What’s in a Title?…Everything!

One of the considerations you should be thinking about during a commercial real estate acquisition, whether a Class-A office building or a strip mall — is how you will hold title.

This is a decision you should not take lightly as there are many eventualities that occur due to this election. Of course (and it almost goes without saying), you should consult your attorney and accountant, and anyone else you feel is relevant, at minimum before making this decision. It should also be advised that this post is not intended to replace professional advice and is only meant to be food for thought as you consider acquiring commercial real estate.

There are at least four chief concerns when thinking through title alternatives: ease of trade/transfer, liability, taxes and estate planning. Ease of trade I would define as the level of challenge you will encounter either on the acquisition side or the disposition side of your commercial real estate transaction. This may not be the most important driver on the hunt to find the perfect title structure, but including this component as you look to acquire may save you headaches and heartburn later.

Liability is one issue that normally is top of mind as you begin to think about all of the stakeholders in your asset and the infinite situations that may lead some to consider litigation against you and your assets. Liability is quite simply how open your personal assets and the property’s equity are to being lost in a lawsuit. It is worth thinking about the breadth of potential lawsuits that may impact this holding as well. We tend to restrict our thinking to what lawsuits may arise in a tenant/landlord scenario only, or matters only directly related to the piece of commercial real estate, when in fact, that may not be the case at all. We could just as easily be talking about a completely unrelated matter that when litigated may affect your asset — in a very negative way.

One reason you may have been attracted to commercial real estate in the first place is the positive impact owning a piece of commercial real estate would likely have on your tax situation. Depending upon how you decide to treat the asset, you could inadvertently make your tax bill bigger, not smaller. Even worse still, like death by a thousand cuts, your tax structure may not be giving you all of the tax advantages that are available to an owner of commercial real estate. You could be paying many hundreds or thousands of dollars more than you rightfully owe.

The fourth problem, estate planning, is somewhat related to both taxes and ease of transfer. You’ve opted to invest in commercial real estate, maybe not just for personal gain, but perhaps for the benefit of future generations. If you aren’t careful in the construction of your title (and/or entity selection), additional tax burdens and concerns over who owns what may ensue. It wouldn’t take more than a few minutes of searching on the internet to find cases where people had spent their lives building a tremendous portfolio of assets just to have that portfolio dismantled after the death of the principal, effectively negating that lifelong effort.

I am sure I haven’t discussed all of the salient points of holding title to your commercial real estate project, but I do hope that I’ve discussed just enough that you will feel compelled to make appointments with the professionals on your team to hammer out your details before you sign on the dotted line. There is no ‘one size fits all’ in terms of how purchases should be structured and operated — and there are a great many variables that must be included as ingredients to your title structure. This process requires thought, research and consultation. On the face of it, rushing, skimping or shortcutting may appear to some, to be a smart and frugal way to approach this process. Results from taking this approach could run from less than optimal to utterly disastrous. You want your commercial real estate investment to fire on all cylinders and work with you to achieve your financial goals. Doing your homework and holding title in the right way is just one piece of that puzzle.

Save Big (or not) With 1031 Exchanges

You’ve found a great asset.  You’ve done your due diligence.  It’s in the best market and sub market.  It has strong financials that are poised to give you just the kind of returns that will set you along the path to financial freedom.  You decide to go for it!

Fast forward 10 years.  Fantastic news!  That great asset you found way back when has done wonders for you over the last 10 years.  Not only has the property appreciated exactly the way you had predicted, but it has been spitting cash at you since you closed.  Now you have a grand new plan.  You have decided to aim at a bigger and better piece of commercial real estate.  The question becomes:  what is the best way to handle the sale of your current property and the purchase of your bigger and better property?

You vaguely remember someone telling you about something called a 1031 exchange.  You might even recall something about a reverse 1031 exchange.  Are any of these methods right for you?  In order to answer that question, we first have to define a 1031 exchange and then think about what the processes involved in a property exchange look like.

A 1031 Exchange Definition

A 1031 exchange (also called a ‘like-kind exchange’) is a tax treatment that allows a property owner to postpone taxes owed on any gains made through the sale of his or her property.  If so elected, the owner selling their property selects a like-kind property to purchase within a specified period of time and re-invests any proceeds from the sale of their first property.  This re-investment of proceeds is not taxed at the time of the transaction as would occur normally, but is instead deferred until that time that the owner purchases another property without the use of a 1031 exchange, or until that time that the holder chooses not to re-invest their gains.  A 1031 Exchange can be used serially and in perpetuity, effectively eliminating the tax burden on gains realized from certain real estate investments.

A Reverse 1031 Exchange Definition

Now that you have a firm understanding of the straight-forward 1031 exchange, let’s examine a ‘reverse’ 1031 exchange.  In the straight 1031 exchange scenario, the steps are fairly straight forward:  you sell your property, select a replacement ‘like-kind’ property (within that specified period of time) and purchase the replacement property.  Under a ‘reverse’ 1031 exchange set up, you effectively do the opposite:  you acquire the replacement ‘like-kind’ property first, and then sell your existing property.  The proceeds from the sale in either case are invested into the like-kind, replacement property according to the rules and limits put in place by the IRS.

Here is an excellent infographic of the 1031 exchange process that explains visually what is sometimes difficult to understand with the written word:

http://dailyinfographic.com/1031-exchanges-the-ultimate-guide-infographic

Purpose

My guess is that by now you have a pretty good idea as to why it is sometimes a great idea to enter a 1031 exchange and why the hassle might just be worth it:  deferral of the typical long-term capital gains rate of 20% on your investment gains until you decide otherwise.

Let’s look at the example we used above.  We purchased our piece of commercial real estate for $1M.  Ten years later, we decided to sell our property for a cool $2M.  Excusing all of the associated costs of the transactions, and any alterations to our cost-basis, we have doubled our money!

If we were to sell outright without the expectation of exchanging into our bigger and better property, we would net (approximately) $800k:

Sales Price:  $2M

Purchase Price:  $1M

Difference:  $1M

 

Taxes (@ 20% of $1M):  $200k

Net to You:  $800k

 

If we opted instead to do a 1031 exchange, this example would look like this:

Sales Price:  $2M

Purchase Price:  $1M

Difference:  $1M

 

Taxes (@ 0% of $1M):  $0

Net to You:  $1M

 

It Might Not Make Sense

A 1031 exchange or reverse 1031 exchange may not make sense for you if you have $50k or less in capital gains.  In this case, the processes involved may be too cumbersome, the interface with intermediaries too costly and the tax consequences not damaging enough to justify involvement.

If it does make sense, a 1031 exchange might just be the ticket to advancing your financial goals.  As with all processes, procedures and rules  surrounding your taxes, consultation with the IRS, tax attorneys and/or a 1031 intermediary is imperative to getting the most out of your tax planning and your commercial real estate transactions.

 

Cash on Cash Return vs. Internal Rate of Return

At a Meetup the other night with other like-minded real estate investors, we got to talking returns on investment. Sometimes, we get to talking in jargon and sometimes we forget that everyone doesn’t have all of the definitions down pat, or they may have forgotten them entirely. I was going to re-create an article addressing the question of cash-on-cash returns vs. internal rate of return (IRR), but why do that when James Miller did such an outstanding job making this complicated topic easy to understand? Enjoy!

Real Estate Go Zone

Cash on Cash Return vs. Internal Rate of Return
by James Miller

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Cash on Cash
Cash in Cash return, or Return on Investment (ROI)  is the easiest Rate of return to calculate. It is also the one I use the most often as it tells me what the money is generating with regard to actual cash I can put in my pocket today.

To calculate it you take the amount you are getting from an investment, typically on an annual basis,  and divide it by the amount you have invested. Multiply this number By 100 and you have a percentage representing Cash on Cash Return.

For example if I have $10,000 in a property that is netting $100 per month, I am getting $1200 per year on my $10,000.

I divide the $1200 by $10,000 to get .12   I multiply this number by 100 to get my percentage of…

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The Missing Pieces

I was on the phone the other day speaking with a tax strategist. Not a CPA (well, he is a CPA, but not for the purposes of this call), not a bookkeeper, not a tax preparer, but a tax strategist. Just one more professional that I have found a need for moving forward. Why? Well, that’s for another discussion. I want to focus on what this tax strategist said to me that struck a chord. It might strike a chord with you too.

Opening our discussion, we initially spoke about being a full-time W-2 worker and what kinds of tax limitations that presents. That’s when the pearl of wisdom erupted from this tax strategist as he drew a very simple analogy.

“Remember when we were kids and we played with those gigantic 4 or 5-piece puzzles?”, he asked. I answered in the affirmative when he said that tax strategy is just like those gigantic puzzles. In order to complete the puzzle, we need all of the puzzle pieces. The puzzle will just not fit if we don’t have all of the pieces. That seemed logical and easy understand. Then, like a ton of bricks, he said that in order to make ANY tax strategy work, you must have all of the puzzle pieces. The important thing here is that as a W-2 worker, you don’t have all of the tax strategy puzzle pieces!

As a W-2 employee, even with a mortgage on your primary residence, you don’t have all of the pieces. He went on to say that the two important pieces that are missing in this scenario are a business and/or a real estate investment. Without those two critical pieces of our tax strategy puzzle, we will not have a satisfactory tax strategy. For it is the business owner and the real estate investor that have the ability to write off even the most mundane expenses. It is the real estate investor that has the ability to take depreciation. As a W-2 employee, you can’t do those things very well.

Each of these incentives even make sense from a government policy standpoint, right? The government wants you to start a business. The government is happy when you invest in real estate, so they “help” you do that with tax policy and incentives. So if you want to minimize your tax burden and formulate a better tax strategy moving forward, remember that starting a business and investing in real estate (and especially commercial real estate) are your missing pieces.