Real Estate

Helping Clients Use Investment Property For Retirement, Income Diversification

David Wieland 27 March 2023

Helping Clients Use Investment Property For Retirement, Income Diversification

The CEO and founder of a US-based real estate business that harnesses technology talks about the diversfication and control issues in the industry.

In this guest article for our publication, David Wieland, founder and CEO of Realized, a real estate wealthtech firm providing investment property wealth management for investors, examines the sector. He looks at how income streams can be diversified. With financial markets on edge as they are, now is a good time to think harder about true diversification and making portfolios more robust. (FWR also interviewed the firm here.)

The editors are pleased to share these thoughts. The usual disclaimers apply to views of outside contributors. We invite replies, debate and comments. Email

Countless Baby Boomers may have a significant portion of their total net worth tied up in investment real estate. This concentration of wealth can bring about several potential risks and pitfalls that may not have a simple solution.

Boomers often took advantage of favorable economic conditions when they purchased their real estate. Millions of Boomers came of age during a time of extended economic prosperity, which allowed them to begin investing in real estate at a time when property values continued to rise. This long-term run-up in property values enabled them to amass significant personal wealth through real estate investments.

There are many potential reasons why Boomers gravitated toward investing in real estate versus putting their money into public equities markets. For starters, real estate is a tangible asset. Unlike traditional public investments such as stocks and bonds, real estate is a hard asset that can be seen, touched, and managed. That fact may have made real estate a more attractive investment because they can see and feel the value of their investment. 

Investment real estate can also provide a stream of income. This income stream is especially attractive to Boomers who may be nearing retirement age and are looking for ways to supplement their income. As the nation’s millions of Baby Boomers continue to age, the value of their real estate investments could continue to grow and play an even larger role in their retirement and estate planning processes.

Storm clouds may be lurking on the horizon though. Boomers’ penchant for investing in physical assets can bring about some possible problems. Here are three potential problems Boomers may experience by having a significant portion of their net worth tied up in real estate.

1. Concentration risk. Concentration risk in real estate refers to the level of exposure or risk that a real estate investor faces due to having a significant portion of their investment portfolio or assets tied to a single or limited number of properties or geographical markets. In other words, real estate investors who put most of their investment capital into one property or into a singular asset class run the risk of losing a significant portion of their investment if the property or market experiences a downturn.

Investors who put all their resources into a single commercial property or one specific location face the risk that their assets’ values could decline sharply due to local or regional market downturns, negative changes in zoning laws, or increased competition from other properties. Investors with diversified portfolios of properties spread across different locations and varying asset classes may be better positioned to weather concentration risk.

2. Capital gains taxes. Boomers who sell highly appreciated real property assets also face the risk of having to pay large tax bills.

Any investment that’s sold for more than its original cost basis generates a tax on the realized gain. Long-term capital gains tax rates on investments held for more than a year are 0, 15 or 20 per cent. The amount of tax owed depends on several factors, annual income, tax filing status, and amount of net gain.

3. Depreciation recapture. In addition to long-term capital gains taxes, real estate investors will also owe depreciation recapture tax on investment properties, even if they never claimed a depreciation deduction while holding the asset. The depreciation deduction allows property owners to deduct a portion of the property's value each year to account for its decreasing value over time. When the property is sold, the IRS reclaims a portion of this deduction, typically at a tax rate of 25 per cent.

Boomers who are considering selling investment properties and are concerned about these potential tax liabilities should consult with a certified tax professional to better understand all the financial ramifications and tax obligations of a straight sale. 

There are several ways real estate investors can break through the storm clouds and see the sunlight, though. Strategies to help minimize tax liabilities include timing the sale to take advantage of favorable tax rates, offsetting capital gains with capital losses from other investments, and using a 1031 exchange to defer capital gains and depreciation recapture taxes.

Let’s take a closer look at how 1031 exchanges work.

Completing a 1031 exchange to defer tax liabilities
One common tax-deferment strategy available to real estate investors seeking to defer capital gains and depreciation recapture taxes is to complete a 1031 exchange, which is the process of selling an investment property and using the proceeds to purchase a like-kind replacement. Investors can defer 100 per cent of any capital gains tax liabilities generated from the sale of their relinquished assets by rolling the entirety of sale proceeds over into a replacement property.

In order to satisfy exchange requirements, investors must purchase like-kind replacement properties that are of the same nature, character, or asset class. Properties don’t need to be identical – a rental home can be replaced with a triplex so long as the replacement asset is similar in usage and character.

Here's a closer look at how the 1031 exchange process works and how it can help Baby Boomers defer taxes on the sale of highly appreciated real estate:

• Engage a qualified intermediary (QI). Prior to initiating the sale of the relinquished property, investors will have to engage an exchange accommodator, also called a qualified intermediary, to facilitate all aspects of the exchange. Investors cannot directly handle proceeds from the sale, nor can they directly purchase a replacement property. Both transactions must be made by an unrelated third party, who will hold funds in an escrow account until the exchange is completed.

•  Identifying replacement property. Within 45 days of selling the original property, investors must formally identify one or more replacement properties. There are stipulations on identifying replacement assets, so consult with a QI to understand the IRS rules and regulations on identification.

•  Purchase of replacement property. Once a replacement property is identified, investors have 180 days from close of sale on their relinquished properties to close on the replacement asset. The purchase price of the replacement property must be equal to or greater than the sale price of the original property. Debt also must align with equal or greater debt – investors can’t use the exchange process to improve their financial position.

• Deferral of taxes. Once the 1031 exchange is successfully completed, investors can fully defer capital gains taxes on the sale of their original properties, and they can continue using the 1031 exchange strategy to defer taxes indefinitely.

It's important to note that a 1031 exchange doesn't eliminate capital gains taxes. Any deferred gain, along with accumulated depreciation recapture, will be due if investors sell their replacement properties in a straight sale. However, if they continue using the 1031 exchange strategy, they can continue deferring tax liabilities and potentially reinvest gains into more profitable properties over time.

The 1031 exchange approach doesn't address the issue of active management for investors who no longer want the responsibilities that come with being landlords. There are many passive real estate investment solutions that provide investors the benefits of real property investments without having to actively manage properties.

Avoid direct property management headaches with passive real estate investments

Here are five common passive real estate investment solutions:
• Real Estate Investment Trusts (REITs). REITs are companies that own and manage income-generating real estate properties. Investors buy shares in a REIT and receive a portion of any income generated from the properties owned by the REIT.

• Real Estate Mutual Funds. These are mutual funds that invest in real estate-related assets such as REITs, real estate stocks, and real estate-related debt instruments.

• Real Estate Crowdfunding. Crowdfunding platforms allow investors to pool their money and invest in real estate projects. These platforms often allow investors to choose the specific projects in which they want to invest.

• Exchange-Traded Funds (ETFs). Real estate ETFs are similar to mutual funds but are traded on stock exchanges. ETFs invest in a variety of real estate-related assets, such as REITs, real estate stocks, and real estate-related debt instruments.

• Real Estate Syndications. This strategy is where a group of investors pool their money to purchase a property. A professional syndicator manages the property, and the investors receive a share of any income generated from the asset. Two examples of this strategy include Delaware Statutory Trusts (DSTs) and Tenants in Common (TICs).

These passive real estate investment solutions offer investors the opportunity to invest in real estate without the hassles of managing properties, but DSTs and TICs are the only real options for real estate investors seeking to defer large tax bills. 

These alternative investments, along with a traditional 60/40 portfolio, can provide portfolio diversification, potentially improve the portfolio's risk-adjusted returns, and typically have low correlation with traditional asset classes. Direct and passive real estate investments also may provide a hedge against inflation because the value of real estate tends to increase as inflation rises.

Importance of portfolio diversification
Portfolio diversification in real estate is the strategy of spreading investments across different types of real estate assets and sometimes in different parts of the country in order to manage risk and potentially increase returns.

Here are some common types of real estate diversification strategies:
•  Property type diversification. This strategy involves investing in different types of real estate, such as residential, commercial, industrial, retail, or hospitality properties.

• Geographical diversification. This method involves investing in real estate assets across different geographic locations, such as different cities or countries, in order to manage risk associated with a negative downturn in a single market or region.

• Investment vehicle diversification. This strategy involves investing in different types of real estate investment vehicles, such as REITs, private equity funds, or direct property ownership.

• Tenant diversification. Investing in properties that have a diverse tenant base, such as residential properties with a mix of long-term and short-term tenants, or commercial properties with tenants from different industries, can reduce the negative impacts of losing tenants due to adverse market conditions or economic factors.

• Risk diversification. Investing in properties with different levels of inherent risk, such as properties that have a high potential for appreciation but also a higher risk of market volatility, along with properties that have a lower potential for appreciation but offer more stable returns, can help manage overall real estate investment risk.

Investors who deploy one or all of these strategies can craft more diversified real estate investment portfolios with assets spread across different product types, asset classes and locations. The benefit is that they can potentially manage their overall levels of risk, as well as increase their potential for greater long-term returns.

Bringing it all together: Using wealth management principles to build a real estate portfolio
To attack concentration and tax risks, we believe that Baby Boomers need to work with a financial advisor who can help them build a diversified, tax-managed real estate portfolio.

These portfolios take into account many factors, including:

• Tax considerations and tax sheltering; 
• Risk-adjusted returns; 
• Due diligence on security selection; and 
• Diversification across different investment spectrums.

In addition to choosing property types that meet the rules of a 1031 exchange, portfolios should be constructed with an eye toward sheltering income, which is the process of using deductions and tax credits to reduce taxable income from rental properties. For example, investors can deduct expenses such as mortgage interest, property taxes, insurance, and repairs, as well as depreciation, to reduce their taxable income. 

By taking advantage of these deductions and credits, investors can lower their taxable income and reduce the amount of taxes they owe.

These strategies can be effective in reducing or deferring taxes for real estate investors, but it's important to note that they have different requirements and limitations. A 1031 exchange, for example, requires the purchase of a like-kind property within a specific time frame. Sheltering income, meanwhile, may be subject to limits and phase-outs based on the investor's income and other factors.

Baby Boomers who make the adjustments necessary to craft diversified and well-managed portfolios can potentially reduce the tax liabilities and risk factors associated with highly appreciated real property assets. Potential benefits may include passive income, improved risk-adjusted returns, and an alternative to traditional fixed-income assets that’s uncorrelated with cyclical market trends. Instead of losing a significant portion of their net worth to economic downturns or federal taxation, they can provide a stronger financial legacy for future generations.

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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