As we start yet another year of economic growth, this may be a good time for you to preview your disposition strategies to make sure you are always ready to take action.
If you have owned your industrial building for a few years or more, you are in the enviable position of deciding what to do with a massive gain in accumulated equity that is the result of the biggest and longest bull real estate market in Orange County’s history.
Many property owners like you are busy updating their investment strategies as they contemplate retirement. Some are deciding to sell outright to reduce the risk of what they see as an inevitable market correction. Others are exchanging into assets with a lower risk profile or getting ready to convert their owner/user facilities into third-party leased investments.
With a new year upon us and a storm cloud or two on the horizon, this is the perfect time for you take a serious look at your options going forward. We are in conversation with property owners just like you every day and these are just some of the options that come up:
Hold for the long term. This is a strategy that has worked quite well for you thus far. Property values have more than doubled since 2011 and have more than tripled for those properties acquired back in the mid to late 1990’s. So, it’s hard to argue with a hold-for-the-long-term approach. And, if your estate strategy is to pass along your current portfolio to your heirs, then it may be wise to stay that course. But, if you have other plans for your equity, then holding on exposes you to the loss of your current gain if the market goes into a significant corrective phase.
Sell outright. For those who have plans to redeploy their equity into other asset classes or other items like homes, boats, cars or other personal interests, cashing out and realizing the capital gain is a viable option. Generally speaking, those who have highly appreciated assets owned long term will pay roughly one-third of their gain in state and federal taxes in the year of sale. Those won’t be fun checks to write, but the remaining two-thirds of the gain are the sellers to use as they see fit and can even be distributed to heirs immediately without further taxation so long as the estate tax threshold is not exceeded. The idea of actually seeing eventual heirs enjoy their inheritance is compelling to many.
Swap ‘til You Drop. This foreboding but descriptive phrase refers to the stepped-up basis strategy that is so prevalent these days, especially for property owners who are otherwise secure in their retirement plan and do not contemplate needing the proceeds from any particular asset to meet their life needs. Perhaps the biggest tax advantage in the IRS’s code book is the step up in basis heirs receive in the event they inherit a highly appreciated asset. Literally every dollar of gain and depreciation taken in an investor’s real estate lifetime will never be taxed if his estate is properly planned and executed. Even if it all started with a $50,000 basis decades ago that has turned into a multi-million dollar portfolio today built through a series of exchanges, heirs take title at current market value at the point of the investor’s death, and are free to sell it all without a dime in taxes at the state or federal level. This is a decades-old proven estate strategy, and for obvious reasons, remains very popular today.
Partial Exchange. This hybrid asset disposition strategy is often overlooked. Investors tend to look at selling or exchanging as an all or nothing proposition, but it doesn’t have to be that way. Some investors choose to access just a portion of their gains to acquire non-like kind property, pay taxes on the share of the gain realized and exchange the balance to defer the remainder of the tax burden. This is a good way to go for the investor who wants to acquire “quality of life” items such as a boat, luxury car or second home. It is the real estate equivalent of “having your cake and eating it, too”.
Convert from Owner/User to Investor. We have been involved in hundreds of owner/user sales over the years, and many of our clients who acquired assets for their own use have gone into those transactions thinking that someday they would move out and lease the building out for cash flow to fund their retirement years. That strategy has its merits, but there is significant risk that goes along with it. Single tenant buildings are either 100% leased or 100% vacant and they are subject to shifts in market pricing and demand. So, it requires some intestinal fortitude to ride out soft spots in market activity, and depending on how much the investor depends on the rental income, it can be a stressful situation. Unless there are other sources of retirement income in place, this strategy is generally not recommended. If not, it may be best to exchange into another asset that carries less leasing risk like a single-tenant-net-lease deal to a major credit retail tenant like CVS store or McDonalds restaurant.
Installment Sale
This time-tested disposition structure, which is best for those who have little or no debt on their properties, does not get the attention it deserves. The installment sale is an excellent option for those looking to sell at a market high point, but who don’t have an attractive alternative for redeploying their capital. In an installment sale, the asset is sold and the seller becomes the primary lender for the buyer. The buyer gives the seller a reasonable down payment in cash and then signs a promissory note secured by a 1st deed of trust on the property for the balance. Federal and state taxes on the sale are paid over time in direct proportion to the percentage of the overall gain actually received each year. At today’s prices, monthly mortgage payments usually exceed the market rent the owner would otherwise receive as a landlord, but without the risks of ownership. In the event of a default, the seller can re-acquire fee title to the property through foreclosure and repeat the process. This is a great way to generate steady retirement income secured by an asset in a market the seller knows well.
Alternate Strategies
There are several other alternative strategies available to owners of highly appreciated assets that are more complex and require a team of financial and legal experts. They include Delaware Statutory Trusts, Deferred Sales Trusts and Charitable Remainder Trusts, each offering unique advantages, but with higher cost to structure and manage. They tend to be employed by high net worth investors with more complicated investment portfolios.
The Bottom Line
The structure you choose for disposing of real estate assets will be based on your unique circumstances. So, it pays to be up to speed on the upside potential and downside risk of each disposition option so that when a decision is at hand, you choose the path that works best for you. A real estate checkup is a great place to start. Just give us a call to get started. We are here to help.
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