When highly appreciated real estate investment property forms part of the marital estate, consider suggesting that your client utilize IRC Section 1031 and Delaware Statutory Trusts (DST) to defer capital gains tax on the sale of the investment property in the divorce settlement process.
By John P. Cito, Divorce Financial Analyst
When a jointly owned highly appreciated real estate investment property exists in a marital estate, the parties have several options regarding the equitable distribution of the property. One party may want to keep the asset and offer to buy out the interest of the other. Another option is to sell the property, have each party receive their appropriate portion of the distribution, and make each party responsible for paying their share of any taxes related to the sale. A third option is to do an IRC Section 1031 like-kind exchange and take advantage of the tax deferral of the gains of the real estate investment property they have sold.
Defer Capital Gains Tax with an IRC Section 1031 Like-Kind Exchange
According to the IRS, the simple definition of a 1031 like-kind exchange is that it provides an exception that allows you to postpone paying capital gains taxes if you reinvest the proceeds from the sale of an investment property (the “relinquished property”) into similar property (the “replacement property”) as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free. The seller has 45 days to identify a replacement property and 180 days to close.
“Rev. Proc. 2002-22, Section 6. Conditions for Obtaining Rulings” details 15 conditions an investment property must meet in order to be considered as a potential replacement property. For the complete list of conditions, go to www.irs.gov/pub/irs-drop/rp-02-22.pdf.
It is important to note that, under the Tax Cuts and Jobs Act, IRC Section 1031 now applies only to like-kind exchanges of real property and not to exchanges of personal or intangible property. See www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips
IRC Section 1031 Like-Kind Exchange: Case Study
My clients, Bob and Linda, purchased a seven-unit apartment building one year after they were married in 1980 for $21,000.00. Their divorce was finalized in 2015 and they agreed to a 50%-50% split of the Fair Market Value of the building. Bob was no longer interested in dealing with the property, but he still wanted the positive cash flow to help with his obligations to pay some of Linda’s expenses as part of their divorce settlement. Linda had no interest in being a landlord and needed the money to begin her new life.
The building sold for $460,000.00. Linda took her portion in cash and Bob decided to defer any capital gains and began looking for a replacement property to take advantage of the 1031 code. Since Bob was not interested in being a hands-on landlord, he asked me to search for a reputable 1031 Exchange Sponsor (an individual or company whose job is to locate, underwrite, finance, and acquire investment real estate for a group of individual 1031 investors). I located a number of 1031 sponsors with a mix of o industrial, commercial, and residential portfolios. After considering the pros and cons of each, Bob chose a sponsor who had a portfolio of apartment buildings held in a Delaware Statutory Trust (DST).
Some of the advantages of a DST are the ability to diversify by property (Bob could have chosen up to three different properties), a lower investment amount, and usually, there is long-term, non-recourse financing.
Bob benefited not only by deferring the capital gains tax on the property, he now has rental income paid monthly without the management responsibilities – the three Ts: Tenants, Toilets, and Trash – and has ownership in several different pieces of Real Estate, which gives him geographic and economic diversification. Linda’s share of the proceeds from the sale of the seven-unit apartment building gave her cash to start her new life, and the income from Bob’s new investment properties allows him to pay her agreed-upon expenses.
John P. Cito is a Certified Divorce Financial Analyst® who is also trained in Collaborative Divorce. His firm, John P. CitoCDFA, LLC, is dedicated to assisting family lawyers and their clients on all things related to finances. Mr. Cito established Cito Capital Advisors LLC, a New Jersey state registered investment advisor, and is Vice-Chair of McDermott Investment Services LLC, a national broker-dealer, Member FINRA, SIPC. www.divorceplan.com
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