Individual investors own more than 14 million properties in the United States, comprising nearly 20 million units.* For advisors, these numbers indicate that direct real estate investments could figure into the current net worth and future financial health of a significant number of their customers.

Advisors need these clients to strategize around their real estate assets as part of a long-term financial plan. By focusing on these three questions with clients who own real estate, one can uncover important considerations for incorporating investment properties into their estate plan.

“Too often advisors don’t think to ask these questions because they don’t see real estate as an asset that they manage in a liquid or custodial account,” says Rob Johnson, head of wealth management for Realized, a platform that helps advisors and investors manage their real estate assets. “But for holistic planning, they need to understand the locations of client assets across all of their investments.”

To start the conversation, advisors should use three questions to find out what investment properties their clients might own and what they might have considered doing with them.

1. How does real estate fit into your overall wealth management plan?

Advisors typically begin conversations with clients by assessing their current financial situation and how it affects their short- and long-term goals. If a client owns one or more real estate properties, it is important to assess how these assets complement more traditional sources of income and the role they can play in building wealth over time.

Some clients may have a clear idea of ​​the role their investment property plays in their financial situation, while others, often those who inherited or received real estate as part of a settlement, may need help to fit into their overall portfolio. Clients who are still decades away from retirement are likely to have a very different view of their real estate holdings than clients who are closer or even retired.

For clients at any stage of their wealth management journey, it’s good to talk about the benefits of real estate as an investment. For starters, real estate has the potential to generate strong returns, especially as some investors may qualify for related tax breaks and deductions. It can also be less volatile than many other assets, and because demand for real estate is highly correlated with expanding economies, it can be a good hedge against long-term inflation. Add in the diversification benefits that come with adding another asset class to the investment mix, and the benefits of real estate are hard to ignore.

2. What is the net income of your investment property?

That said, direct real estate ownership comes with challenges. First: manage the current expenses related to the property, then control the taxes and the insurances. “It’s not enough to have an investment property and know it’s generating income,” Johnson says. “Ultimately, every investment property owner should perform an analysis on their own or in concert with their financial advisor on the net income they derive from that property.”

This analysis can be complicated due to the irregular nature of income and expenses related to rental properties. For example, the loss of a tenant could result in a shortfall in rental income, or unforeseen repairs could require a large outlay that would eat into long-term income. It is important to discuss these possibilities with clients and take them into account when considering a property’s long-term income-generating potential.

Taxes can also reduce property income, with cash flow and income from direct property ownership being taxed as regular income. And a client who plans to liquidate faces a significant tax burden. Profits from real estate sales are taxed as capital gains, which leads to the last important question:

3. Are you interested in keeping the property, liquidating it or exchanging it for another real estate investment?

Some clients may not have an interest in getting rid of their direct real estate investment. The property may have sentimental value or generate enough consistent income that is worth keeping. Of course, clients who opt for continued direct ownership of a property have to deal with the time, effort and expense of maintaining it.

Liquidating a property brings an obvious benefit: the money from the sale. Many people choose to go this route as they approach retirement, with the goal of converting an illiquid asset into higher liquidity. Unfortunately, adverse market conditions, capital gains taxes incurred on profits or both can erode potential gains.

But few advisors or clients are aware of a third option: swapping direct real estate ownership for passive real estate ownership in managed portfolios using a 1031 exchange. These exchanges allow taxpayers to defer paying taxes on gains capital from the sale of an investment property by replacing the property sold with a “similar” property of equal or greater value. This strategy can provide more predictable real estate income with less risk and offers the potential for intergenerational wealth preservation.

In future articles in this series, we’ll explore the pros and cons of 1031 exchanges in more detail. For now, remember that real estate investments can be a great part of a diversified wealth management strategy and a an asset that no advisor should overlook when meeting with a client.

* United States Census Bureau. Rental Housing Finance Survey (RHFS) 2018 RHFS Table Creator Current Ownership Entity of Property

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


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