Tapping Real Estate Equity, Part 2

The rapid real estate appreciation of recent years endowed many families with substantial real estate wealth but not enough cash. Real estate appreciation does not produce cash. But it does result in higher property taxes, and there are maintenance expenses to pay.

Some families also are disappointed with having paper wealth that cannot be spent or does not generate income.

In last month’s visit we reviewed several tax-wise ways families could tap the equity in family homes or second homes. We reveal a few more strategies this month.

When the property is held for business or investment purposes, then a tax-free like-kind exchange is possible. A business or investment property is a rental property or one that was purchased primarily for long-term capital gains.

In a like-kind exchange, one real estate investment is exchanged for another. The exchange is tax free to the extent no cash changes hands and no debt is assumed. One advantage of a like-kind exchange is that an investment property that produces no cash can be exchanged for a rental property generating regular income.

This kind of like-kind exchange provide the parents with income while keeping the wealth, undiluted by taxes, in the family. After an exchange, the new property takes the same tax basis as the old property. If the parents continue to hold the new property until death, then the heirs get to increase its basis to its fair market value. The gain during the parents’ lifetimes is never diluted by capital gains taxes.

The like-kind exchange also can work when the family owns land or a house with a lot of land. It is possible to split the land into a separate parcel that is business or investment property. Then, the land can be sold or exchanged for other property tax free, while the family retains ownership and use of the house.

Another strategy is to conserve the property. There are several ways to do this.

One option is to create a conservation easement. This is done by granting the easement to a government or charitable organization. The easement restricts future development of the property and gives the government or organization the right to enforce the easement against future owners.

The easement reduces the market value of the property, since its development is restricted. This reduction can become a charitable contribution deduction. The tax deduction reduces income taxes, providing cash for the family without selling the home. If the home and land are separate, the easement might make the house that is retained more valuable.

There have been some abuses in conservation easements recently, so the IRS tightened the rules and its oversight. You will need to work with a knowledgeable attorney and appraiser to implement this strategy.

You also might be able to generate cash by selling the land or a conservation easement in it. Many localities have conservation trusts or land banks that buy either development rights or land. Check out the possibilities with the local government or environmental groups. This sale would be taxable at capital gains rates.

Another possibility is to combine the sale to a land bank or government with the like-kind exchange. The family picks out one or more properties it wants to own instead of the current property. The land bank buys those properties and exchanges them for the property the family currently owns.  This like-kind exchange avoids capital gains taxes on the sale, and might also enhance the value of any contiguous property retained by the family.

After a like-kind exchange is complete, the family can take a mortgage on the property. Income from the property pays the mortgage. The mortgage proceeds are used to build a diversified investment portfolio that fits the family’s long-term needs.

Real estate is becoming the most valuable asset owned by many families. Many thousands of dollars can be left on the table if the family does not explore the many tax-advantaged ways it can exploit that equity.