Wealth Building With Real Estate

Three little ideas that can mean big upside for your clients.

September 20, 2007
by Alan Haft

Although there’s plenty of bad press and dark clouds over the housing market these days (see related story in today’s issue), it’s hard to argue that real estate will remain a foundation of many people’s wealth for a long time to come.

As AICPA Wealth Management Insider readers well know, building wealth with real estate can be as simple as buying a house, living in it for many years and eventually selling it for a profit. Building wealth with real estate can also be as “simple” as investing in a commercial property such as a shopping center and collecting an income from it while it presumably appreciates in value.

That said, the purpose of this article is not to address the more familiar scenarios above, rather, to summarize three often overlooked concepts that could be helpful to your clients:

  • 1031 Exchanges (This investment is offered to Accredited Investors only. Have your client consult their financial representative for more information about qualifying as an Accredited Investor.)
  • Tenants-In-Common programs
  • Using IRA money to buy real estate

Let’s take a closer look at each.

1031 Exchanges

In its simplest form, a 1031 exchange provides your client with the opportunity to defer payment of capital gains tax when selling one property for another. By deferring taxes owed on a sale of a property, your client basically has more money available to purchase a new property, essentially receiving a “tax-free loan” from Uncle Sam on the amount of money that would have ordinarily been lost to taxes.

Although 1031 exchanges are relatively simple to implement, there are a handful of important points to understand:

  • 1031 exchanges do not apply to primary residences. Only property held for investment or business purposes can qualify.
  • The property being bought and sold must be of “like-kind.” Generally, “like-kind” simply means exchanging one investment or business property for another. Although the definitions of “like-kind” is generally liberal, state laws could differ so be sure to take a closer look at the state(s) in which the property(s) are being bought and sold.
  • The property being purchased must be of equal or greater value than the one being sold. In addition, the equity and/or debt of the new property must be equal to or greater than the equity and/or debt of the property being sold as well.
  • For a qualified exchange to take place, your client must identify the new property within 45 days and the transaction must be complete within 180 days.
  • The exchange must be conducted through a Qualified Intermediary. The real estate investor cannot take possession of the proceeds from the sale nor can they maintain any control of them. If any of these important criteria are not met, the exchange does not qualify as a 1031.
  • Multiple properties can be included in a 1031 exchange. For example, one can exchange several smaller properties for a single property and vice-versa.
  • Cost basis is carried-forward from the property being sold to the one being purchased. The newly purchased property does not take on its own cost basis.
  • Any taxable gain from depreciation recapture is deferred as well.

There are many other important issues that need to be addressed before any transaction takes place, but hopefully the above summary demonstrates that a 1031 exchange can certainly be a worthy benefit to consider before someone sells an investment property.

Tenant-In-Common Programs

One of the main shortcomings of a 1031 exchange has nothing to do with the process itself. Rather, it has to do with the common problem of simply not being able to identify a “like kind” property worthy of purchase after the original property is sold.

In such a case, you might advise your client to consider one of the many Tenant-In-Common programs available in the country. Otherwise known as a “TICs,” “fractional-ownerships” or “co-ownerships,” these programs provide real estate investors with the opportunity to purchase a partial or proportionate interest in an existing property, instead of owning the entire property itself.

Although a 1031 exchange can take place when “rolling” the proceeds of the sold property into a TIC, some investors shy away from these programs given the lack of controlling interest. Conversely, some investors might actually prefer a TIC program given the management of the property is off-loaded to a third-party, obviously at a cost.

That said, when a 1031 is desired and a property cannot be identified, one might consider a TIC program in order to defer paying the capital gains.

Using IRA Money to Invest in Real Estate

When it comes to building wealth with real estate, this is without a doubt one of the biggest surprises out there. Unbeknownst to many, it is entirely legal to purchase real estate using individual retirement account (IRA) funds, but there are a handful of restrictions and important details to consider before doing so.

Technically speaking, IRAs cannot invest in things such as artwork, rugs, antiques, metals, gems, stamps, coins, beverages, stock in an S corporation, life insurance and other tangible personal property. Other than these items, everything else is generally fair game, including real estate such as land, commercial property, residential property, real estate options and real estate loans.

Although using IRA funds to purchase real estate is generally simple to implement, there are a few restrictions and important details to consider such as:

  • The custodian of the property. Most IRA custodians will not allow real estate to be purchased within their accounts. Only a select few custodians in the country specialize in these types of arrangements.
  • The purchase of real estate can be for investment only. Real estate such as a primary residence cannot be purchased using IRA funds.
  • The IRA cannot buy real estate from a "disqualified person.” A disqualified person is defined as the IRA owner itself, a spouse, a direct descendant or ascendant (for example, a daughter, son, mother or father). To simplify this important point, it is completely legal to use IRA funds to buy real estate from a stranger or parties generally outside the family bloodline.
  • An investor cannot personally guarantee a loan when IRA money is being used to purchase a financed property. For those asked to personally guarantee a loan when using IRA money to purchase a property, various banks do specialize in loaning money to IRAs to help finance such a purchase. However, when financing is necessary, a simpler way to buy real estate using IRA funds might be to purchase the property in partnership with money held outside the IRA, with a third-party or even as part of an LLC which is completely legal as well.
  • An investor using IRA funds to purchase real estate could incur Unrelated Debt Financed Income. UDFI is the income and/or capital gains tax attributable to the financed portion of the property. UDFI must be paid by funds within the IRA. Taxes incurred by using IRA funds to purchase a financed property are typically greater than taxes incurred from a property purchased with funds outside an IRA.
  • If at all possible, when using IRA funds to purchase real estate, it’s ideal to buy property that does not require financing. If financing is required, one should consider purchasing the property in partnership with third parties (as stated above, third parties such as money held outside the IRA or as part of an LLC). In the arrangement where no financing is required when buying the property, the major benefit is that no UDFI would likely be incurred.

Needless to say, the above covers only the general concepts of using IRA funds to purchase real estate. But when it comes to building wealth from investing in real estate, if there is one concept many investors are not aware of, hands-down, I’d say this one is it.

As with all concepts mentioned above, be sure your client understands all the details well before diving in. After all, when it comes to investing, taxes and just about everything else, it’s the details that always count the most.

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Alan Haft is a nationally-recognized author and investment advisor. He offers securities through Workman Securities Corp., Eden Prairie, MN . Member FINRA/SIPC. For more information, please visit http://www.alanhaft.com.