Vol. 23 No.12
REAL ESTATE MARKETS DEPEND UPON LOW COST CREDIT . . .
Real estate buying and selling is a fairly straightforward proposition for the most part. Buyers buy, sellers sell, and brokers put buyers and sellers together to make a deal. The reason why they do this is also fairly basic. Buyers have a need for property they are buying; usually to use it themselves or to rent or sell it to others who need it. Sellers usually sell because they want to make a profit, avoid loss, become more liquid, or because there’s something about the property that they don’t like or are afraid of. Brokers assist in the process to earn commissions. The market these players create is almost totally dependent upon the availability of low cost credit.
Where does mortgage money come from? The credit system depends upon a complex system of relationships between those who save, insurance companies, government, central banks, international trade, businesses, the economy, the bond markets, and politics. When these fail to mesh in just the right way, credit dries up, and so does the real estate market. As you can imagine, in a country where millions of people live beyond their means through the use of credit cards, home equity loans, margined stock, and installment buying, credit shortages ripple through the economy affecting everyone; particularly government.
Much of the vaunted American lifestyle, our medical delivery system, our educational system, social programs, public housing, farm subsidy programs, welfare system, FHA and VA loan programs, etc. depend to a great extent upon government borrowing via the sale of US Treasury bonds. If bond sales dry up, the Treasury has to raise interest rates to attract investors. This makes banks increase rates to keep depositors from withdrawing their savings and buying bonds. Stock market investors, seeing greater returns in bonds than in stocks, sell stocks and buy bonds. Other investors who buy bonds usually pay for them with bank savings.
There’s only one small problem: The money that people want to take out of the banks isn’t there; it has been loaned out. In fact, through what is called the “fractional reserve banking” the Federal Reserve has loaned banks about eight times more money to lend out than they have taken in in deposits. When a depositor wants to withdraw $10,000, the banker has to call in $80,000 in loans from consumers and businesses. They in turn must scurry around to replace these loans, bidding up interest rates further, government then must increase bond yields to keep people from cashing in government bonds. When government can’t borrow money, it creates it; causing inflation. To keep from being paid back in dollars that will buy less and less as time goes on, lenders increase interest rates, and this vicious credit cycle repeats and repeats. The wheels can come off the financial wagon pretty fast.
We saw this happen in the late 1970s when 30 year US Treasury Bonds commanded a 16.5 interest rate to maturity. US T-Bills earned 17.5%. FHA “points” were as high as 7% in some markets. Investors paid 22.5% on second mortgage loans. People fled the stock and bond markets seeking refuge in tangible assets such as gold, silver, collectibles, art, gem stones, and real estate. Silver rose to $50 per ounce. It cost $850 to buy gold Krugerands. People made jewelry out of them. A D-flawless diamond cost $60,000 per carat. Single family houses began appreciating at the rate of 1% – 3% per month in many areas of the country.
The late 1970s were good for real estate as equities climbed by thousands of dollars every month, but there was a catch. Inflation caused everything to rise but net rental cash flow. Oh sure, rents were raised, but so were property taxes, insurance rates, costs of material and labor, and collections. At the same time, although inflation created a lot of millionaires on paper, it was difficult to convert inflated equities to dollars when financing cost so much and income was taxed as high as 70%.
WHEN YOU CAN’T FIND MONEY, HORSE-TRADE . . .
Before the credit system was fully developed, people learned to swap properties with each other. It started in the farm belt, but spread to other areas. In an attempt to regulate property trades, Section 1031 of the Internal Revenue Code was written to authorize tax-free property exchanges. In a perfect world, a person could build a fortune pyramiding real estate, borrowing against equities to provide tax free cash, and continuing to add properties for a lifetime. Upon death, these would pass to his heirs income-tax free; they could repeat the process ad infinitum.
Section 1031 allows exchange of any real estate used in a trade or business, or held for production of income or investment for any other real estate income tax free. The same rules also apply to personal property. But inventory held for sale by a business, property held for personal use, partnership interests, trust shares traded for trust shares, stocks, bonds, Notes, and Installment Contracts are specifically excluded from this Code Section.
For about ten years the courts wrangled over what did and did not comprise a qualifying tax free exchange, but around 1929 things pretty much settled down until a fellow named Starker stretched the exchanging envelope a little by conveying a property to a buyer, then delaying the receipt of exchanged property until he found something he wanted. In the interim, the value of the property was carried on the books as a credit.
In the ensuing uproar, IRC Section 1031 was modified so that those who exchange can actually sell property that they have held by an independent third party for at least one year in one of the above qualifying uses for cash tax free so long as the cash is used to buy a qualifying replacement property. Any number of properties can be exchanged for any number of other properties tax free so long as they are identified within 45 days following the transfer of cash, mortgages, or any other non-qualifying property, and are received in exchange.
When just “shopping” around, trying to decide which property to accept in trade, or if there’s a chance you might not close on any particular property, up to three replacements of any value can be identified. If more than three are named, their total value can’t be more than 200% of the value of the relinquished property. You must complete the acquisition of any replacement property or properties within the lesser of 180 days, or the next date their tax return must be filed, including extensions. If you’re going to make an exchange, keep these time limits in mind.
Being able to trade one property for another and to capture profits tax free ranks among the greatest estate building techniques ever conceived, but to make it all work out, you have to jump through some hoops. First of all, a “qualified intermediary”, someone other than your lawyer, title company, or pals, to hold the cash, checks, Notes, or other property offered in exchange and use them to purchase the replacement property. A number of companies can be found who offer to do this. One whom I’ve known for many years, and who is a real student of the craft, is Milton Armstrong of Orlando, Florida. He’s a past President of the Florida Real Estate Exchangers, and has published a book on the subject of tax free exchanges.
Exchanges can be partially tax-free and partially taxable. Anytime that “non-qualifying” property is received by either party to an exchange, its fair market value will be recognized for income tax purposes. This is also referred to as “unlike kind” property. Personal property of any kind exchanged for real estate, would be deemed unlike kind, and both parties would have triggered a taxable event. A few people saw “market value” as a tax loophole if they could get appraisers to place low values on unlike kind. At one point, somebody figured out that rare US minted coins had a true market value in excess of minted value, but could legitimately be taxed at face value. It didn’t work. The IRS says that properties exchanged at “arms length” between unrelated parties is presumed to be of equal value, and will be treated accordingly by auditors.
PEOPLE EXCHANGE BECAUSE OF DIFFERENT PROPERTY BENEFITS.
Exchanging is one of the best ways to continue to do business when credit markets collapse for several reasons. Especially with larger properties, where seller financing isn’t feasible, exchanging offers a way for investors to dispose of and to acquire properties without depending upon banks or paying high interest rates. It is a very efficient way to transfer ownership of rental houses without disturbing either tenants or rental cash flows. Brokers who can put two or more parties together in an exchange can earn multiple commissions.
What about tax benefits? Warren Harding’s exchanging ads used to say, “Why Buy For Cash When Your Equities Will Buy You More?” When you can move from one property to another without losing 20% of it to capital gains taxes, you can certainly wind up with more equity in the property you’re acquiring, but there’s more. When you exchange one depreciable property for another, your old adjusted cost basis transfers to the new property. You can re-allocate basis between land and improvements. Let me give you an example:
Suppose the land value beneath a fully depreciated free and clear $500,000 commercial building were 35% of its market value, or $175,000. You exchange for five free and clear $100,000 houses and find that the property tax assessor has allocated only 16%, or $80,000 of the value to land and the rest to the houses. That means that you’ll be able to allocate $95,000 of your remaining $175,000 in land basis to the houses and write if off.
Here’s another little tax wrinkle. When you exchange properties, along with your old basis, your old holding period comes along too. When multiple properties are exchanged, the date of acquisition of the oldest property given up becomes the effective “date of acquisition” for the property acquired. In the good old days, Exchangors always tossed in a few scrap tax-deed lots or time-share units that they’d held for a few years as additional equity in an exchange. Even though they might have been paying cash or trading new properties in the exchange, their holding period in these bits and pieces translated into the holding period for all the property they wound up with.
While avoidance of taxes is by and far the most prevalent reason people enter into exchanges, it’s not the only reason. Owners are more motivated when they perceive that they could be trapped owning property they don’t like. What kind of properties might these be? Burned out landlords want to get away from tenants. High tax bracket owners who have run out of depreciation want to step up their basis. People who have relocated to other areas want to move their equities closer. People planning their estates want to simplify their portfolios. People with illiquid properties want liquid properties.
A marriage made in heaven occurs when a broke owner of raw land meets the burned out owner of a fully depreciated apartment complex. The land owner wants the income, and the landlord wants peace and quiet. The same thing happens when the owner of a lot of highly leveraged negative cash flow growth property meets a high tax bracket owner of a large free and clear residence. They exchange and each leases back the property given up at market rates.
Without moving a muscle, the high bracket guy gets a managed investment portfolio, tax shelter and growth. Under IRC Section 121, this would be tax free to him. His basis would be the market value of his residence plus the debt on the property being acquired. The leveraged speculator gets payment relief plus passive income from a free and clear large home that the owner may be leasing back from him.
Exchanging is where creative financing came into being. Suppose Party #1 needs tax-free cash? He might exchange with Party #2. Party #2 would borrow against what he has received, and lend some of the loan proceeds to the original party. Or, instead of lending the cash, Party #2 might buy an Option on other property Party #1 owns. Either way, it can all be tax free to both parties.
CREATIVE EXCHANGES CONTINUE TO STRETCH THE ENVELOPE . . .
Anytime an exchange isn’t completed within the prescribed time limits, profits on any gain in the transaction becomes taxable in the year of sale as they might apply to either or both parties to the exchange effective as of the date that the initial property was sold. Here’s where people really become creative.
Suppose you had sold some property on December 15th 1999 for cash, fully intending to make an exchange. You identified several replacement properties within 45 days, including one owned by a friend or related party. You get income tax filing extensions until August 15, 2000. You’ve got 180 days until June 12th to close and meet your deadline. Now, in August, because of Y2K, you decide not to complete your exchange, but instead to use stock market losses to partially offset gains on your real estate gains. Or, you might discover that the properties you had identified had lost considerable value because of a falling real estate market.
You’re on the horns of a dilemma. If you fail to complete the exchange, you’ll incur a taxable event. If you make the trade, you won’t get full value for your cash. What to do? Remember, we said to identify and include a qualifying property owned by a friend or related party. You could complete your tax free exchange using the property previously identified. Let’s see who these might be:
Whomever you exchange with is going to receive taxable cash, but there are ways to mitigate this. If what they sell you has a high basis, the tax on gain may be a low cost way for them, and you, to raise money while liquidating property. Here’s an example: In 1999 an investor owned 14 free and clear parcels of low-basis qualifying property scattered over a broad area worth about $1,000,000 with a basis of about $550,000. He had a friend whose corporation owned a large residence it used as corporate headquarters. It had a high basis and a high mortgage loan. In view of impending Y2K concerns, the corporation wanted to sell this property. The corporation accepted the cash generated by the sale of the parcels, and paid off the residence, delivering it free and clear to the investor. It agreed to pre-pay a three year lease-back of the corporate headquarters at market rents.
The investor divested himself of scattered properties, consolidating his real estate interests in an attractive large residence that was debt-free. Moreover, it was leased to a corporation who would be responsible for all taxes, insurance, and repairs over the next three years. The pre-paid lease removed any collection problems and placed a considerable amount of rental cash income into his hands that would be offset by depreciation on the building, and taxable as passive income in 2000. In this way, he minimized his exposure to the effects of Y2K, and moved from actively managing his far flung empire to having no management obligations at all. In the process, he avoided all federal and state income taxes. At the expiration of three years, he can move into the residence for two years, and sell it, capturing almost $1,000,000 tax free between the market value of the property and the tax free gain from selling his principal residence.
What were the benefits to the corporation? It down-loaded a high cost asset and paid off its debt, cleaning up its balance sheet and preserving its credit rating. Because it had a high basis in the conveyed property, the taxable gain and three-year pre-paid lease were still less expensive than the continuing interest expense of the property. It always had the Option of sub-leasing space to others to add to its income if need be.
Suppose this corporation had been owned by the investor? The exchange would still have been legitimate, but it would have come under the related party exchanging rules. When “related parties” such as family members or entities controlled by them enter into a tax-free exchange, they must have held the exchanged properties in a qualifying use for two years prior to the exchange, and they must hold the property they ultimately receive in a qualifying use for two years following the exchange.
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