- Written by Marilee Hill, MA Hill Brokers
1031 Exchanges: A Case Study in Bundling
by Marilee Hill, MA Hill Brokers
During 35 years of investing in real estate, Roland and Marvella Bradford had acquired a multi-building folio. The couple wants to sell the properties so they can retire. However, their accountant tells them that the tax consequences would deplete the value of their assets by more than 50%.
When the concept of a 1031 exchange was first presented, the couple was reluctant. However, giving Uncle Sam 55% of sales proceeds was not an option they wanted to consider. In the case of a multi property portfolio with extremes of equity and debt, the couple was advised to bundle as many properties as possible. This required an analysis of how the properties were titled and the outstanding debt and equity.
An inventory of titles revealed five of the properties were held jointly, one held jointly with 50% owned by a non-related party, and one was titled in the husband's name and another was titled in the wife's name. Five others were titled in various partnerships. The analysis revealed that the properties held individually and jointly by the Bradford's could be bundled.
The properties owned by partnerships and corporations formed by the couple presented a different challenge. The couple had disbanded the partnerships and simply reported the income from the properties on their Schedule E. However they had never changed the title. Because three of the properties had not been in a partnership for 15 years and had been reported on the couple's joint tax return, they also could be bundled with the other properties.
To have a successful 1031 exchange, you must replace your property with a real estate asset of equal or greater value. As long as you maintain equal or greater equity, you can increase the price and the debt.
You can always replace debt with equity. Of the $5.4 million total portfolio value, 41% was debt. The exchanges we contemplated were 35% equity to 65% debt. They were safe overall. Nevertheless, in a 1031 exchange, you need to be cognizant of individual properties' debt to equity ratios. In this case, they ranged from less than zero to 100%. One property worth $300,000 had $325,000 of debt and another worth $580,000 had zero debt.
A deal was structured for the owners to sell 10 of their properties to a sole owner who agreed to provide 20% of the purchase price in cash, obtain 55% in financing and for the Bradford's to take back 25% of the value as deferred purchase money mortgage as a first trust on two of the properties. In an exchange, you can either exclude the deferred purchase money mortgage note and pay capital gains under the installment method or include the note by initially showing the Qualified Intermediary as the beneficiary. Including the note in the exchange means selling it during the 180 day period. The sellers in this case elected to keep the note.
One property settled November 10. The sellers identified the same three replacement properties for the buildings that settled February 5. The sellers elected to be cautious. They designated the February 5 settlements as an exchange separate from the November 10 building, even though they were identifying the same replacement properties.
On March 28, the Bradford's settled on a warehouse distribution center as a first replacement property. The equity to debt ratio in this purchase was 34% to 66% with the total dollars being the same. Of the three buildings that went into this replacement property, one was all debt and one was all equity. Through bundling their equity-rich building with their heavily indebted building, the Bradford's avoided a tax bill generated by a settlement with no proceeds. To reset the 180 day clock to February 5 from November 10, the date of the first settlement, the proceeds from the building sold on November 10 were bundled into the purchase of the distribution center.
One of the couple's properties held in partnership with their children with a debt to equity ratio of 28 to 72% settled on March 30. Proceeds were used to buy a new property with a debt to equity ratio of 45 to 55%. The total dollars were 33% more in this case. By increasing the tax basis of the new purchase by adding additional debt, the partnership will be able to add new depreciation write offs and shelter additional cash flow.
The lender stated the sale had to close by May 25. The Bradford's were one building short and needed to do a reverse exchange. The reverse is legally and technically complicated. The practical aspects are quite simple, however. None of the financing in place is altered. The eventual settlement of the property by the Bradford's purchaser would be the same and the money that the Bradford's would receive from the settlement needed to be provided by them without encumbering their relinquished or replacement property. The Bradford's used cash for the reverse and purchased the shopping center by the lender's deadline.
This exchange has many benefits for the owners. First, they have upgraded the quality of their real estate assets. Second, they have diversified their portfolio geographically and by product type. Third, and perhaps most importantly, they have the financial wherewithal to enjoy their retirement without financial pressures. For every $100,000 they did not have to pay in taxes, they will initially receive between $8,000 and $8,500 in income annually. Finally, they will continue to use 1031 exchanges. Upon their death, their children will inherit the properties with a step up basis. Uncle Sam and the State tax collector will likely never collect deferred capital gains tax.