While we enjoy a rising market, it’s always a smart move to consider the eventual dip in the cycle that can severely cripple an investor if they are not forward-thinking in their preparation. Here are several strategies to help insulate your investments and mitigate financial fallout when the market takes a downturn. To recession-proof your investments, consider the properties in your portfolio. Identify where you have made wise investment choices with appreciation that you can reallocate and put to better use.
Here are my recommendations on how to make that gain profitable while recession-proofing your holdings.
- First, stagger your sales. Sell the properties with the least amount of gain, depreciation, and the highest cash equity. For these particular properties, do not 1031 exchange, pay the tax. The properties with high-gain and low-cash equity are the properties you will want to 1031 exchange.
- Use the cash from the taxed sales to pay down your debt on 1031 exchanged properties so that you can recession-proof those properties with a lower debt load.
Pro Tip: You can allocate your proceeds in any way you want in a 1031 exchange. So why not buy two replacement properties – one for cash and one with maximum leverage. Enjoy the recession-proofed debt-free property and the extra ROI (Return On Investment) bang from maximum leverage on the other.
Remember depreciation recapture is taxed the highest. Capital gains are taxed the lowest. Equity is not taxed at all (unless it is profit). So, when trying to reshape your portfolio while minimizing tax, sell the properties that have the least depreciation recapture and the highest amount of equity (lowest debt). If you sell those and pay the tax while 1031 exchanging the others, you will minimize your taxes while sheltering the optimal assets.
For growing your recession-proof portfolio, another recommendation would be to let the market speak on each sale. There’s no penalty in starting and not completing a 1031 exchange. So let your 1031 exchanges commence on each sale, and if you find quality replacements in the 45-day identification period, then finalize your 1031 exchange. If not, then don’t turn in a list and let your 1031 exchange die on Day 46. Sure, you will have to pay the exchange fee to start a 1031 exchange, but there is no penalty from the IRS for not completing one. You pay the tax and a slightly reduced 1031 exchange fee (as it is a deductible cost of the sale). You would want to think of the exchange fee as buying you the identification period while you see if you can find suitable replacements.
Pro tip: If you happen to be selling toward the end of the year and start an exchange, then let it die after Day 45, you will receive the proceeds early the following year, which means you won’t have to pay the tax until April of the year after that. So, for the price of a 1031 exchange, you will get to look at potential properties, and you will defer taxes for an additional year.
My best advice to recession-proof your REI portfolio – keep your options open! Spreading out the tax by selective 1031 exchanges gives you a runway to do what you want with your properties. Look at each property individually, keep the investments with the best NOI (Net Operating Income), sell those with the least amount of gain, depreciation, and the highest cash equity. Look for investments in up-and-coming areas with low maintenance or reinvest in a different property type (if that is what you are looking to do). In the end, remember, no one ever went broke paying tax on profits. (It just feels like you do!)
For help deciding which properties work best for you to 1031 Exchange, see my article: How to Build Wealth Now, Pay Taxes Later with a 1031 Exchange.
*Originally Posted on BiggerPockets.com