All-Cash TIC Advantage for 1031 investments

Some time back, I saw an interesting article by Robert Johnson - president of St. Paul-based AEI Capital Corporation - discussing the advantages of an all-cash tenant-in-common investment. I asked, and received, his permission to re-publish some of the important issues he describes in the article. The full article appeared in the January 2009 National Real Estate Investor. The article contains solid information for 1031 investors that lack debt in their relinquished property and are looking for suitable replacement property investments.

Access to affordable capital has rapidly become a difference maker in the tenant-in-common industry. TIC sponsors that able to use an all-cash acquisition and offering strategy are getting a leg up on their leverage-dependent competition. Moreover, a lack of acceptable financing is forcing some leveraged TIC sponsors to delay bringing. or to pull altogther, deals to the market.

Sales volume in the Tenant-In-Common industry has been reduced due to a decline in U.S. real estate sales and the corresponding decrease in demand for 1031 exchange properties which enable investors to defer capital gains taxes. Despite the drop in sales volume, the TIC property ownership structure remains sound for suitable 1031 exchange buyers.

Benefits of an all-cash TIC transaction include no foreclosure risk, no interest rate refinance risk, and less risk of capital calls. Added benefits include avoiding the bank application process, easier resale, and flexible 1031 exchange closing schedules.

All-cash TIC properties usually generate a slightly lower rate of return. On the other hand, the front-end fees associated with all-cash transactions will normally be less than those of TICs using debt. Ultimately, the all-cash model provides an added layer of protection that is attractive in a market where investors are increasingly averse to risk.

Although TIC offerings requiring leverage are still offered, they are considerably more difficult to organize in today's relatively illiquid market. As financing has become more expensive, and difficult to obtain, the advantages of an all-cash strategy become more meaningful for 1031 investors.

As Mr. Johnson points out, all-cash TIC offerings tend to focus on properties priced under $10 million and may not be suitable for all 1031 exchange investors looking to reduce risk (larger, institutional-grade properties are typically perceived by investment professionals to contain less overall risk). TIC offerings should be reviewed with full due diligence and a complete understanding of the investment risks. If you are considering an investment in a tenant-in-common property, you should discuss the offering details with your legal and tax professionals. For futher details on the ideas expressed here, contact Robert Johnson at 800-328-3519 or at aei1031@aeifunds.com.

Reality of Lending

Our economy is struggling. We all know that. But understanding why, what happened, and how the banking industry and the government is responding can be complicated and timely. The Colorado Bankers Association recently released information about the "lack of lending” in order to encourage the appropriate coverage of the issues surrounding this frustrating topic.

They have released a brochure titled, The Reality of Lending that details what they believe to be reasons for the current "credit crunch". Below is some of the highlights of the facts they are hoping are addressed.

Banking takes appropriate responsibility for its prudent loan standards. We also think customers and the public deserve to understand other factors that significantly impact the ability to get credit in this environment.

The lack of lending (heavily criticized by the public, media, and public officials) reflects low loan demand and is attributable to borrower creditworthiness issues, lender financial constraints, and regulators’ tougher standards, and is exacerbated by the greatly diminished role of nonbank lenders recently. For business borrowers who are key to an economic recovery and already have financial strain this means banks are their primary source of credit and banks are unable to make many of the loans for the reasons stated. This is especially difficult for loans secured by real estate.

Changing regulatory standards in capital requirements, loan concentrations, and loan downgrades often result from subjective judgments and national benchmarks. They disallow recovery of real estate values over time, and often prompt shrinkage of the bank which reduces lending and greatly impacts customers.

Bank lending plays a critical role in our economic recovery. Borrowers and lenders are addressing financial constraints and are working through issues. Bank regulation and examination are essential to a sound banking system. CBA recognizes this essential role but also believes regulators are impairing bank lending and thus the recovery by overly aggressive actions in capital standards, concentration standards, and loan downgrades. CBA is providing essential information to bankers, public officials, the public, and major customer groups.

The site titled Financial Information for Consumers has additional information on this and other topics such as Home Mortgages, Identity Theft, Credit Awareness and Loans.

Related party basis shifting case upheld

A Ninth Circuit Court of Appeals decision to affirm a previous Tax Court ruling further highlights the need for extra scrutiny in 1031 exchanges involving related parties. The 2005 Tax Court decision, involving exchanges of condominium and apartment properties (Teruya Brothers), disallowed the tax deferred swap because it occurred between related parties and the main reason for the exchanges was to reduce the overall tax bills of the buyer and seller.

In the case, the entity (Teruya Bros, Ltd) that owned the apartment building and condominium complex had a built in, large capital gain. Upon the sale, a $13 million capital gain would have resulted to this entity triggering a massive tax bill. Rather than sell, the entity transferred the real estate to an unrelated Qualified Intermediary (QI) which sold the properties and bought replacement land from a subsidiary (Times) in which the entity had a controlling interest.

The issue that causes this related party exchange to be disallowed essentially relates to the overall tax paid. The subsidiary did not exchange into additional replacement property. Rather, it chose to treat the sales as taxable events and accounted for a capital gain of roughly $3.5 M on the property sale to the related entity. However, the subsidiary that sold the property had significant net operating losses from previous operations. These NOLs were used to offset the $3.5 million gain - resulting in no taxes paid on the sales.

Effectively, what the related party exchange attempted was a "cash out". The subsidiary now had the cash from the sales. The two related entities combined had decreased their investment in real property by approximately $13.4 million while increasing their cash position by the same amount. By disallowing the related parties to cash out of a significant investment in real property under the appearance of a 1031 like kind exchange, the Appeals Court upheld the previous Tax Court decision that "these transactions were undoubtedly structured in contravention...that nonrecognition treatment only apply to transactions "where a taxpayer can be viewed as merely continuing his investment.""

It is clear that tax deferred exchanges between related parties are subject to additional scrutiny. Accounting professionals, tax and real estate attorneys and taxpayers should be familiar with, and aware of the potential pitfalls, in exchanging property between related parties. The use of a Qualified Intermediary familiar with the rules and legal precedence in dealing with this advanced topic can be of assistance in handling a related party exchange appropriately.

Qualified Escrow Agreements for Intermediaries

A number of states have instituted regulation for the Qualified Intermediary industry. Nevada, Idaho, California, Colorado, Washington, Maine and Oregon have all passed legislation. A number of other states are looking at adding some law(s) to protect taxpayers in the face of 1031 exchange facilitator fraud and losses.

Existing state law in California, Colorado and Washington as well as upcoming 1031 laws in Maine (went into effect Sept 12, 2009) and Oregon (effective January 1, 2010) require Qualified Intermediaries to:

a) Maintain fidelity bond (typically not less than $1 M), or;

b) Post deposits of cash or letters of credit equal to the amount of the fidelity bond required, or;

c) Hold all client funds in Qualified Escrow or Qualified Trust accounts which require the signatures of both the QI & taxpayer to authorize any disbursements.

As a result of the aforementioned industry losses - and the subsequent insurance claims - many Qualified Intermediaries have recently been unable to obtain option a) - a fidelity bond. If you are looking at doing an exchange, you should ask your exchange provider to provide a copy of the Fidelity Bond Evidence of Insurance to ensure your Intemediary is complying with the fidelity bond requirement. Make sure, if you are acting as a Qualified Intermediary, you are in compliance with these laws!

If your 1031 exchange provider does not have bonding, they must either post cash or a letter of credit with the state or use a Qualified Escrow account. Qualified Escrow accounts are held at a third party escrow agency and provide the greatest level of protection against fraud or missing funds. The escrow agent will only invest the proceeds according to the Agreement. They will also require signatures of both the Qualified Intermediary and the taxpayer client before any movement of those funds takes place.

If you are considering completing a 1031 exchange (or are a Qualified Intermediary without bonding) and in need of establishing a Qualified Escrow, FirstBank Escrow Services and their escrow officers can provide a Qualified Escrow Agreement that is specific to the 1031 exchange. Along with protecting the integrity of your exchange, FirstBank’s team of escrow specialists can work with you to establish an escrow contract that simplifies your risk mitigation requirements and meets your transaction needs. Client escrow accounts are individually segregated and held securely in FDIC-insured deposit accounts. FirstBank Escrow Services provides rapid review and turnaround of the agreement to ensure your transaction closes quickly.

If you or your Qualified Intermediary have need for a Qualified Escrow, please contact one of FirstBank's escrow officers for additional information at 800-964-3444.

Negative Equity Mortgages and Reverse Exchanges

A recent WSJ report indicates that more than 32% of all mortgaged properties in the United States were in negative or near equity position as of June 30,2009. An additional 2.5 million mortgaged properties were approaching negative equity.

The five states with the largest negative equity share accounted for nearly half the nation's remaining states. Nevada, Arizona and and Florida had the largest number of negative equity mortgages. California and Michigan were the other top-ranked states for negative equity loans.

Negative equity - also known as "underwater" or "upside down" - means the borrower owes more on a mortgage than the home is worth. Near negative equity is when mortgages are within 5 percent of being in a negative equity position. Negative equity can occur because of a decline in value, an increase in mortgage debt or a combination of both.

While negative equity continues to be the dominant driver of the mortgage market because it leads to foreclosures, the good news is it actually declined slightly this quarter. Other recent news indicates home price declines are moderating or flattening - possibly indicating we are at the low point in the cycle. Of course, continued bad news in unemployment figures, a worsening commercial real estate market and cold weather seasonality could lead to further declines.

We've noticed a a couple of interesting trends in this negative equity market. It appears a growing number of our long-term, real estate investor clients feel it is the right time to get back in the real estate market and make additional purchases. The trouble they are now finding is that many of the lender-owned properties are receiving multiple offers or it is taking some time to get closed. The other interesting observation is that it still seems somewhat difficult to obtain financing. We've had a number of exchanges that weren't completed because lenders were unwilling or unable to lend on replacement property.

If you are considering buying, and find that perfect property, it may not be wise to wait until your sale occurs. This is where a reverse exchange may make sense. By having your replacement property already lined up and financed, your exchange will not fail because you were continually getting outbid in what appears to be a fabulous opportunity or because of an inability to obtain timely financing. For more information on the benefits of a reverse exchange and how 1031 Corporation, as a bank-owned QI, is uniquely positioned to assist with your reverse exchange, please give us a call at 888-367-1031.

Buy Real Estate With Your IRA Or 401(k)

Since it's my birthday (not telling what number!), I thought I'd take the day off from blogging and publish an informative piece from one of our business partners. Entrust Arizona specializes in record keeping services for individuals and small business owners who wish to include non-traditional assets within their tax-deferred and tax-free portfolios. The following was provided by Timarie McClendon, director of business development with Entrust Arizona.

It’s a common misconception that the only investments allowed in an IRA or 401(k) is stocks, bonds, and mutual funds. The truth is that broader investment options, including real estate, have been available to the public since 1975. The key is to house your IRA or 401(k) at a company that will allow you to invest in real estate. All real estate investing with your IRA or 401(k) is legal - from single family residences to multi family, raw land, developed land, commercial property and even international real estate.

Self-directed retirement plans have quickly become the talk of the real estate community. Not only are real estate professionals self-directing their own IRA’s into property and projects, they are also using their knowledge about these plans to generate more business.

Don’t be confused by the marketing term “self-directed.” All brokerage firms will offer you their version of self directed. This means you can self directed your money into any of the stocks, bonds or mutual funds they offer. But…..that is where your investment choices end. Finding a truly self-directed administrative firm is not difficult. Some refer to this specific type of IRA as a “Real Estate IRA.” While this is not technically the legal description of a real estate investment within an IRA you can see how this might be the perfect description for the investor who is new to this option.

Understand these real estate investments are just that...investments. The real estate investment must be one that is an “arms-length” transaction. This means that the IRA account holder, as well as certain family members and business associates (disqualified persons), cannot live in a property, rent office space in a property, provide a service, or be involved in transactions in which the IRA buys or sells the property. The critical issue for many is making sure the property remains strictly an investment by avoiding self-dealing or prohibited transactions with family members or business associates. And an investor needs to be aware that all expenses, fees, etc. will have to be paid out of the IRA.

Retirement accounts can partner together in an investment. Utilize the investment power of multiple retirement accounts from people you trust and with whom you may already be doing business. Your IRA or 401(k) can even get a mortgage! You can partner your IRA with a 1031 exchange. You may also partner multiple IRA or 401(k) accounts or even partner personal monies!

You may hear false objections from uninformed advisors such as “that’s illegal”, “it’s too complicated” or “I’ve never heard of that.” Simply put, an IRA is a Trust. It’s that simple. If you understand a Trust, you understand an IRA. To simplify things even further, the IRS code is not written to specifically address what you CAN invest in. It is written to address what you CANNOT invest in. The IRS only prohibits two types of investment transactions - collectibles and life insurance.

You can use your retirement account to invest in real estate and harvest the same tax benefits of the IRA you may currently have invested in the stock market. Self-directed IRA administrative companies function just like your brokerage firms except that they specialize in alternative assets as opposed to securities.

For more information about self-directed IRAs and tax-deferred real estate investing, please take a look at Entrust Arizona's website or give them a call at (480) 306-8404.

Maine Adds 1031 Exchange Intermediary Regulation

The state of Maine recently added it's name to a growing number of states instituting 1031 exchange Qualified Intermediary (QI) regulation. Maine Public Law, Regulation of Exchange Facilitators, was enacted by the Maine Legislature in April and will go into effect on Sept 12, 2009.

The new law utilized much of the language we've seen from a number of western states that have been early in adopting new 1031 regulation. Like other states, the Maine law prohibits commingling of exchange funds with operating funds of the QI, but does not require the segregation of each client exchange account (which we strongly support). The new law prohibits any loans to the QI or affiliated person or entity, and requires that exchange funds be invested in a manner that will ensure liquidity and preservation of the principal. Similar to the recently passed QI bills out west, the Maine law also requires ten day notice of any change in control of the QI.

It does require a lower fidelity bonding and errors and ommissions (E &O) insurance coverage that we've seen in other states. The fidelity bonding threshold is $250,000. The Maine act allows the QI, in lieu of bonding, cash deposits or irrevocable letter of credit in that amount or the use of a qualified trust or escrow account. E&O coverage of $100,000 is required (or in lieu thereof cash deposits or irrevocable letter of credit in that amount).

The Maine law does differ in that it requires annual licensure of any person acting as QI for relinquished property in the state. We've written previously about other state licensure provisions being passed. While licensure may allow the state to keep track of those that are acting as QIs in the state, it does little to protect a consumer against fraud until it is too late.

As we've seen in other failed QI cases, having minimal fidelity bonding and E & O insurance doesn't provide as much security to the client as one would think. Bonding and/or insurance protects the firm, not clients of the QI firm. In addition, each act of fraud is not necessarily considered a "per occurance" event so the bonding may fall considerably short of protecting exchange clients.

While each state has, thus far, adopted segregation of client funds from operating funds, we've yet to see a state adopt segregation of each individual client escrow account. This is a recurring issue in the bankruptcies and subsequent legal procedings that have occured in the 1031 Tax Group and the LandAmerica Exchange cases. Clients of failed QIs that do not segregate - and distinctly identify the segregation of funds in their exchange agreement - will, unfortunately, learn that their interest is pooled together in a bankruptcy case as just another unsecured creditor. Since the funds are commonly "pooled" for greater investment returns, individual client funds are not protected as clearly being 'in trust for' a specific client.

Only segregated accounts and an exchange agreement that clearly makes use of segregation language can ultimately provide protection for clients of Qualified Intermediaries that sell. Of course, due diligence should be performed to make sure you know the financial condition of the QI you chose. Publically available financial statements, forthcoming answers to questions of segregation and investment policy/practices and a solid exchange agreement should all be provided.

If you've interest in discussing provisions of this new state law, or any other pending or passed exchange facilitator regulation, the Federation of Exchange Accommodators is working hard to balance the interests of clients and industry member firms to maximize protection of clients while minimizing the regulatory burden/costs and would be happy to answer many of the questions. We at 1031 Corporation would be happy to answer any questions you might have in selecting a Qualified Intermediary or information specific on how we protect our client funds. Give us a call today at 888-367-1031.