It is not uncommon for owners of investment property to fail to analyze their property periodically to determine the level of benefit generated. The most obvious benefit is the cash flow—gross income offset by operating costs—but frequently owners not only do not know the level of cash flow being generated but the rate as well. It is not uncommon for owners either to underestimate or overestimate the value of their property by a considerable amount. In addition, many properties are subject to deferred maintenance, which can obscure a property's value.
Determining the current rate of return on real estate is different from determining the rate of return on other investments. Having held a property for a number of years, an investor may have a good rate of return on the overall investment; however, accounting for current property value and a potential failure to keep rents at market rates, current returns may be very low.
Example Part 1: If a property has a current net value of $900,000 and an annual net income of $40,000, the return is only 4.4%—even though the original investment may have been just $200,000. Most investors would prefer a 7% return—or $63,000 annual income—without any management headaches.*
Property owners have a tendency to hold on to their properties—and to let their rents fall behind the market so that their yield is low. As time goes on, necessary repairs may go unmade and the cost of this deferred maintenance builds up; after all, repairs can be a headache to complete. In such situations, however, tenants become unhappy with their circumstances and let their irritation show, causing more difficulties for the landlord. An owner in such a situation is faced with some choices: make the repairs, raise rents, hire a manager to do both (accepting the additional cost), or sell the property.
Periodically, it is useful to make an evaluation of your property and determine where it falls in this cycle. We will be glad to assist you in this process and to provide you with an objective perspective.
How would most investors proceed if they had their property equity in cash? Buy back into a similar property—or use it in some other way and for some other purpose? Does the investor want to generate income? Or do they want it to grow in value over, say, the next decade? What other ideas would you have for that cash if you were the investor? Estate Conservation Associates can help you narrow your options and identify your true preferences for managing such an investment.
Many property owners are reluctant to sell their property because of the threat of substantial capital gains tax. If the equity you take out of a property can be reduced by one-third as a result of the tax liability—and it can—the reluctance of owners is understandable.
Example Part 2: The owner has $900,000 of net equity and is receiving an income of 4.4%. He sells it and becomes liable for a $250,000 capital gains tax (state and federal), realizing a net payout of $650,000 after tax. After investing that amount at 7% in corporate bonds or a similar instrument, his income new $45,000 (or about $30,000 after taxes) is little more than the previous $40,000.*
This part of the example illustrates the pitfalls of cashing out of real estate in favor of conventional investments. However, if the capital gains tax can be avoided or postponed, a 7% yield could increase his income dramatically. Our job is to help you take both step:
- Defer the capital gains tax, and
- Find an attractive yield.
While capital gains tax on profits from a property sale can be postponed by engaging in a 1031 exchange, it also means that the owner has simply exchanged one property for another. That exchange may not enable the owner to take cash out of the property (if that is an objective) and it does not relieve the owner of a continuing management responsibility (another possible objective). The only other way to avoid the tax is by using a charitable trust or structure of some kind—an alternative that may be better for some investors than a property exchange. Let's examine these two options:
Example Part 3a: The $900,000 property is sold; within 45 days, another property is identified and closed on within 180 days after the initial sale. The new property costs $1,000,000 and produces an income of 7% after expenses, resulting in $70,000 net annually. However, the new investment yields little depreciation to shelter the income and the after-tax position is about the same as donating the proceeds (see below). And, the management problem remains—the investor is either back to work or paying a management company.*
Example Part 3b: The investor establishes a charitable remainder trust with a charitable beneficiary. The property is transferred to the trust, the trust sells the property (without paying taxes) and the investor receives lifetime income from that trust. A 7% income stream from closed end bond funds, for example, generates $63,000 annual income before taxes (about $43,000 after taxes). The income is improved, but the property has been relinquished. (This strategy also generates a tax deduction in most cases that is not included in this illustration.)*
Estate Conservation Associates can help you explore these alternatives to see what would work best for your situation and goals.
The 1031 exchange is very attractive from a tax perspective and, unlike the charitable trust, it enables one to retain the asset in your estate. But, considering the work and responsibility involved, it provides little relief. Ideally, the exchange property would be a reliable, cash-flowing property that generates the desired income, thereby providing the tax shelter and transferring the management to an experienced, reliable team.
Fortunately, several experienced real estate companies are now finding these quality properties for investors and performing the services necessary to deliver a partially tax-sheltered cash flow to investors. Several qualified investors are put together to acquire properties such as area shopping centers, office buildings and storage warehouses, with the goal of high occupancy, good tenant experience, strong prospects for increasing rents, and possible build-out opportunity.
Example Part 3c: Let's assume our investor buys a 10% interest in a $25 million shopping center with his $900,000 with the expectation of receiving an 7% cash flow which is 50% sheltered. The tax on his $63,000 of annual income is only $11,000, making his after-tax cash flow $52,000, considerably more than with any other alternative illustrated. In addition, unlike the bonds or the charitable trust arrangement, this investor can expect to receive his investment back in several years with potential appreciation.*†
We can help you to identify the real estate company that specializes in 1031 exchanges that would be right for you
In order to make this arrangement work, a tenant-in-common ownership structure is used. Each investor is an owner of the property and the purchase qualifies for the 1031 exchange. With every such exchange, certain rules must be followed—or the IRS with determine the transaction invalid. The primary rule is that the successor property must be identified within 45 days from the close of escrow on the sold property. Since there are several real estate companies offering these properties, often making several available at any one time, the 45-day identification period is rarely a problem. An attractive property, structured generally as outlined above, can usually be found.
As with any investment, there are risks to the tenant-in-common ownership of real estate that are important to understand prior to making the investment.
- Fluctuations in the real estate market can negatively affect the value of the property.
- Fluctuations in the real estate market also can negatively affect vacancy rates, thereby decreasing cash flow.
- The loss of a major tenant presents unique risks that can be mitigated—but not eliminated—by multiple tenant situations.
- Major actions, such as refinancing or sale, requires unanimous approval; obtaining unanimity may be difficult when 10 or 20 investors are involved.
Of course, tenant-in-common ownership, like all real estate transactions, is moderately complex. For a complete discussion of all risk factors that are related to the offering, please contact us for the Private Placement Memorandum (PPM).
With a 1031 exchange, it is important that the proceeds of sale never come into control of the investor. From the escrow company, they must be delivered to an accommodator, a company acting as a fiduciary, who holds the funds until they are to delivered for the purchase of the successor property. We or your real estate agent can direct you to a qualified and trustworthy company. For information about and reference of intermediary/accommodators in your area, please contact us at 406-585-5384.
Shopping centers, office buildings, industrial parks, storage facilities, motels and apartment buildings generating a competitive cash flow are frequently available as tax-deferred property exchanges for small groups of investors who are seeking the advantages offered by a larger property as well as relief from management responsibilities. These tenant-in-common ownership arrangements are generally structured as five- to seven-year holds with the opportunity to cash out or to exchange into another successor property at that time. These are structured as private placement securities and thorough documentation is provided prior to making a commitment to the investment property (which can also be inspected on site).Several California companies offer replacement properties, but these are constantly being assembled, financed with investor subscriptions, and being taken off the market when fully funded. Please contact us for further information about properties currently available and/or to facilitate an on-site inspection.