Too often, we see investors stuck in the belief that their equity is in a cookie jar that’s just out of their reach.
Industrial property owners today are sitting on mountains of untapped equity, as the bull run on commercial real estate enters its tenth year.
Values have more than doubled in the last eight or nine years and loan balances have fallen sharply, but most owners continue to sit on their hands because disposing of their properties would trigger an unpleasant deposit into Ol’ Uncle Sam’s bank account. Just the thought of giving up a third of their gain to the taxman is enough for most owners to hang on to their properties and hope the current up-cycle keeps chugging along.
Hindsight has shown us with great clarity that real estate markets are cyclical by nature, and this particular upswing is now officially the longest in US history. You’d think that would be enough of a sign for a lot of investors who stand to realize massive gains by taking their chips off the table. However, current market metrics tell us otherwise. Supply of quality real estate for sale remains as tight as ever and tax-averse property owners are holding on with white knuckles, hoping they will see the next correction in time to get out. A dangerous strategy, at best, and probably not a winner.
Most of the people we talk to think in terms of the two most popular disposition strategies; the straight sale and the 1031 tax-deferred exchange. The straight sale is the most painful from a tax point of view, but it allows an owner to exit the investment and keep the after-tax profits with a basis reset. At today’s price point, that results in a windfall profit even after the government gets its cut.
In the exchange scenario, taxes are deferred but there is no exit because all the proceeds must be reinvested in the up-leg, which means the risk of a market correction is still in play. But, it’s not necessarily a one or the other decision, a fact that few owners take into full account.
The two concepts can be blended and fine-tuned to meet the particular desires of the property owner. For an exchange to be fully tax-deferred, the exchanger must reinvest all the cash proceeds from the down-leg sale and the take on at least as much debt on the up-leg as is being paid off on the down-leg.
However, an owner can choose to defer any portion of his gain in the exchange transaction and pay capital gains taxes on that portion of the gain that is ‘realized’ in cash or in debt relief. This partial exchange is a great option for investors who want to access some of their equity for other purposes and reduce the amount of equity at risk of a market correction.
Let’s say you own a building with equity of $1,000,000, which is four times the down payment you made when you acquired it, and you have a $200,000 mortgage balance. This is a common scenario today and if you are in such a position, good for you.
For the sake of our example, let’s say that you have a gain $900,000 after adjusting your basis for capital expenditures you made and accumulated depreciation taken. Your federal capital gains and state income taxes will likely be just under a third of your gain or roughly $300,000. That’s a lot of wampum, but you have your eye on a second home on a lake in Idaho with its own dock, and you like to fish. The price of that property is $300,000 and you want to pay cash for it.
So, you decide to sell your building and exchange into another investment property with half of your cash, or $500,000, and take on at least $200,000 in new debt. With your next tax return, you would pay half your taxes on the sale ($150,000) and use the remaining escrow proceeds ($350,000) to pay cash for the place on the lake and a new bass boat with all the goodies. You have successfully deferred the balance of your tax on the gain and have effectively reduced your exposure to a market correction by 50%. Plus, you now have a really nice getaway and a new boat that you own for cash.
True, you have also written a big check to pay your taxes, but as the old saying goes, that and your ultimate demise are absolutes.
So, the takeaway from our little scenario is that your disposition strategy can be customized to accommodate your appetite for risk, the degree to which you remain in the game and your desire to pursue personal interests and enjoy your life to the fullest.
Too often, we see investors stuck in the belief that selling real estate is an all or nothing game, and they think of their equity as being in a cookie jar that’s just out of their reach.
More on this topic coming your way soon. In the meantime, if you are interested in learning more about a strategy that works best for you, just give us a call. We are here to help.