By Mallon FitzPatrick, CFP
Seasoned investors who are approaching advanced years may hold significant rental real estate assets as part of their investment portfolio. Given the stock market’s recent volatility, their strategy can make sense, as real estate may offer more stability than other risky assets and can act as an inflation hedge. Rental real estate also generates income, may provide tax deductions, and allows for capital gains deferral to generate tax alpha.
However, retaining several rental properties presents some challenges, including management, concentration risk, business succession, and estate liquidity concerns. For one thing, the next generation may not be interested in managing responsibilities of the family business – or they lack the requisite skills to do so. Note that an overconcentration in real estate, or any asset class, may make an investment portfolio vulnerable to a boom-and-bust cycle, which can be painful in a downturn.
In our experience, we observe that clients are often reluctant to sell their rental properties. They may have significant unrealized capital gains, especially if they’ve deferred taxes through 1031 exchanges. But the tax savings they enjoy from retaining their real estate may be outweighed by ensuing estate planning consequences, including infighting among heirs and a lack of liquidity to pay estate taxes.
For instance, suppose an investor with a $50mm real estate portfolio had taken advantage of 1031 exchanges and deferred taxes during their lifetime. Upon the death of the investor, the properties would receive a step-up in basis. The first $12 million (or $24 million if a couple) would be excluded from the estate. The value of the estate exposed to taxation could range from $26 – $38 million and the tax liability from $10-15million. Should the estate lack sufficient liquidity to pay the tax (typically due within nine months), the heirs would have two choices: either liquidate the property or borrow to fund the tax obligation. Both options could place the heirs in a precarious situation if the real estate market is in a down cycle, and could result in a fire sale. Although investors could always opt to gift properties to their heirs before passing away, if the heirs don’t want them and decide to sell, the heirs would assume the burden of realizing capital gains.
Simplifying – Tax Mitigation and Income Replacement
Many real estate investors hesitate to simplify their portfolio by selling properties because of the tax consequences and their fear of losing income. Fortunately, some viable strategies are available to them: Delaware Statuary Trust (DST) and Charitable Remainder Unit Trust (CRUT).
- A DST resembles a 1031 Exchange in that the trust buys the property, manages it, and distributes the income. Investors enjoy current income and benefit from the property’s appreciation but are relieved from the responsibility of managing it. The downside is that they forego some of the income in exchange for professional management, and they are subject to the material risks associated with owning real property, such as vacancies, fluctuating market conditions, and general economic risks. The initial transaction fee for investing in a DST may also be high, though it depends on the manager.
- A CRUT pays an income stream to either the grantor or a beneficiary, and then passes the assets to a charity at the end of the term. There are other benefits that allow the grantor to take a current income tax deduction, spread tax liability over time, and diversify the real estate portfolio.
Replicating the Benefits of Real Estate Ownership
Real estate investors receiving income from ‘principal’ and reaping the benefits of tax deductions, including the ability to run expenses through the business, may be averse to giving them up by selling outright. However, clients can replace some of those benefits by investing in vehicles such as Real Estate Investment Trusts (REITs), alternative investments, and a tax-aware marketable securities portfolio.
- REITs, either public or private, may provide diversification within a range of real estate asset classes, an income stream, potential appreciation, and tax benefits. The management fee will impact the amount of income. The investor is essentially outsourcing the management of a real estate portfolio.
- Alternative investments may also offer a good substitute for qualified investors. There are many options. One example is a strategy offered by a manager who owns, and leases rail cars. The leases are mid-long term and designed with the intent to offer diversification, a stable income stream, and tax deductions from depreciation.
- A tax-aware marketable securities portfolio, especially a well-diversified one, can provide a favorably taxed income stream of qualified dividends and municipal bond interest. Gains in the portfolio may be offset by losses to improve tax efficiency. Consistent monthly withdrawals may be taken from the portfolio to replicate ‘rental income.’
A Path Forward
In conclusion, it’s natural for clients to remain attached to properties that they have owned for several years. Along with enjoying the income and tax benefits of real estate, they’ve abided by the code, intentionally or unintentionally, of never dipping into principal. But being emotionally attached to properties is likely to impact the decision to sell when the timing is advantageous. Retaining their rental property subjects clients to ongoing management responsibilities that they may wish to forego as they age. It also may expose their heirs to onerous estate planning consequences. Fortunately, there is a combination of estate planning tools and investment strategies available to help investors simplify their estates by selling properties while continuing to reap income and tax benefits – and easing the burden on their heirs.
We have outlined a general commentary on wealth planning for rental property and can offer more specific recommendations tailored to your wishes for your family and estate. Please feel free to contact us if you have questions.
Disclosures
Investment advisory services offered through Robertson Stephens Wealth Management, LLC (“Robertson Stephens”), an SEC-registered investment advisor. Registration does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. This material is for general informational purposes only and should not be construed as investment, tax or legal advice. It does not constitute a recommendation or offer to buy or sell any security, has not been tailored to the needs of any specific investor, and should not provide the basis for any investment decision. Please consult with your Advisor prior to making any Investment decisions. The information contained herein was compiled from sources believed to be reliable, but Robertson Stephens does not guarantee its accuracy or completeness. Information, views and opinions are current as of the date of this presentation, are based on the information available at the time, and are subject to change based on market and other conditions. Robertson Stephens assumes no duty to update this information. Unless otherwise noted, any individual opinions presented are those of the author and not necessarily those of Robertson Stephens. Past performance does not guarantee future results. Forward-looking performance targets or estimates are not guaranteed and may not be achieved. Investing entails risks, including possible loss of principal. Alternative investments are only available to qualified investors and are not suitable for all investors. Alternative investments include risks such as illiquidity, long time horizons, reduced transparency, and significant loss of principal. Please refer to the private placement memorandum for a complete listing and description of terms and risks. This material is an investment advisory publication intended for investment advisory clients and prospective clients only. Robertson Stephens only transacts business in states in which it is properly registered or is excluded or exempted from registration. A copy of Robertson Stephens’ current written disclosure brochure filed with the SEC which discusses, among other things, Robertson Stephens’ business practices, services and fees, is available through the SEC’s website at: www.adviserinfo.sec.gov. © 2022 Robertson Stephens Wealth Management, LLC. All rights reserved. Robertson Stephens is a registered trademark of Robertson Stephens Wealth Management, LLC in the United States and elsewhere.