Do Capital Gains Count as Income?

  You recently sold your house, your boat, or corporate stock for a tidy profit. But as you focus on plans for that extra money, along comes your brother-in-law, who shares an unexpected fact. Namely, the IRS considers sales-generated earnings as taxable income.

You scratch your head, wondering how this is possible. Undoubtedly, the IRS regards your salary, bonuses, and other on-the-job earnings as taxable income. But could that profit on your house, boat, or stock sale really count as income?

The answer to this question is yes. The profit you earn from the sale is a capital gain, which is a type of income. However, the IRS taxes capital gains differently from your take-home pay. As such, it’s important to understand the ins and outs of capital gains, to help you understand what you could owe when your taxes come due.

Defining Capital Gains

Earnings come from two sources, one of which is the above-mentioned take-home pay. The IRS places take-home pay under the category of “Wages and Salary,” or “ordinary income,” which also includes tips, commission, and bonuses. The taxes you pay on ordinary income depending on your tax bracket or how much you earn in a given tax year. The more you make, the higher your tax bracket.

Then there is the other earnings source, known as capital gains. You’ve probably realized that selling a capital asset generates capital gains. And as you’ve also likely discovered, capital assets consist of property acquired to create value over time, such as houses, boats, and stocks. Stamp collections, art, and baseball cards could also be considered capital assets.

Your capital gains are calculated by subtracting the sales price by the adjusted basis. Delving into the dictionary, “basis” is the original price you paid for that capital asset, plus additional expenses involved. For instance, if you make repairs to a house while you own it, your basis will include the original purchase price plus the added repair expense.

To reiterate, the IRS considers both take-home pay and capital gains as income. Both ordinary income and capital gains taxes are based on take-home pay. However, while ordinary income taxes can be as high as 37%, the tax rate on capital gains won’t reach higher than 20%.

How Long Do You Hold?

With the difference between capital gains and ordinary income in mind, let’s move on to the capital asset holding time. In fact, let’s say that you are a “house flipper,” someone who buys houses, fixes them up, and sells them within six or eight months. While you might earn a good profit from this action, it’s important to know that the IRS dubs those earnings as short-term capital gains. However, if you decide to own your investment houses for longer than a year, the IRS considers profits generated from their sale as long-term capital gains. What’s the difference? The IRS taxes short-term capital gains at the potentially higher ordinary income tax rate. On the other hand, your long-term capital gains fall under the possibly lower capital gains tax designation.

Additional Tax Issues

Now, once you’ve accepted that your brother-in-law knows what he’s talking about, the other piece of news is that the capital gains you earned from your house, boat, or stock sale will increase your adjusted gross income or AGI.

Returning to the dictionary, AGI consists of your total gross income, less specific deductions. Adding capital gains to that total could push you into a higher tax bracket. But once again, those capital gains are taxed differently from ordinary income, depending on when you sell your capital asset.

All Income is Not Created Equal

Anything you earn -- whether salary or asset sale -- is considered taxable income in the eyes of the IRS. However, much as you can reduce ordinary income through approved tax deductions, it’s possible to reduce or defer capital gains taxes through reinvestments, exchanges, or other shelters. In short, the more you understand the ins and outs of capital gains and ordinary income, the better prepared you are to lessen your potential tax hit.

To learn more about this topic, contact us today.

---

Source: Do Capital Gains Count as Income?

https://www.creconsult.net/market-trends/do-capital-gains-count-as-income/

Getting Acquainted with Delaware Statutory Trusts (DSTs)

 

The COVID-19 pandemic has real estate investors questioning their portfolios' makeup, interests in managing properties, and long-term objectives. Delaware Statutory Trusts (DSTs), in which investors own shares in a trust rather than full properties, may contain some of the answers. more

DSTs are passive real estate investments run by professionals who manage property acquisitions and day-to-day operations. They often contain relatively low minimums, making them accessible to many real estate investors.  

The History Behind DSTs

The state of Delaware originated DSTs with the Delaware Statutory Trust Act of 1998. DST trustees and investors do not need to reside in Delaware, but they will file a trust certificate with the state when forming a DST.

Once a little-known trust structure, DSTs gained broader appeal with a 2004 Internal Revenue Service ruling. The IRS said, “A taxpayer may exchange real property for an interest in the Delaware statutory trust described above without recognition of gain or loss under § 1031 if the other requirements of § 1031 are satisfied.” The IRS essentially made it possible for passive investors to own fractional shares in a real estate trust and opened the door for DSTs to be included in 1031 exchanges.

A DST in a 1031 Exchange

A 1031 exchange makes it possible to sell one real estate investment and reinvest the proceeds in a like-kind investment of equal or greater value to defer capital gains and depreciation taxes.

While some investors will relinquish one property and choose a single replacement property, the opportunity to invest in a DST gives investors an important tool to diversify holdings, have an interest in large-scale institutional holdings that may otherwise be too expensive, and serve as a backup replacement property if originally identified properties fall through.

Key Benefits of including DSTs in a 1031 Exchange

DSTs can have investment minimums as low as $25,000 and can be combined with other properties in a 1031 exchange. Investors aren’t required to qualify for property loans or establish and maintain a limited liability company (LLC), an expense that can run $1,000 annually, opening the door for investors to have a stake in multi-unit apartment complexes, and commercial office buildings, and other property types.

1031 exchanges require like-kind replacement properties to be identified within 45 days of closing on the relinquished property and close on the replacement properties within 180 days. It’s possible to identify and complete a DST investment in less than five days, making it an ideal backup plan in a 1031 exchange for those up against deadlines.

Professional Property Management

Investors don’t need to be up against a deadline to find DSTs appealing. For many investors, the biggest DST benefit is professional management. A property manager receives the call when a pipe bursts and figures out how to collect when a tenant is late with the rent. While those owning properties outright can always outsource maintenance and management responsibilities, the owner is ultimately the responsible party. Most DSTs are set up for investors to collect regular distributions for a steady monthly income and look to capitalize on the appreciation of assets at the time of eventual sale.

Points to Consider Before Investing in a DST

While DSTs offer various benefits, real estate investors should be sure to read the offering memorandum’s fine print.

DSTs are long-term, illiquid investments that often are set up to last five-to-10 years. DST shares do not trade on an exchange, and if an investor wishes to exit before the trust goes full cycle, they will either need to find other investors to purchase the shares or sell them on a secondary market.

Some fees are not part of an actively management property, including commissions paid to leasing agents, property management costs, and the trustee's fees at the time of sale.

All 1031 exchanges require a Qualified Intermediary (QI) to facilitate the exchange and ensure the investor doesn’t take possession of the relinquished property’s proceeds. The QI may charge approximately $1,000 or more, but an experienced QI can help find DSTs that align with the investor’s goals and help the process go smoothly.

---

Source: Getting Acquainted with Delaware Statutory Trusts (DSTs)

https://www.creconsult.net/market-trends/getting-acquainted-with-delaware-statutory-trusts-dsts/

The Role of 1031 Exchanges in Estate Planning

22

Completing a 1031 exchange can allow real estate investors to defer taxes today and plan accordingly to avoid burdening their heirs with a hefty tax bill later.

A 1031 exchange involves selling a piece of real estate investment and reinvesting the proceeds in a like-kind real estate investment of equal or greater value to defer capital gains and depreciation recapture taxes ultimately.

The possible tax benefits that the 1031 exchange may offer, in combination with the option to divide assets appropriately to benefit heirs down the line, make 1031 exchanges an estate planning strategy worth considering.

Step up in cost basis

While there are reasons a real estate investor would want to sell a property in a standard transaction and pay the required taxes, this path could cost the investor upwards of 30-40% of the profits, which go straight to the IRS.

In a 1031 exchange, taxes on the gains on the relinquished property are deferred. Neither the estate nor beneficiaries face a tax liability upon the owner's death. Instead, the tax basis for the real estate investment that heirs inherit steps up to the fair market value of the date of death when they take possession. If they decide to sell the asset immediately, they will not owe capital gains taxes. They also will not be responsible for any of the depreciation recapture from which you may have benefited over the lifetime of your investment.

If the heirs wish to retain the asset, they would only be liable for taxes on gains in the future that accumulated as of the date they received the step up, up until when they sell the property. They might even consider including the property in a future 1031 exchange to defer taxes and reinvest the proceeds to defer that gain too.

Swap ‘til you drop

When investing in real estate, the properties you currently own may not be aligned with your investment objectives down the road.

It is possible to enhance your real estate portfolio over time and, through 1031 exchanges, defer the taxes each time. There is no limit to the number of 1031 exchanges an investor can complete. Investors can “swap until they drop” so long as each transaction's intent is for long-term investment rather than solely tax avoidance.

It is an opportunity to keep your own investment goals as the priority and use previous growth to have further compounded growth while also positioning your portfolio to benefit your heirs.

When there are multiple heirs

For investors who plan to leave assets to multiple heirs, it is possible to consider their financial situations when structuring your 1031 exchange.

As part of the exchange, investors may purchase multiple, or in some cases, an unlimited number of properties, setting the stage to leave different assets to different heirs. For example, let us suppose one heir will likely need to sell the investment after taking possession while another might want to hold the asset. In that case, it is possible to make it easy for both by purchasing multiple properties and listing each heir as a beneficiary of an individual asset.

Keep in mind that replacement properties must be identified within 45 calendar days after selling the relinquished property. It is viable to identify up to three replacement properties. Still, that limit can be surpassed so long as the replacement properties' value does not exceed 200% of the relinquished property, or the investor closes on at least 95% of the value of the replacement properties identified.

Consider a Delaware Statutory Trust (DST)

A Delaware Statutory Trust is a long-term passive real estate investment in which beneficial interests of a real estate trust are owned rather than individual properties directly. DSTs provide benefits for an investor's current situation by eliminating the headaches that come with active management properties while still obtaining all of the benefits of real estate ownership.

When it comes to estate planning, DST interests can be split among heirs, either ahead of time when purchasing the interests through the purchase of multiple of the same DST or upon death via reregistration based on instructions of Will’s or Entity documentation. This streamlines decisions while defusing potential estate conflicts. Investors should be aware that DSTs are typically designed to last five to ten years, and there is no active secondary market for investors should they need to sell.

1031 exchanges offer benefits for individuals looking to maximize their real estate investments today while setting up beneficiaries to continue building wealth. We always recommend consulting your tax or financial professional regarding how 1031 exchanges may fit your situation.

To learn more, please contact us at any time.

---

Source: The Role of 1031 Exchanges in Estate Planning

https://www.creconsult.net/market-trends/the-role-of-1031-exchanges-in-estate-planning/

The Reverse 1031 Exchange: A Guide for Investors

 

The potential for tax savings is one of the most exciting advantages of real estate investing. Many savvy investors have enjoyed the benefits of deferring their capital gains taxes by engaging in a 1031 exchange.

This process involves replacing an investment property with a “like-kind” property. When done correctly, investors can avoid paying capital gains taxes on the sale of the original property. Even better, it’s possible to continue doing this repeatedly, so you have the potential to build even greater wealth as you upgrade from one property to the next. However, this technique has some limitations.

Property investors looking for even more flexibility may want to consider a reverse 1031 exchange. Here's what you need to know. 

Reverse 1031 Exchange: The Basics

When engaging in a traditional 1031 exchange, you must sell your original property before you can purchase a replacement property. The major drawback here is that if the original property takes a long time to sell, you could miss out on your opportunity to buy the perfect replacement property.

This is where a reverse 1031 exchange comes in. As you might guess, this transaction completely reverses the process.

First, you’ll start looking at properties you want to purchase as a replacement properties. You’ll work with a qualified intermediary to facilitate the transaction when you find one.

Once you close on your new property, you have a maximum of 45 days to identify the property you plan to sell. You’ll also have a total of 180 days to close on the property sale, completing your reverse 1031 exchange.

The Role of a Qualified Intermediary

In a traditional 1031 exchange, a qualified intermediary (QI) is needed to ensure the investor doesn’t take real or constructive possession of the investment funds at any time. Otherwise, the 1031 exchange can be invalidated, and the investor would owe all or some of the capital gains tax. When engaging in a reverse 1031 exchange, there are a couple of different ways the QI may interact with investors. One method involves investors purchasing the replacement property themselves and then transferring the title of the original property to the QI. The other is for the QI to purchase the property using financing provided by the investor and then turn the property’s title over to the investor once the original property sells.

Pros and Cons to Consider

The biggest advantage of engaging in a reverse 1031 exchange is the ability to purchase a replacement property whenever the opportunity arises. This is particularly important when there’s a lot of demand for the types of properties you’re looking for.

However, there are a few potential disadvantages. First, you’ll need to sell the original property within 180 days or lose the favorable tax treatment. It’s difficult to guarantee a property will sell, so there’s some inherent risk in this. You’ll also need to have enough money to purchase the replacement property before you’ve received the proceeds from the sale of the original property. Unless you have a significant amount of cash on hand, you may find that you have difficulty persuading a lender to provide you with the financing you need.

Other Important Considerations

There are a few other important things you need to know. First, the property rules are the same with a reverse 1031 exchange and a traditional 1031 exchange. Both properties must be “like-kind,” held for investment or business use, and must be located in the United States. If the new property costs less than the original property, you’ll also owe capital gains taxes on the difference. The same is true if the value of the new replacement property is less than the sold or relinquished property, keeping in mind you can replace debt by adding equity, but you may not replace equity by adding debt.

The Bottom Line  

If you’ve found the perfect replacement property, using a reverse 1031 exchange can allow you to lock it in without waiting for the sale of your original property. However, unless you’re confident you can close on the sale of the original property within the 180-day timeframe, you’re taking a bit of a risk.

 

Before deciding to engage in a reverse 1031 exchange, it’s a great idea to discuss your specific circumstances with your tax professional, financial advisor, and, in some cases, a real estate professional.

If you have additional questions regarding traditional or reverse 1031 exchanges, Fortitude Investment Group is here to help. Contact us today to schedule a consultation.

---

Source: The Reverse 1031 Exchange: A Guide for Investors

https://www.creconsult.net/market-trends/the-reverse-1031-exchange-a-guide-for-investors/

Things to Know Before Starting a 1031 Exchange

 

If you own an investment property and are thinking of selling it, if suitable, engaging in a 1031 “like-kind” exchange may be a smart move. When done correctly, a 1031 exchange will allow you to defer all or part of the capital gains and depreciation recapture tax you would otherwise need to pay upon completion of your property sale.

1031 exchanges have many moving parts. Here is a closer look at four important things you need to know before getting started.

Assemble a Team of Experts

Putting together a team of experienced professionals right away is important to help ensure your 1031 exchange goes smoothly. The first step is to choose a reputable, Qualified Intermediary (QI).

This party is responsible for preparing and managing the important documents that apply to the relinquished and replacement properties and ensuring you comply with all necessary regulations. The QI also serves as the custodian for the sales proceeds from your property and is responsible for holding the funds until you are ready to complete the exchange. This means you absolutely must have a QI in place before you sell your property; this is not an optional aspect of your 1031 exchange.

In addition to your QI and investment professional, others you may want to add to your team include a real estate agent or broker, attorney, and CPA/Accountant. When creating your team, take the time to make sure each party you choose is intimately familiar with the ins and outs of a 1031 exchange.

Understand all Critical Timelines and Deadlines

If you fail to meet any necessary deadlines, your 1031 exchange will lose the tax advantages. Therefore, it is critical to understand the required timelines and make sure you have a plan in place to meet them.

First, you have 45 calendar days from the day you sell your relinquished property to identify your replacement property or properties (more on that in a moment). You then have a subsequent 135 days to close on those identified property(ies), totaling 180 calendar days to complete the entire exchange from sale to finish. It is important to note that these timelines run concurrently, so if you take the full 45 days to identify your property, you only will have 135 additional days to close on it.

Learn the basics of Property Selection 

IRS rules allow investors to choose from one of three identification rules. You can either,

1. Identify up to three replacement properties and close on any number of them;
2. Or, you can identify more than the three individual properties, as long as the total value doesn’t exceed 200% of the value of your relinquished property sale;
3. Or, in some special cases, you can identify an unlimited number and value of properties, so long as you close on at least 95% or more of those identified properties. 

These rules get tricky and can cause a failed exchange if not done properly. The selection process is a bit complex, so it’s best to consult with your team to ensure you’re making a suitable choice.

You will have met the first deadline once you have identified specific properties in writing to your QI. Then, you will be able to purchase one or more of the properties (consistent with IRS rules) to complete your exchange.

Always Have a Backup Plan

If anything goes wrong with your property purchase, your 1031 exchange could fail. For this reason, it is always a good idea to identify more than one replacement property. Even if you think you know which property you want to purchase, it’s crucial to have a “backup plan” in place.

Naming additional properties using the Delaware Statutory Trust (DST), for example, as your second and third options will give you additional flexibility and help ensure you aren’t left high and dry if you run into a problem closing on your first choice.

Consult with a 1031 Exchange Expert

A 1031 exchange is a common solution for many property investors. However, simple mistakes can often lead to costly results. If you’re thinking about exchanging your investment property, our 1031 exchange professionals are available to answer your questions and help guide you through the process. Contact us today!

---

Source: Things to Know Before Starting a 1031 Exchange

https://www.creconsult.net/market-trends/things-to-know-before-starting-a-1031-exchange/

A Backup Plan for Boot in a 1031 Exchange

44 

Many 1031 exchangers think of "boot" as money proceeds from selling a relinquished property that is not reinvested in the replacement property. Often this occurs because the investor has another use for some of the proceeds and is willing to incur the taxes on the amount not reinvested.

Other times, the boot can occur because an investor cannot find a suitable replacement property to invest the entire proceeds. As you remember, the 1031 exchange requires the investor to find a replacement property of “equal or greater” value to defer taxes entirely.

An example of this ‘involuntary boot’ situation would be if you sold your rental duplex for $800,000 and found a suitable replacement property you liked, but the purchase price was only $700,000. You recognize that the $100,000 in boot is not enough to purchase another replacement property, so you would be responsible for paying capital gains tax on the uninvested $100,000.

If you find yourself in this situation, there is a backup plan that could save your exchange from taxation. If suitable, the Delaware Statutory Trust or DST is a great option.

Kick the Boot

A DST is an investment structure that meets 1031 exchange “like-kind” property requirements. It has become increasingly popular among investors looking to shed the hassles of actively managing investment property while still wanting to own income-producing real estate. A DST is a passive investment where investors own fractional shares in a property or properties that professional management companies manage.

The advantage a DST offers you if you are facing boot in your exchange is the ability to invest a relatively small amount of money – sometimes even as little as $10,000 – in high-quality institutional property that meets 1031 exchange replacement property requirements.

The DST Backup

You can also help relieve yourself from the boot in your exchange by selecting a DST as one of your potential replacement properties. Remember, you can choose more than one replacement property during your 45-day identification period. If you close on your desired replacement property and recognize you will have boot, your backup DST can still allow you to complete a full exchange with complete tax deferral. As mentioned, there are instances when 1031 exchange investors may select to receive a portion of their sale proceeds in cash and pay the tax. However, for other cases where the investor is challenged to find a suitable property to invest the total proceeds and defer their tax liability, the DST has proven to be an effective backup plan! If you would like to learn more about other advantages of a DST, contact us today or schedule an appointment on our calendars here.

---

Source: A Backup Plan for Boot in a 1031 Exchange

https://www.creconsult.net/market-trends/a-backup-plan-for-boot-in-a-1031-exchange/

Inflation and 1031 Exchanges: A Guide for Real Estate Investors (Part II)

 

Our last post discussed how periods of rising inflation can affect commercial real estate assets and how today's rising price environment potentially impacts investment property owners. Depending on the types of properties an investor currently owns, and where they are located, they may find that now is a good time to evaluate one’s holdings and determine if one should make any changes. 

 

Broadly, investment real estate has historically performed well during inflationary environments compared to many other asset classes^.1 And within the commercial real estate industry, some strategies may appeal to investors who own one or a few rental properties and are concerned about sustaining their cash flow potential as inflation climbs higher.  

One of those strategies is the Delaware Statutory Trust (DST), which is becoming increasingly popular among accredited investors selling property using a 1031 exchange. This is because the DST meets "like-kind" property requirements of the 1031 exchange, affording investors the full tax-deferral benefits allowed by the IRC Code. Yet, it also has some characteristics that may help assuage investment property owners' worries today.

Tenant Stability

Many rental property owners are worried about how our high inflation will impact their tenant's ability to pay monthly rents. And many owners dislike the task of replacing current renters with new tenants.

The DST investment structure allows investment property owners to sell their property and exchange it into the DST for ownership of a fractional interest in a portfolio of properties. Because these properties are of typically institutional quality and managed by professional management firms, tenant conditions are more favorable for tenant retention.²

Portfolio Diversification

If one owns an office building or small retail center, they may have experienced what the industry refers to as "concentration risk."³ Perhaps during the pandemic, they were asked by tenants to renegotiate their leases or even provide rent relief. The office and retail sectors were hit hard during lockdowns.

DSTs often hold different types of investment property in other geographical areas, so their holdings are much more diversified. For example, a DST could hold a sizable multifamily apartment in Austin, Texas, a distribution center in Boston, Massachusetts, and a data warehouse in Orlando, Florida. Owning a fractional interest in multiple properties of different types can help manage investment risk when one property type isn't performing as well as others.

In-Place Financing

Ideally, if an investor has a loan on their investment property, it is a fixed rate note for an extended period. That would help a borrower from rising inflation because typically, as inflation increases, so do borrowing costs. But, on the other hand, if an investor needs to secure new financing, they will likely pay more for it today than a few years ago, which could lead to rising operating expenses.

DSTs generally have in-place financing on the properties negotiated at institutional levels within their portfolios. So, by exchanging an existing property into a DST, the need to secure one’s own financing is avoided. And a DST's debt is considered non-recourse to the investors, so the liability is limited.

Professional Management

Often overlooked when the cost of goods increases rapidly is the impact of more expensive materials and equipment on operating expenses. When prices are high, replacing a hot water heater or a new roof could be more costly today than just a year ago.

Since DSTs are managed by professional management firms, the trust and management group manages the expenses incurred to maintain and operate the portfolio's properties. Investors are not required to provide additional capital for repairs and maintenance as allocated within the budget. Perhaps most importantly, investors have no responsibility for operating the properties.

A Time to Consider

DSTs, as with any investment, carry certain limitations and risks investors should be familiar with prior to investing. As we have discussed here, DSTs may provide current investment property owners additional benefits to consider during periods of rising inflation. And they may also be suitable for investors during periods when inflation is not a concern.

Contact our team to schedule a no-cost consultation to learn more about how a DST 1031 exchange may help you address your current real estate portfolio concerns.

---

Source: Inflation and 1031 Exchanges: A Guide for Real Estate Investors (Part II)

https://www.creconsult.net/market-trends/inflation-and-1031-exchanges-a-guide-for-real-estate-investors-part-ii/