to analysis of Federal Reserve data by Realized Holdings, a company that manages investment property wealth. And Realized found that approximately 10.2 families with net worth ranging from $1 million to $15 million had more than 20% of their assets accumulated in investment properties.

This is an area where many financial advisors are outside their comfort zone, according to David Wieland, CEO of Realized. “It’s a giant pool of wealth that has gone unnoticed by most advisors and real estate professionals, generally because they don’t understand real estate at the granular level, and real estate professionals don't understand wealth management.”

Realized Holdings offers a solution for “like-kind” exchanges under Section 1031 of the Internal Revenue Code. These so-called 1031 exchanges permit investors to defer capital gains taxes through the sale of one property and the purchase of another property deemed to be similar. This can be very attractive from a tax standpoint—funds can be reinvested and kept working, and then after an investor’s death the remaining property receives a step-up in basis price. That’s not an easy thing to do with real estate, due to all the complexities and liquidity of these transactions.

Realized Holdings addresses this for its clients by creating portfolios of Delaware statutory trusts (DSTs), which can invest in, and hold, various types of real estate—commercial, industrial, multifamily residential or even vacation rental properties. (That $6.4 trillion figure does include vacation homes, but these can qualify for 1031 exchanges only under certain circumstances.)

DSTs are very different from real estate investment trusts (REITs)—a DST is a direct investment in real estate, backed by hard assets. Unlike REITs, they don’t necessarily move in correlated fashion with financial markets.

DSTs are open only to accredited investors, but many of Realized Holdings’ clients are not ultra-wealthy—they have simply accumulated an outsized amount of real estate in their overall portfolios—much more than the 10% cap Wieland thinks makes sense in most cases.

“They are people who have done very well at building wealth through the acquisition of investment properties—whether that’s a single family residence or a duplex, or perhaps the building where they ran a business,” Wieland says. “By the time they get to their mid-fifties or early sixties, those investments might represent anywhere from 20% to 60% of their net worth, but they’re not really the right assets to have during retirement. They need to shift from growth to income, they’re trying to diversify.”

Bill Howard has a client who fits that description. The president of Durant Wealthmanagement Advisory Services in Mooresville, N.C., worked with Realized on behalf of a client in her mid-70s who bought an office building and owned it for roughly 30 years. Aside from the building, she is not a high-net-worth person. “She is upper middle income,” he says. “She’s frugal and has a home that’s paid for—and she has a SEP IRA worth perhaps $140,000.”

“The office building had a cost basis of $27,000, and she received an offer to buy it for more than $800,000. Selling it made sense to her, but if we had just accepted the cash offer, our tax liability would have been in excess of $300,000. The only way around that would have been to turn around and purchase a property for her, but that’s not what she was looking to do.”

Howard’s client worked with Realized to invest roughly $520,000, divided equally among four DSTs. He wanted to diversify the investment across types of real estate and their maturation—these products have projected lives ranging from five to seven years, and the four selected by Howard’s client feature different dates. The DST investments include a range of multiunit residential housing and commercial retail. The client retained the remaining proceeds for liquidity purposes and to make some home repairs; that portion of the transaction generated a $50,000 capital gain tax bill.

Howard says the four DSTs are generating cash distributions of 5% to 6%, paid either monthly or quarterly. Roughly 75% of the distributions are sheltered from tax due to depreciation on the properties and mortgage expenses.

When the DSTs reach the end of their lives, Howard’s client will have the option to roll over into a new DST or convert to a different investment.

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