Real Estate Strategy for Long Term Owners – Part 2

Last week we began to take a look at the alternatives for property owners who purchased their assets more than 15 years ago.

These are the investors who have the most to gain by selling their properties, but realizing gains through a disposition also has its costs and complexities that deserve full consideration before a decision is made.

This week – two more alternatives that make good economic sense for many investors.

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3. Tax Deferred Exchange

For owners who wish to redeploy equity to expand their portfolio or move their companies to more efficient facilities without precipitating a taxable event, the tax deferred exchange is a great option.

The Internal Revenue Code 1031 tax-deferred exchange provision is perhaps the mostly widely used tax mechanism in commercial real estate. Investors of all types and sizes utilize this tax benefit to expand portfolios, relocate their businesses and redeploy equity to maximize returns.

This has become especially true since the IRS approved new rules to allow for the non-simultaneous exchange, which allows the down-leg (the currently owned property) to be sold before the up-leg (the property being acquired) is even identified.

The rules are clearly defined and strictly enforced, but specialized assistance accessed through real estate accommodators is readily available to make sure that transactions are completed within the IRS guidelines.

In an exchange, the down-leg is sold with the title and proceeds held by an accommodator until the up-leg is in position to close. The up-leg must be acquired within 180 days of the closing of the down-leg and the property must meet the “like-kind” rule, which is defined as property held for investment, trade or business. The rule is broad enough for investors to exchange into a wide variety of alternative investments and defer all or a portion of state and federal taxes that would otherwise be due.

Investor owners who have built significant equity in their down-leg property have the option of acquiring one or multiple properties of greater value by using the leverage gained through low interest rate financing.

Other investors who own properties with poor cash flow, as is the case with vacant land, can exchange into leased assets that offer monthly income they can use to service other debt or to supplement retirement income. Exchanging into several properties in different product types in multiple markets offers a great opportunity for investors looking to diversify their portfolios to decrease overall risk.

Owner/users can utilize the tax-deferred exchange to acquire facilities that have the locational and functional components that reflect the current and future needs of their businesses. Change in the way properties are used is commonplace, and it’s not just a matter of needing more or less space. Business models change for a variety of reasons, and users often find that the building that once fit their business operation to a tee, have become clumsy, inefficient and obsolete.

Fortunately, demand from owner/users to acquire buildings is at an all-time high.

So, any current owner/user looking to exchange need not be concerned with the salability of their existing building. The challenge is in acquiring the up-leg property, as supply is well short of demand in all size ranges in today’s market. Prices have moved much higher, but the availability of 90% loans at fixed rates under 5% has kept demand at record levels.

But for owner/users who have outgrown their space, whether it be in terms of size or functionality, the use of the IRC 1031 exchange provision can be good for business.

4. Outright Sale

At today’s prices, long term owners can use a portion of their windfall profit to pay state and federal taxes and still end up with a handsome profit and a new basis.

Paying up to a third of sale proceeds on taxes is just too much of a stretch for many property owners. They just can’t bring themselves to write those checks, and who can blame them?

The idea of giving away that much of a profit to non-participants who did not share in the risk is enough to give anyone pause.

It just doesn’t resonate as fair given the courage and commitment it takes to buy, maintain and service the debt for industrial property. This reality is enough to keep most owners from becoming sellers and is a major contributor to the acute shortage of industrial properties offered for sale.

Those who can look past the reality of such high taxes see things a little different. Since their view of a sale at today’s prices is viewed from an after-tax perspective, the picture changes. They focus on the after-tax internal rate of return on their original down payment, and the number is so high that it makes good sense to sell, pay the taxes and move on.

They see the massive run-up in prices as an opportunity to pay their taxes with “funny” money, meaning dollars realized by a price spike they may have to give all or a portion of back in the event of a correction. They also know that a major chunk of the tax they will pay is based on the recapture of depreciation write-offs, and that number won’t change no matter what they sell their properties for.

Selling today virtually guarantees a sales price higher than has ever been recorded and after tax proceeds that are still cause for celebration.

There is also a qualitative aspect to the straight sale that may be well worth considering. By realizing a profit, your taxes are paid, your basis resets and the after-tax proceeds are yours to keep. You can finally buy that boat, take a trip around the world or send your children or grandchildren to college. The choice is yours and that is a good feeling.

Yes, the numbers are important and it’s prudent to maximize returns and keep taxes as low as possible. But, the inevitable truth is; you can’t take it with you and there comes a time to take your chips to the cashier and leave with the house’s money in your pocket.

At this point in the market cycle that is not just a possibility, it’s as close as it gets to a sure thing, and that’s tempting more long term holders of industrial property every day.

What would you do with your windfall? If nothing else, thinking about it might just put a big smile on your face.

Coming Up Next

In Part 3 of this discussion on real estate strategy, we take at the Installment Sale. Continue to Part 3 by clicking here.