Tax-Smart Moves When Selling Real Estate
If you’re thinking of selling a real estate asset, a 1031 exchange can protect your gains.
If you jumped into real estate at the bottom of the market around 2008, or if you’ve been holding onto an asset even longer, you may be considering selling it now that values have climbed back to prerecession levels in many parts of the country. But what are your plans for the proceeds?
Your path may well be dictated by your current asset allocation, says Alex Hamrick, Senior Trust and Fiduciary Specialist with Wells Fargo Private Bank. “It’s really a macro question for someone, based on what the entire balance sheet looks like,” he says of the decision to either cash out or reinvest in another property. For example, if you have numerous real estate holdings, and their value has increased faster than your equities or other non-real estate assets, you may be out of balance, too heavily weighted toward real estate.
On the flip side, if all your investments have progressed at a similar rate, you may want to sell one property but reinvest the proceeds into a different real estate asset to keep your balance.
Real estate remains appealing
Hamrick says that while some people might be seeking to cash in on real estate price increases, holding onto real estate may still be an attractive option for those seeking an alternative to fixed-income assets, like CDs or money market accounts, which continue to offer low yields.
“With real estate, your return on investment has the potential to be higher, and you’ve got some tax benefits,” he says.
When weighing your options, it’s also worth noting that the value you can get for your real estate investment wouldn’t be directly reinvested into the equities market. You would face short- or long-term capital gains taxes, depending on how long you’ve owned the property. State and local taxes may also come into play, as may the new 3.8 percent investment income tax associated with the Affordable Care Act.
Advantages of reinvesting
Those taxes can be avoided — at least for a while — if you choose to reinvest the proceeds of your real estate sale into another piece of property, a process known as a 1031 exchange (named after the section of the tax code where the rules are outlined). These types of changes are allowed for investment properties, and not, except in very rare circumstances, for residential property, including vacation homes.
“If you just want to take the equity and cash now and reinvest it into a similar property — what we call an equivalent debt — a 1031 is a great option,” says Derrick Tharpe, Vice President of Wells Fargo 1031 Exchange Services. The equivalent debt is the key to how a 1031 exchange works. This is also known as a “like kind” exchange, both because an investor is acquiring a similar type of property to the one being sold (in this case, real estate), and because — to fully defer taxes — all of the equity received from the sale of a property must be used to acquire the replacement property. If you purchase a lower-priced asset and end up with cash on hand, those proceeds are subject to taxes.
Stefanie Lewis, Senior Wealth Planning Strategist with Wells Fargo Private Bank, says many investors she’s seeing using a 1031 exchange are looking to exit an asset that requires a lot of work to manage in favor of investing in a more passive real estate asset, such as a stand-alone drug store or auto parts shop. These properties typically have high-credit tenants on long-term leases, which lessens the chance the property owner will see their building go vacant or need to look for a new tenant.
Read more at Wells Fargo Conversations: Tax-Smart Moves When Selling Real Estate By Matt Harrington