Real Estate Exit Strategies: 1031 Exchanges and Other Tax-Efficient Options for Investors

Real estate investment strategies can change over time, and you may find yourself asking whether you want to continue owning real estate or whether you should sell and consider other investment alternatives. There are many investment alternatives, but the problem with selling real estate to get into them is that capital gain recognition may be triggered, and you may have less equity to reinvest.

However, there are a few options that may help investors exit or reduce direct ownership of real estate while potentially reducing, excluding, or deferring capital gain recognition, depending on the strategy and the taxpayer’s facts and circumstances. Many of these strategies are complex and their suitability is totally reliant on your particular facts and circumstances, so be sure to talk with your tax or legal advisor before pursuing any of these alternatives.

Option 1: The 1031 Exchange

Internal Revenue Code Section 1031 applies to property held for productive use in a trade or business or for investment, and it allows for the deferral of capital gain recognition if the property is exchanged for like-kind property. Section 1031 applies only to qualifying real property, not personal property. The broad definition of like-kind can help investors in many ways. For example, owners tired of the headache of managing several properties can leverage their equity into one larger one.

IRC Section 1031 also has broad geographic application for real estate throughout the United States. For example, a couple who own rental houses in California but have kids attending college out of state may be able to exchange their California rentals for qualifying investment properties that their children can rent from them while attending college, if the rental arrangement satisfies applicable requirements. Any rental to family members should be reviewed carefully to confirm fair-market rental terms, investment intent, and compliance with Section 1031 requirements.

Many investors exchange real estate throughout their lives and leverage their unused tax dollars to purchase more real estate that generates greater and greater returns. Some investors may have lower taxable income in retirement, which can affect applicable capital gains tax rates. However, the actual tax result depends on the taxpayer’s facts, including holding period, depreciation recapture, net investment income tax, and state tax. Some investors then leave their real estate holdings to heirs, who may receive a basis adjustment at death, which can reduce or eliminate built-in gain for income tax purposes, depending on the facts and applicable law.

Option 2: An Installment Sale

An installment sale, also called a seller carryback note or seller financing, works best for real estate investors who want to sell their real estate but don’t need a lump sum payment. Instead of receiving a lump sum of money at the time of sale, buyers pay the seller monthly income at a rate and term to be decided by the seller. Taxes are not avoided with an installment sale. Under the installment method, a seller may report a portion of gain as installment payments are received, rather than recognizing all gain in the year of sale, subject to important exceptions and limitations. Interest, basis recovery, depreciation recapture, and other rules may affect the timing and character of income recognized. The tax benefit of installment reporting is that because taxes are not due in one lump sum at the time of sale, interest is earned on the deferred dollars over the years. Always discuss the transaction with your tax advisor, as installment sale reporting may be disallowed, limited, or affected by the structure of the transaction.

Option 3: The Charitable Remainder Trust (CRT)

A properly structured CRT may allow an investor to transfer appreciated property to a trust and receive required payments. With this option, the asset is transferred to a trust, the trust can sell the asset without immediate capital gain recognition at the donor level and make required payments to one or more noncharitable beneficiaries, and the remaining trust assets pass to charity at the end of the trust term.

The main advantage of a CRT is that, in addition to required payments and satisfying philanthropic objectives, the donor may qualify for a charitable income tax deduction, which is based on the present value of the charitable remainder interest, subject to applicable deduction limits and other requirements. If the deduction is not fully used in the year of contribution, it may be carried forward for up to five additional years, subject to applicable limitations. CRTs are highly technical and should be structured by qualified tax and legal advisors.

Option 4: Joint Use of IRC Sections 121 and 1031

When a personal residence is sold, IRC section 121 allows for capital gain exclusion of up to $250,000 if a taxpayer is single and $500,000 if a taxpayer is married, as long as the residence has been owned and personally used by the taxpayer for an aggregate of two of the five years before the sale. Rev. Proc. 2005-14 provides guidance on how Sections 121 and 1031 may apply to the same transaction when property has been used both as a principal residence and for business or investment purposes.

For example, if a house was bought 20 years ago for $100,000 and is now being sold for $1 million, the taxable gain is $900,000. If the property is owned by a married couple who converts the house to a rental, they may be able to exclude $500,000 of tax at closing under IRC Section 121, and then perform a 1031 exchange and buy another rental house for $500,000, to potentially defer recognition of remaining gain through a properly structured Section 1031 exchange. The actual result may be affected by depreciation recapture, nonqualified-use rules, exchange requirements, and the taxpayer’s specific facts.

Option 5: Gifting Real Estate Interests

If you want your children to own a portion of your real estate while you are still alive, you can gift portions of the real estate to them each year in the amount of the applicable annual gift tax exclusion, which is adjusted periodically for inflation. Or, if a Family Limited Partnership (FLP) is set up, you can gift limited partnership interests to the children using the applicable annual gift tax exclusions (plus the FLP can be discounted). One caveat: Unlike inheriting real estate in which the heir’s basis is the fair market value of the property as of the date of inheritance (stepped-up basis), a donee generally receives the donor’s carryover basis in gifted property, so recipients of gifted real estate should consult their tax advisor before selling to evaluate potential income tax consequences and available planning options.

There are many other strategies that can be used, and often the best results come from a combination of techniques. There are also many risks and disadvantages associated with all of the options. For example, CRTs can be costly to structure, installment sales involve credit and collection risk, and exchanges require strict compliance with Section 1031 rules. In addition to consulting with a tax advisor, investors should look for a real estate attorney with tax and business experience, and may also want to consult a financial planner regarding broader investment alternatives.