Here is a scenario I often see when designing a financial plan. Mike and Barb have invested in rental real estate property for years.

They have managed and maintained the property well. Due to the increase in real estate values, they have accumulated substantial equity. On paper they are millionaires, but they have relatively little cash. As they are getting older, Mike and Barb would like to simplify their lives and generate more income. They don’t want to be landlords any more, but are gridlocked over the massive potential capital gain and regular income tax they face if they sold the property.

One solution is a 1031 exchange. Nearly every real estate agent, accountant and financial advisor knows about 1031 exchanges.

What is it? Under Internal Revenue Code Section 1031, as a general rule, immediate tax liability will not result from a like-kind exchange. A like-kind exchange occurs when appreciated property held for productive use in a trade or business (or for investment) is exchanged for like-kind property that will be held for productive use in a trade or business (or for investment).

Exchanges work well. Of course, there are many requirements that have to be met or the 1031 may not be a valid exchange. If the requirements are met, the tax problem may be solved —  however the exchange may still keep the owners in a landlord situation, and it may not solve the goal of increased income.

One variation of the 1031 exchange concept is what is called the TIC 1031 or Tenants in Common 1031.

With these exchanges, a professional real estate firm that specializes in larger properties packages a property to meet all the 1031 requirements, and offers it for exchange to investors like Mike and Barb.

Typically, these packages are for commercial buildings often valued in excess of $10 million. Each respective investor sells his or her property and places the proceeds with a qualified intermediary, who holds the proceeds from the sale until the closing of the replacement property.

Most of these TIC 1031 projects require that the minimum exchange be at least $350,000 per investor and that each investor be an “accredited investor.” Accredited means that the investors have a substantial net worth or annual income.

Usually ten to twenty investors pool their proceeds to buy the new property. They hold their interest as tenants in common — hence the TIC.

The real estate firm manages the property for a reasonable management fee, and many of the TIC 1031 programs will not purchase the replacement property with much leverage or borrowing. By minimizing leverage, the property may generate substantial cash flow to the investors. I have seen the income range from five to seven percent per year. This percentage may double the cash flow of the prior property. Of course, this helps meet Mike and Barb’s goals — no capital gains tax, no landlord headaches and increased cash flow.

This transaction is quite complex. Each investor must proceed with caution and not violate any of the 1031 rules —and there are many. Also, the initial property should generally be debt-free. Of course, when investments are packaged by anyone, investors need to watch the transactions costs, fees and other expenses. It is terribly important that the real estate firm be thoroughly scrutinized.

I have seen these types of exchanges work well on rental property, farming or ranching properties, raw land, and business properties.

If you are interested in this concept, talk to you accountant, real estate broker and attorney before making any decision.

Mills is a Registered Investment Advisor and Certified Financial Planner®. If you have questions or topics, call or write him at 1030 Seminary St. Suite D, 254-0155, fax 254-0158 or e-mail suntrm@aol.com