One dollar is worth fifteen

The following except was provided in a recent newsletter from John Temple, President of 1031 Property Watch. I felt the content was important and wanted to include it in our blog. He graciously agreed to allow us to repost it. John writes,

I just returned from a strategic planning meeting with the Tenant-in-Common Association (TICA) Board of Directors. It should come as no real surprise that the effects of the credit crisis that started in the second quarter of 2006 are being felt throughout the industry. Arguably, this real estate correction will take some time to work itself out. In the past 60 days prices have softened to the point where the average cap rate has risen 60 basis points, from 6.20% to 6.80%. This is good news for real estate buyers; however finding value will still require a sharp pencil and an experienced eye as prices continue to correct.

The market is also getting back to real estate basics. Properties are no longer being valued based upon speculative assumptions, but rather through predictable increases in net operating income (NOI). Solid increases in NOI will keep real estate performing over the next few years. I believe it will not only bridge this market correction, but is how a disciplined investor should invest over the long term.

Let me give you an example of how increasing the NOI can add value over time. Let’s say that a given property has an annual rent increase of 2%, for a total of 20% over ten years. Given a cap rate of 6.67%, a $1 dollar increase in net operating income will increase the value of the property by approximately $15. So if your property has an NOI of $100,000 and a rent increase of 2%, in ten years the value of your property would raise from $1.5 million to $1.8 million. In this example, a $20,000 increase in NOI moves the price up $300,000 dollars. This explains why experienced investors look for properties that can sustain long-term occupancy and support small steady increases in net operating income.

NOI / Cap Rate = Sales Price

If you would like a more detailed article on how NOI growth works or if you want more information on how this could affect your property, please give John a call at 877-337-1031. He can also be reached at john@1031propertywatch.com.

Related Party Alternative to a Reverse Exchange

Can a taxpayer set up an exchange, sell his relinquished property to a related party to hold for resale and complete his exchange by taking title to his replacement property? This scenario would make it unnecessary for an Exchange Accommodation Titleholder (“EAT”) to take temporary title to the replacement property and hold it while the taxpayer is searching for a buyer for his relinquished property.

In the usual Reverse Exchange, the taxpayer engages an EAT (usually a subsidiary of the QI) to take temporary title to a property. The property will subsequently be deeded to the taxpayer as replacement property in a § 1031 exchange. This is usually done because the taxpayer has to close on the purchase of a replacement property before the sale of a relinquished property. Under the “safe-harbor” provisions of Revenue Procedure 2000-37 the EAT can hold the property for no longer than 180 days. During this time, the taxpayer must find a buyer for his relinquished property, close on the sale and complete his 1031 exchange by taking title to the parked replacement property.

An alternative which is attracting interest lately is for the taxpayer to sell his relinquished property to a related party (corporation, LLC or partnership which is owned by him and/or related family members)> The taxpayer then takes title to the replacement property and complete the exchange immediately. The related party can then hold the relinquished property while listing for sale to an unrelated third party with no exchange time limitations or holding requirements.

When property is exchanged between related parties, each related party is compelled by the Regulations to hold the property it received for two years. A disposition by either related party would disqualify the exchange and each related party would be required to amend their returns and report the exchange as a taxable sale. A sale to a related party and replacement from an unrelated party has been thought to be subject to this rule as well. It has been the thinking that a related party had to hold the property for at least two years before the property could be resold. However, three private letter rulings issued by the IRS in 2007 say this is not so and that the two-year holding period does not apply (PLRs 200706001, 200712013 and 200728008).

The related party can acquire the relinquished property from the taxpayer at the same time that the taxpayer is taking title to the replacement property. Subsequently, the related party can hold the property for sale to a third party with no 180 day time limit and not be subject to the two-year holding period. The related party has a tax basis equal to the purchase price. So, when the property is resold, there should be little or no taxable gain on the sale. The taxpayer’s exchange is completed and everyone is happy.

A variation on this theme is for the taxpayer to engage the services of an EAT to initially take title to the replacement property. The EAT holds the property for up to 180 days hoping that a buyer can be found for the relinquished property in time to complete the exchange. If a buyer is not found, the taxpayer then sells the relinquished property to a related party and takes title to the replacement property from the EAT. His exchange is complete and is under the protection of the safe harbor provisions of Rev. Proc. 2000-37. This arrangement may be more compatible with the taxpayer's circumstances at the time of the replacement property closing.

Real Estate Investments for a Slowing Economy

Matt Hudgins of National Real Estate Investor has written an excellent short article on the effect a recession in 2008 would have on real estate. He cites a Property & Portfolio Research report that indicates apartment properties, while more volatile in their net operating income during a recession, are better positioned to hold their value. In an odd dichotomy of the effect between net operating income and market-accepted capitalization rates, investors seem support capitization rates better on apartment properties versus other commercial classes of real estate during an economic downturn. Retail, the report says, are the most negatively impacted in a recession as consumer spending dries, lease rates fall and vacancy increases. Rather than restate the whole article, here is Matt's report.

In a November Marketwatch report, John Spence says analysts at UBS disagree somewhat stating that regional malls proved to be the best option during a downturn. He says they held values better and showed their defensive qualities during the last consumer-led recession in the early 1990s. The resilience of consumer spending and patience from larger, national mall tenants makes them more stable. He noted that it takes almost two years of slowing sales before malls start to face falling rents and increased vacancies.

Peter Korpacz, MAI supports this view. He says that regional malls are protected by leases that span recessionary times and by credit tenants whose long-term strategies involve continued mall presence. These top-tier malls will either continue to maintain their values or at worst will suffer minimal, short-term value declines. He also likes grocery-anchored retail centers during tougher economic times. He reasons that consumers typically cut back on durable goods, such as furniture and electronics and reduce their expenditures on soft goods, such as apparel resulting in negative growth in those retail property categories. However, their overall tendency is to continue core buying habits even in a recession. People tend to increase spending on food and drink and other local services typically found in grocery-anchored food centers which support occupancy, lease rates and, ultimately, value.

So who should an investor listen to among the market experts? Obviously, many other factors than the national economy factor into specific property values. Property specific lease and vacancy rates and terms, local economic and political conditions, competition and, of course, property location all are important. Opinions are going to vary as to risk factors that factor in. But property type should be an important consideration in light of economic forecasts that highlight the very real possibility of recession.

The Mortgage Cancellation Act - a Positive View for Investors

The Mortgage Cancellation Tax Relief Act of 2007 may just benefit investors - particularly those who buy short sale properties.

Under prior rules a lender that forgives a deficiency was required to report the forgiven debt as income to the foreclosed homeowner. This added a tax bill to an already struggling taxpayer's worries. However the Mortgage Relief provision excludes this “phantom income” from the sellers’ gross income. No longer do they have the additional worry of a tax bill on their principal residence debt that has been forgiven.

With the passage of the Mortgage Tax Relief Act, homeowners that find themselves facing foreclosure may find it more easy to opt for a short sale. Investors, in turn, could potentially use this information when negotiating with sellers. Sellers may turn to an investor to assist with negotiation of a short sale with the bank. Ultimately, this may lead to an investor being able to purchase the property for a lower price than prior to the Act.

Gloomy housing market forecasts aren't all bad

You could spend a significant amount of your time each day reading various economic forecasts. It seems that everyone has an opinion. While many of them say that we are headed for - or perhaps already in the midst of - a recession, the reasons for it, the severity of the decline and the length of time until a recovery is seen are items of major debate.

In looking at various economic forecasts, I am naturally drawn to those that deal with real estate markets. Having a vested interest in the health of real estate and realizing that the state of the housing market is such a signficant factor in the economy, I am looking for prognostications that talk specifically about this area.

While the increasing number of personal bankruptcies, a growing concern with foreclosure levels and the subprime lending credit crunch have consistently been in the news, a number of other concerns still exist that have many wondering how long it will take for housing to recover.

I recently read a report from Professor Robert Shiller of Yale University that had some very interesting ideas. He believes that, over the past decade, two million excess homes have been built. The combination of low interest rates, rising real estate prices and weak lending guidelines has resulted in irrational speculation in housing product. This in turn has led to builders increasing the product on the market and repeated cycles of overbuilding. The fallout resulting from this glut of real estate is a loss of one trillion dollars in the housing market. Professor Shiller believes that we could still see a loss as much as three times that amount before we hit bottom. What does his forecast mean in terms of percentages? An expectated 20% to 25% further decline in home prices.

There are reports that supported Prof. Shiller's expectation. Comparative, statistical evidence indicates a 24% drop in home prices is required to bring housing prices back in line with building costs, a 27% decline to bring home prices back in balance with rents. Of course, you could argue that building costs or rents are artificially low and could increase to balance some of this necessary balancing decline in real estate prices out. However, current real estate prices are still estimated to be 50% higher than the historical average price per square foot when adjusted for inflation.

Many are calling the headline bad news for '08 to be the counterparty risk in the credit default swap market - similar in scope to the story that subprime was in 2007. Some believe that continuing losses at banks will force the need to raise capital. This further instability in the credit markets will cause further tightening of lending standards - traditionally the blamed culprit. Forecasts call for the next twelve to eighteen months of significant declines in credit availability. Since credit availability is key to real estate market recovery, many see this as concern that the economy will be slower than expected in its recovery.

So where is the silver lining in an economy of tough real estate markets, uncertain political climate, increasing oil prices and a decreasing stock market? Tough times bring about significant opportunity. Many investors were extremely savvy with their investments of RTC-owned property in the early 1990's. I know many stories of investors buying something on the cheap when no one else was buying and looking like a genuis a few years later. These opportunities tend to resurface when times are difficult. It is the smart investor that remains calm and looks for opportunities among the bad news.

State Regulation of 1031 exchanges

Because of a couple high dollar, high profile cases involving Exchange Facilitators that have failed in the past year, many states are considering regulation of the 1031 industry. While some pending legislation makes a good deal of sense, over-zealous regulation proposals provide little real substance while substantially increasing costs to Qualified Intermediaries (which, of course, will be passed on to consumers) and making it more difficult for Exchange Facilitators to do business.

Nevada was first in the nation to regulate the Exchange Facilitator industry. It is somewhat ironic, then, that the first high profile case involved a company in Henderson, Nev. called Southwest Exchange. In response, Nevada legislators worked to revise its existing regulation by placing greater oversight in the licensing approval process. Unfortunately, the costs of the increased regulation were not thoroughly considered and state regulatory administration resources were not in place when the law was enacted. Nevada is now discussing revisions to its regulation to reduce the increased costs of oversight.

Idaho, through its Escrow Act, also has claim on being one of the first states in the country to regulate Qualified Intermediaries. Its regulation aims to "keep things local" by requiring funds be banked in an Idaho bank. It also requires some measures aimed to protect the consumer from fraud.

While both Nevada and Idaho, and other states considering legislation, should be commended for attempting to protect consumers, the regulations put in place don't really address the heart of the issues involving the examples of the failures at Southwest Exchange and 1031 Tax Group. What these two companies have in common is that a change in ownership occured just prior to their troubles. The new owners of both companies decided on a change in "investment strategy" that involved temporarily lending funds being held for exchange clients to related-party, closely-held investment entities. Unfortunately, when it came time to repay these loans, these related, closely-held investment entities were unable to repay the debt causing the Exchange Facilitator companies to default on their client obligations.

While experienced staff, bonding requirements and segregation of accounts is something many honest Qualified Intermediaries already possess, regulation calling for these requirements misses the point. The real problems arose due to the change in ownership and the ability to move and invest funds without fiduciary requirements. Regulation, outside the issue of ownership changes and prudent investment and banking, goes beyond what is needed - at increased cost to consumers - and does little to actually protect exchange clients.

One state with pending legislation has it right.

Legislators in the State of California (yes, believe it or not, I said California - one of the most heavily regulated and consumer protection-friendly states in the country) has initiated regulation that makes sense, provides substantial protection to 1031 exchange participants and allows Exchange Facilitators to do business without substantial increases in cost structure. The pending bill looks at the heart of the matter in the two high profile cases - change of ownership and movement of exchange funds. It requires Exchange Facilitators to notify exchange clients, and the State, of ownership changes. It also requires them to receive the clients' written approval before any movement of funds. It advocates education and responsibility rather than enforcement and restriction.

Had both these requirements been in place, would fraud have occured at Southwest Exchange and 1031 Tax Group? Probably. Bad people are going to do bad things. However, it would have made it more difficult and given law enforcement the necessary tools to penalize them. It would have provided a sensible legal response to regulation of the 1031 industry. All without putting onerous and costly regulatory burden on Exchange Facilitators by adding requirements that don't really do much, in the end, to protect the consumer.

Alternative Minimum Tax, Capital Gains and the Time Value of Money

There are rumors floating around out in cyberspace that Congress will take a hard look at creating a more permanent fix for the Alternative Minimum Tax. More than a few are suggesting the possibility of increasing the capital gains tax rate back to 20% to offset the AMT fix. We've seen talk of these rumors recently begin to kept many from completing exchanges. I've actually heard people say it is better to pay 15% now versus the potential to pay a 20% capital tax rate at some later date. (Most of the time this statement comes right after the other assumed imminence of "when the Democrats take power back".) For that reason alone, some are deciding to NOT complete a 1031 exchange.

While that thinking seems to save 5% in taxes, it also ignores the fact that time and inflation affects the value of money. The time value of the 15% tax money paid today versus the eventual higher (presumed) 20% taxable sale may or may not save the taxpayer. It depends on when that transaction might occur. Follow me?

Consider a scenario where the 15% long-term tax paid would instead be reinvested (we'll even ignore the additional state tax paid). In other words, rather than paying Uncle Sam today, the money is reinvested, via a 1031 exchange, into investment property. Let's assume that this taxpayer is planning on reinvesting the funds and planning to hold the replacement property for ten years. At that time, the taxpayer plans on selling the property and paying the taxes (ten years from now). We'll also assume the reinvested money will conservatively earn a inflation-free rate of 4% a year. In other words, if inflation runs 3%, the investment will earn 7%. (Just to make the analysis even more conservative, we'll even ignore the ability to leverage that tax-free, reinvested money into an even larger investment).

So what is the present value of that 15% in taxes paid ten years from now? To figure this out, let's illustrate what the two scenarios have. If you pay the tax on a $100 capital gain today, you get $85, right? But if you take the $100 and reinvest it for 10 years and earn 4%, after inflation, each year, you'll have $149 in today's dollars (you'll actually have much more if you assume some inflation). So, you then turn around and pay 20% capital gains tax on $149 - winding up with $119 - versus the $85 you'd have today if you paid the lower tax today.

So why again, if you are planning on reinvesting the funds anyway, would you pay the 15% today versus the 20% ten years from now? And let's not mention there is typically a state capital gains tax or talk about the uncertainty that five or ten years from now, the capital gains tax rate will not be, again, changed/reduced.

The Tax Rules for Sale of A Personal Residence

The Taxpayer Relief Act of 1997 brought sweeping changes to the tax rules applicable to the sale of a personal residence. Gone are all of the old rules, including the two-year rollover requirement and the once-in-a-lifetime 55-year old $125,000 tax-free gain rule. These rules were completely repealed.

Effective For Sales After May 6, 1997, The Rules Are -

A $500,000 tax-free gain for married-joint filers and a $250,000 for single persons. However, any depreciation taken on the residence after May 6, 1997 is subject to tax at the capital gains tax rates (maximum of 25% capital gains tax rate).

1st Two-Year Rule - Must live in residence for any two out of prior 5 years.

2nd Two-Year Rule - A second home sale within a two year period is not eligible for this exclusion.. Can only use this exclusion once in any two year period.

Except for the 2-Year Rules, no limit on number of times this exclusion is available.

A residence which was originally acquired as replacement property in a 1031 Exchange must be owned for five years as well as lived in for two out of those five years to qualify (American Jobs Creation Act of 2004).

A prorata exclusion is available for taxpayers for sales which are less than two years apart, or for failure to meet either of the two-year rules due to change of employment, health or other reasons specified by Treasury Regulations. For instance, one year residence or 2nd sale after one year = 50% of the above referenced exclusion.

A rental property converted to a personal residence and sold after May 6, 1997 is eligible for this exclusion subject to the two-year rules. Only the depreciation taken on the property after May 6, 1997 is taxable even though the property was partially or fully depreciated prior to May 6, 1997 before it was converted to a personal residence.

Taxpayers with a gain exceeding these exclusion amounts get no relief and must pay tax on the excess amount at the maximum capital gain tax rate; 15% generally except for the 25% maximum rate applicable to any depreciation taken on the residence after May 6, 1997.

There are a number of 1031 exchange strategies that investors can use in conjuction with the primary residence rules. For a sample of one such option, visit additional primary residence strategy guidelines on 1031 Exchanges.