The Best Kept Secret in Real Estate Investing
by Nate Higgins, M.S., MBA
Almost every real estate investor has heard of a 1031 Exchange - a provision in the US tax code that allows for the deferral of capital gains on the sale of real estate when it is exchanged for a like-kind property. While the 1031 Exchange is a wonderful tool for the active real estate investor looking to build their portfolio, it does have it’s drawbacks. Among them, the investor is under tremendous pressure from a time perspective. The investor must identify a like-kind property in 45 days and close on that property in 180 days. Additionally, if one is looking to scale back from their active real estate holdings, a 1031 Exchange is less than ideal.
You may love real estate as an asset class, but simply don’t have the desire to manage it anymore. You’d like to sell, but over the years you have steadily depreciated the property to the point that the basis is significantly lower than what you paid for the property, while the property itself has appreciated substantially. In other words, if you were to sell today you’d have a sizeable capital gain liability. Enter the 721 Exchange.
A 721 Exchange involves exchanging the property for the shares of a Real Estate Investment Trust (REIT). Where this is advantageous for the property owner:
- Allows the property owner to transfer their real estate exposure from active to passive (i.e. no more headaches from managing tenants or vendors)
- The owner retains exposure to real estate as an asset class in the form of institutional grade real estate
- Receives truly passive income in the form of a quarterly dividend (which they can also elect to reinvest to buy additional shares)
- Unlock the equity in their property without having to refinance or pay capital gains from a traditional sale
- The transaction itself is a low to no fee transaction (aside from traditional brokerage and transaction fees)
- Shares are liquid and can allow the owner to sell a few shares at a time
Disadvantages of a 721 Exchange:
- Property can only be exchanged for shares of the REIT
- Control of the REITs properties is not in the hands of the shareholder
- Property must be in an LLC in order for the 721 Exchange to be initiated
At this point, you’re probably wondering, what is a REIT? A Real Estate Investment Trust (REIT) is a company that owns income-producing real estate. Modeled after mutual funds, REITs provide investors the opportunity to own real estate and the opportunity to access dividend-based income and along with the asset appreciation. REITs lease space and collect rent on the real estate they own. This could be a wide variety of asset classes, including: apartments, medical office, vacation rentals, and industrial. The company generates income which is then paid out to shareholders in the form of a dividend. REITs must pay out at least 90 percent of their taxable income to shareholders.
No capital gains deferral strategy is a magic bullet that will suit every situation. However, there are alternatives available outside of a 1031 Exchange that will empower the real estate investor to defer capital gains while attaining passive, tax-advantaged exposure to real estate as an asset class. Call Equilus Capital Partners to learn more: 509-665-88349.
What is a REIT– Why should I care?
by Nate Higgins, M.S., MBA
Imagine a way in which you could own a part of skyscrapers, vast swathes of farmland, or even a portion of tens of thousands of apartment units. In today’s day and age, this is a very achievable objective. In fact, with a brokerage account, one could obtain exposure to these asset classes in a matter of minutes. However, this wasn’t always the case. At one time, only high net worth individuals and large pension and private investment funds had access to these types of real estate assets. That changed in 1960 when President Dwight D. Eisenhower signed into law the Cigar Tax Extension Act, also known as Public Law 86-779. Overnight, this gave the everyday investor access to institutional grade real estate through the creation of an investment vehicle known as the Real Estate Investment Trust or (REIT).
All of a sudden the common investor could invest in a skyscraper or portfolio of properties with as little as a few hundred dollars. Investors now had access to income producing real estate through a vehicle very similar to a mutual fund. This was groundbreaking and changed the investing landscape in a variety of ways:
- Investors had access to real assets in a liquid vehicle (meaning they could readily buy or sell their interests in the REIT)
- The everyday investor now had a way to diversify their real estate holdings across both asset classes and geography
- Investors could gain the advantages of investing in real estate without the hassle of sourcing a deal, performing due diligence on the property, or arranging financing
The investors weren’t the only ones to benefit from this newly created investment structure. Infrastructure investment in the United States saw a dramatic increase in the next decades as the newly formed REITs pooled investor capital to create new railroads, office parks, apartment buildings, warehouses, amongst other real estate assets. This allocation of capital allowed the United States to see a boom in construction, which created jobs, an increase in tax revenue, and provided investors with a less volatile, inflation hedged stream of income.
When Real Estate Investment Trusts were created in 1960, they came with regulations that were associated with their operation. These rules include:
- REITs must pass through at least 90% of their income to investors in the form of dividends
- Invest at least 75% of its assets in real estate or cash (includes US Treasuries
- Derive at least 75% of its income from real estate (including rents received and the sale of property)
- Have shares that are fully transferable
Well, that’s great Nate. Why should I care? In a time of historically low interest rates, it is difficult for investors to find stable sources of income that are neither distressed nor overvalued. The dividend yield on the S&P 500 is below 2% and bond yields - even amongst distressed issuers - have fallen to near all-time lows. As values have soared in equities and fixed income, it has become increasingly difficult for investors to find both value and cash flow - two elements critical in the preservation of capital, portfolio growth, and income. Also, as interest rates continue to remain low, the value of real assets will begin to rise as inflation increases. Real Estate as an asset class is an excellent way to participate in this rise.
Real Estate Investment Trusts give individuals the ability to source inflation protected, tax advantaged income that provides diversity from the highly appreciated bond and equity markets. It empowers investors by giving them a historically less volatile way to achieve investment objectives. Stocks and bonds are not the only games in town available when it comes to growing one’s wealth. Additionally, some REITs utilize an accelerated depreciation schedule that allows the dividend to be much more tax advantaged than dividend income that is achieved through traditional equities or bonds. As an investor in the REIT you can achieve both growth from the appreciation of the real estate held by the REIT as well as the dividend income that is derived from rent.
REITs should not be the only asset that an investor utilizes, but they do provide one more option for the investor looking for preservation of capital, income, and growth. Contact Equilus Capital Partners for further information.