Real Estate
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 tom.burroughes@wealthbriefing.com
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.