Financial Planning - December 2012

CLIENT

Hot Swap:
Property Exchanges
As boomers retire and relocate, these
tax-deferred deals offer a sweet way
to offload real estate investments.
By Donald Jay Korn

The coming wave of baby boomer retirements is likely to trigger a related shift in the real estate market. As clients retire — and relocate — you may find yourself discussing what to do with a Snowbelt investment property held for many years, which a client doesn’t want to manage from the Sunbelt.

“We see a lot of that here,” says Paul Auslander, chairman and CEO of American Financial Advisors in Orlando, Fla. “Many people in that situation are interested in a tax-deferred exchange, rather than paying tax on a sale.” That, in turn, may draw more attention to property exchanges spelled out under Section 1031 of the tax code.

Even though property values have plunged in many areas from their 2006 peaks, selling may still trigger a huge tax bill. Investment properties are depreciated each year for tax purposes — so long-held real estate might have scant basis, or none at all. Most or all of the sales proceeds may be subject to income tax, and prior depreciation might be recaptured at a relatively high tax rate.

“The tax bill can be surprising,” says William Jordan, who heads a wealth management firm in Laguna Hills, Calif.

Here’s how a so-called 1031 exchange might work: A retiring investor from Las Vegas sells his strip shopping center and lets an unrelated intermediary hold the proceeds. Then the seller arranges for the intermediary to buy a medical office for the investor in Dallas, using the money held from the previous sale. The double transactions let the investor avoid paying tax now; he might be able to hold the replacement property until he dies and the income tax obligation vanishes.

“Deferring taxes by using a tax-free exchange allows 100% of the dollars to be reinvested,” says Rob Studin, executive director of financial advisory services at Lincoln Financial Advisors in Birmingham, Ala. “Assuming some basis, an investor who sells and doesn’t exchange might have 85% to 90% to reinvest after tax.”

KE Y FACTORS

Clients considering a 1031 exchange
should consider many factors, from
existing diversification to life expec-
tancy, as well as taxes. But psychologi-
cally, the weakened real estate market
may be the most important issue.