Updated March 2017 — 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, you have the potential to earn a higher return on investment and possible tax benefits,” he says.
When weighing your options, it’s 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 3.8 percent investment income tax associated with the Affordable Care Act.
Your decision shouldn’t be driven by the tax consequences of selling real estate, but on whether you want real estate as part of your overall investment picture.
Advantages of reinvesting
Those taxes may 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 equivalent debt — a 1031 can be a great option,” says Derrick Tharpe, Senior Counsel with Wells Fargo Law Department. It 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 in her experience many investors using a 1031 exchange are looking to exit an asset that requires a lot of work to manage — this strategy allows them to invest 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.
Not interested in real estate?
Those who are not interested in reinvesting but are still looking to avoid a large tax bill may want to consider an installment sale, notes Lewis. In this type of transaction, the buyer pays a percentage of the price up front and the rest over time. It provides some immediate liquidity, but also a potential tax benefit.
“You pay the taxes as the payments are received,” Lewis says. “So if they pay an installment on January 1, you’ve delayed the taxes on that for a whole year, and you can have that money invested for a while before you have to pay taxes.”
If you are considering a 1031, however, timing is crucial. From the time your property sells, you have 45 days to identify a property you are interested in, and 180 days to complete an acquisition. Otherwise, the proceeds from the sale become taxable.
“You need to start thinking about an exchange when you’re ready to enter the contract,” Tharpe says. The reasoning is two-fold: First, you want to have enough time to identify a like property that you’re interested in, especially since options have dried up in some of the hotter metro markets, where values have rebounded the most. And, second, you’ll want to protect yourself by adding provisions into your contract so that the buyer can’t push back the closing date and impact your ability to purchase your new property.
Tharpe also cautions that investors may not want to wait too long to take advantage of a 1031 exchange. Currently, the US Congress is considering several tax reform proposals, many of which contain proposals to limit the use of the tax-deferred exchange rules, or eliminate section 1031 altogether.
Ultimately, your decision shouldn’t be driven by the tax consequences of selling real estate, but on whether you want real estate as part of your overall investment picture. “You have to ask yourself,” Hamrick says, ‘Why is this piece of real estate I’m moving into a better investment than the real estate I’m getting out of?’”