Brett Swarts, president of Capital Gains Tax Solutions, discussed specific ways to preserve real estate wealth through tax strategies in a recent interview with Joe Fairless. These options include consultations with trustees for deferring taxes, increasing liquidation, and diversifying funds.
Background in Real Estate Taxes
Brett Swarts got his background in real estate while working for his father’s family business in northern California. While serving an internship with Marcus & Millichap, he gained experience in buying and selling apartments.
Real estate taxes came into the picture later. Even though Brett was always involved in learning about real estate in some capacity, it wasn’t until he started two companies out of college that he began to move towards tackling the specific issue of real estate taxes.
Consulting on Deferred Sales Trust
The deferred sales trust was a specific and unique strategy that Brett’s company introduced while working in partnership with Estate Planning Team. The purpose of this partnership was to use the deferred sales trust as a viable option to solve a specific problem faced by property owners looking for an alternative to the 1031 exchange. There was a great need for owners to find an exit strategy from properties that require debt financing to maintain.
Getting out of debt was a recurring issue, and the deferred sales trust was introduced as the most viable method to make this happen. In an anecdotal story, Brett recounted a specific client who goes by the name of Peter from Marin County in California. As an owner of an 18-unit property, he was holding onto a debt that was around $500,000.
Peter was interested in selling the property and getting out of debt by using the deferred sales trust, which would allow him to net $1.3 million out of $1.8 million after paying off the debt. The tax liability also added another $500K on top of the original debt of the same amount; Peter felt boxed into the situation and thought the 1031 exchange was the only way out.
Getting Out of Debt
According to Brett, this situation is extremely common in the residential and commercial real estate market. Relieving the pressure to move ahead on a deal before it actually makes sense is one of the most important benefits of selecting a deferred sales trust instead of the 1031 solution.
Because there is an abundance of 1031 buyers in California interested in paying the asking price for such properties, this solution doesn’t deviate from their expectations when closing a 1031 deal. Since the buyer is unaffected, this option makes even more sense from the seller’s point of view.
To be clear, sellers like Peter are encouraged to put language into their contract that offers the option of a deferred sales trust as a backup plan in the event that the 1031 option fails. The non-constructive receipt is maintained by a QI company instead of sending the funds to the escrow account through the traditional method.
Legal Tax Strategy for Real Estate Investors
The legality of this option is assured, which is an important concern for anyone still unfamiliar with the method. This option is part of a tax law that is 90 years old, but it’s still on the books. It is a creative application of an installment sale, which is not uncommon. Funds can be held by a financial manager, who often puts the money into any number of conservative instruments like stocks, bonds, and mutual funds.
This method doesn’t prohibit the seller from returning to the real estate industry later, so diversification is always possible. The purpose of Brett Swarts’s interactions with potential clients is primarily to educate them about these options, which are often poorly understood. This solution has been proven to work for commercial real estate investors, collectors, businesses, and high-end residential real estate owners.
By contrast, the 1031 option works exclusively for investment properties. After the deal is closed, a fee is applied, and this is the primary method of compensation for his company. Trusts can be extended by a decade, or they can continue into the next generation. Typical earnings on these notes range between 6% and 8%.
The financial advisor also gets a fee, which is typically less than 1%, depending on how funds get invested. Finally, the fee to the real estate tax lawyer is around 1.5%. For properties with a large tax liability, a combination of 1031, deferred sales trust, and the Delaware might be necessary.
Interviewing Clients, Setting Goals
The interview process reveals the client’s goals. This could be to access more liquidity, for example. Other clients might prefer to have a mortgage over basis, or they might be trying to reduce their liability. The key to a successful transaction is to gain access to the client before the buyer removes these options from the table.
Maintaining the proper language within the exchange agreement is key to keeping the options open and accessible. Otherwise, the QI company might just send you the real estate tax bill. There are other options that might be available for lowering real estate tax liability. This is usually a matter of consultation so that the solution adequately matches the situation and the client’s stated priorities and goals.
Avoiding IRS Audits
Avoiding audits from the IRS is another important consideration. The use of the third-party trust is technically legal, but it’s unusual. This is why it’s important to follow the rules very closely. Since this process has been conducted successfully thousands of times, there is no reason to feel that it’s a new technique. In fact, it’s been reviewed carefully by national law firms.
Although this concept is not proprietary, the actual implementation of the strategy falls under a non-disclosure classification. Ultimately, the best way to angle and leverage your position is to buy at the right time when the deal makes the most sense; the real money is made on the buying side of the equation.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.