How Does Real Estate Fit Into a Retirement Income Plan?

Real estate investment offers plenty of potential: a hedge against inflation, sheltered income and asset class diversification, for starters. But owning a property directly carries expenses that can eat into cash flow. That can be problematic for investors who depend on real estate to generate retirement income.

How should you advise a client — liquidate or reassess? You need to understand your client’s goals for holding property within the broader context of their holistic retirement income needs and funding strategy — including whether to consider a 1031 exchange.

“It always has to go back to what’s best for the client, what their plan is, and what their needs and objectives are,” says Rob Johnson, head of wealth management for Realized, a platform that helps advisers manage investment property wealth.

Risks associated with direct real estate ownership

Like any other investment, direct real estate ownership comes with challenges that can create the potential for downside.

Concentration risk. Assets that play an outsized role in an investment portfolio can potentially magnify the investor’s exposure to that asset’s performance — for better and for worse. With investment property, this could take the shape of a single vacant property that not only interrupts the flow of income but also costs time and money to fill. An event such as a flood or fire could render the property uninhabitable for an extended period. Or a slumping local housing market could make the property less profitable and harder to rent out.

Work with your client to determine how much of their projected retirement income would come from direct real estate investments, and make sure they understand the risks. Thinking of their investment property as one piece of their overall portfolio can help your clients decide whether their direct real estate investments suit their risk tolerance.

“We want advisers to approach this as they would any assessment of a client’s assets, and that’s in a diversified manner,” Johnson says. “You never want to have too much of your assets in any one bucket.”

Unpredictable expenses. Your client may plan to perform landlord duties throughout retirement, but decreased mobility as they get older may make that impractical. They may eventually have to pay a third party to manage the property, which could reduce the amount of net income an investor receives from the property. Or an unforeseen major repair could sap income, maybe even force a client to draw down other investments sooner than expected, threatening future plans. Walk through a series of what-if scenarios with your client so they can see how their specific retirement plans might hold up under various circumstances.

Sale considerations. Some clients may be inclined to sell their property outright and invest the proceeds in a different vehicle for retirement income. If they’ve held the property for a long time, it may have appreciated significantly. It makes sense to want to cash in on that at some point. However, this comes with its own risks. The housing market may happen to be down just when your client wants to liquidate their property. Even if the market is favorable, a conventional sale may come with capital gains taxes that eat into the profits. You can help your client understand how much they might walk away with after a sale by modeling a range of market conditions and calculating the effect of the capital gains tax.

How a 1031 could fit into a retirement income plan

For some clients, a 1031 exchange can make sense. A 1031 exchange allows taxpayers to defer capital gains taxes on a sold property by exchanging it for a like-kind property of equal or greater value. “Clients who’ve held properties for a long period of time and have seen strong appreciation may be especially good candidates for a 1031 exchange,” Johnson points out.

Clients can use a 1031 exchange to effectively trade direct ownership of one property for direct ownership of a different property with the intention of deferring taxes. But they will still face all the responsibilities and risks that come with direct ownership.

Clients who are realizing that direct ownership might not be the right option for them could choose to use a 1031 exchange to shift into a fractional ownership stake in a diversified real estate portfolio. This strategy offers clients a way to change the nature of their real estate investment while deferring taxes they would otherwise incur as they sell one asset and reinvest in another.

Using a 1031 exchange can be a strategy for transforming direct property ownership into a passive investment vehicle, such as a Delaware Statutory Trust (DST). It also creates the opportunity for clients to defer taxes on the sale and keep more of their money working for them. And clients are likely to find it’s possible for them to diversify their holdings to a degree not possible under a direct ownership model.

Looking ahead

Remember that every client is unique, and no single strategy will suit every client’s needs, preferences, or risk tolerance. Your clients may have compelling reasons to hold their direct property investments throughout retirement or to liquidate their property and exit real estate entirely.

But it’s always worth discussing the potential benefits of using a 1031 exchange to move the value of their property into a passive real estate vehicle. It might just provide the benefits of real estate investment they prize, while potentially managing threats to the stability of their retirement income. In coming articles in this series, we’ll explore 1031 exchanges in more detail so that you can confidently help clients understand their opportunities.

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.